The U.S. Small Business Administration (SBA) 7(a) loan program is an excellent business acquisition loan for lending institutions to support clients who want to acquire existing small businesses, including franchises. Through this program, SBA 7(a) loans are available up to $5 million and recent modifications to SBA requirements have made this program even more accessible for small business owners.
In this article, you’ll learn the basic information and updates for SBA business acquisition loans, including the types of acquisitions that are eligible, buyout options, equity contributions, and valuation requirements.
How does the SBA define “business acquisition”?
The SBA considers a business acquisition to be a change of business ownership in which all (or essentially all) of the assets are purchased through asset or stock purchases, and the business’s operations continue.
1. Who can use an SBA 7(a) business acquisition loan?
- New owners: New owners include a person or entity that’s not currently an owner who purchases 100% ownership of an existing small business; or an employee stock ownership plan (ESOP), or equivalent, that purchases a majority share (51%) in the business.
- Existing owners: Existing owners can use 7(a) loan proceeds to buy out other owners, resulting in 100% ownership by the new owners. The existing owners cannot bring in any new owners into the structure and must acquire the ownership shares equally. For example, if a company was owned equally by four individuals (each at 25%) and two owners were buying out the other two, the remaining two owners must continue to be equal partners at 50% ownership each. They could not bring in a new owner and or adjust their ownership relative to one another (ie. One remains at 25% and the other increases to 75%).
2. What’s the required equity contribution for new owners?
When the purchase involves a complete change of ownership, the SBA requires the new owner to make a 10% equity injection, based on the total of all costs involved to complete the transaction.
It’s important to note that seller debt can only be considered as part of the equity injection if it totals 50% or less of the required equity injection and it’s fully subordinated for the life of the SBA-backed loan.
3. What’s the required equity contribution for existing owners?
When the business acquisition involves one or more partners purchasing the ownership stake of another partner or partners, the SBA permits the lender to make the final decision on the level of required equity contribution assuming the following requirements can be met:
- The purchasing party must certify it has been actively involved in the business’s operations and has held the same or an increasing ownership interest in the business for at least 24 months prior to the purchase and;
- The business balance sheets for the most recent completed fiscal year and current quarter reflect a debt-to-worth ratio of no higher than 9:1 prior to the change in ownership.
- In the event the above are unable to be satisfied, the remaining owner(s) must contribute at least 10% equity contribution.
4. Business valuation: internal vs. third-party
When it comes to business valuations, the 7(a) program looks at the business’s value, not including the appraised value of real estate and/or equipment. In addition, the SBA considers whether there’s a close relationship between the seller and buyer, such as whether they’re family members or business partners.
- Assuming your institution’s credit policy permits for similarly-sized SBA loans, you can complete an internal business valuation when the financed amount is $250,000 or less and there’s not an existing close relationship between the buyer and seller. When you work with Prudent Lenders, we can prepare an internal valuation for your review.
- When the amount being financed exceeds $250,000, or if there’s a close relationship between the buyer and seller, then a third-party valuation is required.
It’s also important to note that the loan proceeds in a change-of-ownership transaction can’t exceed the determined value of the business.
4. Partner buyout for existing businesses
When the business acquisition involves one or more partners purchasing the ownership stake of another partner or partners, the SBA requires that the purchasing party certify it has been actively involved in the business’s operations and has been an owner, for at least two years prior to the purchase.
In addition, the SBA requires that the owners submit balance sheets for the most recent completed fiscal year and current quarter and that the business’s debt-to-worth ratio, as documented by the required financials, isn’t higher than 9:1 prior to the change in ownership.
The SBA 7(a) as a business acquisition loan
Jim is a manager at a local restaurant and is responsible for overseeing and managing daily operations. He’s held this position for nearly 10 years. At the request of the current owner, Peter, he has just been offered the opportunity to purchase the restaurant as Peter is looking to retire.
The purchase price is $500,000 and will be structured as an asset purchase. The purchase price does not include inventories, as this will be valued prior to closing but has been estimated at $25,000. Jim would also like to obtain financing for about $50,000 to cover working capital and closing costs. He has determined that he has about $40,000 in available personal cash to contribute towards the acquisition.
Jim has applied for a loan with his bank to finance the business acquisition, and the bank opted to route the application as an SBA 7(a) loan due to a lack of tangible collateral. The bank ordered a third-party business valuation, which came back at $510,000, supporting the purchase price. The bank has agreed to allocate the requested $50,000 of working capital into the structure, so the project will total $575,000. As a new owner, Jim must contribute 10% of the total project or $57,500 per SBA guidelines.
Since he only has $40,000 available, Jim approaches Peter about the possibility of holding a note for the remaining portion of his required equity contribution, to which Peter agrees. This seller note will be required to be fully subordinated (no payments permitted) for the life of the SBA as it is counting towards Jim’s minimum equity contribution of 10%. Both the bank and SBA approved the financing request and agreed the strength of the project was in the fact that the continuity of the business would continue at the hands of someone who knew the operations in and out.
In addition to these key points, the SBA has additional requirements regarding specifics such as the roles that sellers can and cannot play after the business is sold and that the seller must provide verifiable financial information.
When you work with clients who are interested in purchasing existing small businesses using the SBA 7(a) loan program, contact your Prudent Lenders representative. We’re here to provide our oversight and expertise during the entire process to make it much easier for you and your borrower.