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 outlines the options for transferring a family business to the next generation.
Chief Executive magazine stated that 80 percent of business owners want to pass the family business on to the next generation. The majority of these businesses will fail after such a transfer, though, according to the Family Business Institute.
Often, business owners try to self-finance the transaction. While this is admirable, it can lead to financial disasters for families for many generations because there is such a high failure rate.
Here’s an example of a business transfer to the next generation: Business owners Nick and Judy are ready to retire and would like to sell their company to their daughter, Kim. The business has a value of $3M. Kim does not have the credit to purchase the business on her own.
One of two things typically happen in this situation: 1.) The owners will go to the bank and co-sign for a loan from the bank or, 2.) The owners will self-finance the business with a loan to the buyer (in this case, their child).
Let’s look at the first scenario, which is often the sellers’ first choice because it gives them instant liquidity when transferring their business to the next generation. Nick and Judy co-sign on a loan at the bank for $2M so Kim can buy the business and then accept a five-year employment agreement to cover the $1M balance. They are paid $200,000 per year. Nick and Judy have to put up secondary assets as collateral as part of the loan guarantee.
Now, say an economic downturn occurs, and Kim cannot afford to pay the obligations to her parents. Nick and Judy are now in a position where their retirement is at risk. They have the proceeds from the $2M bank loan, but they have guaranteed the loan. If Kim defaults, they must pay it back or forfeit their collateral. Depending on what is going on in their lives when this happens, they may even have to dip into their savings because they received the $2M minus taxes. They will also lose the $200,000 income they were being paid by Kim.
Even if the economy is healthy, it is often difficult for children who buy a business from their parents to live with the terms and conditions most commercial lenders offer. Most banks are not comfortable with loans to fund business transfers, so they require a large portion as a down payment and will make the terms short and interest rate high. The pressure of meeting the bank’s terms can be too much for the buyer of the business to manage financially over time.
As a result, selling to the next generation–such as children–by co-signing a loan ultimately increases the financial risk for both generations. When it comes time to leave money from their estate to Kim and her siblings, it will have been depleted. Nick and Judy will ultimately have put their retirement at risk. Once their estate is diminished, they may not be able to provide the support they wanted to offer to Kim’s other siblings or help with college education for their grandkids. This situation can lead to strained relationships within families.
Option number two isn’t an ideal one, either. If Nick and Judy make a private loan to Kim and she can’t pay it back, they lose the money and so does their estate.
Using the SBA
Fortunately, there is another option for retiring owners who want to unlock the value of the business they have built and pass it along to the next generation. This path involves using the SBA’s 7(a) loan program, which is the SBA’s largest lending program. Many people don’t understand how SBA loans work. If you are unfamiliar with the lending process, here is a crash course: When someone borrows money from a bank under the 7(a) loan program, a bank or non-bank lender is the party that makes the loan. The SBA guarantees that if the borrower defaults, the agency will pay back a certain percentage of the loan. A typical SBA guarantee is 75 percent.
Let’s say that the SBA provides a 75 percent guarantee of a $2M loan. If the borrower fails to pay it back, the SBA will pay the bank $1.5M. The SBA loan program also provides for longer loan terms, which often helps with cash flow for a new owner.
Current SBA requirements that were put into effect on January 1, 2018 require the buyer to inject a minimum of 10 percent of the total project cost needed to complete a change of ownership. Seller debt may not be considered as part of the required equity unless it is on full standby for the life of the loan and it does not exceed half of the required equity.
Ideally, every potential borrower has at least 10 percent cash to contribute to a change-of-ownership. If they do not, then seller debt on full standby is a good tool to bridge the gap.
Even if a borrower has at least 10 percent cash, it is always desirable to have the seller carry back debt since this ensures that the seller has a vested interest in the ongoing success of the business. Carrying back debt means lending the buyer part of the purchase price. Seller carry back debt also limits the bank’s exposure.
A standard bank loan would typically require the buyer (who is also the borrower) to contribute at least 40 percent of the purchase price ($640,000), obtain a loan for 40 percent ($640,000) and get the owners to lend them the remaining 20 percent ($320,000). This is typically harder to pull off.
Other benefits to SBA lending
There are other benefits to the SBA’s 7(a) loan program. When it comes to a potential borrower like Kim, who hasn’t built up a long credit history and doesn’t have much in the way of financial wherewithal or net worth, a bank will not normally take on the risk of lending to him or her. With SBA involvement, however, banks often will take on these types of deals.
The maximum loan size in the SBA 7(a) program is $5M. For a business acquisition, the loan can be stretched out for up to 10 years. This stretching out of the loan is called amortization. With a traditional commercial loan, this period would generally be five years. In general, if you borrow money to buy a business, the longer you can stretch out the repayment term, the smaller the loan payments will be.
In transactions where borrowers don’t have much in the way of collateral, such as equipment and fixtures, they usually have a significant amount of goodwill. Goodwill, in simple terms, is a bump in the purchase price that takes into account the value of the company’s brand name, a solid customer base, good employee relations and other intangible assets. A conventional lender might opt for a five-year term for a loan with little collateral, whereas the 7(a) loan from an SBA lender could extend the loan to 10 years. As a result, it is often easier for borrowers to keep up with the loan payments with an SBA loan than if they took out a conventional loan, for which the buyer typically cannot qualify.
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 mergers and acquisitions financing team, or to learn how we can help with transferring ownership of your business to the next generation, visit our website.