Many people have been praying for new opportunities this 2021. For those who delve into business acquisitions, huge changes may already be coming their way. Doug Adams of Emerson Capital and Domenic Rinaldi talk about the significant amendments to the CARES Act, which is mainly about waving SBA fees for all newly booked deals. This huge news will result in cheaper acquisitions for buyers and more cash earnings for sellers, all thanks to leverage banking. Doug and Domenic talk about the many possibilities of how everyone can take advantage of this update, particularly those who want to achieve a serious comeback from a pandemic down this new year.
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Doug Adams: How The CARES Act Will Change SBA 7(a) Loans
We’ve got some great news. It looks like the CARES Act is going to have a round two. This is particularly important because there’s an SBA component that is going to extend a lot of the benefits that were offered for SBA 7(a) business acquisition loans and they’ve even sweetened the pot. I brought back Doug Adams of Emerson Capital to talk about some of these changes. They haven’t been finalized, but in all of the discussions that we’re having with the bankers and the SBA, it looks like this will happen. There are some big changes, some positive news and some great benefits, not just for buyers. It’s making it cheaper for buyers to secure and easier for buyers to secure SBA 7(a) loans for business acquisitions.
I also believe strongly that this is going to be great news for sellers. Sellers are going to be able to attract buyers to their businesses more easily. Buyers are going to be able to cash more sellers out because they’re going to be able to leverage banking. This is awesome news should continue to stimulate both the economy and the M&A sector this 2021 and maybe beyond. Some big changes and lots to offer here in this episode. I hope you enjoy our show. If so, please take a moment to subscribe and review our show. We appreciate it. By subscribing, you’ll be notified of new episodes and the bonus episodes we plan to release in the near future.
In the meantime, if you have any questions about buying or selling a business or need to understand the process better, don’t hesitate to reach out to me directly at [email protected]. I am committed to helping you avoid the common pitfalls so you can maximize value and minimize risks. Please let me know specifically what you’re seeking help with. Thank you for being here. I know you’re going to get a ton out of this episode.
Doug, welcome back to M&A Unplugged.
Thank you, Domenic. I’m happy to be here.
What a way to kick off the new year with this news coming out of the SBA about some changes that they’re going to make to SBA lending in the new year. It’s a continuation of what started last year with the CARES Act, but they’re taking it to another level now. This is great news for buyers and it’s good news for sellers too, because if buyers can more readily get access to lending. It means that sellers are going to be able to walk away with more money at the closing table potentially.
There’s no doubt. This latest stimulus package is designed to do that, stimulate the economy, encourage the banks to lend and make it easier and more effective to keep businesses doing what they want to do, encourage more acquisitions and lending. There’s a number of things that they’ve put into place now. Some of which we’ve had in place before and it’s lapsed and some new stuff, which is exciting for all of us who were involved in financing acquisitions and doing SBA loans.
We completed an interview at the end of 2020. When we heard this news, I said, “We’ve got to get Doug back and let’s dive in.” Let’s do that. These changes have not been approved, but they’re looking likely so that’s the one disclaimer that we’ll put on this discussion. Doug, let’s dive in. What are some of the changes?
The bill was signed. Technically, there are ten days for the SBA to digest and make official whatever changes that they’re going to implement. We are expecting that this will be finalized, but we have a good idea of what they’re going to do. First and foremost, one of the most exciting things about this is that they are going to be waving the SBA fee for all newly booked deals. The program has always had this fee. It’s a sliding scale, 2.5X to 3.5X 75% of the loan amount. In order to encourage more lending and encourage to stimulate growth, they’re going to be waiving this fee. These are not definitive, but this is what we’re being told and this is what’s come out in the mem. Starting February 1, 2021 and going through September 30, 2021, all the banks will be waving the SBA fee on every newly booked deal.
This is significant. Depending on the size of your deal, for example, if you are going to have a loan that’s going to be $1 million loan, the fee is $26,000. If you have a $5 million loan, the fee is $138,000 and everything in between. $3 million is about $82,000 fee. This is significant for every buyer who is booking a deal and it’s exciting. You and I talked about before in 2020, in the first CARES Act, some of these features that have now being reimplemented, but this was not one of them. This is a new feature. It’s going to be dynamite for everybody involved.
