Note: This article was originally posted in the Wisconsin Business Law Blog.
Small-business owners looking to sell their business in the near future need to be prepared for the complexities that will arise during the exit process. One complexity is the tangled web that comes with the buyer of the business obtaining a loan backed by the Small Business Administration (SBA) 7(a) program.
Buyers of businesses are using the SBA 7(a) program in business acquisitions more and more frequently. The terms of the SBA financing package are favorable to buyers compared to conventional financing, and due to a change in the SBA’s rules in early 2018, more buyers are eligible for SBA financing because the down payment requirement minimum is now only 10 percent of the loan cost. Because the SBA is a federal government program backed by federal dollars, there are necessarily many rules and regulations that affect a buyer’s eligibility for SBA backing as well as each individual lender’s underwriting process.
These complexities not only affect buyers, but also affect sellers, often impacting the flexibility of the terms of the transaction that would otherwise be available to the parties in a cash deal or even purely seller-financed transaction. The reality of the market also makes SBA financing a common component of most small business sales.
While a cash transaction is ideal for a seller looking to liquidate his or her equity in the business and carry no risk of reliance upon the success or failure of the business post-closing, cash buyers are scarce, and finding a cash buyer may be difficult, especially if the seller has legacy interests in transitioning to the next generation of the family or a top level employee that doesn’t have the financial wherewithal to pay cash.
On the other hand, a seller-financed deal is a substantial risk to the seller because it involves the seller continuing to bear the risk of success or failure of the business post-closing to get paid, but without giving the seller any direct control over the business operations.
The SBA 7(a) financed transaction may be an ideal middle ground for the seller who wants to maximize the amount of cash received at closing, wishes to avoid the risk of seller financing, but who doesn’t have a buyer with the cash or that can qualify for conventional financing.
When negotiating a letter of intent or even the final purchase contract with a buyer using the SBA 7(a) program, the seller should know how the SBA 7(a) program may affect his or her goals and preferred terms of the transaction before even entertaining a deal involving such financing. Contemplating these issues before signing a letter of intent or a purchase contract is critical for the seller because it allows the seller to pre-emptively deal with the issues at a time where the seller still has significant leverage in the negotiations.
Here are some items of which a seller should be aware before signing a letter of intent or purchase contract with an SBA buyer:
Minimum Buyer’s Equity
The SBA 7(a) program requires the buyer to come to the table with 10 percent of his or her own money to pay toward the total loan cost (which includes the entire purchase price of the business and some SBA and lender fees and costs). For example, in a $2 million transaction, this means that the buyer will need over $200,000 from his or her own pocket to be able to close the deal. As a seller, determining whether the buyer has sufficient assets to meet the 10 percent down payment requirement is important to know before the seller expends significant costs proceeding with a transaction.
Even if the buyer doesn’t have the 10 percent in cash, the SBA will allow the buyer to use a seller financed promissory note for up to 5 percent of the down payment requirement. So, on a $2 million transaction, if the buyer only has $100,000 to put down, if agreeable to the seller, the buyer could execute a promissory note of $100,000 to the seller to meet the 10 percent down payment requirement.
But, there’s a catch! No payment can be made by the buyer on that $100,000 note during the entire term that the note to the bank is outstanding (typically 10 years). Not only that, but the bank providing the buyer the financing will surely require that that note to the seller (and any liens on collateral securing that loan) be subordinated to all of the bank’s notes and liens for the purchase, putting the seller second in line to collect from the buyer in the event of default. In transactions with much of the purchase value being in goodwill, this puts the seller at a significant of risk of not receiving the 5 percent of the purchase price to be paid on that note if the buyer were to default.
In light of this, when negotiating the letter of intent or contract, it is advisable for the seller to obtain and analyze the buyer’s financials to determine the likelihood of the buyer being able to meet the equity requirements to go through with the transaction, as well as to determine the likelihood of the seller being able to collect on any seller financing that is involved in the transaction in the event of default.
