Martinka Consulting's Getting the Deal Done Podcast
Martinka Consulting's Getting the Deal Done Podcast
SBA Loan Changes with Lisa Forrest with Live Oak Bank
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Lisa Forrest with Live Oak Bank discusses the sweeping changes in the May 2023 SBA Standard Operating Procedures. We discuss SBA 7A loan business acquisition loan basics plus changes to:
Life insurance requirements
Buyer equity (cash) injection to the deal
Seller equity post-close (now allowed)
The seller's role post-close
This podcast will make you quite knowledgable about SBA loans.
John Martinka
Jessica Martinka
Contact us via either website or give us a call and be sure to check out our blog pages with new posts weekly.
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Welcome to an encore edition with Lisa Forrest on the Getting the Deal Done podcast series. Lisa and I always do a first of the year podcast about what's going on in business acquisition lending. And this May of 2023, the SBA came out with some modifications to their standard operating procedures on uh loans, non-real estate loans is what we're going to be talking about, business acquisitions in specific. And there's some pretty sweeping changes in some areas, and still some uncertainty over what it all means. Uh obviously, it was written in government ease. So, Lisa, welcome.
SPEAKER_01Thank you for having me, John. Really appreciate it. Yeah, and these uh these are some really big changes. We haven't had this kind of change in um you know about a decade. So uh pretty exciting.
SPEAKER_00Well, let's go back for people who really aren't that familiar with the SBA program, the 7A program, which deals with business acquisitions. Uh, why don't you give us an overview of how much can be borrowed and you know what the SBA guarantee means to the bank and all the paperwork or e-paperwork, etc. Why don't you just give us a give us a quick overview?
SPEAKER_01Sure, I'm happy to do that. I'm Lisa Forrest. I'm with Live Oak Bank. Uh I focus uh my 24-7-day job on business acquisition. Live Oak Bank, we're the nation's number one SBA lender. Uh, but fortunately for business acquirers, there are lots of really good SBA lenders uh across the nation that specialize in business acquisition. So I'm gonna compare and contrast what the rules are, and then I'll do a little bit of comparing on contrasting on how Live Oak might be looking at these to give you a sense of how to think about uh business acquisition and in speaking with your lenders, uh, some questions and observations to bring up with um any given lender. So with SBA, the US Small Business Administration, they have a guarantee program. And for business acquisition, it's called the 7A program, where the US Small Business Administration, SBA, guarantees a portion of the lender's loan. You are also personally guaranteeing it, but the the SBA also guarantees, say, 75% of the lender's loan. And what that does is it compels a lender to make an under-collateralized loan, uh, make a cash flow loan for your business acquisition. Uh, most lenders doing a non-SBA loan or a conventional loan are going to be looking for outside collateral to cover your transaction and also most likely looking at non-SBA loans on a shorter term and also looking for more injection. So the SBA program compels a lender to do an under-collateralized cash flow loan, better terms, better amortizations, and with a lot less equity injection.
SPEAKER_00Okay. So uh what kind of collateral do banks take, even though that they are making a cash flow loan? Or what kind of collateral don't they or can't they take?
SPEAKER_01Yeah, and if you notice, I said under-collateralized. So these aren't non-collateralized, they're just going to be under-collateralized. You're just generally on a business acquisition loan. Uh, even if you're buying the real estate that the that the seller may hold and is selling the real estate with the business, you know, these are all uh cash flow loans where you're going to be under-collateralized. So for the most part, if you are doing an asset light transaction or a transaction that doesn't have any commercial real estate along with it, the lender is going to take all the business assets. We're going to take a lien on all the business assets. And then if you have home collateral, residential, personal collateral, either in your home, rental property, vacation home. If we are, say, doing a million-dollar loan for you, and you have collateral in your personal residence, maybe it's got $200,000 of equity value in it. We're doing a million-dollar loan, we're taking the business assets. And then we'll also be taking a secondary or a tertiary lien on your personal residence, $200,000 value. And that's what the SBA comes into then guarantee the SBA loan because they're going to mitigate the gap in collateral coverage. But we could potentially be taking a personal residence, um, vacation, rental property, and the like. We don't take liens on your 401k. We are prohibited from doing that. And the SBA does leave room for lenders to take maybe a lien on your stocks and bonds, take a collateral assignment in your stocks and bonds. Most lenders aren't doing that. Speaking for Live Oak Bank, we're just looking for your outside personal uh real estate uh to further secure the loan if you have it.
