Loans from the Small Business Administration (SBA) have been instrumental for me in acquiring the majority of my acquisitions, and 2023 had the biggest updates since 2016. It’s a foundational–and critical–instrument for entrepreneurs.

In today’s article, we’re tackling the hard and fast rules for this number one way to finance up to 90% of your acquisition (actually, it’s 90+% now), covering the latest updates as of 2024. 

This information comes in collaboration with our lending advisor at Acquisition Lab, who gave the Acquisition Lab an overview of SBA financing, including benefits, eligibility, and process to obtaining an SBA loan. 

Let’s dive in.

 

How the SBA Loan Works

 

Over the years, the SBA developed several loan programs to support American businesses, with the 7(a) loan program being the most popular for business acquisitions. SBA loans are designed to encourage banks to offer loans they might not typically consider by providing a government guarantee. 

While the borrower receives funds through a conventional bank loan, the SBA guarantees a substantial portion of the loan, mitigating the risk for the bank. Most buyers are initially under the impression that the SBA is directly giving you this loan, but that’s not how it works. While the SBA facilitates these loans, it’s not the direct lender; banks are.

 

Benefits of SBA 7(a) Loans

 

One of the primary advantages of SBA 7(a) loans is their accessibility. They provide potential business owners with capital to purchase businesses that might otherwise be out of reach financially. Here are other key benefits of the SBA 7(a) loans:

 

• High Loan-to-Value Ratio: SBA 7(a) loans allow for financing up to 90% of total project costs, which includes the acquisition of a business, necessary additional assets, associated loan costs, and working capital.
• Minimal Initial Investment: Entrepreneurs can purchase expensive businesses with a relatively small down payment, potentially acquiring a million-dollar business with only $100,000 to $200,000 down.
• Large Borrowing Capacity: Provides a maximum borrowing limit of $5 million, which can be used across multiple projects, enabling business expansion without the need for continual new financing.
• Individual Borrowing Limits: Ensures that each partner or guarantor’s financial exposure is balanced and limited, promoting equitable financial responsibility among investors.
• Full Ownership Control: Enables business owners to retain full control over their operations without needing to give up equity, unlike other funding avenues that may require sharing control with capital partners.
• Favorable Terms: SBA 7(a) loans are structured to be affordable, with features like a 10-year fully amortizing schedule, competitive interest rates, and no prepayment penalties. 

 

The SBA loan doesn’t just provide financing – it also makes for a great strategy when acquiring and growing the asset that is your business. 

 

Source: FasterCapital

 

Unlike traditional loans, SBA financing doesn’t require buyers to have equal net worth or collateral relative to the loan amount. This means you don’t need to have a million dollars in the bank to secure a million dollar loan. 

A lender wants to see you get a return on your investment, put some cash back in your pocket, and more aggressively pay down your loan. Believe it or not, most borrowers pay these loans off in about half the time. 

 

SBA Loan Eligibility and Approval

 

With the incredible benefits an SBA loan can provide, it isn’t handed out to just anybody. Here are the loan eligibility requirements for both the buyer and the business involved. 

 

• Citizenship: The borrower must be a US citizen or hold Legal Permanent Residency (LPR) in the United States.
• Partnership Requirements: If the borrower is not a US citizen or LPR, they must partner with someone who is. The US citizen or LPR must own at least 51% of the borrowing entity, ensuring majority ownership is held by someone legally recognized to operate in the US.
• Domestic Operations: The business must be based and operating within the United States. It must file US tax returns that can be verified by a bank to ensure the business has adequate cash flow to service the debt. Businesses located outside the US that do not file US tax returns are ineligible for SBA 7(a) loans. 

 

Once the loan approval process starts, there are additional requirements, outside of basic eligibility, that both the buyer and business must meet in order to obtain an SBA loan. 

 

Source: Quiet Light

 

Loan Approval Process for Businesses

 

For a business to successfully secure an SBA loan, it must demonstrate healthy finances and a promising trajectory. 

 

Debt Service Coverage Ratio (DSCR)

Banks are going to want a minimum debt service coverage ratio (DSCR) of around 1.2 to 1.25X. For instance, a loan costing $100,000 annually might need the business to show a minimum annual EBITDA of $125,000, which corresponds to a DSCR of 1.25X. This figure guarantees the business can comfortably meet its debt obligations, cover your salary, and fund growth.

 

Financial History and Trajectory

Banks require at least one, preferably two years of tax returns showing sufficient earnings before interest, tax, depreciation, and amortization (EBITDA). Additionally, they consider various factors such as market stability, growth potential, existing contracts, operational history, and overall economic environment. Short historical financial records can be a challenge; however, a strong performance in the current year can compensate by showing potential for ongoing stability and growth. 

 

Cash Flow Analysis

Another critical aspect of the loan approval process is the evaluation of one-time expenses, or add-backs, which can be adjusted in the financial statements to reflect a more accurate picture of the business’s financial health. Common add-backs include health insurance, car payments, non-recurring legal fees, owner’s compensation, and other discretionary spending that won’t continue under new ownership. This adjusted EBITDA helps the bank determine the true cash flow available to service the loan.

 

Source: MidStreet

 

SBA Required Audit Trail

That said, it’s not enough to go with what the seller claims. The SBA mandates a rigorous audit trail for all financial figures used in loan assessments. Banks are cautious and will only accept claims of add-backs with substantial evidence, which ensures the integrity of the loan process and safeguards against overvaluation based on inflated or non-sustainable earnings.

