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When buying a small business, one of the most common ways to structure a transaction is to use a mix of cash, an SBA loan, and seller financing. While it’s rare for a buyer to transact without putting any money down, it’s equally rare for a buyer to purchase a business outright in cash.
Instead, most of the business acquisitions on “Main Street” are paid for with a down payment from the buyer, a sizable SBA 7(a) term loan, and a 3-5 year promissory note between the buyer and seller of the business.
The reason this structure is so popular is because it minimizes the money a buyer needs to contribute upfront, ensures the seller has skin-in-the-game for a smooth transition, and maximizes the amount of money the seller receives at closing.
Why use seller financing with an SBA 7(a) loan?
Most SBA lenders will only lend around 80% of the total project costs. Total project costs include not only the purchase price of the business but also the SBA guarantee fee and other transaction expenses.
While, theoretically, the remaining 20% of the total project costs could come solely from the buyer, the much more common approach is for the remainder to be split between the buyer and the seller. The buyer will put in a 10% down payment, and the seller will finance 10% of the project costs over the course of three to five years.
Why? Both the SBA lenders and the buyer want the seller to be incentivized to help the buyer transition into the ownership role and get off to the races. In fact, most SBA lenders require at least 10% of the cost of the business to be financed by the seller.
After all, the SBA lender has made a large loan to the buyer and needs the transition to be successful in order to get paid back. The buyer has made a personal guarantee on that large loan and likely needs the transition to be successful to remain solvent.
How does an SBA acquisition loan impact the promissory note?
The SBA 7(a) loan program requires that the acquisition loan is the most “senior” form of debt. In other words, if the business fails, the SBA lender will get paid back before the seller will get paid back.
Luckily, it’s quite rare that this occurs. The SBA charge-off rates for the 7(a) product are consistently less than 1%. In other words, the SBA does a pretty good job of underwriting the buyers and businesses it looks at.
What happens in case of default?
If a buyer fails to make required interest or principal repayments to a lender, he or she will enter default. When this happens, the Standby agreement enters into effect.
The seller will not be allowed to accept repayments of his or her seller financing, until the buyer has first cured default with the SBA lender.
If the buyer fails to cure his or her default with the SBA lender, then the lender may pursue the buyer and his or her collateral. The seller will only be allowed to pursue the buyer if the buyer has either settled with the SBA lender or if the SBA lender gives the seller written permission.
While some sellers may feel this is unfair, it’s important to realize that the SBA lender is putting in 8x the money into financing the acquisition.
What is the SBA’s Standby Creditor’s Agreement?
The Standby Creditor agreement is a legal contract that the SBA lenders require that the seller of the business agree to, in order for the SBA lender to fund the loan.
This agreement specifies the terms of the seller financing, as well as the various implications of the SBA loan being treated as “senior”.
Most SBA lenders allow buyers to make payments on the seller financing, so long as they do not default on the SBA loan. However, a few will accept no payments on the seller financing until the SBA loan is satisfied. We highly recommend avoiding those lenders.
How can a lender limit the seller note?
Aside from a few lenders who try to prevent repayments on the seller note until the SBA loan is satisfied, most lenders are quite pleasant to work with.
For most lenders, there are three ways that they can limit the seller’s ability to get repaid:
If the buyer defaults on the SBA financing, then the SBA lender will prevent the seller from accepting payments until the buyer cures the default.
If it comes to a charge-off, the SBA lender gets “first dibs” on pursuing a buyer and his or her collateral, before the seller is allowed to pursue a buyer.
If a buyer starts to get close to defaulting, the SBA lender can prevent the seller from accepting payments until the buyer increases his or her cash flow.
While we’ve discussed the first two instances above, the third instance is one that is a bit more tricky. The SBA lenders often will attach a non-negotiable “Exhibit A” to the Standby Creditor’s Agreement. This exhibit will require that the seller stop accepting payments if the business fails to show a minimum debt-service coverage ratio. It’s almost like a “yellow card” given to the buyer (and seller) that the buyer may be headed to default, and that the buyer needs to get things back in order before he or she can resume making payments to the seller.
In practice, this exhibit quite rarely comes into effect. But, it’s important for sellers to understand what it means and that it’s common across all SBA loans.
What are the ranges for DSCR minimums? What happens if the DSCR dips below the minimum?
We’d recommend checking out our blog post on debt-service coverage ratios. If you haven’t read that before, the short story is that a debt-service coverage ratio (DSCR) measures how much buffer a business has between its earnings and its debt obligations.
For instance, a 1.5x debt-service coverage ratio means that for every $1 of debt owed each month, the business earns $1.50 in earnings. Moreover, a 1.25x debt-service coverage ratio means that for every $1.25 of debt owed each month, the business earns $1.25 in earnings.
For most SBA loans, the lenders will require the DSCR to be at least 1.25 to 1.5 or greater. If the business dips below that ratio for a few consecutive months, then the SBA lender may ask the seller to stop accepting payments.
Conclusion
At Beacon, we strongly recommend transactions use a mix of a down payment, SBA loan and seller financing. It achieves the best outcome for all parties. However, it’s important for both the buyer and seller to understand how the SBA loan can impact any seller financing. Being educated on the SBA 7(a) loan product will help the buyer and seller to work together and achieve a smooth transition.
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John takes a personal approach when advising buyers and sellers on taking the next step. John has deep knowledge of a variety of markets through his background as a member of the Chicago Board of Trade and experience as a licensed real estate agent in Texas and Michigan. Originally from Detroit, John's passion for automotive runs as deeply as his love of Wolverine Football.
Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.
Calder Capital
Sam Domino