2023 Wrap Up: State of the SBA with Lisa Forrest and Sarah Andrews

In the latest installment of our Private Market Insights podcast series, episode 21, we welcome Lisa Forrest, Head of Searchfund Lending / M&A Lending at Live Oak Bank, alongside her colleague, Loan Officer Sarah Andrews. Our discussion, taking place just a day after another significant update to the SBA 7(a) program, offers up-to-date insights into the significant changes of 2023 and their implications for 2024. Drawing on their extensive experience as lenders for SMB acquisitions, Lisa and Sarah provide a unique perspective on how these changes are interpreted and applied by various lenders.

This summary highlights key points for those looking to understand the evolving SBA landscape and its impact on small business acquisitions. For anyone navigating these recent developments and trying to predict future shifts in small business lending, the full episode is an invaluable resource on the latest trends.

We highly recommend checking it out:

2023 SBA Changes: A Timeline of Confusion and Clarification

The implementation of SBA guideline changes in 2023 was implemented in stages, creating some confusion and requiring several clarifications. We started our discussion with Lisa Forrest and Sarah Andrews by establishing a timeline of the changes over the past several months:

·   May 11th: The SBA’s first significant announcement that they would be making changes

·   August 1st: Additional changes came into effect on this date, intended to complement and clarify the earlier ones. 

·   October: A key development occurred at a National Association of Government Guaranteed Lenders meeting, where participants discussed codifying some unwritten rules.

·   November 15th: The changes and clarifications from the prior discussions were formally implemented. This included clear guidelines on partial changes of ownership, full acquisition, and partner buyouts.

·   Breaking News on December 6th: Just a day before our podcast, another update was released, further clarifying rules around partial change of ownership and 100% acquisition. This also addressed the interpretation of the “nine to one debts net worth” rule and reinstated the blended term availability for certain transactions.

Major Changes for Down Payment Rules and Funding Sources

One of the changes that brought the most attention early on in the process centered on required down payments for SBa 7a loans. Under the prior rules,  the SBA’s requirements included a 10% equity injection, which could be made up of 5% cash and 5% in a full seller standby note, the latter meaning no payments for the life of the loan. In the current framework, the SBA has loosened its previous requirement for a cash down payment. Now, for example, a full standby seller note can make up the entire 10% equity requirement, requiring no payments of principal or interest for two years.

This is a significant change because it opens the door for individuals to buy businesses with no personal cash in the down-payment. However, there continues to be some disagreement in the interpretation of this new rule. In particular, Sarah notes that lenders are still adjusting with how to include seller note payments in debt service projections, especially those that have a two-year standby but must be paid before the maturity of the loan.  Some lenders will include these payments in forward-looking debt service coverage requirements, while others may take a more aggressive approach, not including the payments in the calculation. 

Lisa discusses the heated debate within the lender community about zero down SBA purchases. She voices concerns over the bold structuring of such deals and underscores the necessity of evaluating equity sources, mentioning that Live Oak Bank prefers a blend of equity contributions from both the buyer and investors.

Tackling the topics of debt service coverage and business expansion, both guests stress the significance of considering debt service when using seller notes as equity. They cast doubt on the feasibility of completely leveraging a business for acquisition, particularly in situations where the business plan focuses on growth. Moreover, Sarah points out the mismatch between a fully leveraged business and the common growth goals of buyers. She suggests that fully leveraging a business might not be a sound decision in this context, marked by rising interest rates, but stable multiples.

Partial Buyouts and the Importance of “Key” Employees

The 2023 SBA changes bring detailed rules around partial buyouts, significantly impacting sellers’ ability to stay involved in their businesses after a sale. Under the new guidelines, sellers can keep an ownership stake and stay involved in the business. Previously, the 7a program required a full buyout, with sellers not participating in the business post-close. Under the new rules,  if a seller keeps less than 20% ownership and isn’t seen as “key”, they don’t need to provide a personal guarantee; however, if they are considered “key”, they must give a personal guarantee, regardless of how much of the business they own.

This leads to an important question: what makes someone a key employee? As our guests point out, the answer is not straightforward and varies with each situation. Identifying a key employee depends on their impact on the business and customer relationships. For example, just holding a license isn’t enough to make them key.

The complexity increases when we think about the transition plans and how different stakeholders — sellers, buyers, and investors — interact. In partial buyouts, balancing these interests requires careful alignment, as successful transitions are about more than just financial agreements; they’re often shaped by emotions, pride, and ego. From their viewpoint, Lisa and Sarah stress the importance of understanding the transition plan and the buyer-seller relationship, as transitions can be full of challenges even when there is financial alignment.