SPEAKER_00Okay. So some of the details on these loans. What's the maximum amount?
SPEAKER_01Yeah, so SBA loan amount goes up to $5 million. And so any one guarantor can have up to $5 million of SBA dollars outstanding. There are lenders out in the marketplace and the ecosystem that also can, in second position behind the SBA loan, give you additional conventional or non-SBA dollars in a second position. Live Oak is one of those banks, and and I have um other banks out that that I know, my competitors are also doing that, where we can give you a maximum $5 million $7A loan. And then uh, you know, after your injection and seller note, which is in second position behind the bank, if there's a gap need, maybe you're acquiring an eight or a nine or a $10 million business and you need additional gap financing just to kind of get that all of that um enterprise value to fit. We can come in second position behind the $5 million of SBA and give you additional non-SBA debt in second position.
SPEAKER_00Okay. And the SBA loans are still a 10-year amortization period.
SPEAKER_0110-year am. Uh, there are actually a few changes in the SOP about potentially for equipment uh giving you a little bit of a longer term, but um, you know, we're focusing just on the business acquisition here. So we're we're all still assuming it's a 10-year amount.
SPEAKER_00All right. And are there any interest rates minimums or maximums?
SPEAKER_01So with uh variable rate lending, it is maximum of prime plus two and three quarters. SBA limits the uh variable rate plus, and that's two and three quarters. That has not changed. For fixed rate lending, the SBA gives you more room on being able to charge fixed rate plus prime plus. Um, for the most part, most of these are cash flow loans that are under-collateralized. So most SBA lenders are um providing the these business acquisition loans on a variable rate basis, and the maximum is two and three-quarters. Each lender can charge their own prime plus spread depending on sort of the risk-based profile of any given deal.
SPEAKER_00Okay. Okay. And your preferred lender at LIVO, what does that mean about your dealings with the SBA on loans?
SPEAKER_01Yeah. And so we are a nationwide lender. Uh, we lend in all 50 states. Uh, we are preferred in every single state. There are lots of preferred lenders out there. And what that means is that the SBA has come in and audited your book of business. They do that on an annual basis, and they have determined that you are a lender in good standing, where you um, on your own volition, you know, are following the rules and the procedures so that they give us delegated authority where if we approve the loan, then the loan is approved. We still have to go to the SBA for certain uh documentation um and information share in order to get your SBA number uh um uh approved and uh sent out to us, but we are not going to the SBA for their approval on that transaction. There because we do lots and lots of loans and we do lots and lots of loans and lots of uh geographies. There are many, many, many thousands of preferred SBA lenders out there. So it's a question you should ask of your lender. If it's maybe a newer lender or a lender that just doesn't do a lot of SBA loans, uh then they they can have a status that is less than preferred, where they have to package up and actually send the loan to the SBA for their approval. In the vast majority of the cases, you're probably gonna be working with a preferred lender, but definitely ask.
SPEAKER_00Yeah, and I can tell you if it's not a preferred lender, you got to figure you're gonna add at least a month to the process. So, okay. One more question. Uh, then we'll get into the changes. I hear all the time from people well, the SBA will look at this or look at that, and I keep saying, no, the bank looks at it. So, what is the underwriting process for these loans?
SPEAKER_01Yeah, so the SBA has certain rules and regulations, and we're going to talk about some of those changes here in a minute on the recent SOP change. But the the SBA has certain rules and regulations that the bank has to follow. Uh, a bank, the bank, can still have their own underwriting do's and don'ts and their own underwriting philosophy. So when you're working with a lender, definitely ask, is that your rule, bank, or is that the SBA rule? So um most lenders hopefully are good at comparing and contrasting when it's the SBA's rule or their bank's rule. And then bank from bank to bank to bank, you can have different requirements from um lender to lender. So our process, we do a heavy pre-screen pre-analysis process with you. Even before you've got a signed letter of intent with a with a seller, we we work with our buyers even when they are analyzing a pre-LOI transaction. And I would say that's probably similar for a lot of lenders, but we'll spend a lot of time with you even before you get your letter of intent inked. When you do get that letter of intent inked, then um you're usually getting a pre-call letter or a term sheet from your lender. At LiveOak, speaking for us, we uh we'll actually vet our term sheet up front with our senior credit officer. We don't go to committee on our SBA loans. We have a um one senior credit officer we work with. We vet that deal with the senior credit officer up front, give you a really qualified term sheet. From there, it goes into underwriting. Hopefully, we come back with a commitment letter that looks, hopefully, it looks exactly like the term sheet we gave you. That's the goal. And then from there, you go into the closing process. And I would say generally, kind of 90 days from your signed LOI to close. That has been our experience, John. Would you say generally a 90-day LOI to close process? I would SBA.