Those are significant dollars. We should tell the readers that traditionally and historically, those SBA fees get rolled into the loan package. You’re paying for those over whatever period of time. You can pay for them upfront, but typically they go into the loan package. Imagine if you’re saving somewhere between $25,000, $50,000 and $150,000 in fees, that’s substantial over the life of a loan.
There’s no question. They did bundle into what is known as the project cost. In an acquisition, the project costs consist of the purchase price of the business, the SBA fee and then the banks closing costs, which may run about $10,000. You don’t have to pay that $82,000 or that $130,000 out of pocket. You’re going to pay your equity injection in the deal structure, which typically is 10% of the project cost. If your $100,000 fee is part of the project cost, you’re going to pay $10,000 of it as part of your equity injection. It’s still savings over the long-term and most people are happy about that, but we don’t want to mislead anybody to think they’ve got to come out of pocket $80,000 or $60,000.
That’s substantial. Buyers are going to hear that and they’re going to flood to the SBA and lenders and brokers like you to try to get deals done because that’s a big savings.
There’s another huge stimulus part to this and that is that the SBA has agreed to reimplement. This is something they had in 2020, but lapsed and now they’re starting it again in February 1, 2021 and going through September 2021 and that is that the SBA will pay six months of principal and interest payments for any newly booked deal from February 2021 through September 2021. It’s capped this time around at $9,000 a month. There was no cap last time. If it’s six months of payments and it’s capped at $9,000 to $54,000 additional, that you will not have to pay those payments. If they’re not deferring the payments, they’re making them for you. It’s not any debt. Additionally, this time around, which is different from last time that those payments being made are not going to be taxable in any way. It’s not like you have to pay income tax on that benefit of that revenue.
Did you run any numbers? Do you know what a typical loan size is for about $9,000 a month principal interest?
I did not.One of the biggest stumbling blocks for people moving into a new business is the lack of proper working capital. Click To Tweet
It depends on the interest rates and all that stuff, but that’s a sizable amount and it’s going to be a good size loan to have $9,000 a month over six months.
If you think about it, every newly booked deal of, let’s say $2 million or more, is going to save $54,000 in payments and $50,000 of SBA fee. You’re ahead by $100,000 or more, depending on the size of the loan.
That’s a big deal. Money people can put in their pockets, throw into the business, lots of things that you can do with that. Buyers are going to get a massive benefit here, but I also think sellers are going to be the benefactors as well, because SBA is making it easy for buyers to secure these loans now. Sellers are going to benefit from that.
On that point too, I mentioned another one of the benefits that have come out and that is that the program, again, we don’t know for sure, but this is what we believe is going to be the case. The SBA guarantees the banks on these deals and that’s one of the reasons these banks do all these deals with absorbing all this goodwill and being about cashflow and not collateral. Historically the government, the SBA has guaranteed the bank, 75% of their loan exposure. That is now being raised from February 1, 2021 through September 2021 to 90%. All these banks have a 90% guarantee on every newly booked, SBA loan. That’s only going to encourage them to do more. If they’re ever on a fence on a deal, whether they’re going to approve it or not, that hopefully would push them over and accept that risk.
Some points of clarification, for folks who are going through the show for the first time, the SBA is not the direct lender, the SBA guarantees the loans. You still have to go to the local banks that do SBA loans to process the loans. The SBA is only the mechanism standing behind the guarantees for those banks.
The lender is the bank. You’re borrowing money from the bank. Everything is done through the bank. I only work with preferred SBA lenders, which are the banks that can make these decisions and service and do the deals all in-house. The SBA is the guarantor to a certain extent, but there still are the underwriting process with the banks. They still have to look at the cashflow, make sure that makes sense and service the loan.
You bring up an important point. You only work with preferred lenders, which means those banks can make the decisions internally. They never need to go to the SBA for approval. There are non-preferred, but those banks have to process through the SBA, which adds time. The file needs to get sent to the SBA office, out in California. You could add a significant amount of time for those non-preferred lenders.
