Business Valuation for SBA Loan Purposes
This is part one of a three part series dealing with business acquisition financing related to the use of Small Business Administration (SBA) guaranteed loans as provided by both banks and non-banks throughout the state of Arizona. The impetus for this series is recently signed legislation which dramatically enhances the efficiency and availability of such funds for use in facilitating all types of business loans including business acquisition financing.
President Bush signed HR 4818 (Omnibus Spending Bill) into law during the first week of December, 2004, including favorable provisions related to the ability of banks and non-banks to fund small business loans of all types. From the perspective of the business brokerage segment of the local Phoenix economy, the legislation provides the following benefits:
- Streamlined appropriations procedures and SBA decision-making in the future, which eliminates the need to "renegotiate" key elements every year or each time the funds run dry and allows the SBA to reduce fees without legislation
- Increased guarantee amounts to $1.5 million and loan size to $2 million
- Increased pool of potential loans to $16.5 billion, including record levels for the 504 loans
Importantly, the recent experience in early 2004 when thousands of loans were effectively terminated by the SBA when funds ran low (after all such loans had been completely underwritten and approved and the parties were ready to sign on the bottom line!) should not be repeated. The end result should be another record year of SBA-guaranteed bank loans across the nation and in the state of Arizona. This is good news for both the lenders and the many entrepreneurs who thirst for capital to grow their companies, acquire real estate to house their firms and to facilitate the purchase of going concerns by borrowers who have difficulties tapping into conventional loan facilities.
Prior to addressing the “valuation” component of SBA-guaranteed bank loans utilized for purposes of acquiring established businesses, this series will outline the major SBA programs and clarify the basic yet primary criteria which must be met for loan approval (specifically in terms of business acquisition financing). The first article will address the approval criteria that are used by most lenders. Although each bank has the right to craft their own unique approval criteria, there are certain SBA-mandated factors which must be considered prior to granting approval for such loans.
This is a useful juncture to clarify the distinction between a “preferred lender” and a non-preferred lender. Institutions with a long and successful track record of facilitating SBA loans will earn the status of a “preferred lender”, which precludes the need for a second and sequential “underwriting process” on the part of the SBA. In short, preferred lenders have earned the right to “approve” loans without requiring the borrower to jump through a second set of hoops at the SBA regional office. The practical difference is one of timing, whereby preferred lenders can close a loan in roughly half the time taken by a non-preferred lender.
On the other hand, those lenders who have not yet obtained “preferred lender status” may be more aggressive in offering loans and even approving loans in hopes of building up their experience level such that they too can be considered “preferred lenders”. Thus, the extra time involved may be worthwhile in exchange for superior customer service and a more flexible lending approval criteria.
Returning to the three primary loan approval criteria mentioned earlier, the first obstacle to be met is typically met with relative ease. In order to participate in the SBA loan programs, the lender must establish that the borrower has been unable to obtain funding through “conventional” means. In practice, the very fact that a borrower is applying for SBA-guaranteed financing seems to imply that conventional funding is not a viable option. Once this primary but simple hurdle is reached, other factors must be evaluated.
As a former business broker active in the use of SBA-guaranteed bank loans and an avid reader of SBA publications and documents, I recall a three-pronged approval metric which continues to make perfect sense when preliminarily attempting to determine whether or not a given acquisition will pass the lender and SBA “tests”. In short, the probability of approval is quite high if the following three requirements are met:
- Buyer/Borrower has "good credit"
- Buyer/Borrower has "relevant management experience"
- Business generates sufficient "cash flow"
Naturally, the “devil is in the detail” as each of the three criteria are subject to widely-divergent interpretations. In the author’s experience, “good credit” means just that – good credit – but not “perfect credit” or any particular credit score. Bankruptcies, judgments and credit card charge-offs are likely disqualifying (but not always). If the financial problems are far enough in the past and can be reasonably explained, even these obstacles can be overcome (maybe).
The “relevant management experience” factor is also subject to interpretation on the part of the lender and/or the SBA. For example, it is not necessary that the management experience be within the same industry or type of business as the acquisition target, i.e. it is possible for the manager of a Circle K to be considered qualified to own and operate a coffee shop or a manager of print shop to be qualified to manage a service business, etc.
The third requirement is perhaps the most important or at least the least flexible of the three major criteria. If the business is not generating sufficient cash flow, then the credit record and management experience are “non-events”, i.e. it won’t matter if there is a “close match” for the first two factors if the business is not capable of servicing the planned debt service.
The next article will define “cash flow” and present typical “cash flow to debt service ratios” that are considered acceptable by different lenders. In addition, other important approval criteria will be discussed, including the following items (note some overlap with the three original criteria presented herein):
- Equity Investment
- Earnings Requirements
- Working Capital
- Resource Management
The third and final article will explain the relevant SBA loan programs that are used for business acquisition financing and outline the many benefits (and few costs) of using this financing tool to purchase a going concern. The remainder of this third article will address the valuation methodologies that are condoned by SBA policies and procedures and/or other official SBA documentation.
