January 13, 2023
Adam Hoeksema
A Small Business Administration (SBA) loan is one of the most common ways to finance buying a business. In 2018 the SBA changed some of the rules related to using an SBA loan for an acquisition that made it more attractive than ever to use SBA financing to buy a business. Under the new rules (here is the 427 page SBA SOP if you need some light reading), a buyer can use an SBA loan to finance 90% of the purchase price of the business.
The remaining 10% should be equity in the deal, BUT here is the kicker, the new rules allow for a seller note to make up half of the equity in the deal. So this means that a buyer could buy a business for 5% down, 5% as a seller note and 90% as an SBA loan.
Now most buyers will probably want to put down the minimum 5% equity injection and most sellers will want to have the smallest seller note possible that can still get the deal done. BUT keep in mind that the SBA lender might not be willing to finance 90% of the purchase price. Just because this 90%, 5%, 5% structure is possible doesn’t mean it is possible for your particular deal.
In this article I want to talk through some different scenarios for you to consider as you try to structure the financing of a business acquisition and how the SBA and a seller financing can work together in these various scenarios. Here are the different scenarios I plan to walk through:
Seller Notes on Full Standby
- Standard - SBA Loan 90%, Seller Note on Full Standby 5%, Buyer Equity Injection 5%
- No Seller Note - SBA Loan 90%, Buyer Equity Injection 10%
- Business Appraisal Too Low - SBA Loan < 90%, Seller Note on Full Standby > 5%, Buyer Equity Injection 5%
- Lack of Collateral - SBA Loan < 90%, Seller Note on Full Standby > 5%, Buyer Equity Injection 5%
- Business doesn’t Cash Flow - SBA Loan < 90%, Seller Note on Full Standby > 5%, Buyer Equity Injection 5%
- Buyer Lacks Financial Strength - SBA Loan < 90%, Seller Note on Full Standby 5%, Buyer Equity Injection > 5%
Seller Note NOT on Full Standby
- Seller note amortization matches bank note amortization - typically 10 years
- Seller note interest only payments for up to 3 years then fully amortizing over remainder of 10 years
- Seller note has no payments for X years then fully amortized over the remainder of 10 years.
- Seller note interest only over X years then a balloon payment (financed by bank)
- Any other combination that the buyer, seller, and lender can all agree on.
Before I dive into the nuances of these different deal structures and the reasons that you might structure a deal a certain way, I wanted to address why does finding the right deal structure matter when you are trying to buy (or sell) a business?
Let’s say you are a searcher trying to buy a business through a search fund, you will likely look at many, many businesses during your search and probably pass on many businesses because the price isn’t right. You will probably also try to buy several businesses and lose to the competition because your offer was not the best offer. So when you are in a competitive search process you need to have the best offer possible which means you need the best financing structure possible.
That means that you may need to get creative.
The “standard” 90/5/5 SBA loan, owner equity and seller note structure might not be the best offer that works for the buyer, seller and bank, so if you want to close the deal, you might need to consider other scenarios.
Before I dive into the various SBA loan and seller financing structures I need to define a couple of important terms.
What is a Seller Note?
A seller note, in the context of a business acquisition, is when the seller of the business agrees to receive a portion of the sale proceeds over time through a series of payments. Commonly a seller note is used in conjunction with an SBA loan. For example, if you are buying a business for $1,000,000, you might get an SBA loan for $900,000, invest $50,000 of your own savings, and use a seller not for the final $50,000. In this scenario the seller would receive $950,000 on the day of the sale, and would receive the remaining $50,000 from the seller note over a period of time. There are many possible payment structures on a seller note, but one of the most common structures is to have the seller not on “full standby” to the bank loan.
What is a Seller Note on Full Standby?
A seller note on full standby means that the seller will not receive any payments until the bank is repaid in full. Using the example above with a $900,000 SBA loan, the entire SBA loan would need to be repaid before the seller could receive any of the final $50,000 from the seller note. Commonly an SBA loan used for an acquisition has a 10 year term which means the seller would be waiting 10 years to start receiving payments in this scenario.
