LOANOLOGY

QUALIFYING

SUCCESSION LENDING

Equity Buy-in Loans
What 20% Remaining Partners Need to Know

Different conventional lenders approach partial equity purchases or buy-ins differently. For partner buy-ins there is still the cash flow and LTV considerations that a partner buyout have but often the issue for partner buy-in loans is the lender’s guaranty and lien requirements.

A lien is placed on the entire business:
The bank will place a lien on the entire business even though it is lending for an equity buy-in of only 1% of the business. So if only one is getting a loan, the lien is going to encompass the equity of the non-borrowing partner has as well. It's a blanket UCC lien and covers all equity and client assets, now and in the future, and this stays in place the duration of the loan.

Equity Injection is either 0%, 10%, or 25%:
The equity injection, which includes the cash down payment and/or seller financing required for the loan, will range from 0% if the SBA's 9:1 ratio is met, to 10% if it is not. In this scenario, seller financing is not allowed, necessitating 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:
SBA mandates that all partners with at least a 20% stake provide personal guarantees and comply with collateral requirements. A significant concern lies in the collateral requirements related to personal property. If the buying advisor does not have equity in their home equivalent to the loan amount—an issue that occurs approximately 99.99% of the time—then for loans exceeding $500,000, a 20% partner with 25% equity in their home (outside of Texas) would face a junior lien placed on their property to secure the loan for the other buying advisor.

20% Partners = grantor on conventional Loans:
For conventional loans then a corporate guaranty or grantor agreement would be required. The grantor agreement (or equivalent) is where the non-borrower equity owners personally grant the business collateral to the lender. Some conventional lenders based on the buyer and overall loan scenario may also require one or more personal guaranties from existing partners. Conventional lenders are very case-by-case basis on these types of deals but personal guaranties are not common.

Internal Successor
Lending & Financing

Can they use the phantom stock I gave them as a down payment?
Conventional: If the buyer is doing a conventional loan, no problem.
SBA: The equity owned needs to be reported on their last two years tax returns to qualify. If the equity is phantom stock, a verbal agreement, or equity that you gave that has no benefit unless you sell someday, then lenders typically will not view that as eligible equity ownership that could be applied as the down payment.
Can I spread out payments over multiple years without seller financing?
Yes. Part of the purchase can be placed into escrow and then disbursed over multiple years.
Can they get a loan for the down payment and then do an earn-out for the rest?
If they qualify for a conventional loan they can. Any form of an earn-out is not allowed with an SBA loan.
Can I help my successor avoid a down payment?
Other than guarantying the loan, they would need to be 1099 for one year prior to the purchase and own enough assets to value at just over 10% of the purchase price.
What does it cost to see if my successor qualifies?
Nothing, we provide pre-approvals for free.

The Buyer’s Loan Influence on Seller Payment Structures

The loan type a buyer secures to finance the acquisition of a financial practice plays a crucial role in shaping the payment methods available to the seller. Whether the buyer qualifies for a conventional loan or one backed by the Small Business Administration (SBA) directly impacts how the transaction unfolds. Conventional loans typically offer more flexibility, but they often come with stricter qualifying requirements. In contrast, SBA loans may be more accessible for some buyers, yet they come with specific rules that influence the deal structure.

For sellers looking to transition out of their practice gradually through phased equity sales or those wanting to retain a certain level of equity, it’s essential that the selected loan program aligns with these goals. Factors like seller notes, claw backs, and earn-out arrangements are handled differently under each loan type. Conventional loans tend to be less prescriptive, while SBA loans often have strict guidelines regarding earn-outs to ensure compliance with regulations that protect the SBA's interests.

Why does this matter for sellers? Understanding the differences between loan types is vital, as this knowledge impacts the seller's liquidity and risk after the transaction. Sellers need to consider the financing options their potential buyers qualify for early in the process to ensure their desired transaction structure is viable. If a buyer's financing options are limited or misaligned with the seller's proposed structure, it may necessitate a re-evaluation of the transaction terms or even the search for another buyer who meets the preferred criteria. Consequently, negotiating these elements requires foresight and a keen understanding of specific loan terms to avoid any unintended constraints on the deal structure that could jeopardize the seller's payment terms.

While most sellers have an idea that SBA and conventional loans may have different rules lets go over more precisely how depending on SBA or conventional, and which lender the buyer uses impacts the selling advisor.

The Importance of Understanding Your Buyer’s Loan Qualification

External financing is crucial for your buyer's ability to acquire your practice. Most buyers will likely rely on either a conventional loan or an SBA loan to finance their purchase, each coming with distinct qualifying requirements and restrictions related to acquisition or equity buyout structures. While there is considerable flexibility in structuring a deal between buyers and sellers, that flexibility has limits when financing is involved. It cannot extend beyond the parameters established by the specific loan program and lender.

How a Buyer’s Loan Affects Payment Structure Options

Typically, buyers will use either a conventional loan or an SBA loan for financing. Although there is ample room for negotiation in deal structuring, if bank financing is necessary, the options will be confined to what the specific loan program and lender permit.

Payment structures permitted under a conventional loan differ significantly from those under an SBA loan. SBA loans have clearly defined parameters regarding acquisition structure types and provisions. Consequently, the type of loan—conventional or SBA—that the buyer secures, along with the particular lender, will influence the payment structures available to the seller.

If you value an earn-out structure, prefer to sell equity in tranches over time, or wish to maintain a key role years after the sale, it is essential for the buyer to qualify for a conventional loan, which typically has stricter qualifying criteria than an SBA loan. These options are generally not feasible under an SBA loan.