SPEAKER_00I would say that's pretty good because most buyers don't want to get their attorney engaged until they're absolutely sure they've got a bank loan and get that commitment letter. So I think that's a good and good timeline. And of course, the bank usually wants uh the purchase and sale agreement a week or two in advance of closing from their docs. Okay, absolutely. So let's talk about the changes because the changes uh there's some pretty dramatic ones. And as I understand it, where do you want to start? Well, there's still a lot of ambiguity over what some of the language really means. So uh start with what are your top few big changes that uh you're working with.
SPEAKER_01Good. Well, let's start with two of the easier ones because then we'll spend most of our time talking about the harder ones. And as John mentioned, the changes came out in May. They're they're very sweeping. Um, one it took us even uh all banks, all banks are going through this, by the way. There is no bank expert yet on these changes, that's at least in my opinion. The there are allowances by the SBA on what we can do now, and it's still going to take time for each bank to decide how they want to interpret and how they want to step into some of these new rule changes. So I'm just gonna say caveat on that. And uh, there's a couple of these changes where we're really still not sure exactly what the SBA has intended. There is an SBA hotline, eligibility hotline, and I'm sure we lenders across the country uh are just got this SBA hotline email address just uh blowing up, and it's probably on fire on a daily basis. So there are some areas where we are still waiting for some clarification because the SBA puts the changes out, and then lenders, buyers, and sellers start utilizing the changes, and it actually brings up more questions. So I'm gonna do my best here. So let's talk about two of the easier ones. One is around personal financial statement and personal liquidity. There was a time uh before May when as a buyer, you could have too much money. You could be too personally liquid to qualify for an SBA loan. That has now been omitted. So as long as all there's um all the other eligibility criteria have been met, you could have a sizable personal um net worth liquidity amount. And um, for one, you know, as a lender, we love that. I mean, yeah, let's bring on an even stronger buyer. So that that's a that's a positive. So no maximum personal net worth liquidity. And then the others around life insurance, up to this point in time, life insurance in the amount of the loan on our guarantors was required. SBA has softened that requirement. So this is how we're looking at it. If the uh business has a reasonable succession plan, if our new uh guarantor and new operator can put a reasonable succession plan together, if there's an untimely passing, what happens to the uh operations of that company, at least on a short-term basis? And I don't necessarily mean a succession plan to some of your family, i.e. spouse or children, to come in and run it. Um that could be it, yes. But I'm thinking also more like, is there a general manager? Is there, are there employees there that could take jump in on a short-term basis while the bank and your beneficiaries kind of figure out how to continue on the operation? So with a reasonable succession plan, we are most likely going to be doing away with that life insurance requirement.
SPEAKER_00Okay. So what are the tough ones?
SPEAKER_01So let's start with this partial buy-in. And a lot of folks are calling it the equity rollover rule. And it is, but there's a lot of nuance around it. It's really called partial change of ownership, PCO, partial buy-in. So there's a nuance here that I don't think people are necessarily picking up yet. Um, our acquirer, the buyer, is buying into the seller's business. So that's why it's called partial buy-in. So these are stock purchases. Not that you can't have another acquisition vehicle as the new acquirer, that new acquisition vehicle, which might be put in place more for kind of tax purposes or legal purposes, at least the way we're interpreting it and the uh clarification we've gotten from SBA, this is going to be a co-borrower situation. You might have a new entity, it is gonna be in a co-borrower situation with the seller's existing company. And as an example, maybe you acquire 85% of the company and the seller retains 15% of his or her company. So you have a partner. It is a partial buy-in. You have a partner in that the seller is retaining some sort of uh some amount of ownership. If the seller uh retains 20% or more, 20% or greater ownership, they will still be required to personally guarantee. And that's another nuance that has not changed. Our acquirers, anyone who owns 20% of the company of the borrowing entity, has to personally guarantee. So if your seller retains less than 20%, they could potentially be staying on in a long-term role in lots of different capacities on a long-term basis without having to personally guarantee if they're under a 20% threshold.
