Imagine buying your newly-licensed, 16-year old daughter her first car. When you go to the dealer and pick out that car, there’s a decent chance that you will simply pay the full price right then and there and drive off in the “new” car. An all-cash deal; no muss, no fuss.
Unlike with a used car, when you are buying or selling a business, one thing is certain: The sale price will be financed in some way. It is highly unlikely that a buyer will be able to provide the full price up front.
If a seller is unwilling to “hold paper” on (i.e. finance) a portion of the price, it will drive the price down. This means that—just like with the type of sale —the terms of the sale are likely to determine the overall price that you will receive or pay for a business.
Understanding what avenues are available to finance the purchase price of a business will enable you to negotiate and allocate the purchase price more effectively.
To that end, I spoke with Joanne Jolin, Vice President of Government Guaranteed Lending at Customers Bank and a Small Business Association (SBA) loan specialist, to get her advice on an attractive way to finance the sale or purchase of a business.
Pay close attention to:
- Who guarantees an SBA loan
- Why lending to certain businesses is a safe bet
- What the maximum loan amount is
- How your business can get “lender pre-qualified”
Enjoy!
What is an SBA loan?
Ed Alexander: Alright, Joanne, let’s jump right in! So, does the Small Business Administration (SBA) itself make loans?
Joanne Jolin: The SBA directly does not make loans to businesses. The lenders, like my bank, use the SBA programs to lend. The way they are able to do that is with the government guarantee.
Depending on the size of the loan, they can guarantee up to 85% for loans up to $150,000. For larger loans, like the 7a program, the guarantee is 75%.
7a Loan Program
Ed Alexander: What is the 7a program and are there limits on a 7a loan?
Joanne Jolin: A 7a loan is for virtually any loan purpose—working capital, buying a business, starting a business, equipment, even real estate. So, look at it as an all-encompassing loan.
We will guarantee 75% of up to $5 million, and you can have multiple SBA loans. I’ve had clients come to me for financing because they’re opening up a franchise. So, they open the first location, but they only needed, let’s say, a $700,000 loan. Then, three years down the road, they want to open their second location, and they’ve got plenty of guarantee left to get an additional $700,000 loan.
Ed Alexander: I see. So, the SBA will guarantee up to 75% of $5 million worth of loans on the 7a program?
If I get a $1 million loan, it’s going to be 75% SBA guaranteed, so there’s $750,000. Then I could get additional loans after that until I cap out on the 7a program, right?
Joanne Jolin: Yes, that’s right. It’s a great way to grow your business or to finance the purchase of a business.
Pre-qualified Business
Ed Alexander: I’ve seen listings that say that a business is “SBA pre-qualified.” What does that mean exactly?
Joanne Jolin: Well, they shouldn’t be saying “SBA pre-qualified.” The SBA does not like that. They should say “lender pre-qualified.”
That means a lender looked at the business, and they recognize that they can finance that business for a qualified buyer. Most SBA lenders like to do that. Knowing beforehand that the business is healthy enough to be financed really helps the broker and the seller find a qualified buyer.
Ed Alexander: When you examine a business for that pre-qualification process, what are you looking at?
Joanne Jolin: I like to get the business listing from the broker, because it breaks out all of the assets that are being sold. That helps determine the length of the loan. If there’s real estate involved, we can go up to 25 years. If there’s no real estate, we’re looking at 10 years.
We also look at a three-year range of tax returns from the business, as well as interim year-to-date statements. This way we can run the numbers based on the asking price to make sure it qualifies for that amount and the debt service coverage ratios are adequate.
Ed Alexander: Would you mind briefly explaining debt service coverage?
Joanne Jolin: Debt service coverage ratio is a marker that we look at to see how much cash is available to cover the loan used to buy the business. The business being sold usually has little or no debt. So, obviously it’s able to survive. But when a broker comes up with an asking price we need to make sure that the business can carry this new debt and still provide a good income for the buyer. And, because we’re in a rising rate market, we also do a stress test. If interest rates go up by 2%, we want to be sure the business can still carry the debt. That’s good, prudent lending to make sure it can carry that.
Ed Alexander: You mentioned providing tax returns from the business. Business owners have the ability to exercise discretion over some of the expenses of the business. The example I always give is if the business needs a pickup truck, you can buy a regular F-150 or you could buy a fully-loaded F-150. The difference isn’t material to the business, but the owner gets the benefit of driving a truck with heated seats and Bluetooth capabilities. Is the lender going to make that kind of distinction, or is it just looking straight at those tax returns?
Joanne Jolin: We look at the typical add backs first, which are interest expense, depreciation and amortization, and a seller salary. Then we will look at what the new buyer needs for a salary. We have a list that we will consider adding back if it can be documented and shown that it’s on the tax return. For example, sometimes family members are drawing a salary, and they don’t even work there. So, as long as they can show us the W-2, we can add that salary back into net income.
I have a saying. You can’t get paid twice. If you’re taking money out of the till, you know, we can’t add it back, so you’ve hurt your ability to sell the business based on a higher profit.
But it’s got to be easily documented. Things that we won’t typically add back are cell phones and health insurance, because you know what, the new buyers are going to have those things, too. Now, I have seen instances where the owner has her personal car listed, but it’s not really needed for the business. If the owners can show proof that it’s coming out of the business, we can add that back into net income.
Ed Alexander: What happens with cash taken “out of the till”? Meaning, income that just wasn’t reported.
