I talk with hundreds of potential business buyers every month, and one of the most frequent questions that has come up over the years – and especially recently – is how to structure a deal that leverages the benefits of an SBA loan while also raising money from investors.
By combining both, you’re able to use other people’s money and acquire businesses larger than what your own cash reserves would allow.
I’ve been teaching a unique strategy on how to do just this at the Acquisition Lab since 2019. Even though it’s been something I’ve only shared inside the Lab for paying members, I’ve decided to share that strategy with you today.
Before we dive in, I want to share a little bit of my background.
My Path into Acquisition Entrepreneurship
If you’ve read Buy Then Build, you’re probably familiar with my story.
I began buying companies in 2004 right after graduating with my MBA, following the failure of my startup.
After that disappointment, I wanted to acquire an existing business instead because no one in St. Louis was achieving Silicon Valley-level success – even though many were trying. I noticed that instead of getting rich and successful through startups, wealthy individuals in the Midwest were focusing on what many would consider “unsexy,” cash-flowing businesses – and they were getting rich doing it.
I thought, “Why don’t I acquire a business using a bank loan?”
Unfortunately, back then, the SBA wasn’t offering the kinds of opportunities they do now, but they eventually did. They simplified the process by eliminating the need to purchase a company with a lot of hard tangible assets for collateral.
Additionally, the SBA did away with their reliance on large seller notes, a stipulation which often discouraged sellers from selling their businesses (and who could blame them?). Instead, the SBA offered a solution by providing up to five million dollars to buy a company with an “airball” – a term for a business with mostly intangible assets. So now, you could purchase a cash-flowing business using an SBA loan and a personal guarantee. This was a game-changer and my main impetus for writing about this huge opportunity in Buy Then Build.
However, in 2004, I started hearing whispers about recently graduated MBA students from Cambridge and Stanford using what was called a search fund. Today, that term has many interpretations, but I’m referring to a traditional search fund, where a searcher raises capital to find a business over a 24-month period.
Anyhow, I started soft-pitching the idea of a search fund to investors. I won’t bore you with the details, but let’s just say they all ended with me having very few conversations and getting roaring laughter from them every single time.
Years later, I met Jim Southern, the founder of the first-ever search fund, who also bought a printing company like I did. He’s now one of the most prominent search fund investors, and he told me something that resonated, “Walker, if you’re trying to pitch this idea to an investor who doesn’t already invest in this asset class, it’s like pushing a rope.”
Source: LinkedIn | You Can’t Push On A Rope
I learned this lesson the hard way.
Traditional search funds are usually very specific about what they invest in, while acquisition entrepreneurship is much broader, offering multiple ways to buy and profit from companies – options that might not suit a traditional search fund investor. In fact, SBA loans play a crucial role in expanding these possibilities.
Ultimately, when it comes to using an SBA loan and working with investors, it’s all about how you frame your investment. If you make it attractive to investors, they’ll want to invest. Startups often promise high growth with disruptive solutions, but this asset class allows you to offer private capital market returns with added stability. That’s the key.
Now that I’ve provided you with some background, I’m going to share my strategy for how to structure an SBA deal with investors. There are five main steps. Let’s dive in.
1. Start With the Right Entity
When structuring an SBA deal with investors, starting with the right business entity is everything.
The most common choice is a Delaware C Corporation (C Corp), although an LLC or other entity can work. However, the C Corp is often preferred for maximizing exit value and minimizing taxes at the time of exit, which is most attractive to everyone all around. It’s worth noting that while the C Corp structure can lead to double taxation on earnings retained in the business, it ensures that both you, as the operator, and investors are aligned in keeping sufficient funds in the company to keep it operating effectively.
2. Raise Capital & Age the Funds
To kick off your deal, you’ll raise $500,000 in the C Corp. Here’s the key hack: raise this money at least two bank cycles before you place a Letter of Intent (LOI) on a business and apply for bank financing. By aging the funds in the C Corp for a couple of months, the bank will view the money as belonging to the corporation, avoiding scrutiny of where the funds came from.
That said, the challenge here is raising the $500,000 before you’ve even identified a business to buy. To do this, you’ll value your C Corp – your search entity – at $2.5 million.
