The following post is an excerpt from How to Fund Ownership Transfers Using the SBA by Sherrill Stockton, head of underwriting at Live Oak Bank and David Ryan, president of Upton Financial Group, Inc. This post highlights some of the most common misconceptions about SBA lending.
Many buyers and sellers avoid working with the SBA because they have been exposed to inaccurate information about its lending programs. Let’s look at some of the most common misconceptions both buyers and sellers have.
Misconceptions of sellers:
- The buyer must be a bad credit risk to qualify for SBA financing
- You must be declined by three banks in order to apply for an SBA loan
- It takes a long time to get a loan through the SBA
- Borrowers who can pay cash are a better risk than those who get an SBA loan
- SBA loans cannot be used toward goodwill
- You cannot sell a business to a family member using an SBA loan
Let’s tackle these common misconceptions about SBA loans one at a time.
Tackling sellers’ misconceptions
Perhaps the most common one is that you must be a bad credit risk to qualify for SBA financing. That’s simply not true. Nor is it true that you must be declined by three banks to get an SBA loan.
The SBA was created in 1953 to be a gap financing vehicle. Essentially, the SBA was created with the intention of serving people who are not quite qualified to be conventional borrowers. The initial idea was to help small businesses to whom conventional lenders have traditionally been reluctant to lend, especially in the early stages of the business or in a change of ownership.
An SBA borrower is not a bad credit risk. He or she is simply a borrower who appears to be risky because of what conventional lenders’ criteria look like. An SBA guarantee allows banks to make these loans with the certainty that, in the event of a default, the SBA will share in any loss. The guarantee mitigates a bank’s loss if there is a default. Ideally, every SBA borrower who grows his or her business accumulates cash, pays off debt and eventually exhibits the credit characteristics of a conventional borrower.
Another common misconception is that it takes a long time to obtain an SBA loan. When speaking in front of business groups, we often ask for a show of hands from people who have heard horror stories about getting SBA loans. Usually, a lot of hands go up. Many people avoid getting these loans because they think the process will be burdensome and take many months.
While there are sometimes delays with many types of loans, the SBA lending process is generally pretty quick. Working with a bank that is a preferred SBA lender often speeds up the process. When the bank is a preferred lender, it means the SBA has delegated the approval authority—just about everything that you would do with an SBA loan—to that bank. This streamlines the process, and, as a result, the borrower is not directly in contact with the SBA.
When it comes to change-of-ownership lending, there is some complexity. The rules have changed a bit recently. An SBA lender must maintain expertise in the program, especially in eligibility requirements. Sometimes, lenders who say they are experienced in working with the SBA only have done real estate transactions, not loans involved in business sales. These are usually the situations where loans take a long time as a result of mistakes that stem from the bank’s inexperience in business sales financed with SBA loans.
We always coach potential borrowers to make sure that they do some due diligence surrounding their lender’s experience in doing change-of-ownership transactions. Potential borrowers should pose the following questions to the bank: Who will I deal with most often on the loan? How many years has my point of contact at the bank worked with the SBA loan program? Can the bankers refer me to another business owner in your community who obtained an SBA loan through the bank?
Because of the many misconceptions about SBA loans, many sellers don’t want to do business with a potential buyer who requires SBA assistance. They would rather sell to someone who can pay cash.
Unfortunately, this greatly limits their chances of selling the business. Let’s say a business is worth $3M. There aren’t many buyers who have $3M in cash on hand to buy a business. An SBA loan can help to bridge that gap.
People also think you cannot finance goodwill with an SBA loan. Goodwill is an increase in the purchase price of a business that takes into account the value of intangible assets such as the company’s brand name, a solid customer base and good employee relations. In fact, in ownership transfer situations, typically the bulk of SBA loan proceeds will be used to fund the goodwill of the business.
As you might expect, banks verify the value of the goodwill using an independent valuation, rather than basing the value on the owner’s opinion. A third party reviews the financial information of the business over the past three years, and then performs an analysis to determine the business’ value. The company’s financial information is all that the bank and its third-party valuation expert are able to use to determine the value of a business. This helps to keep emotions out of the process.
Another misconception is that business owners can’t sell their business to their families if they use the SBA loan program. While this was the case many years ago, this has since changed. The independent, third-party valuation ensures the bank is lending based on the business’ fair market value.
