IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Heather Endresen of Viso Business Capital (https://www.visocap.net):

The Question Every Business Buyer Wants to Know But is Afraid to Ask

Buying and operating a small business can be an exhilarating journey with many highs and lows.  Those who set upon this path do so with an admirable mix of optimism and grit.  I’ve lent to many of them in my 30 years as an SBA lender, and there is a particular question that usually comes up in an almost apologetic way from would-be buyers.  It usually comes at me in the conversation with a notable shift in tone that lets me know THE question is coming, “What are the odds that I will default on this loan and what happens when defaults do occur?”  Up until researching this article with my partners at Lumos Data, I must admit that I didn’t have an actual statistical answer to the first part of this question, and for second part I always answer that one that parties should do some research on the term “SBA Offer in Compromise” to understand how the SBA and banks tend to resolve the final credit losses than can occur under an SBA personal guarantee.

Before I answer the question about how likely it is for an SBA loan used to acquire a business to end in default, let me start by saying that the SBA makes a wealth of loan data available publicly that is simply not available for non-government guaranteed loans, making it a very important guidepost to lenders in determining their small business credit practices.  However, the SBA did not give us the data points necessary to separate out business acquisition loans from all the other uses or proceeds (such as owner-occupied commercial real estate acquisitions, start-up funding, leasehold improvements, working capital, etc.) until roughly 5 years ago.  The more time that passes from that 2018 starting point, the more this data set will have to teach us about how loan sizes, industries and geographies impact the overall risk of default.  But, after 5 years of data collection, and with the added power of data analytics from Lumos Data, we can start to see some interesting insights from the data we do have.

Business Acquisition Loans as a Component of the Overall SBA Program

Each year, between 4,000 and 6,000 business acquisition transactions are being funded with SBA loans since 2018.  These transactions represent between $4.5 – $6.9 billion in SBA loans per year or roughly 20 – 23% of SBA’s total 7(a) loan program.  If we make a broad assumption that SBA is probably funding an average of 80% of the capital stack, then this translates to roughly $5.6 to $8.6 billion in enterprise value on aggregate.  Average loan sizes have been gradually increasing from $880,000 in 2018 to $1.16 million in 2022.  The data set does not allow us to determine average multiples paid or any trends with regard to multiples because the earnings of the businesses are not represented.

Early-Stage Loan Defaults

The initial transition period gets a lot of attention from bank credit decision-makers, and rightly so.  If the transition isn’t carefully planned for and executed, a borrower can find themselves in jeopardy of not being able to make the debt payment very quickly.  Often, the cause of early-stage difficulties is a lack of sufficient working capital.  I have seen otherwise good deals fail or nearly fail because of this, and it is a terrible thing to see because it is preventable.  This is where working with advisors and lenders who are highly knowledgeable on this subject, as well as obtaining a working capital analysis from an experienced Quality of Earnings provider is essential.  Fortunately, most buyers are able to navigate through the initial 12-18 months of transition – with early defaults for acquisition loans (defined as defaults occurring within the first 12 months) being 0.4%-0.9% annually.

Overall Default Rates Through Different Filters

There are of course, a myriad of other things that can go wrong in operating a small business with leverage, and unfortunately, sometimes they do.  While the SBA and lenders generally give a fair amount of latitude and flexibility to struggling small business borrowers during the initial stages of cash flow difficulties, a small percentage are not able to return to a regular payment schedule, resulting in a defaulted loan.

Working with the easy-to-use data set provided by Lumos Data, an SBA data analytics software firm servicing small business lending institutions nationwide, we took a deep dive into whether loan size, industry, vintage (the year the loan was originated), or geography made a difference in the probability of default on an SBA business acquisition loan.

Defaults by Vintage

The overall default rates shown below include only SBA loans used to acquire a business so that we have the clearest picture possible of what is happening with business acquisition loans, and the good news is, they are relatively low!  The list below is what banks consider a view of the default rates by “vintage” or the year the loan was originated.  As loans age, the default rate naturally creeps up slightly because more time on the books also means more time for some things to go wrong.  But, even the oldest vintage from 2018, still has a very low rate of default of 1.68%.

