New SBA Rules = New Opportunities Part II
Written by David Madison
Last month we began our discussion of the new SBA rules scheduled to go into effect on January 1, 2018. We strongly suggest that you review last month’s article https://diamondfs.com/newrules/ to get up to speed on the basics. Here are the two key rules changes that we’re focused on:
- The SBA will require an equity injection of no less than 10 percent of total project costs. Seller debt may not be used to meet this requirement unless it is on full standby for the life of the SBA loan. Seller debt, even after the buyer has injected the 10%, must still be treated as debt and not equity, and
- Transactions with over $500,000 of intangibles will no longer be treated differently, with different equity injection requirements, than transactions under that threshold. The SBA’s 10% equity rule applies to every transaction regardless of sale price, loan size or intangible amount.
The change is to make sure that the borrower has a genuine up-front investment in the business. The entire down payment, or the majority of it, can no longer come from the seller, with the buyer’s investment coming from the business’ cash flow. The importance of seller financing is therefore greatly reduced.
The big question is what will lenders now do? What will be their minimum equity requirements? Will they change their credit policies to more closely conform to the SBA’s minimum guidelines, or will they require greater than that 10% minimum borrower equity injection? After all, prior to January 1, 2018 the minimum equity injection in transactions with goodwill greater than $500,000 was 25%. Dropping that down to just the 10% minimum is likely going to be too aggressive for most lenders on most of their transactions.
Since the new rules were announced, we’ve been in talks with our top lenders practically every day to explore how they will be reacting and perhaps modifying their credit policies to more closely line up with the new rules. They’ve also been asking us what we see other lenders doing. Here’s how we think things will go:
In general terms, we expect to see things settle out at an overall average equity injection level of 15% – 20% of total project costs up front. The buyers will, of course, have to come in with at least the 10% and sometimes more, and then the sellers can hold subordinated debt for the rest. Standby requirements will be case-by-case depending upon the facts of the situation, but we expect to see them mostly go away as long as there are no cash flow concerns. We certainly will be pushing for their elimination in our transactions.
We’ll be in front of the curve with our lenders when it comes to establishing the equity requirements for our transactions. It’s a delicate balance but we’ve been through this before with previous SBA rules changes. Our thoroughly screened and properly structured and presented transactions, among the strongest ones our lenders will see, will warrant the more aggressive structures that we’ll be seeking for our clients. Our lenders understand that, and they’ll work with us accordingly.
Here’s where the rules changes will create problems… We expect to see some lenders trying to grab market share by jumping out and proposing on transactions with just the 10% borrower injection even when prudent lending says that makes no sense. They’ll bring in lots of volume and tie up a bunch of deals. The first problem is that they won’t be able to handle the deluge in volume. And, when their underwriters and credit folks actually start looking at these loans and evaluating the risks in the various deals, they’ll have no choice but to restructure or decline them.
Now let’s circle back to our lenders, who are all among the top lenders in the market. Loans coming in from “off the street”, i.e. borrowers coming in either directly or from referral sources that aren’t all that well known will likely be treated pretty much as they are now. Lender credit policy, specifically pertaining to deal elements such as loan-to-value ratios will likely remain relatively constant from where they were pre-2018. This approach makes perfectly good sense, as SBA lenders are required to make their credit decisions in a prudent manner.
At the same time, in order to remain competitive for our business and maintain their share of the market, our top lenders will feel pressure to allow the lower equity injections. This will especially be the case when presented with strong, well-structured and professionally packaged loans that they know are in demand. Loans originated by trusted sources like Diamond Financial will be the primary beneficiaries of this more aggressive posture.
Let’s leave things for now with a big take-away and also a structuring idea that you can use for a special type of transaction.
First the take-away… Please be very careful when you hear of a lender offering 10% down loans on pretty much any transaction. Be wary of the jackrabbits jumping out and proposing terms that you know are better than what your transaction truly deserves. Make sure that financing proposals have been green-lighted by individuals or credit committees with the authority to actually approve your transaction as presented. And, make sure that they know about all of the challenges in the deal before they authorize the proposal going out. If you don’t and the lender discovers that negative information later on, you may very well end up with a final approval looking nothing like the original term sheet if the loan is actually ever approved at all.
And now the structuring idea… The importance of seller financing has been reduced in the new rules. But that doesn’t mean that seller financing can no longer count towards the required down payment. It can be, as long as the seller note goes on standby for the term of the SBA loan or until the loan is paid off. That of course sounds onerous, but it may be fine for certain transactions. The best example is when the seller and buyer have a close relationship such as when a son or daughter is buying the parents’ business. Or, maybe a loyal, long-time manager is the buyer. In these cases, the buyers rarely have accumulated the funds needed for the full down payment and the sellers are the primary source of the buyer’s down payment via a gift, bonus, or subordinated debt. Perhaps have the buyer come in with a 5% down payment while the seller holds the other 5%. Sure, we’re working with the bare minimum down payment, but lenders often consider managers and children who have grown up in the business to be the best possible successor owners.
Next month we’ll continue this series with observations and suggestions for dealing with the new SBA rules as we watch them go into effect.
AskDiamond@easysba.com is always available for specific questions regarding this or other SBA rules.