 

Loan Approval Process for the Buyer

 

The SBA loan approval doesn’t just evaluate the business – the bank will also analyze the buyer’s financials and qualifications.

 

Relevant Experience

Banks initially assess whether the prospective buyer has relevant experience in the industry or a related field. That doesn’t mean the buyer needs to have run a similar type of business before, but the bank should be able to correlate the buyer’s work history to running a business in the future (e.g. management or operational experience from corporate America). 

 

Owner Operators Only

The SBA prefers loans go to owner-operators who will actively manage the business rather than to absentee owners. This requirement ensures that the borrower has a vested interest and the capability to sustain and grow the business.

 

Financial Stability

Banks examine the buyer’s personal financial statement to evaluate liquid assets and the ability to provide a down payment, typically 10% of the loan amount. 

 

Source: FasterCapital

 

However, having just enough liquidity to cover the down payment is often seen as a red flag. Banks look for post-close liquidity to ensure that the buyer can handle unforeseen expenses without immediate financial distress. 

 

Ongoing Outside Income

Another factor banks evaluate is the buyer’s ongoing outside income which can play a role in the bank’s decision-making process. This income can demonstrate the buyer’s ability to sustain personal financial obligations independently of the business’s cash flow, which may be helpful in the early stages following acquisition. Without this, banks may doubt the buyer’s ability to maintain the business’s financial obligations.

 

Owner’s Draw Requirement

If there isn’t ongoing outside income, the bank will want the cash flow of a business to cover both the debt service and owner’s draw. 

Banks calculate owner’s draw in these situations is to take monthly expenses, multiply it by 12 (for 12 months), then multiply that figure by 2. 

 

 

Banks want to see that the business is cash flowing greater than the debt service and owner’s draw combined. If the owner’s draw and debt service coverage is equal to cash flow, it’s still not enough — according to the bank, there must be excess cash flow.

If the numbers don’t work, the bank may explore one of two options: having you pay more than 10% down to make the debt service coverage work or having a spouse be a personal guarantor of the loan. Even if s/he isn’t involved in the business, having both of you on the loan will diminish your owner’s draw requirement. 

 

Good Credit and Clear Record

Along with current financial stability, banks require good personal credit and a clear history of financial responsibility from the borrower. Most banks want to see a credit score of at least 660 to 680. Minor blemishes might be overlooked, especially if there’s a reasonable explanation and evidence of improved behavior. That said, severe issues like bankruptcies or foreclosures need to be well in the past and clearly resolved.

 

Be Honest

This leads us to the last point: be transparent about your financial history. Banks are thorough and will uncover any previous issues you’ve had such as old tickets, court appearances, or bankruptcies, regardless of how long ago they occurred. Being upfront about these issues can help mitigate potential setbacks in the loan process. 

Instead of allowing banks to discover these issues independently—which can complicate or halt your application—it’s best to address them proactively and work through them together. This approach not only builds trust but can also influence how banks perceive your candidacy for a loan. 

Don’t be discouraged if one bank declines your application due to past financial problems. Each bank has its own criteria, and another might view your situation more favorably. Stay persistent.

 

Latest SBA Updates

 

If the SBA loan program wasn’t enticing enough, there were three major updates last year that make acquiring businesses even easier and better for buyers today. 

 

1. Seller Financed Down Payment

Recent SBA rules have facilitated the use of seller notes for equity injections. Sellers can now finance up to the entire 10% required down payment under specific terms, including a two-year payment deferral and a requirement for a 10-year repayment period. The only exception to this is that there’s no payment deferral if the seller financing amount is 7.5% or less. 

 

2. Partial Buyouts

Another thing the SBA opened up recently is partial buyouts. For years, there’s been a struggle to get certain deals done because the SBA required buyers to buy 100% of a business. Partial buyouts are beneficial for buyers who value ongoing input from the seller or for maintaining essential business licenses tied to the seller’s continued partial ownership.

What we commonly see is sellers retaining less than 20% of the business, so they can avoid needing to personally guarantee the loan. This setup benefits banks as it mitigates risks and addresses concerns related to the buyer’s inexperience or ability to meet licensing requirements independently. For instance, if the seller retains a small ownership stake, it ensures that licenses critical to business operations remain valid, providing continuity and stability. 

 

3. Multiple $5 Million Loans Across Industries

Previously, the limit for the SBA loan was $5 million across the board. However, now, a buyer can obtain multiple SBA loans across different NAICS codes that don’t count against each other’s borrowing capacity. 

For example, let’s say you have a $5 million loan to buy a trucking company. In the past, this meant your $5 million borrowing cap was met, and you had no more funds available. Now, let’s say you’re the owner of a trucking company and later want to buy an e-commerce company with an SBA loan. Since the two businesses aren’t of the same NAICS code and industry, you have a whole new $5 million you can borrow toward the e-commerce company. 

… And so on. 

 

SBA Loans Remain Competitive

 

SBA 7(a) loans have always been a strategic way to acquire businesses. By offering substantial loan guarantees, the SBA enables banks to provide financing that might otherwise be unavailable, giving buyers a way to realize their business ownership goals. 

If that wasn’t enough, the continual adjustments by the SBA have helped simplify the acquisition process and increase the number of deals completed, allowing for more creative deal structures and business transitions that weren’t possible under the old rules. 

There’s no better time to be an SBA buyer than now.

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.