Misconceptions of buyers:
- Because the SBA guarantees this loan, the lender doesn’t care if it’s a good deal
- The SBA application is over 100 pages long
- I have too many assets to qualify for an SBA loan
- The SBA will finance 100 percent and I won’t need a down payment
- The SBA lending process is only for “Main Street” liquor stores and gas stations
Tackling buyers’ misconceptions:
Buyers have misconceptions about working with the SBA, too. For instance, many buyers think that if the SBA guarantees the loan, the lender doesn’t care if it’s a good deal. That’s not true. The beauty of the public-private partnership between SBA and participating lenders is that both the lender and the SBA have capital at stake. The SBA cares if the loan is repaid because the agency has guaranteed a portion of it. If there is a 75 percent SBA guarantee, the lender has 25 percent at stake.
Like SBA officials, lenders don’t typically put money at stake for individuals they perceive to be bad borrowers. Banks take very seriously the underwriting and analysis of a transaction and they carefully determine whether or not they will be repaid from the cash flow of the business in question. When they perceive risk, it is generally because of new ownership, not bad borrowers.
Although many people have heard that the SBA application is more than 100 pages, this is not true. The forms you fill out are comparable to those you would fill out for a conventional commercial loan. Because an SBA lender prepares a fair amount of paperwork internally, applications completed by borrowers usually require some basic information in one format. Then, the lenders transfer that information to the different forms they need to use in the SBA lending process, only a few of which are different from the forms used in conventional lending.
Some people continue to believe they have too many assets to qualify for an SBA loan. Many, many years ago, one of SBA’s eligibility tests was the something known as the “personal resource test.” It said that a borrower could not get an SBA-backed loan if he or she had a certain threshold of liquidity. If you were trying to get a $1M loan, for instance, you could not have $1M of liquidity.
The personal resource test was eliminated a number of years ago. Banks must now identify personal liquidity and determine the appropriate injection based on the project’s liquid assets and personal financial needs. That being said, if you’re looking for a $1M loan and have $1M in cash, there is potentially a credit issue elsewhere. Remember, SBA lending was created as gap financing to provide financial assistance for projects that conventional lenders often perceive to be too risky or outside of their credit boxes. If a potential borrower has sufficient excess liquidity to fund an entire project, he or she most likely does not need SBA financing.
Expect your lender to look at your credit profile, which remains very important even in SBA lending. That said, if banks can qualify a borrower for conventional financing on reasonable rates and terms based on their credit profile, then there is no need for an SBA guarantee. If a borrower meets a bank’s credit criteria for conventional lending (i.e. more cash in, higher debt service coverage, sufficient collateral, etc.) an SBA loan is not needed.
Another of the all-too-common misconceptions is that the SBA will offer 100 percent financing. Not true. The SBA considers 100 percent financing to be inherently risky. Why? The debt payments will be too high for many businesses to make every month, putting too much pressure on their cash flow. Additionally, it removes any financial incentive for the seller to make sure the business succeeds after it changes hands.
Of course, there are a few exceptions, and 100 percent financing certainly can be achieved if it’s reasonable for the business and for the borrower. However, for the same reason that banks don’t recommend 100 percent, we don’t, either.
So what can parents do if they want to sell their business to a child who doesn’t have any cash to put into a deal? If the parents approach a bank and say that their daughter can’t put any money into the deal, an SBA lender might say that based on the strong cash flow of the business, they would be willing to lend up to 90 percent of the project costs. Mom and Dad can carry back a note for 5 percent on full standby for the life of the loan, but the daughter will need to save up sufficient cash to inject at least 5 percent of the project costs. A note is a legal promise to pay the seller money over the next few years for the balance of the purchase price that was not paid at closing. According to the SBA’s rules, the buyer can write a note payable to the seller. Typically, in a case like this, the sellers receive the majority of the purchase price in cash up front when the transaction closes. This money is not subject to the creditors of the business. This significantly reduces the family’s overall financial risk tied to the business. The seller note can accrue interest, but cannot be paid down until the SBA loan is paid in full. The SBA requires that the seller note be on full standby to prevent undue cash flow strain on the business and the new owner. As an added benefit, the parents never have to worry that they co-signed a loan, which is something a commercial bank would typically require.
Let’s look at one last misconception: Many people still believe that SBA loans are only for “Main Street” liquor stores, gas stations or businesses that have a lot of tangible collateral. This is also not true. We have seen clients get SBA loans for a wide array of businesses, ranging from rock quarries to telecommunications and IT firms.
Loans guaranteed by the SBA range from small to large, with the maximum loan size of $5M in the 7(a) program. For a business acquisition, the loan can be amortized for up to 10 years. To learn more about the SBA program, download the new book, titled How to Fund Ownership Transfers Using the SBA, coauthored by Sherrill Stockton, head of underwriting at Live Oak Bank and David Ryan, president of Upton Financial Group, Inc.