Business acquisition loan calculator: test a purchase against SBA's rules

The three tests

SBA's manual for lenders sets three conditions on a loan that buys a business. They are separate, and a deal can pass two and fail the third.

Equity. The buyer must put in 10% of the total project cost: the price, any real estate, and the working capital and closing costs. Cash counts in full. A seller note counts only if it is on full standby, and then for no more than half of the 10%. For a first-time buyer the 10% cannot be reduced. When an operating business buys another, or owners buy out an owner, the lender may reduce or waive it.

Valuation. The price of the business must be supported by a business valuation. If the price is higher, the difference must be made up by equity.

Cash flow. The business being bought must have earned at least 1.25 times the yearly payments on all its debt after the purchase, or 1.15 when the buyer is an operating business in the same industry. The figure that counts is what the business earned in its last fiscal year, or on average over the last two. Forecasts do not count.

Our guide to SBA loans for buying a business covers the rules in full, with what the loan records show.

The example it opens on

A first-time buyer agrees a price of $1,000,000 and needs $50,000 for working capital and closing costs. The buyer has $60,000, and the seller agrees to leave $50,000 in the business on full standby.

The deal passes all three tests. Equity of $110,000 counts against $105,000 required. The cash flow of $260,000 covers the yearly payments 1.77 times.

Change one thing at a time and it stops passing.

• Take away the seller note. The loan rises to $990,000 and the buyer is $45,000 short of the 10%.
• Lean on the seller instead. With $20,000 of cash and a $100,000 standby note, only $52,500 of the note counts. The buyer is $32,500 short.
• Get a lower valuation. If the business is valued at $850,000, the $150,000 difference has to come from equity. The buyer's cash and standby note fall $40,000 short.
• Find weaker earnings. At $170,000 of cash flow, coverage is 1.16. The loan would have to be about $71,000 smaller to reach 1.25, or the business would have to earn $183,400.

Two kinds of seller note

A seller who finances part of the price can do it in two ways, and the calculator has a box for each.

On full standby. The seller receives no principal and no interest until the SBA loan has been repaid. Interest may accrue. This is the only kind of seller note that SBA counts as equity, up to half of the 10%. It adds nothing to the yearly payments.

Repaid from the start. This is ordinary debt. It lowers the SBA loan, but it is not equity and its payments go into the cash flow test. If the note is interest-only, SBA has the lender test it as though it were repaid over no more than ten years, and the calculator does the same.

Take the example with $110,000 of cash and, in place of the standby note, a $150,000 seller note repaid over ten years at 7%. The SBA loan falls to $790,000. The seller note adds $20,900 a year to the payments, and coverage comes to 1.80.

When real estate is part of the purchase

SBA leaves real estate out of the price of the business. It is appraised on its own, it does not count toward the $350,000 and $3 million thresholds, and it gets a longer term.

The business, working capital and costs are repaid over ten years at most. Real estate may run up to 25. A single loan takes a blend of the two, weighted by cost before any equity is applied and rounded to the nearest year. The calculator works that out.

Add $500,000 of real estate to the example and the project cost becomes $1,550,000. The equity required rises to $155,000, so the buyer in this version brings $110,000 of cash. The term becomes 15 years. At 8.75%, the median for purchase loans of that size, the monthly payment on a loan of $1,390,000 is $14,258.

The lender may instead make two loans, one for the business and one for the property. The calculator does not model that.

What to put in the cash flow box

SBA defines the figure as earnings before interest, taxes, depreciation and amortization. Start from the seller's last fiscal year, or the average of the last two.

A lender may adjust it, and has to justify each adjustment in writing. The manual lists the usual ones: capital spending the business must make but has not financed, income that will not recur, distributions to owners, the seller's discretionary expenses, and what the owner is paid. If the real estate is being bought as well, the rent the business used to pay may be added back.

Be conservative with add-backs. A lender has to check the seller's figures against IRS tax transcripts, and at a price of $3 million or more it must use the earnings figure from an independent quality-of-earnings report, not the seller's.

What the calculator leaves out

• Your lender's own standard. SBA sets minimums. A lender may ask for more equity or more coverage.
• The wider cash flow test. The lender also runs the sum with any affiliated business included, and it must reach 1.00.
• How strictly a lender reads the valuation limit. The calculator applies your cash and standby notes to the price of the business and compares what is left with the valuation. SBA's manual also says the total debt that supports a purchase is limited to the valuation. A lender may read that more strictly when working capital or costs are financed.
• Special-purpose properties. A business bought together with a property such as a hotel needs no quality-of-earnings report. It may be underwritten on projections if the appraised value of the property fully secures the loan, and the loan may run 25 years when the property is at least 85% of the cost.
• Employee ownership plans and cooperatives, which have rules of their own.
• Collateral and guarantees. SBA requires both. Passing these three tests says nothing about them.
• A rate that moves. Only 12% of the purchase loans in the records had a fixed rate. The DSCR calculator shows what a rise in rates does to coverage.

This page is general information. It is not an offer of credit, and we are not a lender.