Let Uncle Sam Finance Your Deal – SBA Financing 

Note: This section applies only to loans of $5 million or less. That’s the maximum size of loans from the Small Business Administration (SBA). In larger transactions, companies use alternative sources of financing.

Many buyers attempt to secure financing on their own, but the reality is that 84% of those loans are denied. 

So what’s a cash-strapped buyer to do? Many buyers, and sellers too, start by calling 1-800-827-5722. That’s the number for the Small Business Administration, which is involved in funding nearly 95% of bank loans for the acquisition of small businesses. 

It’s important to understand that the SBA does not loan money – rather, it guarantees loans made through banks. The SBA, via its 7(a) Loan Program, helps small businesses access credit by guaranteeing loans made by banks. This limits risk for banks offering such loans, which encourages them to lend money to small businesses. As a result, SBA financing can offer buyers attractive loan terms and interest rates while eliminating, or reducing, the need for you, as the seller, to carry a note. 

The availability of SBA financing translates into a potentially bigger pond of buyers in which to fish. But you’re not off the hook. You see, not only must the buyer qualify, but so must your business. After all, it’s your business that needs to generate ample cash flow to cover the monthly loan payments. 

In this section, I go into detail about the SBA loan process and how it can benefit both buyer and seller. I also dispel some popular myths about working with the SBA and offer suggestions about what to do if an SBA loan is denied. 

In other words, what you are about to read is kind of a big deal. 

SBA Loan Types and Overview

SBA loans are guaranteed by the Small Business Administration. There are many programs available under the SBA. However, there are two main loans that are used for business acquisitions: the 7(a) loan and the 504 loan. The 7(a) loan is used to acquire the business only and is the most popular SBA loan used to acquire small businesses. The second type of loan, the 504 loan program, offers long-term financing used to acquire real estate. In this section, we discuss the 7(a) loan.

Isn’t it the buyer’s responsibility to get a loan? 

Why do you need to get your business pre-qualified for an SBA loan when selling your business? Isn’t that the buyer’s responsibility? 

Your business must get pre-qualified for an SBA loan because your business must produce enough cash flow to cover the monthly loan payments. SBA loans are pre-approved based on the cash flow available to support the debt service. The cash flow to repay the loan is generated from your business, so the pre-approval process is dependent on the cash flow from your business.

While the buyer has some burden of responsibility, the principal responsibility lies with you, the seller. Don’t take the attitude that, “The buyer wants to buy my business, so it’s their responsibility to find the money.” Remember, it’s your business that is repaying the debt service. Most denials for SBA financing are related to issues regarding the business, not the buyer.

If your business does receive pre-approval, I recommend that the buyer also get pre-approved as early in the process as possible. The lender will review the buyer’s financial position, credit, management experience, and several other criteria.

If both your business and the buyer have been pre-approved, you have a favorable chance of obtaining financing for the sale of your business.

Here’s an example:

Cash Flow

Annual cash flow = $300,000

Less buyer’s salary = $200,000

Annual cash flow after buyer’s salary = $100,000

Price and Terms

Asking price = $1,000,000

Down payment = $200,000

Amount financed = $800,000

Debt Service

Annual payment = $109,008 (10-year term @ 6.5% interest)

Plus 25% debt coverage ratio (DCR) = $27,252

Annual payment + DCR = $132,260

Cash Flow After Debt Service

Annual cash flow after buyer’s salary = $100,000

Less annual payment + DCR = $132,260

This business would not qualify because the “annual cash flow after buyer’s salary” of $100,000 is not enough to support the “annual payment” + “cushion” (debt coverage ratio) of $132,260.

When pre-approving your business for an SBA loan, the lender may also review additional criteria. 

For example, if revenue has consistently declined in your business in recent years, your business may not be approved. Additionally, the lender will require an appraisal of your business. If the appraised amount doesn’t meet the lender’s requirements, they may deny your loan. In summary, there are several reasons your business may not be pre-approved for an SBA loan. 

If both your business and the buyer have been pre-approved, you know that a buyer has a high probability of obtaining financing to purchase your business. 

If your business can’t get approved for SBA financing, you still have options, which I will discuss in the “Next Step if You are Denied a Loan” section. 

Most denials for SBA financing are related to issues regarding the business, not the buyer.

Why should you use an SBA loan intermediary?

A loan intermediary is a specialist in SBA financing. Loan intermediaries know which banks are aggressively dedicated to committing to SBA loans, and most charge either no upfront fees or nominal ones.

