SBA Financing When Buying or Selling a Business

Executive Summary

Note: This article applies only to businesses valued at $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.

Buying a business requires more than having in hand a sound business plan; it requires 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 of them start by calling 1-800-827-5722. (It’s a number that many sellers call, too; read on to see why.)

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. We’ll get into the weeds of SBA’s role in a bit. First, an overview:

Buyers of small businesses have four major sources of funds:

1. Cash
2. Third-party financing — bank, SBA financing
3. Seller financing
4. Buyer’s retirement funds.

For you, the seller, we recommend pre-approving your business for SBA financing. Why?

• If SBA financing is available, there is no need to offer seller financing.
• If SBA financing is not available, the seller must offer seller financing or ask for all cash and discount the price by 20% to 30%.

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 the seller to carry a note.

For the buyer, this means a lower down payment, lower debt service, and higher net income. Because this is a government-sponsored program, there are highly formal guidelines that any bank must follow when offering an SBA loan. The buyer must also pay a small fee when obtaining an SBA loan, which supports the program. The fee can be thought of as an insurance premium to cover the SBA’s losses in the event of a default.

The availability of SBA financing translates into a potentially bigger pond of buyers in which to fish. However, as the seller, 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 payment.

In this article, we go into detail about the SBA loan process and how it can benefit both buyer and seller. We 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

SBA Loans

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.

7 (a) Loan (Business Only)

The 7(a) Loan Guaranty Program, which reduces the risk to lenders by guaranteeing a major portion of these loans, is the SBA’s primary program. This guarantee enables the lenders to provide financing on reasonable terms to businesses when funding is otherwise unavailable. The program’s eligibility requirements and credit criteria have been designed to accommodate a wide range of financing needs.

Funds can be used for a variety of costs associated with a business, including real estate, franchise fees, leasehold improvements, equipment, working capital, and inventory.

504 Loan (Business + Real Estate)

The 504 Loan Program offers long-term financing used to acquire real estate or equipment for expansion or modernization.

The borrower is expected to put down 10%, and the bank takes a first mortgage of 50%. The remaining 40% is raised by the sale of debentures that provide the borrower with a 20-year fixed rate.

Most 504 loans are in the $200,000 to $5 million-plus range.

Funds can be used for owner-occupied commercial real estate, machinery, equipment, and closing costs.

SBA Loan Criteria for All Loan Types

• 20% to 30% equity injection
• 640+ credit score
• Industry and/or management experience

SBA Loan Terms & Conditions

• Term loans with low-interest rates up to $5 million
• Working capital can be included
• No prepayment penalties on most loans
• Collateral may be required

Related Resource: M&A Talk Podcast — Bruce Marks on SBA Loans for M&A Transactions — If you are buying or selling a business that involves an SBA loan, this show is for you. We spend over 90 minutes discussing the many facets of SBA loans, dispelling many of the most common myths along the way. Learn the differences between SBA and conventional loans, how the value of a business affects the loan, how SBA guarantees work, the requirements for obtaining a loan, how transactions are structured with an SBA loan, and much, much more. Whether you are a buyer or seller, this show will be invaluable to understand the mechanics of SBA 7 (a) loans.

Isn’t it the Buyer’s Responsibility to Get a Loan?

Why do I need to get my business pre-qualified for an SBA loan when selling my 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 generated from your business.

While the buyer has some burden of responsibility, the principal responsibility lies with you, the seller. Do not take the attitude that, “The buyer wants to buy my business, so it is their responsibility to find the money.” Remember, it is 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, we 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 & 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 appraisal does not 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 cannot get approved for SBA financing, you have two options:

1. Offer seller financing;
2. Sell your business for all cash. However, you should reduce the purchase price to account for the fact that you are offering all cash.

Do not take the attitude that, “The buyer wants to buy my business, so it is their responsibility to find the money.” Remember, it is your business that is repaying the debt service. Most denials for SBA financing are due to issues with the business, not the buyer.

