What Business Owners Need to Know About Equity Buy-ins
What Business Owners Need to Know About Equity Buy-ins
Equity buy-ins, where a non-shareholder purchases a portion of equity, are becoming increasingly popular. As succession planning and equity retention strategies gain traction, so do partial equity buy-in loans. While there are advantages to equity offerings, there are also financing challenges and concerns that must be addressed. Some firms opt for internal financing for equity buy-ins, while others believe that such an approach undermines the entire purpose of a buy-in. Still, some business owners prefer bank financing for these transactions but find themselves self-financing due to bank requirements.
What are the potential drawbacks of bank financing for equity buy-ins? Often, there are none, but sometimes challenges can be significant unless circumstances shift. Let’s explore the recent expansion in lending options for equity buy-ins, along with what small business owners need to keep in mind.
Until recently, equity buy-ins were not an eligible loan purpose, but changes have made them so. Previously, only conventional loans were available for equity buy-in lending, but now business owners have two distinct loan options to consider. Since SBA loans have broader qualifying criteria than conventional loans, more small business owners now qualify for equity buy-in loans than they did a year ago.
Different lenders have varying approaches to partial equity purchases or buy-ins. Equity buy-ins still involve cash flow and loan-to-value (LTV) considerations similar to partner buyouts, but issues often arise with lender guarantees, grantors, and lien requirements that can cause concern for remaining partners.
A lien is placed on the entire business: When securing a loan for an equity buy-in, the bank will place a lien on the entire business, even if the loan is for a small percentage of equity. This means that if only one partner is borrowing, the lien will include the equity of the non-borrowing partner as well. It’s a blanket UCC lien covering all equity and client assets, present and future, and it remains in place for the duration of the loan.
Equity Injection is either 0%, 10%, or 25%: The equity injection—comprising the cash down payment and/or seller financing required for the loan—can range from 0% if the SBA's 9:1 ratio is met to 10% if it is not, in which case seller financing is not permitted. This necessitates a 10% cash down payment. Conventional loans typically require a 25% equity injection, with a maximum loan-to-value (LTV) ratio of 75%.
20% Partners = personal guaranty on SBA Loans: The SBA requires that all partners with a stake of at least 20% provide personal guarantees and adhere to collateral requirements. A major concern is the collateral related to personal property. If the buying partner lacks home equity equal to the loan amount—which happens nearly all the time—then for loans over $500,000, a partner with 25% equity in their home (outside Texas) may face a junior lien on their property to secure the loan for the other buying partner.
20% Partners = grantor on conventional Loans: For conventional loans, a corporate guaranty and/or grantor agreement is necessary. In this agreement, non-borrowing equity owners personally grant business collateral to the lender. Depending on the buyer and the overall loan scenario, some conventional lenders may also require personal guarantees from existing partners. These types of deals are often evaluated on a case-by-case basis, and while personal guarantees are not common, they can still be required.
Depending on an endless combination of variables some 20% plus partners will be in a position where the bank requirements for equity buy-in loans are mostly inconsequential. For others it could mean adjusting how and when they disburse equity or even implementing alternatives like initially awarding phantom or synthetic equity and converting to real equity later.
Planning for equity buy-in financing ideally should be considered early in the process when your equity sharing policies are established (but it never is). If you are considering selling partial equity then consider having a conversation with us about how the financing would look for your structure or to pre-qualify an internal buyer for a buy-in loan.
This article is authored by Darin Manis, founder of LoanBox.