- On November 21, 2017
New Acquisition Rules = Beauty and the Beast
SBA’s new rules and requirements for 2018 has paved the way, to be the way more advisors choose for financing acquisition and equity buy out/in loans, than years past.
Starting January 1st, the SBA will have new equity injection requirements for acquisition loans. For most acquisition and equity buy out/ins both buyers and about all sellers, the SBA’s new rules are a thing of beauty.
AdvisorLoans has been a big critic of the SBA’s rules about sellers not being able to stay on after the sale longer than 12 months and the requirement that the seller’s note has to be on standby for 24 months. Because of these restrictions These new rules however provide most M&A deals a path around these requirements.
AdvisorLoans has been putting advisors in conventional and Tri-party loans instead of SBA for many of the M&A needed structures for advisors. These new rule changes increases the attractiveness of the SBA, making it an ideal loan option for many more M&A deals.
The new M&A deal structuring flexibility removes ALL of the biggest complaints sellers have had with their buyers going through the SBA.
For some buyers however, the new rules will be a beast, making it more difficult to get a loan without making a cash injection.
Will the new SBA requirements be a beauty or the beast for your acquisition loan?
If the M&A deal meets all valuation, revenue, profit and DSCR minimums, and most deals will, then SBA acquisition loans become a thing of beauty. If the minimums can’t be met, then they turn into a beast.
SBA New Acquisition Rules for 2018
The 3 biggest impacts on advisors
- Most sellers can now stay on longer than 12 months
This isn’t so much a new rule as it is a clarification of their old rule. Clarification highlighted:
The seller may not remain as an officer, director, stockholder or key employee (an employee who manages daily operations, e.g. overseeing a department or a division, not a clerical staff position) of the business. (13 CFR §120.130) If a short transitional period is needed, the small business may contract with the seller as a consultant for a period not to exceed 12 months including any extensions.
This clarification and distinction allows for advisors to either sell their practices through assets or stock, slow down, and continue in a non-management or non-key employee role. Many sellers want the ability to continue to work after the 12 months on a part-time basis, perhaps another year or two, until they are ready for full retirement. Now they can.
- 10% equity injection
A new rule now requires a 10% equity injection into every business acquisition. It can come from the buyer or split between the buyer and the seller through a seller note.
- 10% can come from the buyer.
- The buyer and seller can split 5% and 5%
- The seller maximum is 5% because the buyer minimum is 5%
- It can also be split as 7% buyer and 3% seller, or any combination split from seller at 1% to 5%.
What can be considered as part of the 10% equity injection?
Equity comes through 3 primary forms:
- Cash from borrower
- Seller note (must be standby for life of SBA loan)
- Assets other than Cash
In the “beauty” section below I’ll show you how this rule, when used creatively, is going to make acquisition and equity loan structures a lot easier and still get 100% financing.
- Seller note standby now for life of loan
If the seller does inject equity through carrying a seller note, the new rule regarding the 2-year seller note standby period just literally got 5 times worse. Instead of the 2-year seller note standby that sellers already detested, the standby now extends for the entire life of the 10-year loan for it to be considered equity.
Below, I’ll share how the 10% rule workarounds allows us to “workaround” this rule as well.
Change of ownership acquisitions are under new rule requirements
- Complete 100% acquisition
- Complete equity buy-outs
- Majority client acquisition where a substantial amount of the practice is acquired. This typically is looked at by SBA lenders as any amount over 50% of revenue that is carved off and sold.
- The buyer is acquiring 100% of the carved-out client list representing the majority of revenue in the practice.
Partial client acquisitions are exempted from this rule
- Partial client acquisitions
- Partial client acquisitions are not considered a change of ownership if not acquiring all, or substantially all of the assets, so the new rules do not apply.
- This typically is looked at by SBA lenders as any amount less 50% of revenue that is carved off and sold.
- The buyer is acquiring 100% of the carved-out client list representing a minority portion of revenue in the practice.
You may be thinking that the 10% injection requirements and seller standbys now 5 times longer than before is all beast and no beauty. But a beastly exterior doesn’t always tell the full story of the beauty inside.
So where does AdvisorLoans find beauty in the beastly 10% injection rule and seller note standbys that are 5 times worse?
The beauty in these rules is when you work around one rule, you side step other rules, and allow for more freedom in M&A structuring.
Let’s walk through how to make the SBA loan beautiful for you.
Above, I listed that equity comes through 3 primary forms:
- Cash from borrower
- Seller note (must be standby for life of SBA loan)
- Assets other than Cash
Assets other than cash
Buyers can utilize the equity in their practice as the equity injection. The goodwill portion of the practice value is allowable to be considered assets other than cash. Even better, you get to add the goodwill value of the practice you’re buying to your own valuation. The goodwill portion of the value for the combined practices represents almost all of an advisory practice.