Why Should I Use an SBA Loan Intermediary?

Note: Morgan & Westfield is not an SBA loan intermediary. Instead, we refer our clients to a network of SBA loan intermediaries we have successfully worked with in the past.

A loan intermediary is a specialist in SBA financing. Loan intermediaries know which banks are aggressively dedicated to committing to SBA loans, and most do not charge any upfront fees for their expertise and to assist with the application.

Advantages

• They help with pre-screening buyers to determine their ability to obtain financing.
• High success rate — most intermediaries have success rates of 90% to 95%.
• They are the buyer’s advocate in the process. They work to get the best deal and the most options for the buyer.
• They work with multiple lenders and can offer a variety of finance options.
• They do not simply “pass” off a loan application and hope for the best.
• They are not bankers — they are business people. Intermediaries need results in order to be compensated.
• Loan intermediaries add working capital and closing costs to a loan in order to reduce the impact of capital needs for the business. An intermediary will assist in pulling together all necessary documents, critiquing the loan application, and speeding up the process from loan application to commitment, improving the chances of securing a loan.
• An intermediary will 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.
• They can provide ongoing status reports, relieving frustration and concerns through the difficult and time-consuming loan process.
• They speed up the process for faster loan commitment and closing.
• They improve the success rate by utilizing creativity in deal structuring and their relationships with aggressive national lenders.

Why Do SBA Loans Get Declined?

Loans are initially declined for many reasons. These reasons usually stem from the borrower’s inexperience and lack of knowledge of the loan process and criteria. If a borrower has limited experience in applying for a business loan, they may experience the following:

• Uncertainty of loan requirements: Does the borrower really understand the bank or financial institution’s requirements to get the loan approved successfully?
• Poorly packaged loans: Do they have the knowledge and ability to professionally present a loan package worthy of full consideration?
• Inability to talk to loan officers: Does the borrower understand the guidelines and concerns that underwriters have in evaluating the merits of their loan application? Do they know how to speak the language of bank financing?
• Wrong source: Banks are always willing to look at an application, but will they approve it? Can the borrower possibly know or understand the bank’s written and unwritten priorities and ever-changing policies or guidelines?

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 loan intermediaries require to qualify the buyer:

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

Without this information, a buyer cannot be placed in the “prequalified” category.

Here is how the information is interpreted once it is received:

• Down Payment: Lenders initially determine the minimum cash down payment required. When calculating the down payment, they will consider IRA-type accounts that can be rolled over to complete this requirement. Most will not consider the seller contribution or “seller note” when prequalifying a buyer candidate.
• Salary: They then explore the buyer’s current personal debt and living expenses to understand the salary level demanded from the new business. They also review the buyer’s credit report and make sure it supports what they have disclosed in the documents they provided.
• Experience: They review the buyer’s resume for relevant business operational skills and advise how to adjust the resume accordingly. For example, they may highlight the buyer’s experience that relates to the acquisition they are considering.
• Opinion Letter: After this due diligence process, the intermediary will issue an “opinion letter” attesting to the fact that the borrower can purchase a business with a selling price up to “X amount.”

Top 10 SBA Loan Myths

Many buyers are hesitant to apply for an SBA loan because of certain common myths. The following myths were provided by Diamond Financial, an SBA loan intermediary that we often work with.

Myth 10: “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 two to three 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 9: “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 8: “The SBA application is over 100 pages. How am I going to get through 100 pages?”

This is actually not true. The average SBA application is about 23 pages. While it may look overwhelming initially, there are only six to eight pages that are needed from a borrower. The rest of the application requires information produced by the seller, such as the history of the business. 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. So, out of those 23 pages, six to eight come directly from the borrower. The rest of the information is already out in the world, and it is just a matter of collecting and correctly assembling it to present to a lender. Unfortunately, this is where most people fail. Buyers do not 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 7: “You must own a house or have other collateral to qualify for an SBA loan.”

