Naturally, people work on financial matters with their banks—so much so that most of the time, they don’t realize their options when it comes to loan brokers. Working with loan brokers can be a very different experience for most, but it can also bring unexpected benefits. Doug Adams is the Principal and President of Emerson Capital Corp. Joining Domenic Rinaldi, Doug differentiates the requirements and benefits of working with loan brokers versus working with banks. Check out the difference and see what works for you.
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Working With Loan Brokers Versus Banks With Doug Adams
We have a special treat. I am being joined by Doug Adams, the Owner of Emerson Capital, an SBA loan broker who specializes in helping buyers secure business acquisition loans. Doug works between the buyers and the banks and provides an invaluable service to his clients, the buyers. Doug works with about eighteen preferred SBA lenders across the country. There are countless reasons to work with a loan broker versus going direct to the banks. We will explore those in detail. What I can tell you from working with Doug for years is that he understands the intricacies of SBA loans like no one else I’ve ever met. He provides tremendous value to his clients. He also happens to be my golf buddy and a great guy. Doug, it’s such a pleasure to have you here.
Domenic, thank you, I’m happy to be here.
Doug, we’ve been working together for years. You’ve done God knows how many loans for buyers that we’ve brought to you. What I want to get into is the process that buyers go through and the things that they need to think about when they want to get in business acquisition loans. Maybe we could start from there. When the buyer first comes to you, what should they be thinking about? What are some of the things that you talk to them about?
It’s a number of different things. Initially, when I’m talking to a buyer, many times they are starting their search for a business. They have not identified a particular business yet. They want to know how to go about obtaining financing. Will they qualify? What do they need to have prepared? There are other situations where I come into the picture where a buyer has already sent in a letter of intent to a seller and they are ready to go into the process, get a deal over to a bank, get it approved and try to close the deal. In the situations where I’m working with the buyer before they’ve identified a business, I’ll spend some time with them. I find out their background, what their skillsets are, how much they have in liquidity. What are they looking to achieve in cashflow, describe how the SBA process works, what we’ll need to put together, the tax returns, personal financial statement?
I make sure their credit is adequate and then determine how much they can put down and leaving themselves some working capital. We can put working capital into the deal structure, but the banks like to see that they have a little bit leftover after they make that down payment. Based on their information, if they’d like, I’ll go ahead and prequalify them as a buyer for a particular industry given the fit that they may have with their background. Sometimes, we’ll work on a little bit of a transferable management experience narrative, which is an important factor for the banks to make sure that these buyers can step in and take over the specific roles of a given seller in a business. We’ll prequalify that buyer.
Pre-qualification, imagine most people reading have gone through the process of pre-qualifying for a home. You’re pulling together all of the relevant information so that you can figure out whether or not they could get bank financing, for what size deal and what type of deal. Those two things matter, what size and what type. You hinted here relevant transferable management experience is key things for the banks.
It’s huge. Some of the banks, it’s an outright requirement and they may want direct industry experience or not. It’ll depend on what kind of rates you can get and the structures you can do. It’s important. It is similar to a prequalification for buying a house. It’s a little different because when you’re going through that process of buying a house, they’re going to analyze your existing cashflows. Here we’re making certain assumptions about what the cashflows will be on the business you end up buying. That comes back to what is an average multiple on the cashflow.
Since the SBA requirement in nowadays world is a minimum of 10% down from the buyer on the project costs, we can determine how much they can comfortably invest and then back into the appropriate purchase price. Make the assumptions of how much cashflow is coming with that business at that purchase price. Make sure after allowing for what their household cashflow needs will be that there’s enough leftover cashflow to adequately cover the required debt service coverage ratios that the bank underwriters will look at.For some banks, direct industry experience is an outright requirement. Click To Tweet
Suffice it to say, people that we have sent to you over the years are glad that they’ve met with you even before they’ve identified a business. That’s important because you’ve been able to help people think through what types of businesses they should focus on. Oftentimes, buyers will come in and they’ll be focused on a cashflow number that they want to get out of the business or an adjusted EBITDA number or broadly in the industry. They may not be able to get a loan for that. You’re able to think through all of those issues with folks and maybe even steer them in a couple of different directions so they can then launch a search. We do that with a lot of folks. We’ll have them start with you because you can give them a good foundation from a lending perspective, so they’re not wasting their time and bringing you deals that you can’t get done for them.