The preferred lenders will go and get what they call a PLP number to assign to each loan. They’re notifying the SBA of each deal they’re doing. The SBA will come in periodically and audit their books and make sure that they’re doing these things according to the rules and regulations that they are supposed to be doing to perfect that guarantee, but they can do it all internally.
Another reminder for everybody, these loans are typically amortized over ten years, minimum. It could be longer if you package in real estate. You could get a blended amortization that could go above ten years, but the amortization on these loans and the interest rates are tremendous. What are we running now, Doug, for interest rates?
On the ten-year deals, we are generally speaking, the highest that any bank is going to be able to lend because of the SBA rules is 2.75% over prime. That puts you at 6%. Many of the banks are a bit lower and the range you’re going to see typically is between 5% and 6%. That’s going to be the ten-year loans and no prepayment penalty. It works out well. If you are getting a longer loan because you have real estate involved, depending on the value of the real estate, compared to the value of the business that you’re buying with it, it will dictate the length of the term. If the real estate accounts for half of the deal or 50% of the total project, then you’ll get a 25-year amortization for everything, which is wonderful. Those longer deals or the deals that are over 14 or 15 years have a bit of a prepayment penalty in the first three years, which is normal. It’s three years, it’s not the end of the world, but otherwise, there’s no prepayment.
Another reminder to the audience is these loans are capped at $5 million for the most part. There are some banks out there that will get over $5 million, but generally speaking, loans of $5 million. It doesn’t mean the purchase price of the business has to be $5 million, just that the loan is $5 million. If you want to put in extra equity, you’re buying a $6 million or $6.5 million-dollar business, you can do that, but the loan value is capped at $5 million.
The 7(a) loan or a 504 for that matter, but if 7(a) loans is the vehicle that we normally use, if you’re buying a $6 million purchase price business, you’re going to put 10% in. Maybe there’s a 10% seller note historically with SBA fee involved, but without it, you’re going to end up around $4.8 million, $4.9 million on your loan so you come under that $5 million exposure threshold. As you and I have talked about, there are banks now that are lending above this amount using SBA loans in conjunction with a conventional loan or a subordinated debt. Some banks do it on their own, some will farm it out.
In those cases, you may have a combined conventional loan along with the SBA loan, so you may be doing a $10 million purchase price deal. You have your 10% down from the buyer, 10% from the seller, you have a $3 million subordinated loan within the bank and then the $5 million SBA. Processed all together and along with the terms that the normal SBA deals would be done, but it allows you to go a bit higher. In conjunction with that, one of the other benefits that now is coming out are the lines of credit. The SBA historically has offered the guarantee for the banks to do an express line of credit. These are unmonitored lines of credit.
Explain what unmonitored means, Doug.
If it’s monitored, which you see in a lot of conventional loans, they’re going to ask you to send in monthly reports or bi-monthly reports of your accounts receivable or your inventory. They’re going to lend a percentage of that. If you’ve got $1 million worth of receivables, they may lend you up to 80% on that, utilizing the funds from your line of credit. The nice thing about the unmonitored is that you use those lines of credit as you see fit. Historically, those unmonitored express lines of credit, which we put in conjunction with the SBA 7(a) acquisition loans many times was $350,000 cap. That was raised to $1 million with the last CARES Act of 2020, stopped at the end of the calendar year. They’ve now re-instituted that again with this batch. It’s back up to $1 million, which is a wonderful thing for everybody involved. That goes through September 2021. At the end of September 2021, it’ll come back down.
However, it’s going to come back down to $500,000 and stay there, not go back down to the $350,000. On these, there’s also things happening in the background where the bank is getting an increased guarantee on the lines of credit. It doesn’t affect the borrower much, but historically it’s been a 50% guarantee on lines of credit compared to the 75% on the 7(a) loans. That’s going up to 75% for the banks for this period capped at $350,000, which gets a little confusing, but there are situations where they’re getting get more of a guarantee on the lines of credit.
This is important because one of the biggest stumbling blocks and challenges for people moving into a new business is a lack of proper working capital. The SBA is making it easy for you to get access to the working capital, get access to more of it in something that buyers should spend more time on in their diligence, understanding what that business is going to need until they’re in a positive cashflow position. You also have to have some dry powder in case there’s a hiccup in the economy. This is important, a big change and a positive change.