This myth has been around for a long time and it is perpetuated because of this simple scenario: imagine your average buyer walking into his local bank asking for a loan. This average buyer has no house, no car, and no other collateral. The local bank denies the loan because he doesn’t have the collateral required, according to their policies. Now, at that same local bank, there is an SBA representative. What just happened is the buyer walked out of the bank thinking that the SBA representative and the local bank were the same and that he had just been denied a loan from both. This is not the case. There are three basic things a buyer needs to secure an SBA loan: 1) a down payment, 2) good credit, and 3) a solid resume that shows you have the skills necessary to run the business you want to buy. Not having collateral in no way disqualifies you from securing an SBA loan.

Myth 6: “You must have a detailed business plan to get an SBA loan.”

You do not need a detailed business plan. Time and time again, people come to see Diamond Financial to help with their application, and they bring in an inch-and-a-half book that details their business plan from start to finish. So many of these people are using online business plan software writing programs, which can be a great tool, but they often take you off in a direction you do not need to go. For example, a lot of these programs anticipate where you will be five and 10 years down the road, including your advertising budget; it is just too much. 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 fifty-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. I’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.

Myth 4: “SBA loans cannot be used toward leasehold improvements or goodwill.”

Absolutely false. A large portion of the loans we write every single day include leasehold improvements and goodwill. If this were true, there would be no franchise start-up loans issued within the country. There would be no little mom-and-pop stores or any of those shops in the strip center. A majority of these are financed through SBA loans.

Myth 3: “The SBA will finance 100%, so I do not need a down payment.”

We hear this all the time, and it is a big myth. So many buyers think, “If the business comes with 25% worth of collateral or intangible assets, and the SBA is going to guarantee the other 75%, then the lender has no exposure, and I do not need a down payment.” This is absolutely not true. There will always be a required down payment on an SBA loan because no lender wants to put someone into a million-dollar transaction with, for lack of a better term, no skin in the game. The only exceptions to this rule are leaseholds or rent replacements, where you have been operating out of a building for quite a while, and now you are going to buy that building or do a partner buyout. Other than those situations, which are very rare, a buyer should plan to have anywhere from a 15% to 30% down payment.

Myth 2: “My credit score should not matter because this loan will be insured by the government.”

Again, this is false; your credit score does matter. Lenders do not want defaulted loans on their books. The lender has exposure when it loans money to buyers, and they have to make prudent lending decisions, according to the SBA rules. So, if you have a 500 credit score, it is going to be difficult to get a loan. However, there are exceptional circumstances. For instance, medical bills are a common occurrence these days, and lenders tend to understand outstanding medical bills. For the most part, a lot of people have some blemishes on their credit, and the majority of SBA lenders are understanding as far as that goes. However, if you have been a habitual late payer, and your credit has always been horrible, then it will be difficult to get a loan through an SBA lender or any lending institution in general.

Myth 1: “You must be declined by three banks in order to apply for an SBA loan.”

This myth has its roots in the late fifties. When the SBA first created this program, they said, “If you cannot find financing on reasonable terms, we will consider backing your loans.” What you had to do back in the late ‘50s and early ‘60s was prove to the SBA you had three official declines from banks. So, there is some truth to this myth. But the three-bank denial requirement went away by the end of the ‘60s.

If you have a loan in place that is on reasonable terms from a bank, refinancing that with an SBA loan is going to be difficult. But if the SBA loan will save you 10% or more through refinancing, and the borrower meets the SBA requirement that it “cannot find financing on reasonable terms,” then the borrower may have the opportunity to refinance the loan through the SBA.

Next Step if You Are Denied a Loan

What’s the next step if I am denied an SBA loan?

In our experience, we have seen many 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 may be more aggressive than the first bank, and loan intermediaries are likely to know who these banks are.

“We’ve seen lots of deals get turned down by one bank only to get accepted by another bank.”

