Are you looking to be your own boss? Tired of clocking in for the typical 9-5?
Well, starting your own company is hard work and takes a lot of time and money. Plus, there is more than a 50% chance you will fail.
For every one of you out there who is tired of working for someone else, there is someone who is tired of running their own company.
When you purchase an existing business you instantly have cash flow and employees to help you grow with your own unique talents and expertise.
Let’s look at how to purchase an existing business with an SBA 7(a) loan.
What is the SBA?
Since 1953 the SBA or Small Business Administration provides assistance to small businesses in the US.
OK, so what is a small business? There are two common metrics the SBA will use:
- Under 500 employees (manufacturing & mining)
- Under $7.5m in total sales (nonmanufacturing industries)
However, the size varies for all industries, you can download the full table here.
So, while your business that has a couple hundred employees and boasts $3 million in sales each year might not feel small, the government still says you are.
Most entrepreneurs are familiar with the SBA in the way they offer access to capital, which is what we will focus on in this article. However, they also assist with:
With over 1,800 locations throughout the US, the SBA provides free one-on-one counseling for small business and low-cost training.
Section 15(g) of the Small Business Act requires federal departments and agencies to award 23% of prime contract dollars to small businesses.
Since 1978, the office reviews and testifies in congressional legislation on behalf of all small businesses in the country. They help assess the impact of new regulatory changes as well as conduct a variety of research.
Types of SBA Loans
While there are other loans out there such as export assistance or disaster loans, today we will focus on those you might consider for purchasing a business.
The MicroLoan program can be a great option if you are starting or expanding an existing business. While the average amount is around $13,000, this SBA program can provide loans up to $50,000.
These loans are usually used for things like:
- Working capital
- Furniture and fixtures
Keep in mind you cannot use these loans to pay off debt or buy real estate.
The maximum repayment term is up to six years and interest rates would be between 8% and 13%.
SBA Express loans tend to have a faster turnaround than 7(a) loans but have a smaller maximum loan amount and can still take up to 90 days to receive funding.
This type of SBA loan could be good if you are purchasing a smaller business or just need a line of credit.
SBA Express loan facts:
- Up to $350,000
- 36 hour approval time
- Maximum interest rate of prime + 6.5%
- The term depends on the type but ranges from 5 years for a line of credit to 25 years for real estate
- No collateral is required for loans under $25,000 but anything over that the banks will most likely use their existing policy
The 504 program (Certified Development Company) is geared towards companies wanting to invest and grow their business.
Funds can be used for things like:
- Purchasing land
- Existing buildings
- Long-term equipment
- Improvements to existing property
- Build new facilities
- Renovate or convert existing facilities
Unlike the other loan types, you cannot use these funds for working capital or inventory.
The 7(a) loan program is the most popular type of SBA loan and can be used for a variety of business needs such as:
- Purchase land (including construction costs)
- Repair existing capital
- Purchase or expand an existing business
- Refinance existing debt
- Purchase machinery, furniture, fixtures, supplies or materials
This is the program we recommend for purchasing an existing business and we will get into more detail later on.
However, in general, 7(a) loans are term loans with a fixed interest rate and monthly payments. Rates and term lengths can vary depending on the size and use of funds.
Pros & Cons Of Using SBA Financing
There are several reasons why you may or may not want to take advantage of an SBA 7(a) loan, let’s dive deep into each of them.
Here is the term schedule for a 7(a) loan:
Loans less than 7 years:
- $0 – $25,000 Prime + 4.25%
- $25,001 – $50,000 Prime + 3.25%
- Over $50,000 Prime + 2.25%
Loans 7 years or longer:
- 0 – $25,000 Prime + 4.75%
- $25,001 – $50,000 P + 3.75%
- Over $50,000 Prime + 2.75%
As you can see the interest rates are favorable compared to online lenders or even traditional types of lending that can climb to 36% or higher.
Favorable Repayment Terms
In general, SBA term lengths tend to be longer and more favorable for entrepreneurs.
7(a) loans can have terms up to 10 years and even 25 years for real estate compared to 3-5 years for a traditional bank term loan.
This allows you to really stretch your capital with lower payments as you will see later on in our example.
Low Down Payment
Ordinarily, banks will require a 20-30% down payment, however, with an SBA loan they may only require as little as 10%. This is known as an equity injection and is required for changes of ownership transaction.
Banks and the SBA both agree that if you have some skin in the game you are more likely to follow through with your business plan and your commitments.