A loan intermediary offers many advantages to buyers and sellers because they:

• Help with pre-screening buyers to determine their ability to obtain financing.
• Have success rates of 90% to 95%, for most intermediaries.
• Are the buyer’s advocate in the process and work to get the best deal and the most options for the buyer. 
• Work with multiple lenders and can offer a variety of finance options.
• Don’t simply “pass” off a loan application and hope for the best.
• Are not bankers – they are business people. Intermediaries need results in order to be compensated. 
• Add working capital and closing costs to a loan to reduce the impact of capital needs for the business. 
• Assist in pulling together all necessary documents, critiquing the loan application, and speed up the process from loan application to commitment, improving the chances of securing a loan.
• Review and critique the business plan, professionally prepare loan documents, develop realistic revenue projections, and help select a lender with guidelines capable of approving the loan.
• Provide ongoing status reports, relieving frustration and concerns through the difficult and time-consuming loan process.
• Speed up the process for faster loan commitment and closing.
• Improve the success rate by utilizing creativity in deal structuring and their relationships with aggressive national lenders.

Obtaining an SBA Pre-Approval

Part of the screening process is verifying the financial stability and funding liquidity of the buyer. Below is a list of items most banks or loan intermediaries require to qualify the buyer:

• Personal financial statement
• Bank statements
• Credit report
• Current resume or CV
• Personal cash flow analysis

SBA Loan Myths

Many sellers and buyers are hesitant to apply for an SBA loan because of certain common myths. The following distortions are addressed with real-world information and examples from Diamond Financial, an SBA loan intermediary that I often work with.

Myth 1: It takes nine to 10 months to get a loan through the SBA.

Not true. At Diamond Financial, we have a high volume of SBA loans, and our average deal takes between 48 and 52 days. So, when we are asked about time frames, we usually quote between 45 and 60 days. Some loans get approved in 2 to 3 weeks, but that’s not the norm. Our overall national average is around 48 days from start to finish. If a buyer produces the documentation that we require, it’s a relatively painless process.

Myth 2: Because the SBA guarantees the loan, the lender doesn’t care if it’s a good deal.

That is absolutely false. The SBA monitors lender’s fault rates, and no one wants to put in a bad loan. Just because the SBA loan has a guarantee behind it does not mean that any lender is going to approve the deal. It boils down to finding and choosing the correct lender because every lender has a different set of criteria. For example, if you are trying to buy a car wash and this lender has never financed a car wash, it is going to be a long and tedious process. Why? Because lenders do care if it’s a good deal – no one wants defaulted loans on their portfolio.

Myth 3: The SBA application is over 100 pages.

This is actually not true. The average SBA application is about 23 pages. Much of the documentation needed for an SBA application has already been produced, whether it comes from the broker, the seller, or whoever is involved in the transaction. Unfortunately, this is where most people fail. Buyers don’t understand this part of the application process, and over 84% of applications are declined because of poor presentation. Being approved for an SBA loan is all about systematically compiling the application and presenting it correctly.

Myth 4: You must have a detailed business plan to get an SBA loan.

You do not need a detailed business plan. What we are really looking for is the answer to this basic question: who is going to handle daily operations? And we want it answered in just a couple of pages, never a 50-page business plan. We provide our clients with a detailed questionnaire that asks them to answer questions such as the anticipated hours of operation, who is going to be opening the store, who is going to be closing the store, who are the management and staff, and who is going to be taking this business forward? It is more of how the operation is going to continue under your supervision. Lenders want to know that you have the ability to run the business they will be financing.

Myth 5: No bank will do this loan. You’ve already asked them all.

This myth stems from exhausted entrepreneurs who once eagerly walked into every local bank asking for a loan and were denied by every local bank they walked into. What buyers need to realize is that your local community bank is not going to put your $800,000 uncollateralized loan in its portfolio. For some reason, everyone automatically thinks, “I need a loan. I should go to my local bank.” This is because the world insists that when you need a loan, you go to where your checking account is or where you got your mortgage. But the truth is, those banks have no appetite for the transaction loans that we provide, and that true SBA lenders provide. If you look at the list of the top 10 SBA lenders in the country, they are not going to be your local community banks. Uncollateralized loans devalue the bank. What buyers will soon discover is they have been asking the wrong people. Rather than blindly walking into all local banks, a buyer should strategically choose where to apply for a loan.

Next Step if You Are Denied a Loan

What’s the next step if your buyer is denied an SBA loan?

Don’t give up. I’ve seen lots of deals get turned down by one bank only to get accepted by another bank. Aside from the objective requirements, SBA loans have subjective requirements that vary from bank to bank.

There may be some niche lenders out there that are more aggressive than the first bank. Loan intermediaries are likely to know who these banks are. As the seller, you need to know if an SBA loan is possible in order to avoid wasting your time on future deals if an SBA loan is not possible. 

Also, it would make sense to run your draft tax returns by a loan intermediary before filing them with the IRS. A loan intermediary can recommend certain adjustments to your federal income tax returns to increase the likelihood of obtaining SBA financing.

Some situations are tricky. For example, deducting the cost of that trip to Hawaii last year that cost you $5,000 may reduce the tax burden of your company. But in the lender’s eyes, this reduces your company’s profitability, which reduces the amount of cash flow available to pay the loan.

Although we make adjustments when normalizing financial statements, banks are conservative in the adjustments they allow. Running your tax returns by a loan intermediary may result in changes that could improve the chances of obtaining bank financing.

