SBA Loans-Collateral, Covenants and Pre-Approvals
Recap from the last 2 issues:
Meet Shannon Hay of UMSB.
SBA 7(a) program basics.
Prepayment, working capital, project costs.
Special option for internal (employee) buyout.
Growth through acquisition
Having multiple SBA loans
Find Part 1 here and Part 2 here.
We left off last time talking about buying the real estate and the business at the same time, but what about the real estate you already own? Does that get involved in this new transaction as collateral? You bet! Well, it depends...
Della: But of course, with real estate, there’s another, I'll say problem, or at least a hurdle, with SBA. And one reason why we haven't gone the SBA route, yet, is because you guys want to take all of our real estate, right?
Shannon: Yeah. Yeah.
Della: Can you talk a little bit about that? I mean, you mentioned the 25% equity in your home, [discussed in the last issue] but what about other real estate that a person may have?
SBA Loan Collateral
Shannon: Anytime an SBA loan exceeds a half million dollars, the bank, the lending provider under that program, must follow the SBA rules, you know, black and white, right? And so that rule states that once you cross that half a million-dollar threshold, the SBA says we have to examine ALL collateral to ensure that we're fully collateralizing as much of the loan as we possibly can. If there's 25% or more equity in that other property, then the SBA requires that the bank take a position on that property. If you don't have 25% equity, there's no attachment requirement, right?
If there's a HELOC or home equity line of credit, utilized or un-utilized, that has a lean position in the way of that 25%, that's counted as part of the mortgage position. So what am I saying? If you intend to make future purchases using the SBA program, now would probably be an opportune time, before you make that business purchase, to obtain a HELOC on those properties. Again, it doesn't have to be utilized, it just has to be in place, and take up that difference.
Other Owned Real Estate
Della: Is that 25% equity rule the same rule of thumb for, let's say, residential rental properties that you may already have, or other commercial real estate you already own?
Shannon: It is. It comes down to individual ownership, controlling interest in that property. If you as the owner of the new business going forward have controlling interest in those properties, the SBA will want to have a position in them. I'm not the strategist on this, but how do you set up a real estate holding company? How would you structure limited rights or transfer control?
I can see your wheels turning there, Della.
Della: They are turning a little bit. You did talk about interest rates and terms, but what about fixed and variable? Are SBA loans one or the other?
Shannon: Every rate is based on today's market. Are fixed rates possible? Yes, they are. Would I ever encourage you to fix in today's market? No, I would not. I don't want to timestamp this recording, right? But the rates are probably the highest we've seen in a long time. And we believe the rates are going to decrease, right?
Della: You've been at this for a long time, Shannon. Have you seen rates higher than what we have right now?
Shannon: I have. I have. Yes. Yes.
Della: Can you tell us when that was and what they were?
Shannon: You're talking 2009, 10, right? The Wall Street Journal Prime was in a similar place, right? Seven, seven and a half, eight and half. I don't think it ever got to nine. Maybe it did.
Della: [I looked it up. In 2006, it reached 8.25%. In 2001, it hit 9%. Current rates are high, 8.5%, but they are not off the charts.]
Shannon: You kind of, you just get comfortable in the moment with what it is. Rates were similar back then, maybe not necessarily higher, but similar. This is really a selling point for a variable rate as you look at the overarching timeline. Right now, I would say it would be unwise to fix a rate, especially when you get the variable option, because then you can just float it down as we expect rates to drop. There’s no prepay in these deals, so if rates later start to tick back up, go out and get another loan that is fixed.
Loan Covenants
Shannon: There's no covenants with these loans as well.
Della: And that's fancy talk for no additional hoops to jump through once you get the loan. Is that right?
Shannon: That's correct. Well, the one minor one is the request for annual financial documentation. The SBA will ask for copies of your tax returns. You could throw yourself into deeper requests if you default. The bank is always going to reserve their right to request updated financial information, but beyond that, no, you're right. No trigger covenants. No cash flow covenants.
In other loan programs, if the amount of liquidity you have falls below a certain level, it triggers a default, right? What's the default? The bank can call the loan, or demand that you pay in full.
Della: As long as you make your payment, and send in your tax returns every year, as a borrower, I'm probably never going to hear from you, or the SBA. And don't make any major ownership shifts, right?
Shannon: Yeah. If it shows up on the tax return, that might trigger something. You sell a big piece of equipment that might have been securing the debt, that might trigger something.
This program has been around since the mid-fifties. It’s really become a name on the street through PPP and COVID and the EIDL loans. That all opened up a new avenue. People began wondering, “What is the SBA?” It has created this buzz and curiosity around it. And now people are realizing that the banks are so much more lenient when the SBA is involved. Our capacity to lend and know a goodwill situation changes significantly.
We're no longer collateral driven. We're more historical cash flow driven. In other words, if you present a business that can historically prove that it can make the SBA payment, and provide a return on investment for you as a borrower, that's a good risk for us.
