The problem with paying for a business acquisition is coming up with the money. The buyer’s savings is a key component of acquisition financing. And in today’s business environment, sellers generally finance at least part of the deal when they’re selling a main street business. But that often leaves a significant portion of the purchase price to be funded by other sources.
A lot of buyers turn to SBA-backed loans to bridge the gap. Is an SBA loan right for you? Here are some pros and cons to help you decide whether you should explore an SBA 7(a) loan, the type of SBA loan that’s most common for acquisition financing.
Pro: SBA loans can be used to finance a collateral shortfall
One of the best benefits of SBA loans is that they can be used to finance what lenders refer to as an “air ball,” that is, the portion of a loan that isn’t backed by collateral. Banks want to make sure their loan won’t be a complete loss even if your business fails, so they prefer for the entire amount of the loan to be backed by collateral such as buildings, equipment, and inventory. Intangible assets like goodwill, trademarks, and seller noncompetes usually don’t count for collateral, but they can be financed through an SBA 7(a) loan. This makes SBA loans especially attractive for buying a service business that doesn’t have a lot of hard assets to be used for collateral.
Pro: SBA loans are a good fit when there’s strong cash flow and a solid credit rating
Since SBA loans are often under-collateralized, the SBA and banks look to the business’s cash flow and the owner’s credit rating to determine whether the business is credit-worthy. If the business has a track record of strong profits and if it throws off sufficient cash to service the debt, the acquisition might be a good candidate for an SBA loan. Also, since the buyer’s financial wherewithal is important to underwriting the loan, a strong credit score is a must.
Pro: SBA loans tend to have a long repayment period
SBA acquisition loans tend to have a longer maturity than conventional loans. The typical 7(a) acquisition loan will be paid out over 10 years. This gives you more time to pay off the loan through the business’s earnings, and it gives you more certainty because you won’t have to scramble to refinance the loan in three to five years.
Pro: the bank can’t charge a prepayment penalty
Banks aren’t permitted to charge prepayment penalties on SBA 7(a) loans, although the SBA can charge a prepayment penalty for loans with maturities of 15 or more years that are paid off during the first three years.
Con: the seller can’t maintain a stake in the business
In a lot of cases, it would be beneficial to keep the seller involved after you buy your business, either as a minority owner or as an employee. But the seller can’t maintain a stake in the business after the sale if an SBA 7(a) loan is used to finance the purchase. This means that the seller can’t keep a minority ownership in the business. It also means that you can’t keep the seller on as an employee after you buy the business. You can, however, engage the seller as a consultant for up to 12 months in many circumstances.
Con: earnouts aren’t permitted in SBA acquisition financing
When a buyer and seller can’t come to agreement on the value of a business, they often turn to earnouts to bridge the gap. An earnout is an arrangement whereby the seller receives additional money for the business if the business meets certain financial or operational thresholds during the first year or two after closing. But based on the reasoning that the seller can’t maintain a stake in the business after closing, the SBA doesn’t permit earnouts. So if you’re having trouble coming to agreement with the seller on the value of the business, you won’t be able to turn to an earnout if you intend to finance the purchase with an SBA loan.
Con: setoffs against seller notes aren’t permitted in SBA acquisition financing
Another common feature of business acquisition agreements that the SBA frowns upon are setoffs against seller notes. In most acquisitions the buyer will negotiate contractual protections in case the business has problems that weren’t uncovered during the due diligence process. In deals that are partially financed by the seller, the buyer often negotiates a right to deduct damages from money that the buyer owes the seller after closing. However, as a general rule, the SBA doesn’t allow such deductions, although setoffs are permitted if the seller note isn’t considered part of the equity injection that is required for the loan.
Con: The buyer will have to personally guarantee the SBA loan
The SBA requires each person who owns 20% or more of the business to personally guarantee the SBA loan. This means that the owners will be on the hook for the business’s liabilities if the business can’t pay its bills. This is a major drawback of SBA financing for people who want to shield their personal assets from their business’s liabilities.
Is an SBA 7(a) loan right for you? As you can see, it depends on your particular financial situation as well as the type of business you’re buying.
Image credit: Shutterstock. Image may not be copied or downloaded.