SPEAKER_00Okay.
SPEAKER_01So what questions do you have for me on that, John?
SPEAKER_00Well, what is okay? So if what is the role of the seller? If they sell 85%, they can stay on, they can work there, no restrictions.
SPEAKER_01Correct.
SPEAKER_00No restrictions.
SPEAKER_01You just have to really spell out the transition plan. You know, what's the seller doing today? What are you going to be doing? I mean, the same old questions that you and I have been asking for decades on that transition plan, post-closed plan of who's doing what, all of that same absolutely uh applies.
SPEAKER_00And what about if the seller sells 100% like most deals? Uh, what can the seller's role be during transition or thereafter?
SPEAKER_01Okay. And I'm going to sort of mash this up um with 100% buyout and the partial buy-in. I'll kind of mash up my question that kind of toggles back and forth between both. So with 100% buyout, the SBA rules haven't changed. The seller, if you're buying 100%, the seller is still required to exit within a year on a formal basis, sort of in writing, that we know about. So 100% buyout, it is um meant for the seller exiting in a year. They can stay on in a transition or a consulting role. And then they would be exiting um after 12 months. And in these cases, you would be buying a company that really doesn't have um seller dependency. We'd want to be really clear that these aren't highly seller dependent. Um, and then John has some off-the-record comments always when I say this.
SPEAKER_00Things we can't say here.
unknownYeah.
SPEAKER_01Uh, you know, and then this is where you want to work with your lender one-on-one if if the seller might stay on in some kind of commission role that's not key. There's some uh additional conversations you want to have with your lender on that.
SPEAKER_00Okay.
SPEAKER_01So I I want to I want to go back to the the partial buy-in, partial buyout. There's there's a really big nuance here because before you've always had to buy 100% of the company. This is completely new. We thought the change was going to really take care of the place where, John, you know, where it was cumbersome when there was a 5% owner or a 10% owner that was really um, you know, the floor manager or the estimator that got some incentive comp by having some amount of ownership. We thought at first, when we heard that that um partial buy-in was allowed, we thought it was going to take care of that, which has been cumbersome for years, where that 5% employee literally had to exit. So this absolutely solves for that. But then the new rule went so much further past that, where really the seller can stay on, maybe even a in a 40% role or a 30% role. I mean, you picked the percentage um retained ownership. You know, it it could be really interesting in some cases. In some cases, it could be a disaster. All of a sudden, now you have a 30% partner or even a 15% seller that's staying on. And what happens if you guys don't get along? I mean, there's there's lots of um good stories of post-closed relationships. There's this an equally troublesome amount of stories of post-closed relationships that don't go well. So this is not gonna fit for every transaction, um, nor should it. But is it gonna open up some really great um opportunities? Yes, it's not gonna fit for every transaction.
SPEAKER_00Okay. And I hear there's a change in how much the buyer has to put in in equity cash into the deal. What are the rules for that now?