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, if you have not filed your recent federal income tax returns yet, it would make sense to run your draft tax returns by a loan intermediary before filing them with the IRS. A loan intermediary can review your tax returns and recommend ways to increase the likelihood of obtaining SBA financing.

Some situations are tricky. For example, deducting the cost of your trip to Hawaii last year, which cost you $5,000, may reduce your company’s tax burden. However, 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 or us may result in changes that may 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

Should we reduce the asking price for the business if our loan wasn’t approved?

I don’t want the buyer to think that we are asking too much for the business just because the bank isn’t on board.

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.

“An SBA loan denial often has little to do with the fairness of your asking price.”

We 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. We had our appraiser critique the bank’s appraisal, and we were able to get the loan restructured. Ironically, the appraisal was performed by a “third party” — the same third party that several large broker networks recommend.

Never take the first no; there are always other lenders that are more aggressive. Keep persisting and keep the revenue stable, and we will get a deal done eventually.

What is a pre-approval?

A pre-approval means that our lending partner has analyzed the business, its financials, and federal tax returns and determined there is a high chance one of their lenders would finance the acquisition. They estimate their chances of approval are 85% to 90% with a strong buyer. Our lending partners know the lenders, and they feel confident the business is priced correctly to obtain approval, has cash flow, and has a solid history. Our lender partner has successfully completed hundreds of transactions with these lenders and has a strong relationship with them. Our lending partner works with multiple SBA lender sources and partners and the most aggressive cash flow lenders who will finance acquisitions. These lenders put more emphasis on the cash flow from the business than on the collateral and related buyer experience. In order for the lending partner to determine if the transaction will be approved, a term sheet must be reviewed first, and the buyer must be further qualified.

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.

Does the SBA loan money?

No, the SBA only guarantees the loan. The actual loan is made by a lender (e.g., Wells Fargo).

What are the different types of SBA-approved lenders?

Lenders are either GP (General Program) or PLP (Preferred Lending Program) 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.

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.

Why does the buyer need to get qualified?

The cash flow to repay the loan must come from the business. When qualifying a business for SBA financing, lenders must determine if there is sufficient cash flow to cover the debt service. While the borrower’s financial strength and business assets are considered, they are regarded as secondary sources. Lenders assess not just the cash flow history of the business. They also assess the borrower’s ability to maintain that cash flow into the future.

Is it possible to get a loan if someone has already been turned down by another bank?

Very possibly, yes. But that’s based on why the loan was declined in the first place. Each lender has its own credit policy as well as bank portfolio preferences and needs. A perfectly good loan may be declined at one bank because they do not work in that industry. The same applies to credit standards, loan underwriting methodology, and other important lending elements.

How lengthy is the process?

The process is not overwhelming nor necessarily difficult, but there is a fair amount of paperwork involved. It is best to work with a lender or loan intermediary who will take the time to explain things, work through the various forms, and, most importantly, help structure the loan request properly.

Will lenders review my tax returns when they consider my business for financing?

Yes. There are some exceptions, such as medical practices; however, in the majority of loan applications, the lender will primarily base their decision on 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 and/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 on the amount of the portion of the loan guaranteed by the SBA.

What level of down payment is required?

The SBA specifies that the minimum down payment from the borrower must be at least 10% of the total business cost. The cost consists of the purchase price of the business, plus the loan closing costs, including the SBA Guaranty Fee, plus the working capital included in the loan by the lender. Each bank then applies its own credit standards on top of that. Typically, this results in down payments ranging from 10% to 20% on business acquisitions.

What are the terms?

Terms are usually ten 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) rate is prime + 2.75%, typically 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 there a prepayment penalty?

There is no prepayment penalty unless the loan amortization is fifteen years or longer.

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 small business sales 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.

We estimate that over 95% of the loans made to purchase a small business are 7 (a) SBA loans. For this reason, we recommend first exploring if the business would qualify for an SBA loan. If it does not, then you may explore other options.