Lenders might not always require a seller note to be on full standby, it really depends on the details of the deal. As I walk through the following scenarios and structures you will get to see situations where seller financing will be on full standby and situations where there might be more flexibility.
Seller Note Example
An example of a seller note structure is for the note to accrue interest for 10 years with no payments until the SBA acquisition loan is fully repaid, then the seller note might fully amortize in the following 5 years so that the seller note would be fully repaid in 15 years.
You can find some example Seller Note Clauses.
SBA Loan Structures for Business Acquisitions
Now we are going to walk through many of the most common structures for using SBA loans and seller financing to buy a small business. This is not an exhaustive list and you will see that depending on the situation you can get pretty creative, but these are scenarios that you can consider as you try to come up with a winning deal structure for the buyer, seller and bank.
I also found this article helpful: Best Practices: Seller Notes and Standby Agreements
SBA Loan Scenarios with Seller Note on Full Standby
I am going to start by looking at scenarios and structures for SBA loans where a seller note is on full standby. The SBA recently updated their seller note rules which we cover in detail in this video:
Standard SBA Loan and Seller Note for Buying a Business
In this scenario the source of funds for the acquisition of the business would be:
- 90% SBA Loan
- 5% Seller Note
- 5% Buyer Equity Injection
I am calling this first structure the standard because this is probably the default structure that each deal starts with and then based on the specific details of the deal you might make adjustments from this standard structure.
This is likely the scenario you would end up with under the following circumstances:
- Business has sufficient cash flow measured by a debt service coverage ratio of at least 1.25
- Loan has sufficient collateral, enough to consider the loan fully collateralized
- Buyer has a good credit history and a healthy cash reserve
Also, this structure is probably most common when the deal is solid, but not the best deal you have ever seen from the lender’s perspective. If the deal is too strong, then banks might start competing for the deal and find creative ways to make the deal more favorable to the buyer and/or seller in order to win the deal.
SBA Loan with no Seller Financing
In this scenario the source of funds for the acquisition of the business would be:
- 90% SBA Loan
- 10% Buyer Equity Injection
I know I am supposed to be talking about seller note structures, but I did just want to mention that not all deals will have seller financing. If there are multiple buyers bidding for the same business, the seller may not be interested in accepting an offer that includes a seller note, especially if the note is going to be on full standby.
SBA Loan and Seller Note Structure when Business Appraisal is Lower than Purchase Price
In this scenario the source of funds for the acquisition of the business would be:
- Less than 90% SBA Loan
- Greater than 5% Seller Note on Full Standby
- Greater than 5% Buyer Equity Injection
When the business is appraised for less than the purchase price, the lender is not going to want to finance more than what the business appraises for. Similar to a home mortgage loan, the amount of the mortgage loan you can qualify for is a percentage of the appraised value of the home. So when you have a business that you want to buy for $1,100,000, but it appraises for $1,000,000, you can expect the lender to only lend up to 90% of the appraised value. That means the buyer and seller will need to come up with the remaining $200,000 in this scenario. Whether the buyer or the seller fills that gap with a larger seller note or a larger equity injection really depends on who has the most leverage in the deal. If there are multiple offers on the table for the business, then the buyer will probably have to fill the gap. If this is the only offer on the table, then the seller will probably fill the gap with a larger seller note.
SBA Loan and Seller Note Structure when Loan is not Fully Collateralized
In this scenario the source of funds for the acquisition of the business would be:
- Less than 90% SBA Loan
- Greater than 5% Seller Note on Full Standby
- Greater than 5% Buyer Equity Injection
Similar to the above scenario where the business doesn’t appraise, if there is a lack of collateral, you can also expect the SBA loan to be less than 90% of the purchase price and the buyer or seller will need to fill the gap.
