We’ve heard a lot of buzz about the SBA making changes to the requirements for small business financing. TELL ME MORE!
The Small Business Administration released a new Standard Operating Procedure which went into effect January 1, 2018. SOP 50 10 5 (J) has some changes which are material to existing and prospective small business owners seeking financing. The primary change and the one getting the most attention is related to the new equity requirements on a change of ownership. The new policy states that in a change of ownership scenario, a minimum of 10% of the total project cost is required to come in the form of equity with the remaining 90% financed via an SBA guaranteed loan facility. This was a reduction from the previous requirement of 25% which was enforced when intangible assets exceeded $500,000. There are two terms which require further definition to understand the implications of this new rule: “total project cost” and “equity.”
So you’re telling me I should be prepared to contribute 10% toward the purchase, but 10% of what?
The equity requirement is calculated on the total project cost which is all costs required to complete the change of ownership regardless of funding source. This would include purchase price, working capital, closing costs, etc.
I’m going to need you to walk me through this…
Ok, let’s look at an example: Let’s assume we are purchasing a funeral home business including the associated commercial real estate for $1MM. In addition to the purchase, we are going to perform a few minor updates/renovations to the facility upon acquisition which are estimated to be around $150,000. We will also need working capital of approximately $70,000 to support operating expenses during the first couple months of transition. We’ll assume around $80,000 for associated closing costs (appraisals, environmental reports, property taxes, surveys, UCC searches, legal fees, and the SBA’s guaranty fee) which brings the total project cost to $1,300,000. The 10% equity requirement is calculated on the total project cost; therefore, the required contribution would be $130,000.
Note: The same 10% requirement applies to startup ventures with project costs defined as “all costs required to become operational, regardless of funding source.” Furthermore, 10% equity is required in a partner buy out scenario (which results in the borrower(s) assuming 100% ownership) or in an expansion scenario where an existing owner/operator wishes to acquire or start another location to expand their existing market share. In the partner buy out, or expansion scenarios, existing equity in the business may be considered, but the proforma equity position after the transaction must be at least 10%.
Ok, I think I’m getting it. Now that I know how much my equity requirement is, can you define “equity”?
The following may be considered as part of the equity injection:
- The clearest source of equity is the applicant’s own personal liquidity. Personal liquidity includes cash on hand, checking/savings accounts or other assets which are readily available and can be liquidated and injected at the closing table (cash surrender value of life insurance, marketable securities, property, etc.).
- Funds which are “gifted” with no obligation of repayment. Verification of gifted funds would require a letter which certifies the recipient is under no obligation to repay the gifted sum.
- Funds which are borrowed through a personal loan to the business owner with repayment demonstrated to come from a source other than the cash flow of the business (i.e., outside spousal income, guarantor’s wage from ongoing outside employment).
- Assets (machinery, equipment, land, etc.) which are contributed to the project may be considered with appropriate valuation.
- 401(k) or IRA rollover. Please be sure to consult with your tax professional to facilitate this process and avoid costly taxes and penalties for early withdrawal. You may choose to consult the following sources for more information: http://directedequity.com/ or https://www.benetrends.com/business-funding-solutions/401k-business-financing
- The final source of equity may come in the form of “seller equity.” In this scenario, the seller may choose to hold up to 5% of the total project cost in a separate promissory note which is subordinate to the primary SBA loan and mortgage holder. To qualify as seller “equity,” the seller’s note must be placed on full standby with no payments of interest or principal received until the SBA loan is paid in full. The seller note may accrue interest during this time, but no payments may be made or received.
I’m feeling a little better about things now that I know my options. But I am curious, why the change?
The SBA’s sole focus and objective is to support small businesses across the US. The requirement of equity in a small business venture is first and foremost to prevent small businesses from becoming over-leveraged or burdened by debt at the onset. If cash flow is strained from the beginning, the subject small business has a very slim chance of survival. Cash is king. Without sufficient cash flow, an independent funeral business is handicapped when death rates drop, resulting in call volume decline or rates increase on existing debts, or necessary repairs arise. SBA requires a minimum 15% cushion in historic cash flow to support unforeseen cash flow demands or business reinvestment.
Got it. This has been very helpful! I think I’m ready to begin the application process. How do I get started?
To start the application process, you can visit our online application portal and follow the prompts to begin the journey toward ownership.
Not quite ready to start the application, but interested in learning more? Please give me a call at 910-550-2293 or send me an email at email@example.com.