Your goal is to keep the $500,000 raise under 20% of the equity, around 19 to 19.9%, meaning you, as the operator, retain the remaining 81%. When it comes to SBA loans, if an investor has less than 20% equity, he or she doesn’t have to sign a personal guarantee.
3. Search For a Business
Now, with the funds raised and aged, your aim should be to find a business within six to 12 months.
The enterprise value of the business you target should be around $5 million, aligning with your existing capital of $500,000 (many SBA loans will allow you to put just 10% down, so $500,000 gets you a $5 million business).
“But Walker, I thought you said the value of the C Corp was $2.5 million?”
It is. Or, it was. By acquiring a business with a higher enterprise value, you effectively double the paper value of your investors’ money. In this example, if you raise $500,000 but go out and buy a $5 million business, the investors’ stake in the C Corp doubles in value on the day of closing.
4. Communicate With Your Investors & Return Any Excess Cash
As you structure the deal, it’s important to communicate clearly with your investors. You might be tempted to get into detailed financial metrics like internal rate of return (IRR), but focus instead on the tangible benefits.
Tell them, “I’m going to pay you back all of your money plus 20%, and you’ll be the first to get paid.” This straightforward promise – aiming to return 120% of their investment within three to five years – will resonate with most investors.
If there’s excess cash after the acquisition, distribute it back to the investors immediately. By doing this, you didn’t only double the paper value of what they’ve already invested, but you’re already giving them back a return they weren’t expecting.
Additionally, the $500,000 you raised should accrue interest while sitting in the C Corp, though this should be handled outside the operating agreement. When the business is acquired, pay the accrued interest – let’s say 5% – back to the investors immediately. This interest payment, although modest, is a goodwill gesture that will reassure investors they’re in a solid position with you.
5. Implement Waterfall Structure Post-Close
Now, let’s talk about the financial flow once you’ve purchased the business, or the order of priorities in which payments go out. This is referred to as a waterfall structure or distribution waterfall.
Your first priority is to maintain enough working capital in the business – this means having a cash flow buffer to cover operating expenses, inventory, and accounts receivable minus accounts payable. To give you a rough idea of how much you should have in reserves, aim to keep 90 days of operating expenses in the business at all times.
After securing working capital, the next step is to ensure you, as the operator, receive a guaranteed payment. This payment is important because it compensates you for running and growing the company. However, if the working capital peg isn’t met, you don’t get paid – but the amount accrues on the balance sheet for future payment.
Once the business is acquired and operational, the first major payout to investors comes when they receive 120% of their initial investment. After that, any distributions or bonuses follow the “pari passu” principle, meaning payments are made according to ownership percentages – 81% to you and 19% to the investors.
Why This Strategy Works
The beauty of this structure is that it aligns everyone’s incentives. Investors receive their capital back with a profit and continue to benefit from any future distributions, and you have a majority stake in a business you wouldn’t have been able to afford otherwise.
Once investors receive their 120% return, they’ve not only recovered their initial investment but also gained an additional 20%. They also earned a modest interest at the outset. If you successfully implement this strategy, investors will be thrilled with the deal. They’ve already earned 5% while their funds were held, received any excess cash right away, and maintained priority in the payout structure at 120%.
Every time you take a bonus, it’s simply a distribution from the C Corp, meaning they continue to receive their proportional share (19%) of these distributions. For the cherry on top, when it comes time to sell, your investors stand to gain even more. If you grow the business and sell it for $7.5 million five or ten years down the line, their return on investment becomes even greater.
In the end, this approach isn’t about complex financial engineering; it’s about being straightforward and ensuring that everyone involved in the deal is taken care of. By putting the health of the company first and aligning incentives, you create a win-win situation that makes investors eager to support your next venture.
This method allows you to leverage SBA loans while raising the necessary capital to acquire businesses that might otherwise be out of reach. It’s a practical, street-smart strategy that has been proven effective over years of application in the Acquisition Lab. If you follow these steps, you’ll be able to structure SBA acquisitions that meet your financial goals and also attract and satisfy investors.
Ready to acquire a business in the next 12 months? The Acquisition Lab is your first stop. Reach out to us today and get on the fast track to becoming an acquisition entrepreneur.
