Spokane Journal of Business

SBA loan limits give small business buyers more options

As acquisition market improves, changes made in '10 are helping now

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SBA loan limits give small business buyers more options
Paul Keller

According to the latest economic census, there are almost 9,000 companies in Spokane County with combined total revenues of nearly $18 billion. In the manufacturing sector alone, there are more than 500 companies with average annual revenues that exceed $6 million; approximately one-third of those enterprises are relatively larger, employing more than 20 people.

The owners of those businesses, along with thousands of owners across other industries, will be pleased to learn that business acquisition financing has become more readily available over the last year or so, even while the economy continues to stabilize. So while retirement may be not as close as some business owners might have hoped, it may not be as far off as they think.

In 2006, an economist at Cornell University estimated that the baby boomers—the first of whom were turning 60 that year—controlled some 8 million privately-held companies in the U.S. As the baby boomers reached retirement age and transitioned out of business ownership, the resulting wealth transfer was projected to total some $10 trillion. But that was 2006.

In July 2007, the Dow Industrial Average closed above 14,000 for the first time in history; less than a month later we started learning about subprime mortgage-backed securities in the portfolios of banks around the world. Suffice it to say that the subsequent economic conditions caused challenges not only for the U.S. as a whole, but also for millions of business owners that were otherwise planning to retire. Business revenues and profits decreased, lowering the value of many companies and forcing owners to put off retirement while they work toward recovery.

Thankfully, things are improving—albeit slowly. Today, many small companies are gradually working their way back from declines they suffered over the last several years. Optimism is beginning to return, even though some businesses have not fully recovered their value. Perhaps more importantly, thousands of business owners in the greater Spokane area may be surprised to learn that conditions for selling have quietly improved while owners have been focused on serving customers, reducing costs, and shoring up their balance sheets.

In late 2010, the U.S. Small Business Administration made important changes to its loan programs. And although the news may not have seemed significant at the time due to other economic conditions, the result is that many more business sellers stand to gain when the time comes to sell.

A business owner that sells a company typically should be focused on maximizing the cash received at closing. After all, a seller will no longer have control of the company or its direction and consequently shouldn't have risks tied to the operating results. The challenge arises because many companies worth $2 million to $6 million are purchased by individuals, but few individual acquirers have enough cash to purchase a company outright. Moreover, many small companies are worth far more than banks are willing to lend based solely on their assets. The SBA helps with this challenge through its 7(a) program, which guarantees a portion of acquisition loans, thereby encouraging lenders to loan well beyond a target company's assets.

Prior to 2010, the SBA would guarantee up to 75 percent of a $2 million acquisition loan. This program provided attractive acquisition financing for many business that were valued at $2 million and less. Unfortunately, if your business was larger than $2 million but not so large so as to attract private equity or strategic buyers, then getting cashed out at closing was a challenge.

By way of example, a well-funded individual acquirer with an SBA loan might only be able to pay $3 million or $4 million in cash on a $6 million company; the remainder of the financing—one-third to one-half in this example—would have to come from the seller. Justifiably, few business owners were willing to stake their retirement on loan payments from an acquirer, no matter how qualified.

SBA loan sizes were increased as part of the Small Business Jobs Act passed in October 2010. As a result, acquisition loans under the SBA's 7(a) program were increased to $5 million—and higher in some cases—while real estate loans under the 504 program were increased to $12.8 million. In practical terms, the 7(a) increase means that a well-funded acquirer with an SBA loan can provide all cash to a seller whose company is worth $6 million. The transaction is obviously far more attractive to the seller.

What is less obvious, but perhaps even more important, is that a larger number of prospective buyers are capable of purchasing larger companies under the new loan limits. Sellers always obtain better prices, better payment terms, and more attractive tax treatment when their companies are made available to a larger number of qualified prospective buyers, provided that the process is handled carefully and confidentially.

While increased loan limits definitely translate into more cash at closing, business owners should be aware that lenders may not want the seller to be cashed out completely. Acquisition lenders argue that they are demonstrating considerable confidence in the company's ability to perform under the acquirer's leadership post transaction. Not surprisingly, lenders, not to mention buyers, often want to see the seller demonstrate similar confidence in the form of a promissory note. The seller note might be token sized, or it could be considerably larger depending on the strength of the company, the nature of its assets, the stability of its earnings, and the qualifications and financial strength of the acquirer. The size and terms of a seller note are largely negotiable; the seller's best negotiating leverage comes from the presence of multiple prospective acquirers.

Every business will eventually undergo an ownership transition; the only questions are how and when. Some business owners, particularly those who can transition leadership to family members or an existing management team may be able to retire even while their companies still are recovering. Other owners who intend to sell to a third party may need to wait for a full recovery; they are hopefully using the intervening time to carefully plan their transition. In any case, thousands of business owners in Spokane and millions around the country have had to postpone their retirement. When those owners are eventually ready, they could benefit from the recent changes in SBA financing programs.

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