Navigating the SBA 7(a) Maze (Updated)

June 5, 2024 | Issue #99

Big Deal Small Business: Navigating the SBA 7(a) Maze (Updated)

June 5, 2024 | Issue #99

Most self-funded searchers acquire businesses using SBA 7(a) debt. Managing the 7(a) process requires significant effort, attention to detail, and a willingness to push the boulder up the mountain every single day.

This issue provides a behind-the-scenes look at how my process went from initial outreach through bank commitment papers — I’ve adjusted some details for privacy, but also to account for new changes to the SBA process since I went through it myself.

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Quick Note: Thank you to Lisa Forrest and Sarah Andrews from Live Oak Bank for fact-checking this. They are my recommended lender for search acquisitions.

How to Reach Out: To contact Live Oak, please email Lisa and Sarah — Lisa(dot)Forrest(at)LiveOak(dot)bank, Sarah(dot)Andrews(at)LiveOak(dot)bank. Please cc me using admin(at)guessworkinvesting(dot)com — that will allow us to track referrals.

When to Reach Out: Unlike most lenders, Live Oak is open to talking to you early in your search, before you have a deal under LOI — so if you’re serious about searching, that’s the moment to reach out to them. They spend countless (unpaid) hours coaching searchers through the pre-LOI process to ensure the LOI you submit is actually workable per SBA & Live Oak standards.

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Let’s dive in.

This post is a longer and more detailed than usual, but hopefully helps at least one person get their deal funded. Please pass along to whoever may find this useful.

PLP 7(a) Lenders

7(a) loans are 75% guaranteed by the federal government. However, the underwriting process is made by the lender, not by the government – the government only steps in later if something goes wrong in the deal.

So the lender does all the underwriting and puts up 100% of the capital — they are relying on the government guarantee in case the borrower defaults.

In order to provide that guarantee, the SBA requires that the lender meets very specific underwriting requirements & procedures for the loan. Otherwise lenders could run amok, make terrible loans and just lean on the government when some go sideways.

To streamline that underwriting process, the SBA has created a “Preferred Lender Program” or “PLP” status for 7(a) lenders, which is a key distinction versus a General Partner 7(a) lender, or “GP”.

If your bank is a GP 7(a) lender, the SBA has to actually sign off on the deal before the loan is funded. This can add 2 weeks to 90 days to the underwriting process depending on how busy the SBA is.

With a PLP lender, the SBA has signed off on the lender’s underwriting procedures in advance.

This means that a PLP lender can fund a loan without the SBA’s review & approval, and still have it qualify for the guarantee. The lender takes some risk that the loan might get rejected by the SBA after the fact — but in that case the loan has already been funded — your deal closed, just the lender is left with no government guarantee.

In most deals, you generally want to be moving fast — time kills deals. Adding the timing delay & uncertainty of SBA sign-off introduces material deal risk.

As a result, I recommend only working with PLP lenders.

Side Note: For larger deals, some of the banks (like Live Oak) may be able to do part of the deal as conventional debt after the $5 million SBA loan size is exhausted. Something else to consider in selecting your lender if you have a larger deal size.

Finding a PLP 7(a) lender

There are four paths to find a PLP 7(a) lender, and I used all four in my search for a lender.

Tried & True National Search Fund Lenders:

• A couple of the big national players in search are Live Oak (Lisa Forrest & Sarah Andrews) and First Bank of the Lake (Bruce Marks).

• These lenders will move through underwriting efficiently, but importantly, they understand the search fund ownership structure whereas other lenders will have a million and one questions about that.

• On the other hand, they’ve seen so many deals over the years, they sometimes will have stricter lending criteria than other SBA lenders. That’s okay — if they decline to do your deal, it doesn’t mean you’re dead in the water.

SBA Lender Match (← link)

• You submit the high-level parameters of your deal, lenders mark themselves as interested, and then you receive their contact info.

• In one of my inquiries, this resulted in three interested banks, two of which passed on the deal and one that provided a term sheet.

Regional SBA Office

• Each regional SBA office should have a list of active lenders on their website. These lenders will lean in more to deals in their region.