To take that a step further, once we can figure out how much they can adequately invest in a business, then we look to what do they want to obtain in cashflow to live on out of this business. A lot of the buyers may not have already thought through. If you buy a business that has $1 million of cashflow and let’s say that the purchase price for that business is $4 million. That sounds great, but then you have to figure what is going to be the debt service on that business purchase after you structure it with 10% down and maybe 10% seller note. What are your payments going to look like to the bank? If there’s a seller note involved, adding in those payments. You look at what your expected total debt service is going to be in on that million dollars’ worth of cashflow, you may well use up $500,000 or $600,000 of it in debt services. What is your expected amount that you’re going to take home? Is that adequate for you or not? Make sure they’re thinking about these things in that regard.
You’re throwing out this term cashflow. Let’s describe it a little bit more. When you talk about cashflow especially if it’s an individual buyer and not a company, you’re looking at what that business is going to spit off and then you’re also taking into account what are their personal needs. Maybe you could talk a little bit about that. I think the term is global cashflow.
The banks are going to look at the cashflow from the business that the business is historically throwing off. They’re all about pointing to the last taxable year of cashflow because they feel that that’s a third-party verification of what the real cashflow is. They’ll start with the net income in a given business. From there, they’ll look at the appropriate add-backs. It’s common for the banks to include and accept the add-backs that are verifiable to get to what is commonly known as the seller’s discretionary earnings. The seller’s salary depreciation, amortization, interest, things that the seller put through the business that either was one time in nature or non-business related, depending on how big of a number that is. It may or may not have to be verified later. They’re looking at that cashflow that the business is throwing off.
As far as what the household cashflow needs are for a buyer, the bank is going to analyze that as well. They’re going to look at their mortgage payments, car payments, any credit card debt, dependence in the household, and they’re going to come up with what is in their opinion a minimum household draw that this buyer will need. If that buyer has continuing outside income from a different source or a spouse that provides income to the household, then that number can be reduced. If there is no outside continuing income, they’ll take this available cashflow from the subject business. They’ll subtract that household need draw, be it $75,000 or $100,000. From what’s left, they’ll look at the coverage ratio on the debt service that is going to be as a result of this loan, the debt service on the bank loan and the seller note. Typically, the banks are going to want the minimum requirement of coverage after allowing for that household draw is a 1.15 according to SBA rules and regulations. Most of the banks, however, would want at least a 1.2 coverage.
Explain that calculation. How does somebody calculate what the debt service coverage is?
What you do is you figure out what the expected loan structure is going to look like. If you are buying that $4 million business, you’re paying 10% down and the seller is holding a 10% note, after the down payment and the seller note is going to be the bank loan. These are generally ten-year terms unless real estate’s involved, you can get a longer-term. If that’s $3.2 million, then you’re going to figure what the loan payment is going to be on $3.2 million amortized over ten years at 7%, let’s say. You can see what that payment is going to be and you can do the same thing for the expected seller note if that’s being amortized over five years at say 5% or 6%. You can get at what the debt service is going to be in this deal structure and then compare it to what the available cashflow is that this business is historically throwing off. After you take out that slice for the household draws from what’s left. If you’ve got let’s say $900,000 of cashflow out of that $1 million that the business is throwing off because $100,000 went to the household, how does that $900,000 compared to the $600,000 worth of debt service and look at that coverage ratio?
Some banks have different thresholds. Some might have 1.1 or 1.2 or 1.25. What they include and don’t include in the cashflow differs from bank to bank, right?
It does. The minimum that the banks are allowed to push through to maintain their guarantee beyond these SBA deals is a 1.15 coverage. However, most of them are going to want something a little bit higher. There are lots of banks that want 1.5 coverage. A lot of the ones that we utilize are typically going to be in the 1.2 to 1.3 minimum. Generally, 1.2 is okay as long as the other components of the deal are satisfactory. How they calculate that cashflow is also, as you alluded to, different for every bank. They’re going to look at what the projected cashflow is for the business once this buyer or any buyer buys it. They should factor in the expected interest. When you’re going to look at the net income that the business is throwing off, some banks will assess the taxes on that. What are the expected taxes going to be? To take that a step further, how they’re calculating that tax on the net income or better how they’re calculating the net income depends on whether or not they take into account the non-cash expenses like depreciation, amortization, interest and those kinds of things. To get at what is the appropriate net income and then apply their tax on that.
