If you’re looking to sell your business in the not-too-distant future, there’s one under-discussed advantage you can build right now: Your understanding of SBA-7A loans.
You might think your buyer’s financing situation is their problem – and this is true to a certain extent – but understanding the buyer financing process is a useful tool for creating the best possible deal for you as an owner. And if you can help a potential buyer get financed it means you can facilitate a better deal for everyone involved.
In this article I’ll explain:
- How SBA-7A loans work
- What you as an owner can do to make your business more financeable
- How you can steer your potential buyers toward a good lender
First a quick primer on SBA-7A loans (and why you as an owner should care):
There were over $5 billion of SBA-7A loans issued in 2023 to buy existing small businesses.
The Small Business Administration is a government agency that helps business owners and aspiring entrepreneurs gain access to capital. The SBA does not directly lend money.
Instead, they set criteria for loans to be underwritten – then they guarantee a large portion of these loans – which are provided by their lending partners (banks, credit unions, etc).
If a borrower defaults on their SBA loan the SBA provides a backstop and helps make the lender “whole” for a good portion of the loan. In exchange, the buyer pays an “SBA guarantee fee” – similar to an insurance premium – at the front end of the loan.
This “federally guaranteed” framework allows banks to give financing on deals which otherwise have minimal collateral. Most service businesses are “Asset Light” and their value is based more on profitability rather than if their equipment was sold for cash.
SBA-7A loans allow business buyers to recognize this and still get financed to purchase cash-flowing businesses with minimal (0 to 20%) down payments.
Even better, SBA-7A loans can be used to fund “goodwill” transactions.
A “goodwill” deal is when the bank lends money based on confidence that the future profits of the business being bought will be sufficient to pay off the SBA loan regardless of whether or not the assets could be sold to recoup the loan’s value.
Since most loan options require substantial collateral, the willingness to finance “goodwill” deals is a key advantage of the SBA-7A program.
Here are 3 ways you as an owner can work with an SBA-7A lender on the front end in order to help create a “no brainer” deal for potential buyers of your business:
1. Business Prequalification: The Golden Ticket to Marketing Your Biz
When your business is listed for sale, your broker or M&A advisor will prepare what is known as a Confidential Information Memorandum (CIM). This is a summary of key info that buyers need to evaluate the merits of buying your business.
And one piece of information that can improve the appeal of your business is “prequalifying” it with SBA-7A lenders.
This means lenders will prescreen your business and let a “qualified buyer” (more on this later) know that if they want to acquire your business the lender is open to financing the deal via an SBA-7A loan.
The CIM can also include:
- Indicative down payment (ideally 10% cash)
- Loan duration (often 10 years)
- Estimated interest rates
A CIM with an SBA-7A prequalification signals to your buyer that the deal is worth spending time investigating – and that a bank has reviewed your business and found it to be financeable.
Now gathering this information up into one report is useful…
But the biggest “lever” you can pull in this process has to do with which lender you seek prequalification from as this is who buyers will be steered toward.
And all lenders are not created equal.
Different lenders are not equally likely to finance a deal – or to offer favorable terms.
You want to steer buyers toward a lender with the appetite for financing your specific business.
This is why someone like me will have regular conversations with lenders to understand their specific criteria and industry preferences.
This way we can play “matchmaker” – and help pre–qualify your business with the right lender.
So what does the “right” lender look like? The SBA has two classifications of lenders: Preferred Lender Program (PLP) and General Program (GP) lenders.
A Preferred Lender does not have to submit the entire loan finance request to the SBA for approval – PLP have the authority to green light deals in-house. This can shave weeks off the sales process.
A General Program lender on the other hand does have to submit the entire loan request directly to the SBA for approval. This creates another step for something to go wrong.
Working with a PLP will accelerate the timeline of the overall deal and likely speeds up the process to receive funds for the purchase of your business.
On top of that different SBA lenders have different views of different industries.