If your business is not approved for SBA financing, you have two options:

1. Offer seller financing.
2. Sell your business for all cash and reduce the purchase price by 20% to 30% to account for the fact that you are asking for all cash.

Frequently Asked Questions About SBA Loans

Let’s look at a few more common questions about the SBA loan process.

Should you reduce the asking price if your loan wasn’t approved? 

A bank’s denial of a loan often has little to do with the fairness of your asking price. Lenders are, by nature, conservative, especially when granting an SBA loan, so don’t let this dampen your enthusiasm. Loans are often denied based on subjective requirements that do not have a bearing on the value of a business. I did a deal recently for around $700,000, and the bank performed an appraisal that came in at about $100,000 less than what we had accepted for the business. I had our internal appraiser at Morgan & Westfield critique the bank’s appraisal, which contained several errors, and I was able to get the loan restructured. Never take the first no – there are always other lenders that are more aggressive. Keep persisting and keep the revenue stable, and you will get a transaction done eventually.

What is a pre-approval? 

A pre-approval means that a lender has analyzed the business, its financials, and federal tax returns and determined there is a high chance they would finance the acquisition. They estimate their chances of approval are 85% to 90% with a strong buyer. 

What are the costs to the seller for an SBA loan? 

There are no fees assessed to the seller as a result of the buyer seeking SBA-guaranteed financing.

What are the different types of SBA-approved lenders? 

Lenders are either General Program (GP) or Preferred Lending Program (PLP) originators. The difference between the two is that while GP lenders must obtain certain approvals from the SBA through the transaction, PLP lenders have been granted full delegated underwriting and closing authorization on behalf of the SBA. The process is faster when working through a PLP lender.

What credit score is required? 

Most loans require a credit score of at least 640, though some buyers may be approved with a lower credit score. But far more important than the credit score are the underlying details of a borrower’s credit history.

Will lenders review your tax returns when they consider financing? 

Yes, lenders will review your tax returns when they consider financing for your business. There are some exceptions, such as medical practices; however, in the majority of loan applications, the lender will primarily base their decision on the cash flows shown on the business’s federal income tax returns. If the income reported on your tax returns isn’t high enough to cover the debt service, the buyer’s salary, and a debt cushion, it’s unlikely your business will qualify for a bank loan.

Can working capital and inventory be financed? 

Yes, working capital is routinely included in a loan in the form of permanent working capital or a line of credit. Loan funds can also be used to finance inventory as well as other business assets. Funds can be applied to building and leasehold improvements, equipment, debt restructuring, working capital, and franchise fees, all as part of an acquisition package.

What fees are charged? 

With the exception of a loan packaging fee, which can be no more than $2,500, all costs and fees charged to a borrower are actual out-of-pocket costs borne by the lender in the process of providing the loan. This can include the lender’s legal fees, business valuation costs, credit reports, and a variety of other expenses. Most often, the largest fee is the SBA Guaranty Fee, which is calculated based upon the amount of the portion of the loan guaranteed by the SBA.

What are the terms? 

Terms are usually 10 years for business acquisition loans, but if the commercial real estate housing the business is also being acquired, the term can be as long as 25 years.

What is the interest rate? 

The maximum, and typical, interest rate is prime + 2.75%, normally adjusted on a quarterly basis.

What happens if the buyer sells the business? 

SBA loans are fully assumable under certain conditions, but most often, they are paid off upon the sale of the business.

Does the seller have to carry a note? 

There is no SBA rule requiring the seller to hold a note. That determination is made by the transaction’s parties and the lender during the process of structuring the deal.

Is a business appraisal necessary? 

Business valuations are required if the loan is $200,000 or more.

How is real estate handled? 

The real estate associated with the business can be acquired and financed as part of the business acquisition and financing process.

Why is bank financing for a small business so hard to get? 

There’s one main reason why bank financing is rarely involved in small business sales. In an effort to boost profits, business owners reduce income taxes by not reporting all their income or by deducting as many expenses as possible. This lowers the income that is reported on the business’s tax returns, which in effect reduces the cash flow available to repay the debt service. Banks are, by nature, conservative and must follow guidelines and procedures when granting a loan. Banks have a specific process when pre-qualifying a small business loan. They start by reviewing the federal income tax returns. Then they add back a minimum number of adjustments, which may include interest, depreciation, amortization, and the owner’s salary. This resulting number is normally lower than the seller’s discretionary earnings (SDE). This number is used to determine the maximum amount of debt service available to repay a loan. Banks are conservative in the adjustments they make to your financial statements. They do not add back other perks you may be running through your business, such as personal travel expenses, meal and entertainment expenses, and other discretionary or personal expenses.

Are there other options besides SBA loans? 

Yes, but they are rare. Buyers can often access their retirement funds tax-free to buy a small business. If the buyer is a veteran, they may qualify for a VA loan. It is estimated that over 95% of the loans to purchase a small business are 7(a) SBA loans. For this reason, I recommend first exploring if the business would qualify for an SBA loan. If it does not, you may explore other options.