Doug, what you’re covering here is the reason why we as a firm decided to have someone like you involved in the process because every bank is different. The rules and their processes change. Staying on top of all of that is all a full-time job. We tell people when we refer them to you that you’ve got eighteen banks. They all look at these things differently. You can sift through, depending on the situation, which bank or banks are best for that buyer to be talking to, figure out where they can get the best loan and where’s the highest likelihood of getting a loan. That’s the real value that I see in someone like you doing what you do day in and day out is you keep all of that complexity in-house and you’re able to sift through that for buyers and get them the best outcome.
There’s no doubt. Not all SBA lenders are created equal. All the banks have their own approach. They’ve got their own underwriting standards. Some of them are going to require higher coverage ratios. Some are going to be more aggressive. Sometimes, the more aggressive, and when I say more aggressive, I mean they’re going to go ahead, approve and willing to do deals for a buyer who may not have an immediately identifiable tie to a given industry. We have to do often these transferable management experience narratives to connect the dots so that the bank underwriters can determine and illustrate for them that the buyer has the skillsets to take over the specific roles that the seller had.
There are many banks, especially over certain threshold will want to make sure that this buyer has direct industry experience. Those banks may have relatively lower rates, but you can’t get a deal approved there if you don’t have direct industry experience for a deal that’s $3 million or more or they add a certain threshold. It requires more scrutiny and more people looking at it and it’s tougher to get approved. Every bank has its own approach to identifying the coverage ratios to giving rates out, giving terms. Some can offer working capital express lines up to $350,000. Others will tend to put working capital into the deal structure. There are different effects on either of those approaches. You have to know which bank is a good fit for a particular deal.
Over the years, we’ve even had some banks who have come to us in one year and have said to us, “We want to do deals in this industry.” They do a bunch of deals in that industry and then two years later like, “We’re done doing deals in that industry.” The landscape, rates and the terms change quickly. You heard cats all day long for your clients and it’s great because there’s a lot of comfort in knowing that you can put them in the right place and get them the right deal. Doug, let’s move on from prequal. Somebody works with you. They get a good sense of the deals that they can get financed. They understand what their lending limits might be and their thresholds. They go out and find a deal and they bring it to you. What should they prepare for from a bank perspective from that point forward? What documentation? What does the process look like? How long does it take to get through the underwriting and approval process?
One of the benefits of working with the SBA loans is that it’s fairly standardized in terms of what the requirements are and the rules that all the banks have to adhere to. When a deal is made and a buyer has found a business or if I already haven’t, I’ll collect copies of their last three years personal tax returns, a personal financial statement, a resume or a summary of their work experience. That coupled with an executed LOI, the three years of taxes from the seller, their present year profit and loss statement and balance sheet, I can go ahead and write up that deal based on the terms in the LOI and present it to a bank or request a term sheet for the loan.
We’ll go in and ask them to do a term sheet. The bankers who I work with are all good at what they do. Otherwise, I’m not using them. These guys are experienced. They can look at these transactions and relatively quickly understand that there’s a deal here or there’s not. Assuming there is, then they’ll issue that term sheet and they’ll lay out the general terms and conditions for the loan, typically ask for their signature. Sometimes they ask for a refundable deposit along with it, maybe $2,500. It’s totally refundable if the deal is not approved and if it is approved, it counts towards their equity injection, so it’s not a separate fee. We will then help them fill out a couple of forms, personal history form where they will have already done that SBA personal financial form because that’s one of the forms I give them.
Send that deposit, sign that term sheet, the forms back to the bank. They’ll be required to do two years of projections for what the business is going to look like under their ownership, starting from what the seller had for their last period P&L and making whatever line item changes are appropriate for what it’s going to look like for this buyer to step in there. We’ll put that together. If we haven’t done a narrative on the managerial experience piece and if it’s required, we’ll put that together as well and get it into underwriting. These are all preferred SBA lenders that I work with, which means they make their decisions in-house. Typically, it’s two weeks or less in the underwriting process. The underwriters, once they get the file, they’d probably come back with a list of questions or requests, accounts receivable, agings, accounts payables, you name it. We’ll get them that information.Not all SBA lenders are created equal. Click To Tweet
Typically, the bank will approve that deal in two weeks. They’ll issue a commitment letter. The customer will sign it. They’ll send it back to the bank. The deal will be assigned to a closer in the bank who will give us a closing checklist. On there will be all the things that we need to get the bank in order to close the loan. Final purchase agreement. If the buyer is forming a new entity, they’ll want the tax ID number, articles of incorporation and various types of insurance for the business. They may require life insurance on the buyer as part of the transaction. If the premises are being leased, they’ll want to see the new lease or an assignment of the existing lease and make sure that they’ve got the legal right to stay there for the term of the bank loan.
