SBA/Bank Lending 101

Is a bank loan backed by the Small Business Administration right for your business acquisition? Maybe, but it's anything but a slam dunk!

It surprises most prospective business buyers (and business sellers) that the vast majority (perhaps 90%) of all businesses for sale DO NOT qualify for an SBA-guaranteed bank loan. Many buyers assume they'll be able to put 20% down for a business, get a loan from an institution for the rest, and get the deal done. That scenario is the exception. More typically, deals don't qualify for institutional financing because the income (as shown on the tax returns) isn't sufficient to cover the debt service and owner's salary with the requisite margin. Without passing any judgment, it's not uncommon for business owners and their accountants to take advantage of the tax code to write-off certain expenses which may be discretionary. For example, while the company is allowed to deduct certain expenses for the company's annual meeting, the owner may choose to take the family shareholders to a resort location for the weekend to hold the meeting. There are many legitimate business expenses from the IRS standpoint that can be deducted against income. Buyer and seller may agree that this, and other discretionary expenses were not required to operate the business, and therefore may be considered part of the total owner benefit, or seller discretionary earnings (SDE). However, many of these so-called "add-backs" are not viewed as such by the SBA or bank lenders. They're primarily looking at the sum of pre-tax profit, officer's salary, depreciation, amortization and contributions to a retirement or pension fund. Other expenses may also be included, but must be well documented. As a rule of thumb, the more explaining that's required to justify an add-back to the bank loan underwriter, the less likely it will pass muster.

So, in many cases, seller financing is required to get a deal done. Depending on the needs of the seller, it may be very impractical for them to carry a large or long-term promissory note for the business.

When SBA-backed financing is a possibility, realize that not all lenders are created equal. Lender have varying degrees of experience, quote different rates, emphasize different underwriting criteria, have different fees and of course, provide different service levels and expertise. Some are good "cash flow" lenders; others focus only on real estate loans. Some will be aggressive in earning your business, others may not be as interested in your project.

Some lending institutions have been granted the authority to operate under the SBA's Preferred Lending Program (PLP). This program gives the lender the authority to approve, process and close the loan on the SBA's behalf. This has led to a more streamlined and efficient loan process. For some situations, SBA guaranteed loans are the product of choice for many small businesses as well as experienced lenders and institutions.
  
"Why would my business want an SBA Loan?" you ask. Flexibility and advantageous terms is the answer. The SBA program can be a good credit enhancement. It takes a good loan and makes it better (for borrower and lender). For instance, if a piece of commercial real estate would help your company, but you don't want to tie up the large amount of capital and corresponding loan payments it takes to finance the property with a conventional real estate loan, you could finance 90% of the project cost (including fees) and stretch the payments over a longer period (25 years) using a SBA loan. Maybe you are tired of working in corporate America and want to control your own destiny with a small business. Since the lender gets a significant percentage of the loan guaranteed by the SBA, some lenders are more willing to finance intangible assets (goodwill) and short term assets with long term financing. All of a sudden your project is much more achievable. SBA loans generally require lower down payments, have longer amortizations, allow for a lack of collateral, have higher advance rates, and can factor in projected income as a source of repayment.

SBA Lending consists of three primary programs: 7a, 504, and Express. 7a is the flagship program of the SBA and is the most common and versatile. 7a proceeds can be used for almost any business purpose - commercial real estate, business acquisition, machinery and equipment, inventory, working capital, leasehold improvements and business start-ups. The 504 program is restricted to financing only long term fixed assets (i.e. commercial real estate or large equipment). Despite its limited scope, the 504 program provides the borrower attractive terms for large commercial real estate projects. Express is the newest of the SBA programs. This program is used primarily by lenders to fund short-term working capital needs (lines of credit) for established businesses. 
 
Working with an experienced SBA lender is critical for a smooth process. Even though the program has made great strides in becoming more user friendly, it is the bank or credit union, their processes and experience that make the program easy to navigate. Managing timelines with an experienced lender (PLP status is helpful) becomes very manageable. Loans can often be approved within 2 weeks and close within 4-6 weeks. As with any loan, real estate has a more complex closing process (appraisals, title work, etc.) and thus takes longer, usually 6-8 weeks. 

Credit qualification for SBA financing is similar to most commercial loans, but generally has more relaxed guidelines. Most experienced SBA lenders look at four key credit criteria: cash flow - the business's ability to repay; management experience - often judged by length of time in business or the industry; equity - availability of required down payment, and personal credit of the principals. While collateral can help make a lender comfortable, it is often not a priority for experienced lenders. In fact, the SBA will not decline a loan due solely to lack of collateral. However, if you do have more than 20% equity in real property, generally speaking, the lender will require it as collateral. (Ask us for a helpful tip about this issue.)