It’s a great thing. We’re already seeing many banks utilizing it and doing these lines of credit much larger than $350,000. The banks also have the capacity of putting working capital into the deal structure in addition to or instead of if you prefer for some reason to have your working capital that way, which is available to you the day after you closed the loan, which is fine as well. Raise your equity injection requirement are a bit, which is why the lines of credit are a bit more attractive. Plus, once you take those funds out, they start amortizing into the balance of the loan. You can’t borrow it, pay it back and reborrow it like you can with the line of credit.
This goes into the loan amount and gets amortizing you’re paying it off over that 10-year period?
If you don’t use it, you don’t pay for it. Once you do, it’s part of the package.
Doug, these are positive changes, great way to start off the new year. I know as we started the episode off, we’re waiting for final approval, but hopefully that is a day or two away we’ll be able to start implementing this. As we close up here, Doug, any other overall comments about lending the market in general, what you’re seeing from the banks, what they’re saying?
The banks are still lending as they have throughout this COVID environment. They’re looking closely at the 2020 numbers as they always do. As you and I have talked about many times, many of these numbers are down with a number of businesses and how are they reacting. How are the underwriters treating those deals? Are they still willing to understand them? If you have a business that was down in March and April and May of 2020 but has rebounded now and has stabilized at some number, then the banks will take that into account. They will get on board with the fact that this was a one-time thing associated with the lockdowns and that situation and will focus on what they’re doing as long as it’s similar to what they did prior to the beginning of COVID-19.
The business shows that it’s rebounded to pre-COVID levels or close to pre-COVID levels that banks are getting confidence and they’ll move forward.
As long as the coverage is still there, they still want to make sure that they’ve got debt coverage. They’re not going to go into a situation where the business is not throwing off enough cash to make the debt payments, but if it is, then they will try to get those deals done.The CARES Act will allow sellers to attract more buyers to their business, and vice versa. Click To Tweet
Have there been any changes to the debt service ratios one way or another?
Not that I know of. That’s a stable thing. They want a minimum of 1.15% coverage after allowing for a buyer’s household cashflow needs. The reality is that most banks want something North of a 1.2% or 1.25% coverage, so they’ve got a bit of a cushion.
Can you describe debt service coverage so folks who haven’t been through this before are clear about that?
The banks are going to take the historical cash flow from the business you’re going to buy. If absent of outside, continuing income from the buyer, they’re going to slice off a piece of it for what is perceived as the buyer’s household cashflow needs. From what’s left, they’re going to compare that amount of cashflow to the debt service going forward. They’re imposed, the SBA loan, the seller note payments if there is a seller note, as well as a fully utilized line of credit interest, interest only on the line of credit. Those components will make up the debt load going forward. If you compare the cashflow to the debt load, that’s where you’re seeing those ratios. You have to have at least 1.2% or higher to be safe in this environment.
Of cashflow or what we call adjusted EBITDA or seller discretionary earnings has to be 1.25%, whatever that debt service is.
Above the debt service, and also allowing for the household cashflow needs.
That’s great, Doug. I imagine you’re going to be busy here. If folks needed to get in touch with you, how could they reach you?
They can always call me. I’ve got my phone with me all the time. It’s (773) 368-9611 or email me at [email protected]
I’ll add in closing that, I know you do a great job for buyers. Your fees are paid by the bank, it never comes out of the buyers, but your ability to package up a deal and help the buyer through the process is incredible. You’re detail oriented. I would highly recommend that anybody give you a shout because you’re in good hands.
I appreciate that. Thank you, Domenic.
Doug, Thanks for coming on.
Thanks for having me. Take care.
I hope you enjoyed this episode. If you enjoy our content, please remember to subscribe and review our podcast. I look forward to seeing you again on the next episode of the M&A Unplugged podcast. Until then, please remember that scaling, acquiring or selling a business takes time preparation and the proper knowledge.
About Doug Adams
Doug Adams is the principal and president of Emerson Capital Corp. Doug has over 30 years experience in small business lending including: Acquisition finance structuring, Loan Structuring, Credit Underwriting, Expansion financing, Partnership buyouts and equipment financing. Additionally, Doug has SBA loan program expertise, with well established lender relationships.
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