If there’s a seller note involved, they’ll want to see that. They’ll prove up the equity that the buyer is bringing to the table. They’ll also order a third-party valuation during this closing process. The banks will hire that out and that valuation company will come up with a value on the business based on the cashflows in the industry and the trends. The banks are not allowed to lend more than the valuation amount. Typically, it’s not a problem as long as the multiple is reasonable. The bank will do their searches and all that kind of thing too. The closing process is about 3 to 4 weeks. If it’s four weeks in closing and two weeks in underwriting, say a week but it shouldn’t take this long to do the term sheet back and forth. You’re about 6 or 7 weeks in the overall process.
Let’s talk about underwriting. What are the typical questions that an underwriter might come back with? What’s your process for handling that with the buyer?
The underwriters are going to be looking at all of the buyer’s financials, any debts that they have. Many times, buyers own other businesses or other LLCs that maybe own real estate, maybe they have rental income and maybe they have another small business or a spouse that has a small business. They’re going to require the financials on any business in which that buyer owns 20% or more of the company, the taxes and financials. They’re going to factor that in. Is there any debt on that other business? Do they have multiple mortgages? It’s to make sure they’re figuring out what they’re global cashflow needs are. They’re going to ask questions and get back up so that they completely understand that and whatever else the buyer is doing.
On the subject business itself, they’re going to sink their teeth into it. They’re going to want to know what this business does. What is the business model? If the business model, let’s say it’s an electrical business or something in which the company bids for jobs. They’re going to want to know how that takes place. Who does the bidding? Who maintains the inventory? What are the roles of the seller that you’re going to step into, the buyer is going to step into, and can he handle them? What are the receivables? What is typical aging on the receivable? What are the working capital needs? Why did cashflow go down or up last year or the year before? They’ll look at the expenses in the business. If they see a wide fluctuation, they’ll want to know what took place there. They’re going to sink their teeth into this and understand it. We know that and that’s why we prepare for those things and in our summary and in the offering memorandums. We try to give them as much of that information upfront as possible.
What about forecasts? How large of a role does a forecast play in the buyer’s overall picture in what the bank is looking at?
It’s important and depending on the given transaction, if you have a business where every year the buyer’s revenue is $2 million and their cashflow is $600,000, give or take $10,000, $15,000, one way or another. That’s stable. The buyer who comes into that, it’s likely the bank is not going to be overly focused on the forecast because it’s evident that this business is stable enough to throw off those numbers. If you have a situation where the business one year has $2 million of revenue and the next year it has $3 million and then the next year it has $1.5 million, they’re going to get into it more. They’re going to want to understand what is expected going forward. It does come to, what are these buyer’s qualifications and skillsets? What is his reasoning for believing that he can improve the business? Many sellers have run their businesses for years and don’t do a lot of advertising, marketing or social media.
We’ll get a buyer who comes in and feels that he can increase his business nicely because of his existing skillsets in those areas. It’s important to show that. We’ll start with the seller’s profit and loss and we’ll do a spreadsheet that segregates by month going forward for the first twelve months and look at each line item. Determine if that revenue expected to stay the same. Do you have reason to believe it’ll increase? If you do, by all means, we’ll show an expected increase. What about the salaries expense? What about advertising expenses? Is the rent going to stay the same? Are you going to have to add any employees? Factor in the proposed debt service and take away the add-backs or the expenses that the seller had that the buyer’s not going to have. It’s important that the projections look appropriate. If not, the underwriters will question them. We spent a fair amount of time doing those projections.
Let’s hit on one other piece in underwriting that I think is important that people need to understand. You referenced third-party valuation. Can you talk a little bit about that?
Every business acquisition in the SBA world requires a third-party business valuation. It’s a protective mechanism for the banks and the buyers to make sure that they’re buying a business that is appropriately priced. It’s not overpriced. They hire that out. It’s a desktop thing. They’ll send the financials to the valuation companies. There are companies that specialize in this and all the banks use them. There are a number of different ones and banks use different ones. Some are maybe more conservative or more aggressive.
