New SBA Rules = New Opportunities, Part III
By David Madison
Happy New Year! Everyone here at Diamond Financial wishes all of you a healthy and successful 2018. This year has started off with more reported activity from business brokers, lenders, and our own phones than any we’ve experienced in quite some time. We expect this to continue and are looking forward to what we believe will be a record breaking year.
Over the past couple of months we’ve discussed the new SBA rules that went into effect on January 1, 2018. You can read these articles by clicking on Part One and Part Two to get up to speed on the basics and to learn how we are approaching the changes. The two key rules changes that we’re focused on so far are the new minimum buyer equity requirements and the treatment of seller subordinated debt, even with transactions having over $500,000 of intangibles.
Before discussing how we see lenders actually implementing the new SBA rules, we’d like to bring to your attention three other changes that might come into play in your transactions:
The first relates to purchases of franchise businesses. The SBA has created the SBA Franchise Directory, and you can find it here If the franchise is listed in the directory, you are good to go. If not, you aren’t. It’s pretty much that simple. No more costly and time-consuming lender reviews of FDD’s!
The next change relates to partner buy-outs. It’s a simple change that allows these transactions to conform to the same equity requirements as with outright business purchases. After the change of ownership, the new owner’s equity position must be at least 10% of total assets.
Now the most important one… it pertains to when a buyer brings in minority ownership cash investors to help with the down payment. The old rule was if a minority partner owned less than 20% of the business, he or she would automatically be exempt from personally guaranteeing the loan. This is now not necessarily the case, a potential deal killer as your buyer could lose their ability to raise the funds necessary to complete their transaction.
Lenders are now required to use what might be described as the “duck rule” – you know, the one where if something looks, quacks and waddles like a duck, it probably is a duck. Lenders must use their judgment as to what’s really going on here. If the investor is truly just putting money into the venture, with no ongoing responsibilities, decision-making, or pro rata economic benefits, then the investor likely will not be required to guarantee the loan as long as their ownership position is under 20%.
But, if that investor does have operational or decision making responsibilities, and/or is going to be receiving a greater share of the income, eventual proceeds when the business is sold, or other benefits beyond what would be in line with their share of ownership, then the lender can require him or her to guarantee the loan even if they own less than 20% of the business. The lender must look at the essence of the transaction and determine if the investor is indeed the real player here and is simply hiding behind a stated 80%+ owner, effectively determining if the investor looks, quacks, or waddles like the real owner. This is a perfect example of why you need to have someone like Diamond Financial on your team, as we’ll be able to make the strongest possible case to the final decision makers to not require the investor guarantee the loan.
Failing to bring in every appropriate guarantor, especially the ones who are likely to be the strongest financially in the deal, creates a huge risk of the SBA pulling its guarantee on that transaction. We even know of one major lender who has invoked a 7% rule. They want investors individually owning no more than 7%, or the investor will be assumed to be the real buyer and the borrower will effectively have to prove that the investor is truly passive and therefore should not be required to guarantee the loan.
How lenders are reacting to the revised rules
Since the new rules were announced and now implemented, we’ve been talking with our lenders literally every day, and closely observing the broader market. So far, everything is as we predicted in our recent newsletters. We’re hearing scattered reports of isolated lenders being especially aggressive, but overall sanity seems to be prevailing. Please keep in mind that the low down payment numbers are at this point just conversions or maybe proposals. It’s too early to see any actual approvals and loans closed with those numbers.
With our transactions we’ve been encouraging our lenders to move more closely to the new stated minimums when the facts within a given transaction warrant it. On heavy goodwill and cash flow based transactions with especially strong borrowers and/or other unusual positives, a 15% equity injection into the business portion and 10% on the related commercial real estate component seems to be the speed limit. Our strongest deals are getting by with just that buyer’s equity requirement and no reduction in lender LTV via subordinated seller financing. On more typical transactions the lender provides a loan equal to 75% or maybe 80% of the purchase price plus working capital and the closing costs including the SBA guarantee fee. The buyers come in with 10% -15% and then the sellers holding some paper (but not on standby), with debt coverage being calculated based on both the lender’s loan as well as the seller’s note payments.
Things are still in flux as the new rules come into play. We strongly suggest that you do the following in order take advantage of the opportunities afforded by the changes:
- As we warned in last month’s newsletter, 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
- Work with well-respected financing partners like Diamond Financial who will structure and present your transactions in a strong and thorough manner. We’ll help you and your clients get the best possible terms, and then get your transactions closed in a controlled, timely, and predictable manner as we apply pressure to our lenders to allow the lowest reasonable equity injections in order to remain competitive.
Next month we’ll wrap up this series as we check back in after lenders have had more time to implement the new SBA rules. We’re more optimistic than ever about prospects for a record-breaking year, with more transactions and for more dollars than in any year in recent memory. We’ll be here to help you achieve your best year ever!