Low down payments, low-interest rates and longer repayments terms all combine to really stretch your capital so that it works for you and not the other way around.
In addition, up to half of the down payment can be in the form of seller financing as long as they are willing to wait until the SBA loan is repaid first.
This might be a hard sell but it allows you to offer higher multiples to buyers and they will still get 85-90% of the purchase price up front. Plus, they will earn interest over the life of the seller note.
As you might have guessed, there are many forms to be filled out and plenty of paperwork to turn in.
It may take you a decent amount of time just to complete the application and gather all of the documents needed.
Then the bank runs their analysis, which will take even more time (assuming you have sent in everything they need)
It then has to go to underwriting and the SBA itself for approval.
You should expect the whole process to take 60-90 days and even up to 120 days to complete in addition to several hours of your own time.However, some preferred lenders can close the financing in 45 days if you have all of your paperwork in order.
While the minimum credit score depends on the individual lender you go to, you will need a good or great credit score to take advantage of the 7(a) loan program.
Most lenders will require a credit score of at least 680, so it is essential to know your score ahead of applying for the loan.
If you check your score and find it is less than 680, you should thoroughly review the report to check for any errors that you may be able to dispute.
Otherwise, you will need to work on paying off debt and find other ways to increase your score.
Personal Guarantee & Collateral
By far the biggest con to be aware of is that a personal guarantee is required when purchasing a business with an SBA 7(a) loan.
There is also a good chance the lender will require you to put your primary residence up as collateral.
It’s for this reason that many acquisition entrepreneurs choose to work with a group like Acquira, since we dramatically lower that risk.
Purchasing An Existing Business With SBA Financing
Now let’s look at the process and potential returns that using an SBA 7(a) loan can bring to your deal.
Imagine you find a business that is earning $450k over the last 12 months. After performing your diligence you decide you want to try to close a deal using SBA financing.
Let’s walk through the necessary steps to close this deal!
Structuring The Deal
There are several ways you can structure a deal when purchasing a business, however, when using SBA financing you may find your creativity stifled as they only allow certain structures.
The first thing you need to think about is your offer to the seller. While using an SBA loan allows you to offer higher multiples because of the benefits we have already discussed, the business still has to pass a third-party valuation.
That means the bank is going to send your purchase agreement along with the company’s financials to another company and see if they agree with the valuation.
So how do you come up with an offer? Let’s take a look:
- Total the assets – this is probably the simplest way to value a business but most likely the company is worth more than this and most sellers would not go for it.
- Multiple of revenue – this is another simple calculation but if you are not calculating profit into the equation you could end up overpaying for your business.
- Multiple of earnings – this is what we use and the way we recommend valuing a business. Using earnings allows you to predict how long it will take to get your investment back. 3x or below is fairly standard but can be higher or lower depending on many factors.
- Other considerations – sometimes you have to go beyond using formulas and consider things like location (for brick and mortar businesses) or the ability to cross-sell with other companies you own.
For this example, we are going to assume we found a company that is earning $450,000 a year and after performing thorough due diligence we decide to offer a 3x multiple ($1,350,000) to purchase the business.
However, after factoring in fees and a working capital budget, the total purchase price comes to $1,525,500.
Because we offered such a great price the seller has agreed to issue a 10% seller financing note, knowing that he won’t receive that until after the SBA portion is repaid.
Since this loan falls under a change of ownership, we as the buyer must inject at least 10% into the deal however, it could be more, based on the judgment of our lender.
The equity injection can come from personal cash, cash that is borrowed (as long as repayment is made from a source other than the business), other assets or standby debt.
We will put 15% down in cash in this example leaving $1,144,100 to be financed.
When purchasing a business with an SBA 7(a) loan you must acquire 100% of the business. Even if you are buying out existing partners, the change in ownership must result in 100% ownership, otherwise, the SBA loan will not be approved.
Because of this, earnouts and other performance-based financing are not allowed.
This also means the seller cannot remain as an officer, director, shareholder, or key employee of the business.
The only thing that is allowed is a short-term (12 months or less) consulting agreement with the seller.
So as you can see, the way you structure the deal is limited, but the benefits can certainly outweigh the cons.
Now for the fun part, let’s take a look at what your return on investment might look like.
With our example above we put down $228,800 (15% of $1,525,500) to purchase a company that is earning $450,000 per year.
Now, a good portion that will go towards your new SBA loan. Assuming a 7-year note and a 6.8% interest rate, your payments will be around $210,000 per year.
