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 will discuss how to determine the most likely buyers of businesses and will highlight SBA financing options for business ownership transfers.
In many families, there may not be anyone in the next generation who wants to buy the family business. In those cases, sellers need to be aware of other likely buyers who might be interested. They can get valuable insight from the quarterly Market Pulse Report that Pepperdine University and the Graziadio School of Business and Management publish with two mergers and acquisitions (M&A) trade associations–M&A Source and IBBA–which compiles results from more than 300 business intermediaries. One section analyzes who bought the businesses sold during the quarter and how much the buyers paid for those businesses. Also included in the report is information on how the transactions were structured and whether or not they included working capital.
Who is most likely to buy a business?
So, which people are most likely to be buyers of businesses? For a firm that is valued at $1M-$5M, the buyer is most often an individual or existing small business. The buyer must often contribute a substantial amount of equity because a traditional bank is unwilling to finance the transaction. Most banks don’t want to finance business acquisitions because they see them as risky due to the lack of borrower collateral and unproven new management.
In such a scenario, using the SBA can be very helpful to the seller. According to the Market Pulse Report, when buyers purchase a business worth $1M-$5M using a traditional commercial bank loan, they typically come in with 40 percent of equity, bank financing of about 40 percent and a seller-financed note for the remaining 20 percent of the purchase price (see the table below for typical deal structure). With an SBA loan, in contrast, buyers must come up with at least 10 percent of the equity, while bank financing makes up to 90 percent. The 10 percent can include a number of different components. Typically, as we will discuss later, the buyer will come up with 10 percent, but the seller can contribute 5 percent of the project costs in the form of a seller note on full standby for the life of the SBA loan. As you can see, using the SBA lowers the amount of cash the buyer must put into the deal, opening the pool of potential buyers. A seller will usually receive more cash up front, as well.
Typical deal structure:
Traditional vs. SBA
The chart below shows a comparison between a traditionally-structured transaction and an SBA-financed transaction for a business valued at $2.8M, as found by the Pepperdine survey:
In our example, we are using the average deal structure represented in the survey. It requires the buyer to inject $1,120,000 (40 percent), the seller to carry or finance $560,000 (20 percent) and the lender to provide a loan for $1,120,000 (40 percent). This structure would deliver a business value of $2.8M to the sellers of the business.
The buyer needs to come up with a lot more cash with traditional financing options than he or she would need when using the SBA 7(a) loan program, where the bank lends $2.52 million (90 percent), the buyer must put in $140,000 (5 percent) and the seller must carry $140,000 (5 percent), for a total of 10 percent. Sometimes these terms may vary, depending on the uniqueness of the business, and the buyer may be required to inject more than 10 percent. Even then, however, the required equity in an SBA transaction dramatically increases the pool of potential buyers. Nonetheless, the injection will be far less than the $1.1M required in a traditional loan scenario.
What are the options?
What if buyers of businesses cannot come up with their required equity injections? There are a number of options, including the borrower tapping into the equity in his or her home by taking out a home equity line of credit (HELOC). If a buyer has other outside sources of income—for example, a spouse who works or investment properties that produce income—the borrower can show that the repayment of that HELOC is not reliant on the business’ profits to service the debt associated with the HELOC and the money borrowed can be counted toward the 10 percent minimum equity requirement. Any amounts buyers borrow that they can repay outside of the business cash flow are considered equity, and can help borrowers reach the required equity injection.
There are situations where sellers may be willing to carry more than 5 percent. This often comes up when they want to sell the family business to their children. There are many creative solutions to this. A good business broker can walk you through how that would work. For more information on selling to the next generation, check out our post titled, “Funding Ownership Transfers: Transfer to the Next Generation.”
SBA loans can also offer an advantage when it comes to terms and conditions of the loan. Using the average terms and conditions for the market right now, the buyers would have roughly a seven percent interest rate with either a conventional loan or the SBA 7(a) program. The amortization for a traditional bank loan is typically five years. This often requires the business to go through another round of bank financing to refinance the balance due in five years. If the economy and the business are struggling, refinancing the loan could be problematic.
Compare that to an SBA loan, which has a 10-year amortization. The monthly payment for a traditional loan of $1.12M would be approximately $22,000, whereas for an SBA the loan of $2.52M the payment would be approximately $29,000 a month (see the table below to compare loan payments). While the payment on the SBA loan is larger, the amount the purchaser has borrowed is twice as large. Buyers of businesses can benefit from SBA financing in a variety of ways.
Comparing loan payments:
The SBA provides a much more stable operating environment for the business because the cost of financing the loan is more manageable due to the longer payment amortization. When you consider that the SBA borrower did not have to come up with an additional $840,000 (which is the difference between the 40 percent down of $1.1M with the traditional transaction and the $280,000 with the SBA sample), it is because of this cash preservation that the business is in a much more financially secure position. This helps protect the “golden goose” for the next generation.
One of the complaints people have about SBA loans is that there are too many fees, but it is important to compare “apples to apples” to compute what they will really cost you. SBA loans can provide stability when it comes to fees. This becomes clear if you compare an SBA loan with a 10-year amortization to the fees of a loan due in three to five years. Fees could double or even triple during the life of a traditional loan due to the need to get re-approved one to two more times over that 10-year period. This will simply not happen with an SBA loan, due to the 10-year term of the loan.
Additionally, there are no prepayment penalties with an SBA loan to finance a change in ownership. With a conventional bank loan, there are prepayment penalties. Usually, these will cost in the range of one to three percent of the outstanding bank loan balance.
As you can see, there are many nuances in SBA lending, and it is important to work with a banker who understands them. A banker experienced in SBA lending can help come up with creative solutions to finding the cash the buyer needs to put in to meet its minimum threshold. Many less experienced bankers don’t know that the buyer does not have to personally come up with the equity injection. It can be a gift from a direct family member, or it can be an injection from a minority partner. Anybody who purchases less than 20 percent ownership does not have to provide a personal guarantee.
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.
To learn more about Live Oak Bank’s M&A financing team, visit our website.