• 2018-2020 – 1.22%
• 2018 – 1.68%
• 2019 – 1.24%
• 2020 – 0.70%
• 2021 – 0.42%

Defaults by Loan Size and Industry

Digging in more granularly, we can see that certain factors have a larger impact on default rates than others.  Two major factors are the loan size and industry type, both of which are within the control of buyers and lenders. Larger loan amounts generally lead to lower defaults. True, the monthly debt obligations will be higher, but considering the loans are to larger and potentially more established businesses, the risk tends to be lower.  This may be counter-intuitive to first-time buyers, but the statistics reveal that going up market to a company on the larger end of your criteria may have many benefits compared to trying to acquire something smaller.

Industry also has a big impact on the probability of default.  We looked at industries with a PD of less than 3%, and the results were not surprising.  At the low end of the scale are many essential services industries such as healthcare, home health, nursing care facilities, and pharmacies.  You also see pest control and funeral services as well as a couple from the real estate industry, with RV parks at a very low 1.8% default rate (in the top 10 for low rates of default) and the very lowest rate of default with Self Storage which currently sits at only 0.78%.  Middle-of-the-road industries with default rates above 3.5%, are car washes, auto maintenance and landscaping.  Among the industries with default rates nearing 5% and above are trucking and freight, millwork, fitness centers, janitorial and the “winner” for the worst SBA acquisition default rate is not surprisingly mortgage brokers at a staggering 13.9%.

Of course, most loans in those higher defaulting industries are performing and there are, no doubt, many good deals that have been done in the higher risk industries.  However, it is helpful to know the odds so that when a buyer is considering one of those industries, the risks can be lessened with a lower price multiple, or lower SBA leverage combined with more seller “skin in the game” through a larger seller note, forgivable seller note, or rollover equity.  It’s always important to note that careful and thorough diligence with experienced deal team members is always a good way to reduce risk regardless of the industry.

Relationship between Default Rates and Interest Rates

There is little movement in the probability of default between fixed or variable rate loans, somewhat surprisingly.

• Fixed Rate: 0.19% change in PD
• Variable Rate: 0.30% change in PD

However, the probability of default almost doubles between the low and high end of the potential interest rate range.  This is not at all surprising because of the increase in debt payments caused by higher rates.

• 95^th percentile of Treasury spread (2.6): 6.03% PD
• 5^th percentile of Treasury spread (-0.1): 3.08% PD

Unemployment and Inflation

Factors that surprisingly do not have as large an impact on the probability of default are increases in unemployment and inflation.

1 point increase in unemployment:

• Term Loan: 0.28% change in PD
• Revolving Loan: 0.53% change in PD

Inflation has been a concern and headline over the last 18 months. So, what role has it played in increasing default rates?  Surprisingly little, in part perhaps because many small businesses have been able to pass along their cost increases to customers.

• Average expected inflation (2.97): 4.31% PD
• 95^th percentile of expected inflation (4.6): 4.71% PD
• 5^th percentile of expected inflation (2.2): 4.13% PD

Does Geography play a role in Default Rates?

Our final anecdote has to do with geography. There is a large swing between the state with the lowest PD and the highest.  Montana wins the battle of the states coming in at 2.73%, with Florida losing the battle coming in at more than double at 6.74%.  What’s going on in Florida?  I won’t even try to guess, I’m just glad that my home state of California stayed out of the headlines on this one with a middle-of-the-pack default rate of 4.5%.

So Far, So Good

While we can only speculate on whether or how much default rates may rise if economic conditions remain challenging or worsen for small businesses, it is good to know the baseline has been good so far.  Overall, the risk of default remains quite low when using an SBA loan to acquire a business.  Being armed with the hard facts can help a buyer make informed decisions and might even help some sellers get more comfortable with carrying a seller note.  While all loan defaults cannot be prevented (sometimes things happen that are simply unforeseeable), careful diligence and working with an experienced and thorough deal team can make it far less likely for your loan to become one of the few unfortunate statistics.

If you have any questions relating to the content of this article or using a SBA loan to acquire a business, Heather Endresen would welcome the opportunity to answer them.  Ms. Endresen can be reached at (714) 404-3648 and heather@visocap.net.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, accounting, legal, and financial planning communities on subjects relevant to the purchase & sale of privately held companies and family-owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.