In most all cases with the advisor borrowers we work with, this will meet the full 10% injection requirement.
Buyers whose practice is valued at $750K and has no existing debt, meets the 10% equity injection up to a $5MM loan, which is the maximum.
Another beautiful thing is if the equity amount of the combined practices doesn’t meet the full 10%, it reduces the 10%.
So, if the total practice equity injection comes out to 7% then you would only have an additional 3% to deal with. The buyer can inject 3% cash instead of 10% in this case. But there is flexibility. The seller could also inject the 3% as a seller note but it will be on standby for life of the loan. Or the buyer and seller can split the 3% (or whatever the percentage is with seller maximum at 5%).
For the example above the 10% injection could be 7% practice equity, 1% buyer cash injection, 2% seller note.
Yes, the seller note is on standby for the life of the loan (almost always 10 year term loan) but in this case, most sellers would be happy to get 98% cash and 2% seller finance.
If the 10% is fully met with just the assets under cash practice equity option, or covers enough of the 10% where buyer can handle the rest in cash so the seller doesn’t have to inject anything, then buyers and sellers can have flexibility in other structures of the M&A deals.
Now, buyers and sellers have more flexibility to structure the deal how it best suits them for their individual situation. Some buyers may still want, or need, the seller to finance some of the loan with a seller note. Sellers will now be more willing to do so when there is not a standby of any kind, and for some all the more so, since they can now stay on past 12 months post-sale, although in a more limited capacity.
Acquisition loan amounts over $250,000 require a third-party valuation on the seller’s practice. When using the assets other than cash option, the lender will want to justify the value of the buyers practice. Different SBA lenders will approach this differently, some will want a valuation on the buyer’s practice, and some will simply match the seller valuation requirement and require buyer valuations for loans over $250,000.
In most acquisition scenarios, using this strategy will require third party combination valuations on both the buyer’s and seller’s practice.
Using this workaround, most M&A deals can be now structured where there is:
- No cash down payment from buyer
- No seller note or seller note standby requirements
Assets other than cash Equity Injection Formula
This is an easy formula to see if the combined practice equity of the buyer and seller is strong enough to be considered to meet the all or part of the new 10% injection requirement.
Formula constant: Buyers whose practice is valued at $750K and has no existing debt meets the practice equity injection up to a $5MM loan which is the maximum.
90% > (buyer existing debt + seller practice value) / (buyer practice value + seller practice value) + 2%
Let’s walk through an example on using the formula. The goal is to come under 90%.
(buyer existing debt + seller practice value)
Buyer existing debt: $200K balance on a previous seller note.
Take the $100K + Seller practice value of $3MM = $3.2MM
(buyer practice value + seller practice value)
Buyer’s practice value is $750K (does $300K recurring revenue)
Take the $750K + Seller practice value of $3MM = $3.750MM
$3,200,000 divided by $3,750,000 = 85%
Take 85% + 2% = 87%
Anything under 90% meets the 10% injection requirement. In this case, the deal can be 100% financing.
If the result is over 90% then another injection needs to be made to make up the balance. Like the example I used above in Assets other than cash section, if it came in at say 97% then there is 3% that can be paid by buyer, seller, or split between the two.
There is the beastly side of these new rules if the deal doesn’t qualify for assets other than cash.
For the M&A deals whose equity was not strong enough to meet any or only a 1% equity injection requirement, that’s not a big reduction of the 10%.
A smaller practice with existing debt are the most vulnerable to be subject to the 10% cash injection, and when buying a bigger practice will have a hard time qualifying.
Unless there is a pre-existing relationship with the seller, as a general rule you’ll have a hard time getting a seller to finance any of the equity injection if they have to be on a 10 year standby. Sellers already didn’t like the 2-year seller note stand by period and will dislike the new requirement 5 times as much.
The new 10% injection rule is a beast on the cash flow DSCR pressure for qualifying for the loan. Qualifying on cash flow was a lot easier when the seller was typically financing 25% than at 10%, 5%, or likely none. That was so 2017.
Buyers may find it difficult for some sellers to agree to 5% seller note and be on a 10 year standby. Before the rule, most deals were done with 75% up front and seller note of 25% on a 2 year standby. To a buyer that seems like a fair tradeoff, and 5% may not seem too much to ask of a seller, and some sellers will agree. Once 2018 hits and a little time goes by, sellers won’t be comparing 5% with 10 year standby vs. 25% with a 2 year standby because it then becomes a false choice. The real choice for most sellers will be whether to take a buyer’s deal where they have to finance 5% with a 10 year standby when most sellers will have other buyers not asking this of them.
Call a Loan Advisor at AdvisorLoans to see if the SBA loan would be an ideal structure for your acquisition loan or if conventional or Tri-party loans may be a better match.
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