CREDIT FACTORS A POTENTIAL BORROWER SHOULD KNOW
To determine if you can qualify for SBA's financial assistance,
you should first understand some basic credit factors that apply
to all loan requests. Every application needs positive credit
merits to be approved. These are the same credit factors a
lender will review and analyze before deciding whether to
internally approve your loan application, seek a guaranty from
SBA to support their loan to you, or decline your application all
1. EQUITY INVESTMENT
Business loan applicants must have a reasonable amount
invested in their business. This ensures that, when combined
with borrowed funds, the business can operate on a sound
basis. There will be a careful examination of the debt-to-
worth ratio of the applicant to understand how much money
the lender is being asked to lend (debt) in relation to how
much the owner(s) have invested (worth). Owners invest
either assets that are applicable to the operation of the
business and/or cash which can be used to acquire such
assets. The value of invested assets should be substantiated
by invoices or appraisals for start-up businesses, or
current financial statements for existing businesses.
Strong equity with a manageable debt level provide financial
resiliency to help a firm weather periods of operational
adversity. Minimal or non-existent equity makes a business
susceptible to miscalculation and thereby increases the risk
of default on -- failing to repay -- borrowed funds. Strong
equity ensures the owner(s) remains committed to the
business. Sufficient equity is particularly important for
new business. Weak equity makes a lender more hesitant to
provide any financial assistance. However, low (not non-
existent) equity in relation to existing and projected debt
-- the loan -- can be overcome with a strong showing in all
the other credit factors.
Determining whether a company's level of debt is appropriate
in relation to its equity requires analysis of the company's
expected earnings and the viability and variability of these
earnings. The stronger the support for projected profits,
the greater the likelihood the loan will be approved.
Applications with high debt, low equity, and unsupported
projections are prime candidates for loan denial.
2. EARNINGS REQUIREMENTS
Financial obligations are paid with cash, not profits. When
cash outflow exceeds cash inflow for an extended period of
time, a business cannot continue to operate. As a result,
cash management is extremely important. In order to
adequately support a company's operation, cash must be at
the right place, at the right time and in the right amount.
A company must be able to meet all its debt payments, not
just its loan payments, as they come due. Applicants are
generally required to provide a report on when their income
will become cash and when their expenses must be paid. This
report is usually in the form of a cash flow projection,
broken down on a monthly basis, and covering the first
annual period after the loan is received.
When the projections are for either a new business or an
existing business with a significant (20% plus) difference
in performance, the applicant should write down all
assumptions which went into the estimations of both revenues
and expenses and provide these assumptions as part of the
All SBA loans must be able to reasonably demonstrate the
"ability to repay" the intended obligation from the business
operation. For an existing business wanting to buy a
building where the mortgage payment will not exceed
historical rent, the process is relatively easy. In this
case, the funds used to pay the rent can now be used to pay
the mortgage. However, for a new or expanding business with
anticipated revenues and expenses exceeding past
performance, the necessity for the lender to understand all
the assumptions on how these revenues will be generated is
paramount to loan approval.
3. WORKING CAPITAL
Working capital is defined as the excess of current assets
over current liabilities.
Current assets are the most liquid and most easily
convertible to cash, of all assets. Current liabilities are
obligations due within one year. Therefore, working capital
measures what is available to pay a company's current debts.
It also represents the cushion or margin of protection a
company can give their short term creditors.
Working capital is essential for a company to meet its
continuous operational needs. Its adequacy influences the
firm's ability to meet its trade and short-term debt
obligations, as well as to remain financially viable.
To the extent that worthwhile assets are available, adequate
collateral is required as security on all SBA loans.
However, SBA will generally not decline a loan where
inadequacy of collateral is the only unfavorable factor.
Collateral can consist of both assets which are usable in
the business and personal assets which remain outside the
business. Borrowers can assume that all assets financed with
borrowed funds will collateralize the loan. Depending upon
how much equity was contributed towards the acquisition of
these assets, the lender also is likely to require other
business assets as collateral.
For all SBA loans, personal guarantees are required of every
20 percent or greater owner, plus others individuals who
hold key management positions. Whether or not a guarantee
will be secured by personal assets is based on the value of
the assets already pledged and the value of the assets
personally owned compared to the amount borrowed.
In the event real estate is to be used as collateral,
borrowers should be aware that banks and other regulated
lenders are now required by law to obtain third-party
valuation on real estate related transactions of $50,000 or
Certified appraisals are required for loans of $100,000 or
more. SBA may require professional appraisals of both
business and personal assets, plus any necessary survey,
and/or feasibility study.
Owner-occupied residences generally become collateral when:
- The lender requires the residence as collateral;
- The equity in the residence is substantial and other credit factors are weak;
- Such collateral is necessary to assure that the principal(s) remain committed to the success of the venture for which the loan is being made;
- The applicant operates the business out of the residence or other buildings located on the same parcel of land.
5. RESOURCE MANAGEMENT
The ability of individuals to manage the resources of their
business, sometimes referred to as "character," is a prime
consideration when determining whether or not a loan will be
made. Managerial capacity is an important factor involving
education, experience and motivation. A proven positive
ability to manage resources is also a large consideration.
Mathematical calculations on the historical and projected
financial statements form ratios which provide insight into
how resources have been managed in the past. It is important
to understand that no single ratio provides all this
insight, but the use of several ratios in conjunction with
one another can provides an overall picture of management
performance. Some key ratios all lenders review are: debt
to worth, working capital, the rate at which income is
received after it is earned, the rate at which debt is paid
after becoming due, and the rate at which the service or
product moves from the business to the customer.
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