The US Small Business Administration (SBA) enables private lenders to make loans for buying a business that they ordinarily would not be able to make by guaranteeing that a portion of the loan proceeds will be repaid to the lender in the event of a default by the borrower. Among many other uses, SBA financing is the primary vehicle through which small business acquisitions are financed.The two loan types that are most commonly used are the 7(a) and 504 loans, which are discussed briefly below.
The 7(a) loan is the most commonly used type of SBA loan due to its versatile nature. Proceeds from a 7(a) loan can be used for nearly any legitimate business purpose including buying a business, real estate construction and acquisitions, debt refinance, business expansions, business startups, equipment and working capital. The term of a 7(a) loan is dictated by the use of proceeds. Prepayment penalties are non existent for loans with maturities of less than 15 years, and are extremely lenient for loans with longer maturities. Interest rates are nearly always variable and based on a spread over the Prime Rate.
The 504 loan program is intended solely for real estate and fixed assets such as heavy equipment. 504 loans are unique in that they provide for maximum leverage (up to 90% loan-to-value) with favorable terms including maturities out to 25 years and relatively low interest rates which can be fixed for the life of the loan. 504 loans are also unique in that they allow for loan sizes up to $5,000,000 (greater in some instances). The structure of a 504 loan is different from that of a typical loan in that it is a combination of two separate loans. The first loan is a 50% conventional first mortgage that is not guaranteed by the SBA, and the second loan is a 30% - 40% second mortgage made by an independent non-profit entity known as a Certified Development Corporation, or "CDC". The CDC portion of the loan is 100% guaranteed by the SBA.
The Process from Start to Finish
Many lenders can make SBA loans; however, very few actually make SBA lending a priority. When seeking SBA financing, it is important to determine that you are dealing with a lender who maintains the coveted PLP designation. These lenders are known as "Preferred Lenders", and have the ability to originate, process, and close SBA loans much quicker than their counterparts who do not maintain a PLP designation. Qualifying for a SBA loan is straightforward and simple. The information that your lender will need to review in order to tell you if you qualify varies from transaction to transaction; however, the following list of information will be sufficient in most instances to obtain a financing proposal from your chosen lender:
- Business Tax Returns for last 3 years
- Current Year Interim Financial Statements
- Schedule of Existing Debt related to the business
- Background on Business & details on real estate if applicable
- Borrower’s Personal Financial Statement (SBA Form 413)
- Credit Check on all guarantors
- Borrower’s Resume or information on the borrower’s professional experience
- Information pertaining to any other businesses controlled by borrower(s)
A financing proposal is a non-binding letter that outlines the terms under which a lender would be willing to loan money and provides an estimate of the costs associated with the loan. Once you obtain a financing proposal from your chosen lender and agree to the terms of the proposal, your lender will typically need to collect the balance of the information needed to underwrite the loan as well as an underwriting fee or "packaging fee". Most PLP lenders are able to underwrite a loan request within 1 to 3 weeks. After the loan is underwritten it will be submitted to that lender’s credit authority for approval. If the loan is approved, a commitment letter will be issued to you, typically within 24 hours. The commitment letter is a binding letter that outlines the lender’s intent to fund a loan under stated terms and conditions. Most lenders will require you to submit a loan deposit with your signed commitment letter. The deposit will be credited to closing costs and third party fees incurred by the lender, such as appraisal costs.General time frames for closing an SBA loan after a commitment letter is issued, signed and returned with the deposit range from 3 weeks to 45 days.
There are numerous variables that affect the time it takes to close an SBA loan, including but not limited to real estate considerations, construction requirements, and business valuations and / or real estate appraisals. The best way to control the closing time frame is for you, the borrower, to respond to your lender’s requests for information in a timely manner.
Three Guidelines for Financing a Business Acquisition with a SBA Loan
- Cash Flow is King! All business acquisition loans are evaluated based on the historical cash flow reported in the business’s tax returns. The performance of the business subsequent to the most recent year’s tax returns is important, but your lender will be relying heavily on the cash flow reported in the tax returns to ensure that there is sufficient cash flow to repay the loan. Your lender will also be evaluating your personal financial situation to understand what your personal debt obligations are and how much money you need to withdraw, if any, from the cash flow of the business. Businesses with minimal or even negative cash flow can often still be financed if the borrower has a favorable personal financial situation.
- Experience is Important! Your lender will want to know why you are qualified to own and operate the business you want to buy. If you don’t have experience owning, operating, or working within a similar type of business, you will need to make a strong case that you have professional experience that is "transferable" to your target business in order to qualify for SBA financing.
- Create a Business Plan! Even borrowers with extremely strong industry experience will be asked, at a minimum, to create financial projections that reflect the borrower’s estimates of revenues and operating expenses after the business is purchased. Many lenders will require all borrowers applying for a business acquisition loan to provide a business plan, regardless of experience. Borrowers with less impressive resumes can attempt to mitigate their lack of experience by providing a thorough, comprehensive business plan that shows the lender they have completed a substantial amount of due diligence on the business being purchased.
How much money do I need to buy a business?
Different lenders will require different amounts of cash equity to be injected into the purchase of a business. Most lenders will view the amount of equity required in terms of a percentage of Total Project Cost. Total Project Cost is equal to the sum of (a) the borrower’s cash injection, (b) the amount of debt offered by the lender, and (c) the amount of any 3rd party financing obtained in conjunction with the transaction (such as a seller note). Total Project Cost will usually include closing costs. Most PLP lenders will require between 10% and 25% of the Total Project Cost to be injected into a business acquisition by the borrower. Some factors that will typically decrease the required amount of borrower equity include:
- Real estate included in the sale. If real estate is included, "general-multi-purpose" (such as an office building or warehouse) is preferred, as opposed to "special-use" (such as a car wash or marina)
- The borrower has a secondary repayment source for the loan other than the business purchased (such as a spouse or co-borrower with outside employment)
- Other collateral available to pledge (such as a rental property or securities)
- Significant industry experience or transferable experience
- The seller of the business carries a seller note
- The business has strong historical cash flow
In general, it is difficult to approximate the exact amount of equity a lender will require without having a conversation about the above issues. However, most business acquisitions that don’t include real estate will normally require at least 20% cash equity. In some cases lenders may approve a loan to a borrower who is injecting less if the right factors are in place.