If you’ve read the previous post introducing SBA 7(a) loans as a potential funding source for buying a business, you may want more details on loan eligibility and application specifics. Consider this post your introductory guide to how the loans work and what it takes—at least at a high level—to get one. As I said in the first post, the application process for SBA loans is neither quick nor easy. So before applying, you need to know what to expect and what factors make an application more likely to be approved, as well as what your other financing options might be outside the SBA universe.
Some Important Things to Know About SBA 7(a) Loans
First and foremost, any business being bought with a Small Business Administration Loan must qualify as, well, a small business. So what does this mean? What qualifies as a small business is based on specific criteria—usually annual receipts or number of employees—that vary by industry (Table of size standards | U.S. Small Business Administration (sba.gov)). Thinking of buying a silver mine? It can have up to 1,500 employees and still qualify as a small business. But a furniture wholesaler will no longer qualify if it surpasses just 100 employees. Most retail businesses are judged by receipts. A seller of fruits and vegetables must bring in no more than $9 million annually to be a small business, while a boat dealership can go all the way up to $40 million! These numbers may seem a bit arbitrary, but this is exactly the type of thing that makes getting an SBA loan a detailed process.
Furthermore, according to the SBA (Terms, conditions, and eligibility | U.S. Small Business Administration (sba.gov)), in order to use a 7(a) loan to buy a business, the borrower must “not be able to obtain the desired credit on reasonable terms from non-federal, non-state, and non-local government sources.” The purchase must also be for the entire business rather than a partial interest. And quite a few types of businesses—including those involved in gambling, speculative activities, or lending—are ineligible for these loans.
As far as business-specific information, among other items, your application for the loan is likely to require financial projections, as well as the usual historical financial statements (7(a) loans | U.S. Small Business Administration (sba.gov)). There must also be an unlimited personal guarantee from each new owner who has a significant stake in the business (usually defined as 20% or more). And even owners with smaller stakes may need to provide a limited guarantee. This means that if the business defaults on the loan, each owner who has made a guarantee will be personally liable for repayment.
Do not take this requirement lightly. It means you could conceivably lose your savings, automobiles and personal property if the deal doesn’t work out the way you expect. Depending on your state, bankruptcy may provide some protection for your primary residence, if it comes to that. To be proactive, some borrowers try to shelter key assets by transferring ownership to family members before making the guarantee.
Though the SBA has no specific minimum personal credit score for applicants, the lender facilitating the loan may impose requirements of their own, and a score of 680 or better typically improves the odds of being approved. SBA 7(a) loans also require a down payment of at least 10%, but there is a loophole. Current rules allow for half of the down payment to be financed by the seller. That means you could in theory put as little as 5% of your own money into the deal. And if you’re a veteran, the SBA’s Veterans Advantage program offers savings on fees (5000-1172 (sba.gov)).
In many acquisitions, the buyer will want the seller to stay with the company in some capacity, and/or include an earn-out arrangement—in which the seller receives future compensation based on the performance of the business. These can make the ownership transition smoother and help align everyone’s incentives with the firm’s continued success. Unfortunately, SBA loans prohibit earn-out arrangements, and the seller must exit the company in conjunction with the buyout. Seller consulting agreements are allowed but cannot last longer than one year.
Advice on Using SBA 7(a) Loans for Acquisitions
Now for my take on SBA 7(a) loans: they have quite a few advantages (as discussed in the prior post), but are not always the optimal source of funds for a deal. Depending on the situation and your financial circumstances, a conventional loan may offer a comparable (or sometimes even lower) interest rate and more appealing terms, without the personal guarantee required for an SBA loan. And while SBA loans can be made in any amount up to $5 million, they may not be worth the trouble to underwrite for less than $50,000.
The bottom line is that you should always explore all the options available to you when buying a business and get quotes from as many different sources as possible before deciding. There is no shortage of funding options out there—friends and family, equity investors, unsecured bank loans, commercial asset-backed financing, seller financing, home equity lines of credit, or even credit cards (though you want to be extremely cautious with the latter two).
Looking at a larger acquisition that may require more than $5 million in debt financing? One thing that should not necessarily dissuade you from an SBA 7(a) loan is the $5 million limit. You can always explore a pari-passu (Latin for “equal footing”) loan, in which your lender pairs the SBA loan with a companion loan under similar terms—though not guaranteed by the SBA—to make up the difference. This could allow you to use an SBA 7(a) loan as partial funding for a business acquisition costing $10 million or more. Overall, if you prepare ahead of time and aren’t rushed, the application process can also be useful in other aspects of the acquisition, from understanding the state of the business to making a pitch to equity investors to aligning on go-forward plans with management.
With all that in mind, if you’re ready to move forward, where do you go for an SBA loan? Hundreds of lenders offer them, but choosing the best one is extremely important—almost as important as choosing the right business to buy. Fortunately, data on SBA loan origination is publicly available, so you can see which banks are active in SBA financing (https://www.sba.gov/partners/lenders/lender-reports). Typically, if a bank is issuing more SBA loans, and in particular if they have experience underwriting businesses and/or financial situations similar to yours, that can be a real plus. Regardless, always shop the loan to different lenders and compare quotes to get a feel for where the market is.
Depending on where you’re starting from, gathering the documents and applying for the loan could easily take up to a month, if not more. Approval and funding can often take an additional 90 days, though many cases will be quicker than this. All in all, SBA 7(a) loans are an extremely helpful source of funds for smaller entrants who may be new to the exciting and potentially lucrative world of private equity. And at ASM we are all for more people finding ways to generate wealth through acquisitions! So if you decide to take the plunge buying a business with an SBA loan, let us know how it goes, and we will continue to share insights for those of you interested.