SBA-Financed Business Deals
Many buyers of businesses use loans backed by the Small Business Administration (SBA) in order to purchase businesses. SBA-backed loans absorb lending risk for banks by guarantying the loan used to buy a business. Both the buyer of the business and the underlying business itself must properly ‘qualify’ under SBA guidelines for loan approval. The financial profile and personal background and experience of the buyer must be paired with the characteristics and the assets of the actual business under consideration in order to determine if the deal has a strong chance of ultimately being approved during the underwriting/appraisal process.
‘Pre-Approval’ for SBA-Financed Business Transactions
Most lenders do not issue the same type of ‘pre-approval’ letters given to buyers seeking mortgage financing for the purchase of a home. This is because the financial traits and qualitative characteristics of the business being potentially purchased factor in to whether the buyer qualifies. Instead, buyers may obtain a generic letter of good standing from their bank indicating that the bank will work with the buyer to obtain SBA financing. This will be based on the buyer’s relationship with the bank and on the buyer’s general financial profile. It is usually premature for buyers to claim that they have been ‘pre-approved’ for SBA financing until the business itself is evaluated.
‘Term Sheet’ Issued by Bank After Preliminary Due Diligence
Once the buyer seeking an SBA-backed 7(a) loan identifies a business to purchase, they must complete a thorough loan application. The application covers the background and characteristics of the buyer and provides information about the underlying business itself. If the bank feels that it will be worth their time, most banks will issue the buyer a ‘term sheet’ (subject to later appraisal) The ‘term sheet’ discloses the proposed loan amount, terms of the loan, and any required seller-financing (typically around 10% of the purchase price). Most buyers should obtain a term sheet when they propose an offer via a Letter of Intent (LOI) or shortly after an LOI is signed. Obtaining a term sheet not only signifies that the deal is likely to pass underwriting, but it also tells the seller that the buyer is serious and able to complete the deal.
Appraisal Conducted by Bank After Term Sheet
Once a deal is ‘under contract’ where there is a signed LOI or purchase agreement, the buyer must pay for an appraisal of the business. The appraisal is conducted by the bank (under SBA guidelines), and may take several weeks. Standards and judgments regarding the worth of a business may change depending on the appraiser. In most cases, however, the appraiser will look at the tax returns of the business to gauge the profits of the business, evaluate the local market conditions, and examine the tangible or physical assets of the business. The more transparent the financials and the higher the value of tangible assets (which may be used as collateral against the buyer’s loan), the greater chance the business has of being appraised at a price level which enables the deal to go through.
Factors Used to Determine SBA-Backed Loan Eligibility
- The SBA will examine many characteristics of the buyer and the underlying business when evaluating a 7(a) loan application to buy a business.
- First, the buyer’s personal credit score (690 or above preferred) and the buyer’s personal finances are closely scrutinized.
- If the buyer has debt obligations and a high cost of living, then that will weigh against the application.
- The buyer’s liquidity – or the liquid funds (such as cash, stocks, or bonds) that the buyer has – is examined.
- The buyer should have a sufficient amount of liquidity to cover the down payment of the business (around 20% of the purchase price), with leftover funds available.
- Next, the SBA will examine other assets of the buyer – such as real estate, investments, or other personal property – to gauge the collateral that the buyer will be able to use against the loan.
- It is important to remember that the buyer must be able to use either its own personal assets or the assets of the business as collateral to secure its loan.
- If the business owns real estate which comes with the business, then that too can help secure the buyer’s loan.
- The most important factor used to determine SBA-backed loan eligibility is the income that the business will provide the buyer compared to the buyer’s debt service obligations.
- The projected income that the business will provide the buyer is based on the financials of the business itself, as well as what the buyer’s role in the business will be (which may change the projected income).
- Debt service obligations will come from the debt from the business loan and from any other debt which the buyer (or buyer’s spouse) may have.
- The projected income that the buyer will receive from the business must be significantly higher than the buyer’s projected costs from debt service obligations.
Work Experience of Buyer
For many service businesses – especially in the construction-related and home repair industries– the SBA often requires the buyer to have sufficient work experience in the field in which the business operates. Further, the SBA may also require buyers for such businesses to have the necessary licenses to operate the business. In practice, such requirements are meant to ensure that the buyer will have the requisite amount of skill level and experience necessary to profitably run the business and make good on the loan. The exception is for the purposes of buying franchises, where the franchisor is expected to train and further qualify the buyer.
Buyers who wish to use SBA financing in order to purchase a business should thoroughly educate themselves about the SBA lending process (which often takes several months and involves extensive servicing and appraisal fees) prior to looking for a business to purchase. The buyer’s personal finances and work experience, the characteristics and assets of the underlying business being purchased, and the available collateral which may be used against the loan are all key factors when assessing whether a buyer is SBA-qualified.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.