One lender may be more open to doing a deal than another.
One lender may be more open to a smaller down payment. You want to work with lenders who will offer your buyer the best terms possible.
This is why you need to prequalify with a lender who is suited to your specific business.
Even a qualified buyer is unlikely to understand all these nuances and you can save a lot of time and headache by steering them in the right direction. Then if a buyer suggests using their local bank you can explain why your business was prequalified with a specific PLP lender.
But there’s an even more compelling reason to prequalify: A proactive lender can clue you in to “red flags” that could prevent your business from being financeable at all.
The earlier you spot the red flags the faster you can fix them.
If there is bad news it’s best to get it early rather than spend a lot of time and energy marketing a business for sale that is unfinanceable.
One last point: In order for prequalification to work for your business your tax returns need to be accurate.
If you’ve significantly underreported your income lenders will only value your business (and approve a buyer’s loan) based on what was reported.
2. Debt Service Coverage Ratio (DSCR): The Valuation Gut Check
DSCR is the most important thing a lender will assess and understanding this concept comes down to one question:
Is the cash flow inside your business enough to pay the loan debt and cover the buyer’s lifestyle? This gives the lender an automatic “sanity check” to the listing price of your business.
As a rule of thumb, lenders like to see at least 1.25 DSCR. This means the business cash flows are enough to cover 125% of the debt payments. A DSCR of .95 means cash flow will only cover 95% of the debt payments. Not good.
Now in volatile industries lenders will want a DSCR that is higher.
One example would be the restaurant industry: Running a profitable restaurant is heavily dependent on the economy and a lender might like to see a higher DSCR in order to finance a deal in the restaurant biz.
The opposite of this would be a plumbing business with a lot of government contracts where cash flow is far less dependent on outside factors and so a lower DSCR would be acceptable.
The DSCR is a safety net for the bank – they don’t want the buyer to be financially ruined and unable to pay back their loan with a slight downturn in business. Again all lenders are different.
One lender might require a significantly higher DSCR than another. If you’re working with a reputable advisor the DSCR shouldn’t come into play – we will be stress testing our valuation against our lenders’ DSCR requirements. (If your advisor is not doing this you have bigger problems.)
Otherwise a good starting point is to communicate with lenders who prequalify your business, get a feel for the DSCR they’re looking for, and communicate these expectations with your potential buyer.
3. Evaluate Buyer’s Qualifications: Do they even make the cut?
A lender can also prequalify a potential buyer. The lender will vet buyers based on their criteria:
- Credit (+700)
- Resume (any related experience?)
- Cash for down payment on hand?
- Enough cash flow to meet the buyer’s salary requirements?
When it comes to salary requirements the lender will look at the buyer’s credit report to understand what financial obligations they have: car payment, house, etc. This way the lender makes sure your business has enough profit for the buyer to pay their other obligations on top of the SBA-7A loan. If the lender isn’t comfortable you should have second thoughts on moving forward with that buyer.
Before you accept a seller’s offer it’s wise to have them prequalify with a lender if they are planning to use an SBA-7A loan. This way you don’t turn away other potential buyers and go into an exclusivity period with a buyer who can’t qualify for a loan anyway.
Understanding and leveraging the SBA-7A loan program can be a game-changer in the sale of your business.
It not only elevates your business’s appeal but also streamlines the financing process for potential buyers smoothing out potential bumps along the road to closing. And the straighter and smoother the path to a closed sale the faster you’ll have money in your pocket.
By prequalifying your business, getting in with the right lenders, and vetting out high-quality buyers you set the stage for a smooth deal – and avoid dragging out the sale process or having to put out unnecessary fires along the way.
If you’re thinking about selling your business within the next 1 or 2 years feel free to shoot me an email with any questions or concerns – sean@tws-advisory.com
And if you’re ready to start the process of selling your business but need some clarity on the best path forward book a call with me here: Calendly Link