SPEAKER_01Yeah, and this is where it gets really, it's this is where it gets a little crazy. Um so let me let me talk about a hundred percent buyout first, and then I'll come back to the partial buy-in. So if it's a hundred percent buyout, then basically the the the SBA is still requiring 10% down payment on a hundred percent buyout. SBA is still requiring a 10% down payment. But on a hundred percent buyout, it can be divvied up in a couple of different ways. And you this could be down payment equity coming. In from the operator that's going to be the guarantor, and it could be a combination of operator guarantor equity plus outside investors. Uh, in some cases, it could be the majority of investors coming in. Again, remember, anyone who owns 20% or more has to personally guarantee. So now of that 10% that's required, the buyer, the guarantor, has to have at least a minimum of two and a half percent. The seller note could uh represent seven and a half percent. Two and a half, seven and a half equals ten percent. The seller note can either be on full standby for 24 months, it can also have some interest only for 24 months. And it's our understanding that the seller note payment still needs to be included in the debt service coverage calculation. So now we're at a point where these already highly leveraged transactions can now be financed with extremely low levels of buyer cash. I'm telling you right now, not every lender is gonna allow this. This is where you need to go lender to lender on how much cash, um, how much balance of that cap stack is going to be allowed lender to lender. I can already tell you, I'm not so sure I'm gonna be allowing two and a half percent down payment. It's gonna have to be a real, real rare case. I'm always happy to talk about what that case might look like. There are lenders out there that are already saying, no problem. Minimum amounts of cash, a-okay for us. Keep in mind these are still cash flow loans. You still have management, transition risk, and the post-close uh transition, your buyer-seller relationship, that's all still risky stuff. But SBA has um opened up a an ability for either even lower amounts of cash to acquire a company. That's on the 100% buyout.
SPEAKER_00Yeah, and you and I have talked over the years about you know, someone wants to can only put in that amount. That's really not a good situation for the buyer. That's a lot of debt. And should they really be buying that business if they can only put in two and a half or five percent or something like that?
SPEAKER_01So yeah, I you know, I points of view. This is all about points of view. I'm here to share the new rules, I'm not here to pontificate on good or bad, just really um, really make sure you're um thinking about the amount of equity that's required on any given transaction. It makes me nervous, I'll just say personally, professionally, it makes me nervous on that little amount of equity. So let's go back to this partial buy-in. And this is where I hope I'm getting this right. Because just wait until I share this with you. So with partial buy-in, as far as how much cash you have to bring in, and this is what SBA is allowing. Now, again, bank to bank, I'm still probably in this 10% down uh fresh equity bringing into a transaction. That's probably where I'm gonna be. Um, but this is the allowance. So now with partial buy-in, and it doesn't matter how much the seller is retaining, it's just any kind of partial buy-in, the amount of equity that's required now mirrors the partner buyout rule. So with partners' buyouts and the rules around partner buyout, i.e., you have two partners, 50-50 owners, one partner wants to buy out the other, those rules haven't changed. And now the amount of cash you need to bring to a transaction for a partial buy-in is going to mirror partner buyout. And it is this if prior to the transaction on the seller's existing balance sheet, if you have no more than nine to one debt to worth, you could consider the amount of equity on the balance sheet to count for your down payment. So with partial buy-in, conceivably a new acquirer could come in without any additional equity, fresh cash equity in. Makes me nervous. I'm just gonna say it. My point of view makes me nervous. But there might be some transactions where that might make a lot of sense. If the debt to worth is more than nine to one on the seller's existing balance sheet, then 10% equity is required by the new um, the the acquirer coming in. Seller notes, standby notes, lots of ways to kind of count to that down payment. And um for the most part, nine to one debt to worth is it's like gives you a lot of runway too. So um, you know, the uh the idea of getting in with uh little to no cash also applies to the partial buy-in.
SPEAKER_00Okay.
SPEAKER_01So what do you think about that, John?
SPEAKER_00Yeah, that means uh you know, the scenario I see is that someone someone has a company, they've borrowed a lot of money to buy equipment or something, and yet they're they're taking out a lot of distribution, so they don't have much net worth to the business with all that debt. And we've all seen companies like that where the owner, you know, leverages the company and takes out all the money personally.
SPEAKER_01So yeah, and in those situations, in this case, too, if it puts them at the nine to one, and that's not tangible net worth, that's just total net worth, then the down payment's going to be required by the the buy-in folks. And I would say that generally over the last several decades, an average SVA transaction looked like this. It was 10% down, it was 10 to 15% seller note, and then the bank was doing sort of 75 to 80 percent financing. I think that's been a real tried and true structure for decades. And the the new rules here are really just kind of blowing that up. Um, they're allowing a lot less seller participation, and they are allowing a lot less new um, you know, equity in. They are allowing lenders to decide that they are okay with really significant amounts of leveraged leverage. And the the SBA 7A program was already highly leveraged to start with. So SBA has opened up for lenders to make their own judgment calls. And um, I just hope good judgment is going to be um used.
