The Good, The Bad and The Ugly of SBA Financing “Whether Buying, Selling or Refinancing, Here’s What You Should Know”

By: Tony Colson
Tuesday, February 1, 2022

The Small Business Administration (SBA) works with lenders to provide loans to small businesses. The agency doesn’t lend money directly to small business owners. Instead, it sets guidelines for loans made by its partnering lenders, community development organizations, and micro-lending institutions. The SBA claims that they reduce the risk for lenders and make it easier for the lender to access capital. As a result, they say that this makes it easier for small businesses to get loans. While this sounds good in principle, that’s not the result I have experienced.

If SBA 7(a) funding is being used as the financial vehicle, you need to read this. I want to qualify my remarks in this way. I am neither an accountant nor a lawyer nor, do I have an MBA from a top business school. What I do have is over 30 years of experience in this industry as a former CEO, executive, owner, and now, business advisor who has taken the journey and helped many others. I do not claim to be a lending subject matter expert. I do consider myself a very well-informed lay practitioner and if that has value, so be it.

Numerous lenders are making many promises about what they can do to help you buy a business or help with succession planning. Many advertise prominently in the industry journals and publications featuring personalities we’ve come to know well. In general, they are sincere professionals who mean well, certainly want to do business, and have the best intentions. The reality is, buying, selling, or refinancing is anything but easy and certainly doesn’t happen quickly. Anybody who tells you, “I can do this in 90 days” is simply not being straightforward. A more realistic timeline is six to nine months and during that time, you’re going to go thru the equivalent of a financial enema.

You will talk to at least four (4) people for sure, perhaps more. These people are the loan officer you begin with, a financial analyst, an underwriter(s), and a closing specialist. You might even encounter someone called a relationship officer. You’ll submit some of the same documents, multiple times. Don’t be frustrated, but rather be organized! Keep everything in either a literal folder or an electronic one. Print every email, save every form and letter. This journey has a lot of turbulence along the way.

The destination to “cashflow” financing using SBA funding is marked with 515 mind-numbing pages of a Standard Operating Procedure manual (SOP 50 10 6) followed by an Appendix of 72 more pages that were published and became October 1, 2020. For you to navigate this path successfully, you must have the 3 P’s: Patience, Perseverance, and Persistence. The banks have their 3 P’s as well: Provisions, Payment terms, and Process. I have been through this twice in acquiring the businesses I own and have helped other buyers and sellers over the past two years navigate this journey.

First, regardless of the funding source, you need two competent support resources to take this journey. A skilled CPA who is knowledgeable in more than tax preparation and second, an attorney who is skilled in Mergers and Acquisitions (M&A) specifically where SBA funding is to be used. You may remember a movie called “The Blindside” about the life and career of NFL player Michael Oher. The roles that the attorney and accountant play are exactly that, to protect your blindside, and believe me, there can be a lot of unexpected plays coming your way. If you are considering an SBA loan and would appreciate a referral, please call and I will provide two excellent legal counsel.

 Buyer side. 

The SBA provides three types of loans for Buyers. They are the 7(a), 504, and Microloan, each type has its own specific purpose, terms to qualify, and loan terms. The most common for funeral home transactions is the 7(a). The SBA describes the 7(a) as quote – “The SBA’s most common loan program and includes financial help for small businesses with special requirements.”

This is the best option when real estate is part of a business purchase, but it can also be used for:

  •  Short- and long-term working capital
  • Refinance current business debt
  • Purchase furniture, fixtures, and supplies

The maximum loan amount for a 7(a) loan(s) is $5 million. A borrower may not have more than $5.0m outstanding in total SBA loans. Key eligibility factors are based on what the business does to receive its income, its credit history, and where the business operates. The 7(a) also provides maximum leverage and requires only 10% equity in the deal and 90% financing of the rest.

What this means is; If you are buying a funeral home for Three Million ($3.0m) dollars the equity portion is $300,000 and the balance is the amount provided by the bank. A conventional loan would require an equity amount of at least twice this amount to do the deal.

The “cashflow” part of this comes in concerning the sources of equity available to a buyer and the creditworthiness of the business. A Buyer can always provide the entire amount of equity, no problem. Many buyers don’t have three or four hundred thousand dollars laying around to deploy. In the past, the SBA would accept as equity, as much as 25% down in the form of a Seller Note. This is a portion of the purchase price the Seller would accept as owner carry back and paid by the Buyer over time.

The SBA now says, the equity must be 10% minimum, but the Seller note cannot exceed (5%). The Buyer must provide the remainder in cash as a down payment. So, in the $3.0m example, up to $150,000 can be a Seller Note and the other $150,000 must be cash by the Buyer. If the Buyer has and wants to put more Don’t wait – contact us to reserve your vehicle today NOW TAKING ORDERS FOR 2022 MODELS Eagle Cadillac XT5 Kingsley Eagle Cadillac XT5 Echelon 28 Southern Funeral Director Magazine w November/December 2021 than half of the equity down, they certainly can. Most buyers want to optimize the leverage and put as little “out of pocket” cash down as possible.