Other Significant Changes to SBA Lending in 2023

The conversation continued with an overview of four additional important changes, ready to offer a more adaptable and accessible approach to SBA lending, potentially transforming how borrowers navigate the process.

Enhanced Borrowing Capacity Across Industries

Forrest points out an important update for experienced business operators. When acquiring a business in a different NAICS code from their initial acquisition, borrowers can now access an extra $5 million in SBA borrowing capacity. This change opens new possibilities for diversifying business operations across various industries.

Relaxed Rules for Home Equity Loans (HELOC)

The SBA has made major changes to the use of HELOCs. Previously, borrowers needed outside income to cover HELOC debts used for equity injections. The new rule allows the income generated from the acquired business to be used for covering HELOC debts, thus offering greater financial ease for acquisitions.

Removal of the Personal Resource Test

According to Sarah, this change removes the previous liquidity cap for borrowers, benefiting individuals with strong financial records. It expands the pool of potential borrowers who can now qualify for SBA loans.

Simplified Equity Seasoning Process

The SBA has simplified the equity confirmation requirements, aligning them more closely with conventional loan standards. Banks are given the choice to set their own requirements for this process, with some banks requiring only a month’s bank statement to confirm equity availability during underwriting.

Diverse Interpretations and Approaches of SBA Lenders

A recurring theme throughout the conversation centered on the different interpretations of SBA lending rules by various lenders. This diversity is a long-standing characteristic of the SBA lending landscape and not just related to recent changes.

Our guests believe this variability is advantageous, as it leads to a more personalized fit between lenders and borrowers. Each lender has a distinct approach, shaped by their own policies and experiences. For instance, Live Oak adopts a more flexible attitude towards recent SBA changes, such as partial buy-ins and including seller notes in debt service coverage.

Sarah points out that individual bank policies significantly shape the application of SBA guidelines. These policies can affect crucial aspects like debt service coverage requirements and how much equity borrowers need to contribute. The key takeaway is that interpretations of SBA lending rules will differ among lenders, emphasizing the importance for borrowers to comprehensively explore and understand different lenders’ unique methods.

Navigating Potential Government Shutdowns in SBA Lending

The risk of government shutdowns often causes significant worries among clients, mainly due to how it might affect their loan processes. Lisa and Sarah note that while concern about government shutdowns and their impact on SBA lending may proliferate online, the actual risk to borrowers is typically low. Sarah points out that government shutdowns usually last a maximum of two to three weeks, with the longest going up to around 45 days. In the span of a usual 90-day loan process, such shutdowns mainly impact loans that are close to finishing.

Lisa discusses the use of continuing resolutions as a common way to keep government programs, including SBA lending, running during political standoffs. She advises borrowers to be well aware of their progress in the loan process, particularly regarding getting a preferred lender number from the SBA, which is key for securing the necessary funds. She also emphasizes the importance of borrowers being actively involved in their process, especially when a shutdown seems likely. Lenders play a crucial role in guiding borrowers through important steps and keeping them informed about the process and any potential delays.

In cases where a shutdown lasts longer than usual, trustworthy lenders might provide temporary loans, according to Sarah. These loans help complete the transactions, which can be refinanced under the SBA once the government is back up and running. She assures that while government shutdowns can be troublesome, they rarely completely stop the lending process.

Future Projections for 2024

Looking ahead to 2024, our guests share insights on the notable trends observed in 2023 and their potential impact on the upcoming year. A prominent trend is the decrease in borrowers’ capacity to secure larger loans, which, contrary to typical market behavior, hasn’t led to a decrease in sellers’ asking prices. This mismatch poses a significant challenge, as buyers find it difficult to meet these higher demands with limited borrowing power.

Addressing this situation, Sarah encourages buyers to exercise patience and creativity. She advises recognizing financial boundaries and seeking deals that align with strategic objectives, rather than pursuing unattainable ones. Lisa added that inconsistent 2023 financial results relative to 2022  caused several deals to fall through, underscoring the need for thorough evaluation and possibly revising pricing strategies.

In discussing future projections, our guests also speculate on potential SBA lending modifications that they would like to see. Suggestions include revisiting rules for veteran benefits and considering more lenient guidelines for strategic acquisitions, especially beneficial for veterans, women-owned businesses, and other underserved communities. Additionally, Sarah expressed support for reintroducing the blended term in SBA lending, which simplifies loan structures for transactions involving a mix of assets.

In Conclusion

As we enter 2024, these anticipated changes, alongside current market trends, point to a need for adaptability and strategic planning in the SBA lending market. The experts highlight the importance of adjusting to the evolving market, especially given the challenges in forecasting debt payments and economic trends. How these potential policy changes and market trends interplay will be crucial for stakeholders navigating the SBA lending landscape in 2024.

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