Buyer’s Salary Replacement
Della: Now you just talked about the return on investment for the borrower. And you mentioned earlier that a business buyer is probably leaving a job where they got a regular paycheck. So they need to get paid from this new business. Does the SBA determine how much the borrower needs from this business on a personal level? Do they look at their personal expenses to determine that? Do they look at the job that they're leaving? Are you matching the salary? What do you use? All of those?
Shannon: All of those, yes. It's a global view, right? We're definitely going to take the individual's experience, debt to income ratio, personal needs, personal credit, liquidity, all into consideration.
When I'm evaluating a possible transaction, I'm making a determination as to whether to give a borrower money. The borrower's situation is not 100% of the equation, right? It's really only 30% of the equation. We're going to be scrutinizing the business that you're buying, and making sure that the cash flow is there.
And then for you as a buyer, it’s really about personal credit, personal liquidity and then experience, right? Can you prove that you can manage this business going forward and that you're the right person for that? If you can meet those equations, or what I call the 30%, the other 70% then turns to the business. We're math nerds, right?
Della: Ha!
Buyer Qualification
Shannon: We're gonna dig into the numbers and we're gonna make sure that the historical debt service coverage works. To determine your individual debt to income needs, we're gonna look at the following:
What do you spend on an annual basis?
What is your mortgage?
What are your car payments?
What are your credit card repayments?
Do you have any other loans, such as student loans, recreational debt, like an RV, a boat, a motorcycle. That is all part of your credit bureau and what your monthly payment requirements are.
We're going to take your monthly payment requirements, times that by 12, then times that number by two. So if your monthly payment requirements are $3,000 right? Times 12 is $36,000 a year. Times two is $72,000 a year. That's your debt-to-income ratio.
The job that you're leaving, hopefully you've already been making $72,000 a year, in this example, or you wouldn't have good credit and be able to buy a business in the first place. But then, can that business pay you that same salary and continue to pay you that minimum of $72,000? And can it pay you and pay the payment for the business, right? How much is the sales price of the business? What's that payment with a 10 -year term at an interest rate of 11%? What's the repayment on that? Now we want debt service coverage of 1.25 times, maybe 1.3 to be on the safe side.
Della: [In other words, does the business make enough money to make that loan payment plus a cushion of another 25%. If the monthly payment is $100, the bank wants the business to have $125 available to make that payment.]
Pre-Approval for Buyer/Business
Della: Hey, I have one last question here, which we've led into perfectly, but is there such thing as pre-approval? I mean, if I'm the business seller, can I get my business pre-approved? And then on the other side of that, if I'm a buyer, can I get pre-approved or do we all have to wait till we have a specific deal in mind?
Shannon: Well, so what drives the bank financing is the purchase price, right? And so a buyer has to decide what they're willing to pay for the business, and a seller has to decide what they're willing to sell for. So the Letter of Intent for the bank is really that trigger point, or the preliminary asset purchase agreement. But until we know how much you're paying for it, it's hard to really structure things. So pre-approval on both sides of the equation becomes complicated. Can I look at a business and say, yes, that's a good business for SBA financing? And can I look at a buyer and say, yes, they're a good buyer for SBA financing? I can do both of those, but…the value presents itself in that Letter of Intent. So if I don't know, you could be paying $700,000 for a business, or you could be paying a million for the business. But that variance is big.
Della: In real estate, which is a really hot market, but even in our little town, if you're a buyer and you're looking for a new home, you have to have your letter from the bank that says, yeah, I'm pre-approved and I can buy a house in this price range, before you're even going to get in the door. So can you get a letter from the SBA lender or is that not really how it works?
Shannon: No… I encourage you, if you're looking to buy a business, and you know that you're not going to be paying cash for most of it, and you aren't going to get full seller financing, you're going to need cash. You probably should be having some conversations with lending institutions about what that looks like for you and if they think it's feasible. I always tell my buyers to tell people you spoke with me. Have the broker send me an email. But as far as an actual pre-approval letter, again, I can say, yes, you're a viable buyer and have been preliminarily screened for SBA financing, but everyone, including the broker should know that the SBA financing is based on the business that they're buying. What is it worth? What are they paying for it and so on and so forth.
I always say structure drives value, right? Meaning, is there seller participation, or maybe retention agreements in some way that increases the value of the business. But a lot of that's laid out in the Letter of Intent. As a lender, I can't really know what those terms are until you guys have come to an agreement. And that's where I think LOIs are the most important part of a deal. You're laying out the terms of what the deal looks like and there's no surprises in the asset purchase later. Hopefully, right? That's the goal.
Della: All right! This has been super fun, Shannon. Any last minute tips for us as first-time buyers heading down the SBA path?
Shannon: Seek the knowledge. Continue to educate yourself. There's so much information out there, not only on LinkedIn and Twitter and YouTube. Seek out knowledge like this. There's obviously lots of reading that can be done. And then call an expert. We love to share the love. We talk about sharing the love all the time. So I boldly say my cell phone number is 614-648-9199. My email is shay, S-H-A-Y@UMWSB.com. Reach out anytime. Happy answering any questions.
Della: Perfect! I love it! Thank you so much, Shannon. Thank you so much and peace out!