SBA Loan and Seller Note Structure when Business doesn’t Cash Flow
In this scenario the source of funds for the acquisition of the business would be:
- Less than 90% SBA Loan
- Greater than 5% Seller Note on Full Standby
- Greater than 5% Buyer Equity Injection
Another reason that the SBA loan might be less than the maximum of 90% is that the business doesn’t cash flow. What does this mean? It means that based on historical financial data, plus the new proposed debt financing, the business is not able to reach a debt service coverage ratio of 1.25. This is a measure that is commonly used to determine whether a business can comfortably service its debts. If the business struggles to cash flow the proposed SBA loan, then ways to improve cash flow would be to increase the amount of the seller note and put it on full standby so that the business doesn’t have to make any payments to the seller until the bank loan is repaid in full. Learn more about SBA Cash Flow Requirements
Typically, the bank is going to look at the historical financials (tax returns) of the business and apply the new SBA loan to those financials and then calculate what the debt service coverage ratio would be.
In some situations the buyer might be able to convince the lender to measure debt service coverage ratio based on projections. Using our Acquisition Financial Projection Template you could enter in the company’s historical financials and then create a forecast based on the changes you expect to make to the business. For example, let’s say that the business you are acquiring pays $50,000 per year in rent, but after you acquire the business you plan to move the business into a building that you already own which will save $50,000 per year. That might be the extra cash flow you need to meet a 1.25 DSCR and you might be able to convince your lender to use your projections instead of historicals.
SBA Loan and Seller Financing Structure when Buyer Lacks Financial Strength
In this scenario the source of funds for the acquisition of the business would be:
- Less than 90% SBA Loan
- 5% Seller Note on Full Standby
- Greater than 5% Buyer Equity Injection
When the buyer has less than ideal credit history, less than ideal cash reserves, collateral or net worth, the lender may not approve a loan worth 90% of the purchase price, but the seller may also not want to fill the gap in this situation since it is the buyer’s lack of financial strength that is creating the gap. That means the buyer is probably going to have to fill the entire gap with additional equity invested in the deal.
SBA Loan Structures with Seller Note Not on Full Standby
Now there are some situations where you can get an SBA loan without the need to put the seller financing on full standby. The key question is whether any of the seller financing was being counted toward the 10% equity injection requirement. If for example, the buyer injects the full 10% of the equity required in the deal, then there could still be a separate seller note and that seller not may not need to be on full standby.
For example, let’s say that the lender is going to finance $800,000, the buyer invests $100,000 of equity and the seller provides a $100,000 seller note. Since the buyer is putting in 10% of the million purchase price, the seller not would not need to count toward equity. So now we can get more creative with how the seller not is repaid. Here are some possible structures for seller notes that are not on full standby.
Seller note amortization matches bank note amortization - typically 10 years
Assuming that the business can cash flow both the bank loan and the seller note at the same time, then you could match the seller not amortization with the bank note amortization which is typically 10 years.
Seller note interest only payments for up to 3 years then fully amortizing over remainder of 10 years
If cash flow is tighter in the first few years post acquisition you may be able to structure interest only payments for the first few years and then fully amortize the loan over the remaining term of the bank note.
Seller note has no payments for X years then fully amortized over the remainder of 10 years.
Similar to the last option, but you could structure it so that the seller note has no payments initially and just accrues interest and then is fully repaid of the remaining period.
Seller note amortization over 10 years with a balloon payment at year 5
Sometimes a lender is willing to pay off the seller note early, so what you might do is structure the seller financing to be repaid over a 10 year term, but after 5 years or some other time period you could work with the bank lender to provide a lump sum to just pay off the seller note with a balloon payment. Lenders would be willing to do this if the business is performing well. Lenders want to make loans to good businesses, so just as one lender might refinance another bank’s debt, they would also refinance a seller note if things are performing well, and assuming the seller note is not required to be on full standby by the SBA.
Any other combination that the buyer, seller, and lender can all agree on
Finally, there are endless combinations of potential structures that might work if the business appraises well enough, cash flows well enough, has sufficient collateral and has strong borrowers. It can be a fun exercise to take our Acquisition financial model and just play around with lots of different scenarios to see what structure might work best for everyone and hopefully allow you to win the deal.
If you have any questions about how to enter a specific scenario into one of our financial forecast spreadsheets just reach out and we can help!