SPEAKER_00Well, you and I both know that while you have some pretty high standards for debt coverage ratio, at least 1.5 to one. You know, I say if it's a smaller deal, it should go up even to two to one. But there's a lot of banks who don't have that, and they'll they'll just make that loan and they'll have a very low debt coverage ratio that uh if you look at it, probably doesn't even cover the tax it would be due on the principal payments, and that's where they get into trouble. So uh it seems like they've opened the door to do some really good things, but you can like always you have to be careful what the risks are when you want to take full advantage.
SPEAKER_01Yeah, absolutely. And it's uh it's not a blanket, you can't apply these on any given on any given day as a lender. Uh you can't necessarily blankl blanketly apply your your policies. You've really got to look at the the deal-to-deal and and all the the various players in in that particular deal.
SPEAKER_00Yeah.
SPEAKER_01Um, to your point, I think this is going to open up some really um unique opportunities that wouldn't have been allowed for business acquirers and the next generation of entrepreneurs getting into certainly their first acquisition. I think a lot of new opportunities are are opened up for that. Um and I do think that the opportunity is opened up for maybe taking it a little too far as well. So hopefully everyone's just using really solid judgment on any given deal.
SPEAKER_00Well, you're giving people too much credit with that one.
SPEAKER_01Well, you know, um, I'm we've known each other for decades now.
SPEAKER_00So well, you know, I tell the buyers you want a bank to ask good questions, tough questions, does thorough underwriting. You don't want the bank to say, oh, sign here and you get your loan. We don't care. You want them to be that extra set of eyes and ears and and and and provide analysis. So Lisa, we've covered a lot, gone a little longer than we planned. You went into some really good detail on the SBA program and all the changes and all the still open for interpretation areas. Any final thoughts?
SPEAKER_01Um, I do have one thing I want to bring up, and this is the idea of when minority owners have to personally guarantee. I also want to bring up, obviously, we know at 20% or more, they have to personally guarantee on the partial buy-in, but uh really want acquirers and sellers to be thinking about the role of the sellers post-close and how key they're gonna be. So depending on like certain licenses or or any given elements in a transition plan, I just want to make sure I'm clear that even if a seller partial uh buy-in is less than 20%, they might be that dependent to the deal and a and a PG might be required even if you're less than 20%. So I just wanted to make sure I got that out there. And that's gonna be a deal-to-deal analysis. We're not making any blank and statements about when or when that wouldn't be required. And then to just mention that it's still a great time to be a buyer, even more so. We still have so many of our privately held, uh, largely baby boomer owners that are exiting and need to exit. We've got a lot of interest rate that has just been digested. I mean, we're in the 10, 11% interest rate realm. And it's taken the market, this lower middle market, time to think about it, react, and uh come to conclusion on what um affordable prices are these days. And I know it's been a lot of um kind of soul searching for our sellers out in the marketplace. And I give sellers a lot of credit for really needing to um understand what an SBA buyer can afford because of the interest rate stabilization. So it's been taking, it's taken a couple, two, three, four months here, and it's probably gonna take another three months for I think the the buy-sell market to stabilize and um sort of get um good acquisitions sort of back on track again. But they're there, they're out there, they're gonna be there, and I'm I'm just excited to still be in this space of helping the next generation of entrepreneurs uh step into the the seller's legacy role.
SPEAKER_00Yeah, well, it's a good program. Um, and as far as I know, it has pretty much been in the black, other than like during COVID or something, and which means the government's money and the well, actually the fees that the borrower pays, like an insurance premium, have uh made it a profitable program. So it is a win-win-win between buyer, seller, and bank. So on that note, tell us how people can get hold of you.
SPEAKER_01Uh emails great, lisa.forest with two Rs at liveoak.bank. I have a weekly um office hours, a weekly power hour every Wednesday, where I talk about all things SBA every Wednesday. And then every Thursday, um I share deal vetting templates every Thursday. If you email me, um I can send you links to um uh to attend those. Um happy for one on one calls and um just um excited to have shared some time with you again, John.
SPEAKER_00Okay. Well, thank you, Lisa. Thanks for taking the time to go into great detail, and I'm sure it's gonna benefit a lot of people. All right.
SPEAKER_01Thanks so much.