If Payment Method is as Important as the Sale Price

For many sellers, the sale price is just one consideration; the payment method is equally significant. Most sellers prefer to receive as much as possible upfront at closing, while some may want part of the payment spread over multiple years. Others might opt for an earn-out, receiving a percentage of revenues or profits over several years. These payment structures are common in wealth management mergers and acquisitions. However, if a buyer requires external bank financing to purchase your premium-priced practice, not all payment structures will be available to them.

Seller Guaranty

If your buyer chooses a conventional loan but doesn't qualify on their own, a seller guarantee may be necessary to go conventional. Internal successors with insufficient equity or client assets, as well as employee-based successors, typically require these guarantees or grantor agreements. For SBA loans, a seller guarantee is not needed except in a partner buy-in scenario where any remaining 20% partners also have to be a personal guarantor on the loan.

Target or Develop Buyers Who Qualify for the Desired Loan Structure

If a specific loan program does not support the structure the seller desires, it’s vital to assess whether potential buyers qualify for a loan program that does. Unfortunately, many prospective buyers are unaware of their financing options. While many buyers are actively seeking opportunities, most haven’t taken the time to prequalify for external financing. First-time buyers, in particular, may not know if they qualify for a conventional loan, an SBA loan, or any bank loan at all.

Just because a “larger producer” expresses interest in acquiring your practice doesn’t guarantee they will qualify for a loan that permits your preferred payment structure. Some advisors and firms with substantial assets under management (AUM) and revenue may carry significant overhead and debt obligations from previous acquisitions, limiting their capacity for additional debt.

Even if your potential buyer has financed multiple prior acquisitions, this does not ensure they will qualify for financing for your sale. Advisors heavily engaged in acquisitions may already be leveraged to a point where approval for another loan could take a year or more.

When considering selling your practice, it’s prudent and efficient to focus on prospective buyers who are pre-qualified for financing that aligns with both the amount you want to be paid and the method of payment.

Succession Equity Buy-ins Tranches Through SBA Lending

5% now, then 76% to 94% in 2 years, then the last shares whenever final retirement happens.

This is not an official SBA program but how we work with the SBA rules to achieve desired outcome of a next-gen advisor going from no equity to 100% ownership over time based on financing timeline benchmarks. This structure outline can work for a business owner who is ready to slow down but not retire, who want to sell most but not all of their equity to firm employees, wants to help position these employees for SBA financing, and does not want to guaranty their loans.

1. Minority <5% Equity

Some small amount level of equity like 5% is transferred to successor(s). This can be paid in cash or provided as services rendered or converted from phantom stock or the promise of equity into actual equity.

An SBA loan can be done for this initial piece but a seller guaranty from all 20% partners would be required.

2. Wait 2 Years

The successor receives K1s for ownership for two years. At anytime after 2 years the next-gen minority partner(s) can purchase can pursue full financing to buy out another 76% to 94% partial equity purchase.

Other partners with less than 20% do not have to personally guaranty the loan.

3. 76% to 94% Equity Sell

Successor purchases a sum equity that can range from 76% equity which leaves seller with 19% to 94% equity which leaves seller with 1%. This is now a partial partner buyout loan. No seller guaranty required.

4. Retire When Ready

Senior shareholder maintains minority partner status owning from 1% to 19% of equity. Can sell the rest at once or in tranches to the same buyer or to whomever the partnership agreement allows for.

1.15 DSC: The deal structure needs to cash flow at better than 1.15 DSC.

9:1: The business balance sheets for the most recent completed fiscal year and current quarter must reflect a debt-to-worth ratio of no greater than 9:1 prior to the change in ownership.

Equity Buy-in Loans

Comparing SBA & Conventional Equity Injections

An equity injection can be provided by the buyer through a cash down payment or from the seller by providing a seller promissory note (subordinated to lender) or satisfied through a combination of buyer down payment and a seller note. Conventional and SBA loans have completely different rules for equity injections, with conventional being more consistent for all loans but also significantly higher than what SBA loans allow for.

0% or 10% SBA EQUITY INJECTION

The equity injection requirement for partial equity acquisitions is waived if the new owner contributes at least 50% of the equity in the business.

Complete Partner Buyout
For the complete partner buyout there is a 10% cash down payment requirement unless two conditions are met:

1 - 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.

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

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

1 - There is also the same nine-to-one maximum debt-to-worth condition.

2 - The second condition is 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.

9:1 DEBT-TO-EQUITY

Calculating the 9:1 ratio

The 9:1 ratio for equity injection in SBA SOP 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.

25% CONVENTIONAL EQUITY INJECTION

25% is the typical equity injection for conventional loans.

While a borrower's personal financial situation, experience and competency, and credit scenario impacts if a bank may require an equity injection, all loans will have a primary equity injection policy and for conventional lenders it is based on Loan to value - LTV. Conventional lenders have maximum LTV requirements typically at 75% but one or two will go to 85%.

For acquisitions, LTV is calculated by combining the value of the buyer's and seller's businesses, resulting in most conventional acquisition deals meeting the LTV requirement. If a $1M value business acquires a $1M value business then $1M loan/$2M value = 50% LTV. When a $333,000 value business acquires $1M value business then $1M/$1,333,000 = 75% LTV.

Rule of thumb if both businesses valued at same multiple, the buyer’s value needs to be at least 33% of the seller’s value to meet a 75% LTV.

See equity injection section for more details.