Using the SBA 7(a) Loan in M&A Transactions

By EdgePoint

One of the least understood and used financing sources for M&A transactions is the SBA 7(a) term loan. Because of its maximum loan size of $5mm, it can be used in smaller middle-market transactions, especially individual, management and partner buyouts with companies up to $3mm in EBITDA. This type of loan is made by a bank, and is guaranteed by the SBA up to 75% against any potential losses that the bank may have on a defaulted loan. The SBA rules (also called SOPs) must be strictly followed by banks to be eligible for default reimbursement.

For those transactions that are appropriate and qualify, the terms of the loan structure are very attractive. Banks are allowed to extend up to 10 year terms, on a mortgage amortization basis (level payments) and are capped on the interest they are allowed to charge at prime plus 2.75%. There is supposed to be no minimum collateral requirement, but some banks apply arbitrary collateral standards for the transactions they are willing to enter into. For those banks that follow the SBA guidelines, no minimum collateral is required, which makes these loans especially useful for services, distribution, or high margin businesses, where there would not be a sufficient amount of collateral available to secure the loan amount.

For normal cashflow loans, most lenders that are willing to do an under-collateralized transaction under $3mm in EBITDA would require repayment terms of 3-5 years, and generally recapture excess cashflow to pay back the loan in the shortest amount of time they can. This uses precious cashflow for repayment of senior debt in the first years after a transaction, which generally could have been used more effectively for growth, working capital and any transition issues that may have come up. Instead, the bank requires the accelerated repayment of its loans, and that can stifle the growth of the business. SBA loans generally have 7-10 year repayment terms, with no cashflow recapture, allowing the business to use the cashflow for those more important reasons.

In order to consider whether this loan program is appropriate for any transaction, certain pre-requisites apply. First, this is a personally guaranteed loan, which would prohibit most funded private equity groups from using this loan structure. Individuals or investor groups willing to guarantee the loans are required in order for the bank to make this type of a loan. In fact, any investor that owns 20% or more of the equity post-transaction is required to sign personally jointly and severally for the full amount of the loan. Many buyers misunderstand and believe that they have to have the amount of guaranteed loan available to the bank to collect, which is not true. The bank is required by the SBA to get the guarantees to comply with the loan guarantee program, but it is not necessary to actually have any particular net worth to qualify for the loan.

The second consideration is the type of transaction that is being proposed. There are certain rules that need to be followed according to the SBA SOPs. Some of those rules are below:

• Buyer must purchase 100% of the equity of the selling shareholders or own 100% of the equity after buying assets. Selling shareholders cannot “roll over” equity, or be partially bought out. The buyer needs to purchase the entire business in this transaction.
• No Earnouts – the price must be a fixed price, and cannot have any contingencies to the valuation such as earnouts, royalties, extensive commissions to the sellers, etc.
• The buyer must have functional control over the business after the transaction. If there are investors backing a manager to run the company, the manager cannot generally be fired.
• Certain types of companies and industries are excluded: firearms, multilevel marketing, and other specific industries are not allowed to use the SBA loan programs.

Another consideration for 7(a) loans is the equity contribution. For any loan that is not fully collateralized, and the company has more than $500k of goodwill (which will be most lower middle market transactions), the SBA requires that there be 25% “equity” in the transaction. That equity can be made up of existing equity (partner buyout), cash and/or seller notes that are deferred for two years, with no payments of interest or principal until the third year, and then can be paid as agreed. Most banks will require at least 10% cash or existing equity for acquisition transactions, but the remaining amount can be in the form of a deferred seller note. This gives a great deal of leverage to the buyer with essentially 9x leverage on equity, with 10 year terms for a senior bank loan and seller notes.

The credit test for the banks that follow the SBA guidelines is that the deal must cashflow to a 1.15x fixed charge coverage, meaning that the EBITDA needs to be 1.15x the Principal, Interest, Taxes, and Unfunded Capex, and the SBA considers that to be sufficient cashflow to make the loan. On a 10 year, low interest rate loan, this generally accommodates between 3-4x EBITDA comfortably against this test. Some banks will require higher financial ratio tests, or cap the loans at a senior debt multiple, but generally those caps are still much better than what you would get at a traditional cashflow lender and at lower interest rates.

Some advisors and buyers erroneously believe that the fees are too expensive to make the SBA loan worth it. Loan fees for the SBA are a graduated percentage that goes up to 3% as a loan closing fee that is paid to the SBA. Even on a $5mm loan, with a higher than actual full 3% fee ($150k), the cashflow savings in the first year assuming a 10 year loan term rather than a 5 year term is almost $500k. The interest savings from a lower rate versus a cashflow lender is probably a breakeven in 1-3 years, and easy to justify over the term of the loan. SBA loan fees should be irrelevant when considering this structure as they pay for themselves many times over.

Unfortunately, most small business banker lenders don’t fully understand the SBA rules, especially when it comes to acquisition transactions. Most middle market lenders never use this tool. Further, most banks make additional rules and credit standards which are more limiting than the SBA actual guidelines of the transaction structures they would support. This is partly because if the bank doesn’t follow the SBA SOPs, the government will decline to honor the guarantee, and the bank is facing a large loss that wasn’t anticipated when they made the uncollateralized loan in the first place.

EdgePoint has worked with banks across the country to develop transaction and loan structures that comply with the SBA guidelines and have formed relationships with the banks that do these types of deals. Knowing who to go to, what to ask for, and how to follow the SBA SOP rules have allowed us to close numerous transactions for our clients using this incredibly effective but highly misunderstood financing tool.

© Copyrighted by EdgePoint. Tom Zucker can be reached at 216-342-5858 or at tzucker@edgepoint.com