“Provisions” The 7(a) has many provisions. Too many to speak to in this article but, there is a “Provision” regarding the Seller Note that is dictated by the SBA and you need to understand. It’s called the “Full Standby Provision”. Watch Out for the Full Standby Provision! The Buyer and Seller need to be fully informed about it and understand the implications. Why is this important? Because the Seller must be willing to accept the terms completely or the deal cannot be done. The “Standby Provision” says in lay terms, a Seller cannot accept any interest or principal payments of this note until the banknote has been paid in full. If the bank provides a term for the loan of say, 15 years (common) for the Buyer, the Seller cannot begin accepting any payments until that time has passed. Let’s say your Seller is 68 years old. (common) This means they won’t get a dime until they are 83. That’s a long time to wait for their money.

“Payment Terms”. You are going to hear things like tangible asset ratio, debt service coverage ratio (DSCR), loan to value, and many others. All these affect the rate and term of the loan. An SBA lender makes their money on the margin spread of the loan over the Prime rate. The SBA allows a lender to charge up to 2.75% over the Prime rate at the time of origination as the rate of the loan. Beware, these loans are variable rate loans and will change over time as the Prime Rate changes! Let’s say the Prime Rate is 3.25%. If the lender you have chosen applies the maximum Margin Spread of 2.75% then the beginning rate of your loan is 6.0%.

The spread will not change over the term of the loan. There are only four ways to change that. Negotiate a lower margin rate with the lender at the outset, find a lender with a lower margin spread, ask the lender after the loan is consummated for a modification (slim chance; most wouldn’t do it for their dying mother), or refinance at some point. There are also two types of SBA Lenders. One is a “General Lending Partner”, referred to as GP or a “Preferred Lending Partner” known as PLP. You want to work with a PLP. Ask your lender that question at the outset. Believe me, the implications of this are critical. Know your lender type.

Depending on the value of the real estate, the term of a loan can be as long as twenty-five (25) years, which certainly helps with monthly debt service and cash flow. The higher the value of the real estate as a percentage of the purchase price, the better off you will be as the Buyer. Just know, most loans are constructed using 15 years as the amortization period. If real estate is not included in the asset purchase, the maximum term is 10 years.

“The Process” Your selected bank (SBA Lender) will begin by asking you to complete an application. They will also want to see the signed Letter of Intent (LOI) between you and the other party stating an agreed-upon price and a business plan of how you will manage the business. You will need to be prepared to complete numerous SBA required forms. These include authorizations for Personal Tax return transcripts, Personal Financial Statements, resumes and the biographies of the borrowers, organizing and operational documents, state certification documents including Articles of Incorporation, fictitious name (dba), business entity, EIN number, and business license. This is just the beginning.

Initially, if the lender accepts your application and plan, you will receive a Letter of Intent (LOI). Don’t get too excited. This is simply a statement that says the bank has received your application and plan, finds both credible and intends to work with you to secure financing. In no way does it mean they are committing to financing or approval. The next letter you will receive that gets your heart racing a little faster is a Letter of Commitment (LOC). This is sometimes referred to as a “term sheet”. It usually contains the financial analysis and framework of the proposed deal and terms. (Interest rate, margin quote, maturity date, fees, etc.) It will begin with a statement like this: “I am pleased to provide you with this commitment for a $___________ SBA 7(a) loan. This letter reflects the proposed terms and conditions, subject to United States Small Business Administration (“SBA”) approval and satisfaction of the conditions listed below:” Here is where your contribution of cash typically begins. You must sign the LOC, return with the requested amount by the bank to begin the process and then the fun begins. You’ve just taken off!

At this point, your attorney will be working diligently to create the documents necessary to “paper” the deal. The largest of these documents is called the “Asset Southern Funeral Director Magazine w November/December 2021 29 Purchase Agreement” (APA). This is a very important document because the Buyer and Seller are making “Representations” about the conditions of the business and “Warranties” to be used as remedies in the event these representations are inaccurate. Many people ask, “How much are legal fees?” I advise that counsel for the Buyer will generally spend between 100-125 hours of work. Multiply that by the hourly rate of the attorney you retain, and you can forecast your legal expenses to do the deal.

Some lenders allow for the dynamic give and take of negotiation with the Seller and allow the development of the APA right up to almost the date of closing. Others insist, this document must be completed and signed by both parties before they will begin underwriting. Ask your lender this question at the outset. Another part of the process is Due Diligence and Third-Party reports. Specifically, every lender requires that five (5) reports be completed by independent sources that the bank will select but you will pay for. These reports are: 1) MAI Certified Real Estate Appraisal, 2) Business Valuation, 3) ALTA land survey, 4) Phase I environmental report, and 5) Title search. In general, the costs for each of these range between $1,500 to $3,500. If you are buying a business with multiple locations, these will vary. The estimates above are for a single location entity. In total, be prepared to pay between $12 – 20K for these reports. These generally take 4-6 weeks to complete.