Joanne Jolin: I have a saying. You can’t get paid twice. If you’re taking money out of the till, you know, we can’t add it back, so you’ve hurt your ability to sell the business based on a higher profit.
Lender pre-qualified pricing
Ed Alexander: I’ve often heard of brokers justifying the asking price based on the business being “SBA pre-qualified” or rather “lender pre-qualified.” Do you have any thoughts on that issue? For example, they might say, “The offering price of $500,000 must be a valid price, because we got a lender pre-approval.” Does a lender go through and do an analysis in the same way that a buyer should go through on the pricing of a business?
Joanne Jolin: We look at it from a cash flow standpoint. The business has got to cash flow that debt. So, obviously that’s one of the markers that anybody that’s doing an evaluation is going to look at. Usually, we have an internal evaluation that we put it through. We plug in their information and determine what it’s really worth based on that information. But on loans $350,000 and up, we still require a third-party evaluation.
Ed Alexander: Are you looking for a full-blown, 100% evaluation that analyzes the economic circumstances, the industry that they’re in, and all of those types of things?
Joanne Jolin: Yes. We get the full-blown analysis. They talk with the seller and really get to understand that business. So, it should provide some comfort to the buyer.
Are all lenders the same?
Joanne Jolin: Ed, if I may add an observation of my own that will hopefully be useful. One of the questions I hear a lot is: Are all SBA lenders the same?
The SBA is out there encouraging more and more banks to get involved because of the guarantee. It does really help them, and it helps the community to grow when new businesses open or businesses transition. Now that we’ve come through the big market dive of 2008–2012, there are more and more baby boomers retiring and selling their businesses.
Small businesses are 90% of our economy, and the transition of those businesses needs to happen to buyers. The SBA lenders use the programs to help get those businesses transitioned. They work with an SBA program, but they also have their internal credit criteria.
So, my short answer is that my bank is going to be different than every other bank out there. Everybody’s different in what their appetite is. But even if it’s somebody that I can’t work with, we encourage that borrower to talk to someone else. We actually will put that person in touch with a lender who has an appetite for that type of loan.
Ed Alexander: So, if they have a law practice, you’ll know who is going to be financing the sale of law practices regularly and who understands that business?
Joanne Jolin: Yes. And actually, at my bank for example, we like attorneys. We will provide 100% financing for attorneys and some other professionals.
Business plans and projections from buyers
Ed Alexander: Changing tacks a little bit. When a buyer submits an application, do you require a business plan and business projections in connection with the application?
Joanne Jolin: Yes, in three circumstances. If it’s a startup, we must have a business plan and projections—three-year minimum, the first two years need to be on a month-to-month basis. If it’s a business acquisition, SBA requires that as well, because they consider that almost like a startup, because a new owner is taking it over. Also, if a business is expanding we’ll need a business plan to show how they’re going to transition and handle additional locations.
Ed Alexander: Now, business plan means different things to different people. What generally are you looking for in a good business plan for an acquisition in particular?
Joanne Jolin: It’s funny, everybody always asks that. Less is more, is how we like it. I don’t want a 50-page business plan with a lot of fluff in it. I want the borrower to tell me what they need, who’s involved in the business, their equity injection, where their money is coming from, and what is it being used for. It’s kind of like the who, what, when, where, and why.
Ed Alexander: How about the financial projections? What level of detail are you looking for there?
Joanne Jolin: It needs to be detailed enough that we know how the money is being spent and how they see the revenues coming in. It needs to be pretty detailed. And assumptions? We’re really talking about a good cash flow statement.
Ed Alexander: That’s an area where I think people end up stumbling. So, what can a borrower do to make sure their loan is approved?
Joanne Jolin: Okay. The biggest thing to do in my opinion is they need to really understand their business. And they need to have some kind of background into what they’re going in to. That’s critical. We like to see a minimal of two years’ experience in whatever they’re looking to do.
Evaluations of hard assets vs soft assets
Ed Alexander: Most businesses today are not hard asset heavy. We have a lot of services businesses, we have a lot of software, and that is all intellectual property, intangible property, goodwill, etc. So, is there a difference in the way that your bank evaluates a business that has a significant amount of goodwill rather than hard assets?
Joanne Jolin: We’re going to analyze that industry and the cash flow. I personally like service industry businesses. They do well. The goodwill portion is really what lenders look at. That’s where their exposure is, even with the guarantee. Our appetite for those goodwill business loans is around $1.5 million. I’ve actually had larger loans approved with that amount of goodwill: $1.6 million, even $2 million!
Ed Alexander: For an attorney, whose practice is going to consist largely of those intangibles like goodwill, that’s very important. So, even if you’re buying a $2 million practice and there’s $500,000 of hard assets and $1.5 million of goodwill, you would still be able to do that loan?
Joanne Jolin: Absolutely. Yes.
Helping Business Owners Make Smarter Legal Decisions
Here at Alexander Abramson, we focus exclusively on business-related legal matters. Our attorneys have advised closely held businesses and business owners on everything from raising equity capital, to buying or selling a business, to partnership arrangements.
Ed Alexander is also a Florida licensed business broker and a shareholder of FitzGibbon Alexander, Inc., a Central Florida consulting, business valuation, and business brokerage firm.
We would love to speak with you directly about how we can help you sell your business. Call us 407-649-7777 or email a team member directly set up an initial consultation.
