What is an equity injection?

This is basically skin in the game from the lender's perspective for an acquisition loan. The equity injection has nothing to do with an asset or equity purchase, it is referencing equity to mean that either cash or assets are injected into the deal. An equity injection can be provided by the buyer through a cash down payment or waived based on their current book of business value. A seller can inject equity into the deal by providing a seller promissory note for a portion of the purchase price. And equity injections can be satisfied through a combination of buyer down payment and a seller note.

It's all about the LTV - Loan to Value

While a borrower's personal financial situation and credit scenario impacts this the primary equity injection requirements from conventional lenders comes down to the LTV. Conventional lenders have maximum LTV requirements typically at 75% but some can go to 85%.

Given that LTV is calculated by combining the value of the buyer's and seller's practices, acquisition deals generally bypass LTV qualification hurdles. However, LTV ratios become a crucial challenge in conventional loans when the buying advisor’s practice is valued at or below 33% of the selling practice’s value. In such scenarios, the loan agreement could breach the LTV maximums set by conventional lenders, pushing the need towards an SBA-backed loan.

For SBA loans, the threshold of concern is when the buyer’s practice is worth approximately 11% of the seller's; this figure is a trigger point for exceeding conventional LTV limits, necessitating the pursuit of an SBA lender for financing.

Understanding the New SBA Equity Injection Rules

The SBA equity injection rule stipulates a ten percent equity injection on loans that lead to a change of ownership. This rule applies to the total project costs and not the loan amount. The 10% equity must come from a source outside the business's existing balance sheet.

Change of Ownership Loans

These loans entail acquiring a business, assets, or equity, where the ownership is entirely transferred from the seller to the buyer. These loans include new business purchase loans, expansion business purchase loans, and complete and partial partner buyouts.

In terms of Equity Injection for a Business Purchase, there are three ways to meet the equity injection requirement: 10% Cash, Full Standby Note, and Partial Standby Note. If choosing a Standby Note, the borrower will have two loans: an SBA loan with the lender, and a promissory note with the seller.

For changes of ownership resulting in a new owner (complete change of ownership): At a minimum, SBA requires an equity injection of at least 10 percent of the total project costs, (all costs required to complete the change of ownership, regardless of the source of funds) for such transactions.

Seller debt may not be considered as part of the equity injection unless the seller’s loan does not include a balloon payment and, for the first 24 months of the 7(a) loan, the seller debt is on either (a) full standby; or (b) partial standby (interest payments only being made) and the Applicant’s historical business cash flow supports the ability to make the payments, and at least a quarter of the SBA-required equity injection is from a source other than the seller.

What are change of ownership loans?

A loan resulting in a change of ownership is when you are purchasing a business, assets or equity, whereby 100% of the ownership transfers from the seller to the buyer.

These include:

A new business purchase loan

An expansion business purchase loan

And complete and partial partner buyouts.

Complete Partner Buyout Loan:

A complete partner buyout is purchasing 100% of the equity owned by that partner. For conventional loans down payment is mostly dependent on the Loan to Value (LTV) based on the combined equity ownership. For an SBA loan the complete partner buyout there is a 10% cash down payment requirement unless two conditions are met.

First, The borrower must have been active in the operations of the business and has been a ten percent or more owner over the last two years. This needs to be attested to by both the borrower and seller.

The second requirement is a Maximum Debt-to-Worth of nine-to-one. This is determined based on the business balance sheet over the most recent year and quarter.

Banks have to be able to document both requirements.

Equity Buy-in Equity Injection

An equity buy-in is when a non-shareholder buys into a firm by purchasing less than 100% of the equity. An equity buy-in operates on the same SBA rules as a partial partner buyout which also is when less than 100% of the equity is being acquired. The partner who is selling will remain on as a partner since they are selling just part, and not all, of their equity.

This loan also requires a ten percent cash injection unless two key requirements are met.

A Maximum Debt-to-Worth of nine-to-one (9:1). This is determined based on the business balance sheet over the most recent year and quarter.

Any remaining owners of the business who have twenty percent or more in equity, are subject to the SBA guarantor requirements. This includes the personal guaranty and the property collateral requirements.

Calculate the 9:1 ratio

The 9:1 ratio for equity injection in SBA SOP for partner buyout loans is a measure of a business's financial health. This ratio compares the business's debt to its equity, which represents the amount of capital invested in the business by its owners. A lower debt-to-equity ratio indicates that the business has more equity and is less reliant on debt, while a higher debt-to-equity ratio suggests that the business is more heavily indebted.

Calculating the 9:1 Ratio: To calculate the debt-to-equity ratio, divide the business's total debt by its total equity. For example, if a business has $500,000 in debt and $100,000 in equity, its debt-to-equity ratio would be 5:1.

Interpretation of the 9:1 Ratio: The SBA considers a debt-to-equity ratio of 9:1 or higher to be indicative of financial risk. When a business's debt-to-equity ratio exceeds this threshold, it may be required to inject additional equity into the business to demonstrate its financial stability and reduce the risk of default on an SBA loan.

Example of a Business Below the 9:1 Ratio: Suppose a business has $750,000 in debt and $150,000 in equity. Its debt-to-equity ratio would be 5:1, which falls below the 9:1 threshold. In this scenario, the business would not be required to make an equity injection as it is considered financially stable.

Example of a Business Above the 9:1 Ratio: If a business has $1,200,000 in debt and $100,000 in equity, its debt-to-equity ratio would be 12:1, exceeding the 9:1 threshold. In this case, the business would likely be required to inject additional equity into the business to lower its debt-to-equity ratio and meet the SBA's requirements.

Equity Injection If Cash Payment

The equity injection can be paid by the borrower in cash, preferably wired to the lender a week or two before the loan closing. The money can come from savings, investments, a Home Equity Line of Credit (HELOC), or as a gift (with a gift letter as proof). Lenders usually require the most recent account statement for verification.

Full Standby Note

The SBA made a big change to the full standby seller note. Now the seller can finance the full ten percent of the equity injection requirement.

No principal or interest can be paid during the first two years standby period.

This option enables the borrower to purchase a business with no money down.

Partial Standby Note

A partial standby is where interest only payments can be made for the first two years but not principal payments.

The seller can finance up to 7.5% in a partial standby note.

The SBA requires 2.5% to come from a source other than the seller.

Adequate cash flow has to support the partial standby option.

Advisor Expansion Through Acquisition

Expansion Loans

Business Expansion Loans do not require an equity injection. When an existing business starts or acquires a business that is in the same 6-digit NAICS code with identical ownership and in the same geographic area as the acquiring entity and they are co-borrowers, SBA considers this to be a business expansion and not a new business.

Expansion Acquisition

When an existing business purchases another established business.

There is no down payment requirement for one business purchasing another business if three conditions are met.

1. The target business to purchase is in the same industry

2. The target business to purchase is in the same geographical area as your current business

3. The exact same current ownership structure will be applied to the purchased business.

If all three of these conditions are met then no equity injection is required. If all three conditions are not met, then the ten percent equity injection rules apply.

What down payment sources qualify for SBA loans?

Savings

Liquidating from investment account(s)

Gift (gift letter must be provided)

HELOC

What is the process of making payment?

For SBA loans the typical way it works is the down payment is wired to the bank. The bank is required by the SBA to see statements that show the amount was in that account for two full months before the down payment was sent. If the money was pulled from multiple accounts then multiple account statements will have to be provided.