• Here’s an example from Seattle – this a full list for that region. You can generally check their PLP status on their website.

• One note – use this list to find regional lenders, not national lenders. For example, you’ll see Live Oak on this list, but with a random local contact listed, not Lisa Forrest or Sarah Andrews, the ideal contacts at Live Oak. For the big national lenders, figure out who focuses on search funds and reach out to them.

Loan Broker

• I have less familiarity with loan brokers, but their role is to package up your “pitch” and send it to a number of high-quality lenders. Their role is to try to find you the best deal out there.

• I have heard of different pricing models for this support — in some cases, the borrower has paid the fee, in some cases the lender pays the fee. Clarify this with the loan broker in advance.

• The two folks I see serving the search space specifically are Heather Endresen at Visio and Matthias Smith at Pioneer Capital Advisory.

One other note — if your deal has a business broker listing it, ask her if she has any recommendations. They often know the local lenders quite well.

7(a) Loan Steps

At a high level, these are the steps to go from outreach to bank commitment paper. Below I tick through each one.

• Outreach to Lender

• Initial Discussion

• Diligence Requests – more business-related

• Non-Binding Term Sheet

• Picking a Term Sheet

• Diligence Requests – more process-related

• Binding Commitment Paper with List of Closing Conditions

• Complete Closing Conditions

• Close

Outreach

I started with a simple email outlining the basics of the deal, industry, size of project, etc. In one deal I worked on, I reached out to ~10 lenders and got immediate no’s from five.

The immediate no’s were due that deal being a tourism business significantly impacted by COVID. I had a good story around customer deposits underpinning a business recovery, but it was a non-starter for many banks.

For context, the five that remained interested consisted of the following: 1 national bank, 1 from Lender Match, 1 from SBA regional office website, and 2 shared to me from the deal’s listing broker.

This highlights the benefit of using all available channels to find a lender.

Initial Discussion

For the five banks that were interested beyond the initial outreach, I had calls with each of them to walk through my background, business plan, credit highlights, etc.

I prepared a short (13-slide) presentation that covered the following:

• Credit Highlights (one slide)

• My Background (one slide)

• Company Overview, including transition plan, financials and business plan (seven slides)

• Industry Overview (two slides)

• COVID-19 Impact (one slide — more relevant at the time of this deal)

• Working Capital analysis to support WC request (one slide)

The key here is to be professional and talk about your plans to reduce debt over time. Remember, lenders don’t get to share in the upside from you growing the business — they care about downside protection.

Don’t spend 20 minutes talking about how you’re going to reformulate the business to take it to the next level. A lender may hear that as “I’m introducing operating risk on day one.”

Focus on how resilient the business is, how you plan to manage the seller transition, and all the other reasons why this deal will end with them getting the loan paid back.

I plan to write a piece later on how to position your business to lenders & investors, but a couple key risks that lenders will be focused on include customer concentration, seller dependence, exposure to cyclical industries, and inconsistent historical performance.

Diligence Requests – Business Related

After this discussion, I had to provide a range of information to help them complete initial underwriting, which the lenders called a “pre-flight” or “blood test” or similar. Live Oak has a fairly standardized template you can use for them, which I found quite helpful.

This diligence request from the bank generally includes a written business plan, two years of monthly financial projections, your resume, your personal financial statements, etc. A couple of the banks also ran a credit check on me.

Important to note here - at most banks, your initial contact will be effectively a salesperson, in charge of creating loan volume. They are not the actual underwriter, though they can help the underwriter get to the finish line.

Depending on the bank, the salesperson may be able provide an initial term sheet with limited internal discussion, which can lead to deal falling apart once it gets to actual underwriting.

As a result, you should challenge your contact to run the deal by their actual underwriters. The sooner you get a real read from the decision-makers, the sooner you’ll know if there’s a viable path to get funded. You’d rather have a no, than a fake yes.

Remember, the goal is a funded loan, not a non-binding term sheet.

Initial Term Sheet

After preliminary underwriting, three of the five banks provided a non-binding term sheet which outlined term, rate, prepayment penalties, and a few other key terms.

The banks may make it sound like these are just standard terms prescribed by the SBA, but in my experience, they are highly negotiable.

