Basic Eligibility Requirements for an SBA Business Acquisition Loan
For most entrepreneurs, buying an existing business or franchise is only possible with some form of financing. There are options to get traditional loans from a bank, take on investors, negotiate seller financing, or borrow money from friends and family.
The first stop for savvy business operators, though, is an SBA guaranteed loan. Borrowers benefit from some of the best interest rates available, flexible repayment terms, and modest down payment requirements. Lenders benefit thanks to the backing of the Small Business Administration, allowing them to minimize risk. Many business sellers will get their business pre-approved for an SBA loan as a way to entice buyers.
While SBA loans are the most business-friendly, there are criteria that borrowers will need to meet. Read on to learn about the five main eligibility requirements.
1. Minimum Down Payment
A 10% minimum down payment is the SBA requirement but there are many factors that can change the down payment requirements. It is important to note that the down payment should not be an “all in” leaving the buyer without a “rainy day fund.”
A successful business acquisition loan should be structured with sufficient post-closing liquidity to guarantee a successful business ownership transition. The lender can add a reasonable amount of working capital to help with closing costs and transitioning to new ownership.
Here are examples of just such structures:
Plan On 10% Down For Loans Over $350,000
A down payment of 10% for loans over $350,000 is probable if the buyer and the business are both strong. Here is an example of a strong business acquisition loan:
Business price (plus loan closing costs) is $600,000 and the buyer puts down $60,000 for a loan of $540,000.
What are some factors that would make this a strong loan?
- Business is correctly priced and has had strong cash flow for several years. The business is not in a recession prone industry and is in generally exceptional shape. The SBA-required business valuation came back strong making the lender’s loan to value (LTV) under 80%.
- The buyer has experience in the industry and good credit history.
- The buyer has $20,000 cash left after taking over the business and also has 50% equity in his home which allows the lender (per SBA requirements) to take a junior lien on the house which further strengthens the lender position.
- The buyer has a second income in the home such as spousal income, investment income or real estate income such as payments from a rental property.
Not all of the bullet points above are required but, in general, the transaction needs to be solid for both the lender and the buyer. Life happens — so lenders expect some dings and things to overcome.
Here are some examples of issues that can be typically overcome:
- Medical bills that were successfully handled and worked through.
- A divorce which caused some credit issues.
- Not quite enough cash in the bank post-closing so the lender adds $50,000 working capital to ease in the transition. It’s usually good to add some working capital to a business acquisition loan to cover closing costs so adding $20,000 to aid in a successful new-owner transition is usually good for all parties.
- The buyer doesn’t have direct industry-experience but has successfully managed projects and employees or successfully run businesses.
- The buyer doesn’t own a home.
- The lender isn’t quite comfortable, so an additional guarantor is sought. This can be a spouse, business partner or parent.
For an existing franchise purchase, plan on the above being true for loans over $150,000 up to $5 million.
Plan On 20% Down For Loans Under $350,000
The larger down payment on smaller loans allows the lender to keep the loan to value (LTV) around 80%. Here is an example of a typical loan for a $250,000 business:
Business price (plus loan closing costs) is $250,000 and the buyer puts down $50,000 for a loan of $200,000.
What are some factors that would make this a strong loan?
- Buyer has about 10% left over in cash after closing. The buyer may use a retirement plan rollover or sell some stock to come up with a down payment but has around $20,000 cash in the bank to operate the business during the transition to new ownership.
- Business is correctly priced and has had strong cash flow for several years. The business is not in a recession prone industry and is in generally exceptional shape. The SBA-required business valuation came back strong making the lender’s loan to value (LTV) around or under 80%.
- The buyer has experience in the industry and a good credit score. Lenders use a specific FICO credit score developed for the SBA which must be above 40.
- The buyer is a homeowner and has more than 20% equity in her home.
- The buyer has a second income in the home such as spousal income, investment income or real estate income such as payments from a rental property.
The lender will get the business valued by a 3rd party to make sure the price is in line with the market. It is similar to getting an appraisal on a home before getting a mortgage. The bank will want to keep Loan-to-value at or below 80% in most cases. Adding other collateral such as real estate or the corporate guaranty of another business can help add collateral to the loan.
2. Down Payment Sources
Cash is King. The best source of down payment for a business acquisition is most likely cash or savings. Other sources of down payment can include:
- Home equity can be used as a down payment source if there is outside income to cover the HELOC payments such as spousal income or rental property income.
- A gift from a family member or friend documented by a formal gift letter.
The SBA requires the lender to document the source of the down payment for at least 3 months. The buyer needs to show the lender where the cash down payment has been for at least 3 months.
3. Business Cash Flow
The business cash flow needs to be strong enough to support overhead, operations, new owner salaries and the SBA monthly loan payment.
When calculating business cash flow, keep a few things in mind:
- Many small businesses will do what they can to show less profit for tax purposes. Banks understand this and can make certain adjustments to cash flow within reason. You can subtract the previous owner’s excessive benefits and some extraordinary expenses. The seller or the seller’s business broker can provide a list of suggested add backs. You can subtract the previous owner’s excessive benefits and some extraordinary expenses. Common examples include personal auto expense, meals & entertainment, excess insurance & benefits for owners, eliminating or reducing owner salaries
- If buying the building, the rent expense can be eliminated
- If there is other household income, there may not be a new owner requirement for a salary.
- Business cash flow should be consistent and positive but there can be circumstances where this is not the case, which may be okay. An example may be a health issue that is forcing the sale of the business and contributed to a “down” period.
4. Industry Experience
You should have direct experience in the industry of the business you are planning to purchase. If not direct experience, then plan on having solid experience with:
- Having run a successful small business
- Having experience in the same industry. For example, it is not uncommon for a widget expert at a large company to buy a small business which supplies some part of that same widget to businesses such as the large business employer.
- Managing employees, payroll, budgets, and P&L.
There are other factors which can strengthen the buyer position, such as:
- Key employees that will stay on to run the day-to-day operations
- The seller agrees to stay on for a period of time to help the buyer learn the ropes and help transition key relationships with vendors and customers.
- Key relationships with the business such as with suppliers or customers
5. Personal Credit History and Background
Be upfront with the bank if there are any derogatory marks or background issues so they can be properly addressed. The lender will work with you to provide the proper explanations and documentation during underwriting.
For loans over $350,000, there is no set minimum score requirement so the lender will look more at credit character. Even so, a poor credit history will most likely not be accepted by the lender.
Not all bankruptcies are created equal, and many result from reasonable circumstances like divorce or unforeseen medical bills. If the credit score has recovered and there are no current issues, the lender may be comfortable with a past bankruptcy.
Student loan and other government debt issues may make the buyer ineligible for an SBA Loan. It is best to bring up any issues early on so the lender can do research on the specific issue to see if it causes eligibility issues for the buyer.
For more on SBA loans to buy a business, see Demystifying SBA Loans for Buying a Business or Franchise.