Post-Closing Employment and Health Insurance
As a seller, the SBA 7(a) program prohibits you from staying on as an officer, director, stockholder or key employee of the business after the Closing (though allows the seller to be paid as a consultant for up to 12 months after closing for management transition purposes only). This is especially important for business owners who are not yet eligible for Medicare, yet need to have health insurance to bridge the gap until they are Medicare eligible. In a non-SBA financed transaction, the seller may stay on as an employee eligible to obtain benefits given to all other full-time employees, one of which is the group health insurance plan. An SBA rule prevents that arrangement.
The alternatives are to obtain such insurance out of pocket on the open market via an individual plan, or, if the seller has a spouse that is employed and is offered health insurance, obtaining insurance through the spouse’s plan. Since having health insurance is so critical, finding a cost-effective way to bridge the gap from the date of a sale of the business to the date of Medicare eligibility is a major concern for many business sellers.
Where a post-closing employment arrangement which includes health care can be structured into the deal in non-SBA transactions, it’s paramount for a seller to be aware of this restriction on post-closing employment from the beginning of the negotiations of an SBA transaction, especially in negotiations of price or interest rate on an allowable seller note. This additional out-of-pocket cost for health insurance should be accounted for by the seller in these negotiations. In the very least, the seller needs to have a plan in place for health insurance after the sale.
Required Independent Valuations
The SBA requires that, where the parties are related (either by family or a close relationship such as a key employee, or co-owner), an independent appraisal be conducted to justify the loan amount and/or purchase price. The SBA also requires this in transactions where the initial appraisal or purchase price allocation shows that the purchase price less fixed assets equals $250,000 or more. For many businesses, this latter scenario is common, as much of its value is in goodwill (typical in-service oriented businesses or where the price is based heavily on sales numbers, not the value of fixed assets). Often in the initial stages of negotiations, the buyer may forego the cost of an appraisal and merely justify the purchase price based upon a review of the sellers’ financials.
If the appraisal report determines the value of the business is a lower price than the agreed upon purchase price, in order for the transaction to occur, the bank may require that the buyer infuse additional equity (either with cash or via a seller standby note for the difference), or possibly allow an additional, non-standby seller note to cover the difference between the appraised price and the agreed upon purchase price.
Often, when the independent appraisal is required by the bank, the parties are already under contract, with the buyer obtaining a financing commitment being a contingency to closing. Where the contract has already been signed or a letter of intent heavily negotiated, there are costs that have been incurred by the parties in getting to that point. These sunk costs may make it a hard decision for the seller to determine whether he or she is willing to walk away from the deal, and gives the buyer leverage by threatening to walk. This may force the seller to begrudgingly accept a lower price or unfavorable terms to accommodate the appraisal. The seller may not have been willing to accept these terms if they were contemplated before signing the letter of intent or purchase contract.
Taking pre-emptive steps to avoid getting into this position before signing the letter of intent or purchase contract can help avoid these outcomes. One good way to do so is for the seller to obtain an independent valuation themselves prior to entering into a contract or letter of intent. Often sellers have a rough idea of how much they believe their business is worth. It’s possible that that price is accurate, but sometimes the seller’s idea may be completely unrealistic.
Getting a reality check on price via an independent valuation may save everyone’s time and money before signing a letter of intent or purchase contract. Or, if the seller has a particular price in mind for his or her retirement that doesn’t match the valuation, if the seller can afford to do so, knowing the realistic price ahead of time will give seller the knowledge of how to get that desired price. The seller may elect to hold on to the business for a period of time to earn enough income to bridge the gap between the valuation and the desired price, or take the time to look for a non-SBA buyer willing to pay that price. If the conditions for an SBA required independent appraisal are present, having a realistic idea of price before signing a letter of intent or purchase contract will allow a seller to avoid those outcomes or at least plan accordingly.
Contract to Closing Timing
It’s also important for the seller that the buyer choose a lender that is reputable and experienced with the SBA 7(a) process. Some banks are deemed “preferred” lenders, which essentially means that the lender can make all of its own underwriting decisions without the requirement of the SBA going through an additional and independent underwriting process (which takes more time).
A seller looking to avoid a long, drawn out financing contingency period and get a deal closed quickly is advised to insist upon the buyer using a preferred SBA lender from the start of the negotiation process and in the letter of intent or purchase contract if the deal is to be SBA financed.