For me, I wanted to have prepayment flexibility – I wanted the ability to pay down my loan more aggressively to re-amortize the loan (lower monthly payments) without incurring early payment fees. One of the banks resisted that, two of them were okay with it.

The interest rate margin were also different at various lenders, so worth pushing back to see if you can get them to land at the lowest level.

Term tends to be fixed at 10 years unless you have real estate in the deal.

The most important risk mitigant in a highly-levered is access to liquidity. In SBA world, that comes in 3 ways:

• IO-Period: You can ask for an early interest-only period. This will give you a few months to stockpile a bit of extra cash, which can be meaningful down the road.

• Line of Credit: My #1 financing tip for searchers — secure an SBA LOC alongside your SBA 7(a) loan at the time of acquisition. You won’t be able to get it after the fact, almost ever. You will KICK yourself for not having it later on, even if you never use it. The peace of mind is invaluable to your mental psyche.

• Working Capital: You have to specify the amount of working capital you need in your request — this comes to you in the form of cash to the balance sheet on Closing Day. They include it as part of the fixed loan, but only if you can justify the need and they can underwrite the resulting loan amount. Negotiate for as much as you can reasonably justify — liquidity is king.

I asked for a large amount of working capital due to it being a seasonal business. In the three term sheets, two agreed to the amount, but one said they could only do ~50% of my working capital ask. That’s a big difference in my operating flexibility down the road.

Selecting a Term Sheet

Once you’ve negotiated term sheets, you have to decide which lender’s term sheet to sign and progress into full diligence with.

At this stage, most banks will expect a deposit of $3K to $10K at this stage to continue their work, which will be used for third-party fees like SBA Packaging (if they use an outside company) or business appraisals.

These fees ultimately get rolled into the loan if it closes, but this is your first real dead deal cost risk.

As a result, most people only select one lender to push forward with. Some folks recommended that I bite the bullet and put down two deposits.

The downside of selecting two is you duplicate the third-party expenses, and you also burn the bridge with the lender you leave at the altar if both get to the finish line.

I don’t have a prescriptive answer, it’s something to think hard about when you’re at that stage. You may want to make the decision based on how much confidence you have in the banks to close.

In an early deal (not one that closed), I only went with one bank, which I had found through the regional SBA office. That turned out to be a mistake as you’ll find out below.

But in the deal that closed finally, I had much more confidence in the selected bank (Live Oak), and so still proceeded with only one bank.

Diligence Requests – Process Related

This is the part where you drown in paperwork. It feels endless and can be a burden for the Seller too, who must fill out certain items for the bank. Give your Seller a healthy notice that this will be a grind. Take time to check in with them to make sure their head is staying above water.

I have no advice here other than to buckle down and get it done. Try to do everything right the first time because it adds 2-3 business days each time you must make corrections and re-submit.

I’ve highlighted a couple thorny issues below.

Business Appraisal:

• The SBA requires the lender order an expert appraisal of business valuation and that valuation must exceed the loan value (not the full purchase price).

• Some banks will complete this before issuing a commitment letter, some will do it after the commitment letter (so it becomes a closing condition).

• Read this appraisal in detail if it comes in too low - one of mine had material errors in it, so you may need to go back to the appraiser and get them to correct their report.

Equity Injection:

• The process below describes how the SBA used to operate, and some banks may still. The SBA recently changed verification rules to simplify this process, so this may vary bank to bank. For Live Oak, they now only require a single current bank statement to reflect adequate liquidity, as well as the final wire transfer verification from the expected source. But read on for the “old school” version that may still be in place and some banks.

• The SBA generally requires the equity injection be real equity i.e. not a loan from someone else. The way they (used to) confirm that is by checking if each investor had sufficient funds in their accounts at least 60 days pre-closing.

• Logistically, a couple weeks before closing, the lender will require each equity investor to submit the two most recent bank statements showing they had enough funds on hand to cover their piece of the investment.

• In my early deal that died, the lender tried to complete this verification before providing a commitment paper (recall my note above that many lenders aren’t used to an investor group search fund structure).