Typically, they’ll go ahead and take about 1.5 weeks, 2 weeks and analyze it all. They’ll come back with some questions invariably on the operation itself. Maybe what the expectations are going forward or question certain components of the cashflows. They’ll come back with that valuation amount. This takes place during the closing process after the approval. The banks are not supposed to lend more than the valuation amount. Typically, it’s not a problem. We have seen where the valuation comes in lower than hope for whatever reason. You have some maneuvering to do.
If the parties still want to do the deal, then they’ll either have to lower the purchase price or increase the down payment or perhaps increase the seller note amount so that the bank loan matches up with the valuation amount. That’s happened before. If there’s a big discrepancy, the buyer can state why he still wants to buy it at that particular price and we can send it in to the SBA and get their approval. It’s part of the process and it happens concurrently with the rest of the closing process when the buyer’s finishing their due diligence and we’re getting all the items on the checklist.
This has been awesome information. The thing that I would point out to people too is probably besides all of the hard work and effort that you put into these deals, the best news is that the buyers don’t pay your fee. The fee is paid by the banks. It’s not an addition to their loan amounts. It’s not like it’s being added in because you did all the work that you did and you brought that deal to them so they’re paying your fees. For buyers out there, it’s low risk to use Doug and his services and the benefits are amazing. The comments we get back from clients who have used you to secure their loans are unbelievable. They didn’t realize how much work and effort and back and forth going into it and all the coaching that you can do to keep people out of trouble when they’re in a deal is amazing.
I agree with you there. It is nice. I get the referral fee from the banks for bringing the deals over there and I don’t charge the customers anything. It works well. The best thing about this is for me personally. Everybody’s in business to make a living, but it’s rewarding when you help these buyers realize their dream of owning a business. You take them through the process and they’re excited like anybody would be in buying a house. When they close the deal, it feels good to help them get there. That’s what I do all day long. It’s a nice thing. It works well and we’ve had fantastic success.
That is always one of the things about this business I try never to forget is how much fun it is to see people either sell their businesses and get paid for their life’s work. This one big lump sum at the end of all of it and then to see somebody new come in and have all that excitement about what they’re going to do with that business. It always is exciting. Doug, it’s been great to have you on. Do you have any last comments that you would offer to the M&A Unplugged Community?
I would say that if you want to buy a business and you’re interested in looking at whether or not you think you might qualify for a given size, give me a call. I’d be happy to talk about it with you. One of the things that I do with all of my buyers and clients is I’m happy to go through, often as you know, these buyers are looking at multiple businesses and may take them months to years to find the right one. As they go through them and they’re analyzing them, I spend a fair amount of time with one and I may have 25 calls or more with a given customer who is looking at different businesses. We’ll get the financials in. We’ll analyze the cashflow and look at the add-backs that are being shown here. Are they appropriate? Will the bank go along with them? Are you comfortable as a buyer with that? Go through the structure and make sure that fits the criteria that they’re looking for and the likelihood of it getting approved. It can take a while but the results generally are great and it works out well.Underwriters are going to be looking at all the buyer's financials and debts. Click To Tweet
Doug, how can people reach you if they wanted to get in touch?
Doug, thanks. It was a pleasure to have you here.
Domenic, thank you for having me.
If you’re a buyer out there in the audience and have been thinking about acquiring a business, a great first step is to do a prequal. Sit down with someone like Doug and have him work through your background and your capabilities not just financially, but from a good business fit perspective, which is critically important once you get to banks. Start there. It’s a great place to get calibrated on what a business search should look like. From personal experience, several years of doing this, there are many pitfalls in making an acquisition alone. In the lending process, there are many pitfalls.
Having somebody like Doug, who’s a consultant for you to help you through every step, to keep you out of trouble and to keep your deal moving forward is invaluable. I can think of any number of stories where he came in and kept a deal going forward because he knew where to push the right buttons and where to help the buyers. If you would like to learn more about the process of acquiring or selling a business, please visit our website at SunAcquisitions.com. Feel free to reach out to me at [email protected]. I look forward to seeing you again on the next episode of the show. Until then, please remember that scaling, acquiring or selling a business takes time, preparation and proper knowledge.
About Doug Adams
Doug Adams is the Principal and President of Emerson Capital Corp. For 11 years, Doug has provided consulting services for obtaining financing for small business acquisitions, expansions and partnership buyouts.
He has over 30 years experience in small business lending including: Acquisition finance structuring, Loan Structuring, Credit Underwriting, Expansion financing, Partnership buyouts and equipment financing. In addition, Doug has SBA loan program expertise, with well established lender relationships.
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