There are also SBA Guaranty fees which are calculated as a percentage of the purchase price and covered in the financing. Make no mistake though, you the Buyer pay them. I can go on and on about Buyer expectations and requirements, but these are most of the impediments to know about and navigate.

Seller Side

In general, the Seller is along for the ride. Arriving at a fair market price for the business is critical. Having a Business Valuation Opinion/Estimate before offering the business is a wise investment. Knowing this number before discussing. One of the things many brokers and/or buyers will want at the outset is a unanimous Shareholder resolution signed by the Board members and shareholders stating all agree to sell the business. The seller should also carefully consider what they want as life after the deal. One thing you should understand is the Seller cannot remain as an employee of the business. The SBA prohibits it! A buyer and seller may come to a consulting agreement for specific services but, the buyer is now the owner and ultimately responsible.

The seller needs to consider whether they want an allcash closing or willing to carry a portion of the financing in a seller note and the implications of that. If all cash closing is your desire, you’re talking about the national/regional consolidators; you know their names. Know that if SBA funding is the selected source of the Buyer, there is no quick timeline here and the requests for documents by the bank affect both parties. Your list of requested documents will be voluminous as well. Ultimately, the total timeline to complete the deal will depend a great amount on the preparation, organization, and diligence of the respective parties and their representation.

The Seller needs a competent and practiced attorney who will review all the documents submitted by Buyer counsel and negotiate the language to protect your interests. In most transactions, the counsel for the buyer will have the power of the pen in creating the original draft of documents. In general, expect half to two-thirds of the buyer’s legal hours. An estimate of 50 to 80 hours at the rate of the attorney you retain is reasonable and you can forecast your legal fees to do this deal.

There is more to know for sure, but this addresses most of the journey for the Seller. As the Buyer, the APA is the most critical document to both parties and critically important to understand what you are agreeing to.

Refinancing

When I purchased my funeral home in 2014, some of the current 7(a) rules were not in place. The biggest difference was in the Standby Provision. At that time, the SBA only required a two (2) Year Stand-By before the Seller could begin receiving payments. In my case, the seller accepted a note. The note payments were based on a fixed rate of interest amortized over 15 years but had a balloon to pay the balance at the end of 72 months. This was a common capital structure and has/had been used as a tool of the deal for years.

The assumption at the time we purchased was that after six (6) years, the balance of the banknote, and the seller note would be sufficiently reduced such that I could refinance and consolidate the two balances into one new bank loan. From a financial perspective, typically, the math works well and is advantageous for everyone. However, as a result of the January 1, 2018 revisions to the SOP, a pervasive misconception arose among lenders. This is important for you to know the truth and accurate facts of the matter! If you ask virtually any SBA lender about refinancing an existing SBA loan with a new SBA loan, they will tell you they cannot. They claim to be prohibited by the 2018 SOP rules. This is inaccurate! I know because I just did it! It took two years, working with two different lenders and hearing all the reasons and enduring gut-wrenching delays. The crazy thing is, they will also tell you at the outset, “we’ll figure it out, there are things we can do, there are exceptions, etc.” Then, after 6 months into the process you’ll wake up to a cold and harsh email from somebody you probably haven’t met yet, that is explaining, “I regret to inform you that SBA rules prohibit us from proceeding with your loan.” After the second time around of this nonsense, I finally got to the truth of the matter by engaging the help of my local SBA District Office in Indianapolis.

The fact is, you can absolutely refinance an existing SBA loan or even do a consolidation but some qualifying criteria must be met. The first is, you must ask your existing lender to do it. Whether rates go down and you simply want to take advantage of a lower rate (driven by prime, margin spread, or both) or you need to consolidate and pay off a Seller, you first must make a request of the current lender. Most won’t and will issue you a Letter of Decline. This letter is the first requirement for the exception.

Second, you then must select an alternative SBA Lender. Remember, you want to work with a Preferred Lending Partner (PLP) bank. This is especially critical now. Once you select the lender, submit the Decline Letter. They will ask you for most (if not all) of the financial disclosures to begin the evaluation process. Therefore, keeping a copy of everything is critical. The second exception requirement says the savings in monthly debt service must be equal to or greater than a 10% improvement over the current loan(s). If these two criteria are satisfied, the Lender absolutely can do it.

This is not to be mistaken for underwriting. The underwriting process will be very similar to that of a Buyer. It is long, arduous, and will test your patience. The benefit is worth it though, especially if you must satisfy a seller’s obligation.

The journey is a long one and has many bumps and turbulent air. If you have the right navigator and co-pilot though, you can get thru it. I am always available to discuss further the process and my services as a business advisor with anyone considering buying, selling, or refinancing. Good luck and get a healthy amount of commercial courage before embarking! 

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