• This was a logistical hassle for me at that stage of the deal, given I didn’t have all the investors lined up. I ultimately got the bank to agree to just look at my personal bank accounts and those of a couple of my largest investors, with the understanding we would confirm everyone else right before closing.

• In my deal that closed with Live Oak, they understand the investor structure and automatically waited on the verification part until closer to the end. (Again, that has changed since my deal closed at banks like Live Oak to be even simpler.)

Seller Notes:

• Many deals use seller notes to incorporate skin-in-the-game for the Seller post-closing. In the early deal that died, I used a partially forfeitable seller note that required the business hitting specific metrics, otherwise the note would be forfeited.

• On first pass, my bank said this was not allowed by SBA - they claimed that no form of contingent purchase price was allowed in SBA 7(a)-financed transactions.

• This is not true (wasn’t then, and isn’t now, even under the latest SBA underwriting protocols). You cannot have 1) any earnouts (growth-oriented) or 2) any seller notes that are forfeitable based on growth metrics.

• You can, however, have a seller note that is forfeitable based on achieving historical metrics that have already been achieved.

• In my case, I ended up emailing the SBA 7(a) help desk, which got back to me in under 30 minutes with a definitive answer confirming my position, which I forwarded to my underwriter. Thanks to that, the underwriter approved the forfeitable seller note despite the original position that the forfeitable structure is not allowed by the SBA.

Hopefully the above makes clear that the underwriting process is slow, detail-oriented, and not perfectly understood by even the lenders at times. Ask questions, be a pain, and keep pushing the underwriter to see your perspective.

Bank Commitment Papers

Finally, the lender delivers commitment papers that binds them to fund the loan so long as certain closing conditions are met.

In reality, the binding nature of the commitment papers allow for PLENTY of reasons for them to walk. It’s less a legal commitment as it is a general good faith agreement that they intend to close based on everything they’ve seen to date.

In my deal that didn’t close, my chosen bank didn’t actually close even after providing commitment papers. Their credit committee decided later in the process that they wanted to go get SBA pre-approval first.

Recall how I talked about the benefits of working with a PLP? Turns out that even a PLP lender may require SBA pre-approval to be 100% certain the SBA agrees with their underwriting.

In that deal, that introduced another 2 weeks to 90 days of delay, which was untenable and would have killed the deal outright. I spent an hour on the phone with the bank’s head of credit committee to push them to rely on their PLP status, to no avail.

As a result, I reached out to another other bank that had provided an acceptable term sheet, but I hadn’t selected.

Luckily, that bank was still interested. Given all the paperwork had been completed, including the business appraisal, completing the new loan application with my other bank proved relatively painless.

They saddled up and got through underwriting in two weeks and delivered the binding commitment papers and list of closing conditions. (That deal still ended up dying, but for other reasons.)

Closing Conditions

Just to give you a sense for what closing conditions look like, here are some key items on the list:

• Life insurance assignment (required to have life insurance on myself in the full amount of the loan – make sure to start that process early as it can take 6-8 weeks to put in place)

• Verification of business insurance

• Verification of various business licenses

• Verification of cash equity injection (as discussed above)

• Verification & review of deal documents including PSA, Seller Note, and Non-Compete

• Verification & review of any titles & registrations for vehicles you’re acquiring in the transaction

• Consent Agreements from any landlords — this can get dicey!

Again — this is a sit down & get it done exercise. I will note that if something seemingly minor appears to be holding up the deal, you may have luck pushing the lender to make it a “post-closing” commitment.

Conclusion

While folks complain (myself included) about the frustrations and limitations of the SBA 7(a) process, it’s worth highlighting that in the end, self-funded searchers are getting approved for $3-$5 million in financing despite having no meaningful personal balance sheet and no meaningful operating experience.

My dad, who grew up in a less business-friendly country, was shocked that this was even possible. It’s worth celebrating the SBA program for a moment as an incredible government accelerator of entrepreneurship & risk-taking. It also highlights the value of a strong legal system and bankruptcy code.

That said, the process requires attention to detail and a dogged willingness to push the ball forward every day. Hopefully this post provides some insights on how to do that.

Thanks,

Guesswork Investing