Equity Injection Rules for Small Business Acquisition Loans
Equity Injection Rules for Small Business Acquisition Loans
When discussing financing options for acquisition loans, small business owners often want to know about cash down payment requirements, seller financing options, and details related to equity buy-ins and seller guarantees. This article focuses on the cash down payment requirements for bank loans in small business acquisitions.
What is an Equity Injection? An equity injection represents both the buyer’s and the seller's "skin in the game" for an acquisition loan. It signifies the infusion of either cash or assets to reduce the leverage of an asset or equity purchase. This injection can come from the buyer as a cash down payment, or the seller can contribute equity through a promissory note for part of the purchase price. Therefore, equity injections can be met through the buyer's down payment, a seller’s note, or a combination of both.
Conventional Loan Equity Injection While a borrower’s personal financial situation and credit profile play a role, conventional lenders primarily focus on the Loan-to-Value (LTV) ratio for equity injection criteria. Typically, conventional lenders cap LTV at 75%, though some may allow up to 85%.
For acquisitions, LTV is calculated by combining the values of both the buyer's and seller's businesses. For example, if a $1M business acquires another $1M business, the LTV would be 50% (i.e., $1M loan/$2M value). If a $333,000 business acquires a $1M business, then the LTV would be 75% ($1M/$1,333,000). In this scenario, an equity injection (down payment and/or seller financing) may not be required based on LTV, though lenders might still prefer to see some level of injection (5%-10%). As a rule of thumb, if both businesses are valued at the same multiple, the buyer’s value should be at least 33% of the seller’s value (or vice versa) to meet a 75% LTV.
SBA Loans Have New Rules for Equity Injections The SBA made significant changes to their equity injection requirements for loans involving ownership changes. Let’s explore how these new SBA equity injection rules apply to advisory acquisitions, partner buyouts, and equity buy-ins.
It’s important to note that the SBA is increasingly deferring decisions to the individual lender's internal policies. While the SBA sets forth rules and procedures, each SBA lender may impose additional policies on top of the SBA's requirements. As a result, not all SBA lenders approve the same loans or the same way. One lender might require an equity injection while another might not, depending on various factors.
Expansion Acquisition
For established business owners looking to acquire, not needing a down payment or seller financing can be a game-changer, provided certain criteria are met. If the target acquisition meets the following three conditions, no equity injection is necessary:
The target business operates within the same industry as the acquiring business.
The geographic location of the target business aligns with that of the acquiring entity.
The ownership structure of the acquiring business is exactly replicated in the acquired business.
By meeting these conditions, business owners can sidestep the 10% equity injection requirement. However, if any of the three conditions are not satisfied, the standard equity injection rules for non-expansion acquisitions will apply.
Non-Expansion Acquisition
The SBA mandates a 10% equity injection for non-expansion loans involving a change of ownership. This requirement applies to the total project costs rather than the loan amount or purchase price, and the 10% equity must originate from outside the selling business's existing balance sheet.
For advisors these acquisitions refer primarily to those deals where the buyer's ownership structure is different and don't qualify to be considered an "expansion" by the SBA rules. The first two requirements of an expansion loan (same industry and client footprint) are met with most advisor-to-advisor acquisitions. The third expansion requirement of the buyer's ownership structure being the same can get triggered if an advisor is partnering with another advisor for the acquisition or if using a different entity for the acquisition.
Even so, the SBA provides a path for the buyer to not have to make a 10% cash down payment in the full standby note option.
10% Equity Injection Required:
Equity Injection If Cash Payment: As a small business owner, it’s crucial to understand that the equity injection can be paid in cash, ideally wired to the lender right at or just before closing your loan. This cash can come from various sources like savings, investments, a Home Equity Line of Credit (HELOC), or even as a gift (just make sure to have a gift letter for proof). Remember, lenders typically ask for the latest account statements to verify these funds.
Full Standby Note: Good news! The SBA has updated its policy regarding the full standby seller note. Now, sellers can finance the entire 10% equity injection requirement. During the first two years standby period, no principal or interest can be paid. Just keep in mind that your loan shouldn’t have a balloon payment in order to qualify; it must have a structure that ensures full repayment after the standby period. This option can help you purchase a business with no money down!
Partial Standby Note: A partial standby allows you to make interest-only payments for the first two years, without any principal payments. Sellers can finance up to 7.5% in a partial standby note, but the SBA does require that 2.5% comes from another source. It’s essential to have adequate cash flow to support this option. Like the full standby note, your loan must fully amortize after the interest-only period and should not balloon.
Partner Buyouts
When it comes to equity injections for partner buyouts, they apply in both complete and partial scenarios. In either case, a seller promissory note for the equity injection isn’t an option. For ownership changes, the cash contribution can either reflect a debt-to-worth ratio of no greater than 9:1 on the pro forma balance sheet or be at least 10% of the purchase price, whichever is less. In partial ownership changes, SBA will assess ownership percentages after the sale to determine guaranty requirements.
Complete Partner Buyout
If you’re buying out an existing partner to own 100% of the equity, you’ll need a 10% cash down payment unless two conditions are met:
You must have been actively involved in the business operations and owned at least 10% over the past two years, which both you and the seller need to attest to.
The maximum debt-to-worth ratio of 9:1 must be documented based on your business balance sheet.
Partial Partner Buyout
When purchasing less than 100% of a partner’s equity, a 10% cash injection is typically required unless you meet certain conditions:
You maintain the 9:1 maximum debt-to-worth ratio.
Remaining owners with 20% or more equity must comply with SBA guarantor requirements, including personal guarantees and collateral.
Equity Injection via Cash Payment: If you’re paying the equity injection in cash, it’s best to wire the funds to the lender just before closing. This cash can come from various sources like savings, investments, a Home Equity Line of Credit (HELOC), or even a gift (with a gift letter). Lenders will usually need the latest account statements for verification.
Full Standby Note: The SBA has recently updated the full standby seller note. Now, sellers can finance the entire 10% equity injection requirement, provided no principal or interest is paid during the first two years. To qualify, the loan must not include a balloon payment; it must fully amortize after the standby period. This option allows you to purchase a business with no money down!
Partial Standby Note: In this scenario, you can make interest-only payments for the first two years, with no principal payments. Sellers can finance up to 7.5% of the equity injection through a partial standby note, but you’ll need to source 2.5% from outside that financing. Keep in mind that your cash flow must adequately support this option.
Equity Buy-ins
When a non-partner buys into a partnership by acquiring less than 100% of the shares. This is treated with SBA loans in the same way a partial partner buyout loan is handled. A seller promissory note option to contribute towards the equity injection requirement is not allowed. This loan requires a ten percent cash injection unless two key requirements are met:
10% Cash Injection Required Unless:
A Maximum Debt-to-Worth (equity) of nine-to-one (9:1). This is determined based on the business balance sheet over both the most recent year and quarter. To determine the debt-to-equity ratio, divide the total debt of the business by its total equity. For instance, if a business has $900,000 in debt and $100,000 in equity, its debt-to-equity ratio would be 9:1 and eligible for 100% financing. A business with $1,000,000 in debt and $10,000 of equity would be a debt-to-equity ratio of 100:1 and require a cash equity injection
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.
This article is authored by Darin Manis, founder of LoanBox.