That still leaves $240,000 (~$20,000 per month) in cash flow available to you, the new owner in the first year. So you have successfully made a 105% return on your money in the first year.
Assuming you can grow the company by just 5% a year, a reasonable goal, then your returns for the next 4-5 years look like:
Most people would probably be happy with that, it looks pretty good.
But what if you sold the company after four years of operations for just the same multiple you purchased it for?
This is where things get interesting. You are now earning $547,000 per year at a 3x multiple gives you a sales price of $1,641,000, however, you will most likely need the help of a business broker to sell. They typically charge a 10% commission.
Still after the commission plus paying off the SBA note and the seller note, you still net over $900,000 in cash after the sale.
This is almost a 400% return on your investment for the year but over a 10x cumulative return…
Now what? Should you reinvest your earnings to repeat the process?
What if instead of selling you purchased a similar size business that compliments this one and rolled them into a single entity?
Companies with higher EBITDA tend to sell for higher multiples. What if you had over $1m in earnings that sold for 4 or 5x?
Using SBA financing really opens up many possibilities and allows you to stretch your cash further than traditional financing.
As we mentioned, obtaining SBA financing can potentially be a challenging process, but not impossible. At the end of the day it will be well worth the effort.
Keep in mind the following are required for all partners that have over 20% ownership.
While it will depend on the lender, most will require a credit score of at least 680 for the primary business owners.
As we mentioned earlier, for changes of ownership this will be at least 10% with the possibility of the lender requiring more.
This will vary by lender but since the SBA is guaranteeing a portion of the loan they don’t need to be 100% collateralized.
The SBA will want to see that you have management and industry experience although it is usually not a deal-breaker. However, credible degrees are normally not enough, they will want to see real-world experience.
Usually, lenders and the SBA will want to see at least two years of operations, three is better. Startups can receive funding but it is much more difficult.
When looking at the history of the business, your lender will want to see stable or growing sales and earnings. If you have recently suffered a drop it may be difficult to obtain financing.
Ability to Repay
This is probably the most important ratio the lender will look at. The business needs to have a debt to earnings ratio of at least 1.25:1 So, the business needs to earn at least $1.25 for every $1 of loan payments it has. You should have a pretty good idea of what your loan payment will be before submitting the application.
Preferred Lender vs. Standard Lender
You should try to work with a preferred lender if possible. They are able to underwrite the loans in-house which helps reduce the time to get your funding. Standard lenders will send your application to a regional SBA office which obviously adds time to the process.
Even if you work with a preferred lender they may still have to send your application to an SBA office if they can’t get it approved in-house.
However, they have the experience to help you through the process faster. Some preferred lenders can close financing in 30-45 days where standard lenders may take 60-90 days.
- Personal financial statement – standard for most loans. Be prepared to list all sources of income, assets, debt payments and other liabilities
- 3 years of personal tax returns – they want to evaluate your own ability to repay, not just the business
- Loan application – will vary by lender
- Borrower information form – this is an informational document the SBA requires
- Pro-forma financials – projections for the business you are acquiring
- Business plan – this isn’t always necessary but is a common request
- P&L for your businesses – if you own other business that will be connected to the new business, plan on submitting these
- Balance sheets – applies the same as P&L’s
- Purchase agreement – terms of the deal
- Tax returns – plan on submitting 3 years of tax returns if available
- 4506-T – this confirms that your return was filed and up to date
- P&L – three years that should match up with the tax returns
- Balance sheet – three years that should match up with the tax returns
- Proof of ownership
- Business licenses
- YTD P&L
- YTD Balance sheet
The bank or SBA may require life insurance on Key Individuals, that is you. You may want to consider getting screened early so they are not waiting for you.
The SBA will also take a first lien on the business assets, should you go into default, they would have the right recoup their losses by liquidating the business assets first followed by any personal assets you put up for collateral.
Purchasing a business does not come without its risks so make sure to only invest what you can afford to lose and most importantly to do your homework on the deal.
In this example the business would have to drop by more than 50% to start affecting the ability to repay.
Hopefully we’ve convinced you of massive benefits to securing an SBA loan despite the rigorous process it requires. Imagine the different ways you can stretch your cash to make it work for you.
Of course, you could always let our team do the heavy lifting for you.
Contact us today to see how we can help.
Whether you are buying and selling a business every three years or making bolt-on acquisitions to build your own private equity empire, Acquira can help you navigate the process
Have you used SBA financing to acquire a business? Let us know how it worked for you in the comments below!