Understanding Debt Service Coverage in an SBA Loan Context

Jun 27, 2023

In the 1990s when I purchased my first home using an FHA loan (https://www.investopedia.com/terms/f/fhaloan.asp), the minimum cash down payment requirement was 8%.  Conceptually, I understood this requirement, at the time, to be based on the fact that if I purchased the home, the value remained static, and I was forced to sell it due to health or relocation issues that I could exit the property without out-of-pocket expense.  The 8% equity in the home from day one would cover the commissions associated with professional representation in a sale, associated taxes, and transaction costs.   My mortgage banker at the time, Kevin Smith (https://www.linkedin.com/in/kevin-smith-1521317/), also vetted my income to ensure I could afford the mortgage payments, property taxes, and insurance associated with the residence.  The end result loan was good for the seller of the property (They received 100% cash), my fiancé & I, and the bank.  When we moved to a new house, five years later the debt was retired.  This is how a sound banking loan process should work. The motivation for making a loan by a bank should be to deploy capital for an investment return resulting from repayment.  The loan can be potentially sold by the originating bank to offer the return to other investors and recapture capital to lend again.  Government support for a program is put in place to encourage bank lending practices that would not normally occur. Prudent, citizen-centric programs of this nature in the United States, including by the FHA, and SBA (https://www.sba.gov/funding-programs/loans), have resulted in a higher percentage of homeownership and entrepreneurship in the country than is found in virtually every nation around the world.  Programs like these are excellent examples of government working at the highest level for the common good of the citizens.

In the time period leading up to the Great Recession, banks started to abandon these sound lending practices allowing people who were not financially qualified to buy homes through either purchase with no cash injection element supporting the acquisition from the buyer or inadequate verification of the backing income to support payment of the mortgage.  What ultimately occurred is well documented for the unfamiliar theatrically in The Big Short (https://www.youtube.com/watch?v=vgqG3ITMv1Q).  It also occurred in the commercial loan marketplace (https://www.nbcnews.com/id/wbna33576310) with loans backing business acquisitions.  One of the underlying causes for economic turbulence by mortgage & commercial lending companies was that they abandoned assessment of the return on investment from interest income as a primary motivation for making the loans and focused instead on the sale of the loans and the upfront origination fees paid by borrowers as income streams.  The result was many loans that should not have been made by banks.  IBA is one of the few business brokerage firms in the Pacific Northwest with the institutional knowledge & experience gained through professionally serving the entrepreneurial community during the high interest rates of the 1980’s and the Great Recession.  It is our job to share that knowledge & experience to allow parties to make intelligent business decisions.

The situation in the SBA loan marketplace is not the same as 2007 in 2023, however there are elements in the marketplace that are causing me concern for both business buyers and sellers.  I share this as someone who has been requested multiple times to train bankers regionally facilitating Small Business Administration (SBA) Guaranteed Loan programs for the U.S. Government, wants business owners to receive fair market values for their companies, buyers to be successful entrepreneurs post business acquisition, and banks to have low default rates serving the small business community to encourage more investment in the sector.

In my review of the new SBA loan guidelines & regulations going into place nationally this summer with multiple bankers, one identified area of concern is the acceptable debt service coverage ratio allowed to secure an SBA guaranteed loan.

The acceptable minimum for a bank to secure an SBA loan guarantee is 1.15.   The easiest way to understand that figure is to use a loan where annual debt service is $120,000 per year or $10,000 a month.   A 1.15 debt service coverage ratio means that for loan approval the business will need to have $11,500 per month or $138,000 per year in cash flow after paying a fair market salary to the business buyer for filling the executive ownership position they will be replacing in the company.  The bank will use a higher figure for the replacement cost of ownership, if the borrower’s personal expenses (Mortgage, Tuition for Children, etc.) necessary to maintain their preacquisition lifestyle are greater.

In a perfect world, a 1.15 debt service coverage is likely sufficient, however, it is my opinion that it insufficiently does a Monte Carlo Simulation (https://www.investopedia.com/terms/m/montecarlosimulation.asp) to adequately prepare for all potential post-sale outcomes for the company.  Factors that can impact a business after a business sale range from external forces like the economic environment and competition in the marketplace to internal elements like executive leadership and acumen. The one item that cannot be sold in a retirement sale is the executive ability of the departing owner.   The new owner will be better or worse. They will never be exactly the same.  IBA has a standing “best practice” policy to only seek SBA loans in deals where the debt service coverage is 1.25 – 1.50.  In our nearly fifty-year history of successfully facilitating transactions involving SBA loans, we have found that this policy has resulted in one of the highest buyer success rates and lowest SBA loan default rates in the United States for a firm that has done over a 1000 deals.  IBA has successfully transferred ownership of over 4200 privately held companies and family businesses.

The question often raised by our sell side clients is “how are a proper debt service coverage ratio and risk allocation between the parties achieved in IBA transactions”. The answer has the following major elements:

  1. Proper Business Valuation – A correctly sized loan for a transaction is not possible unless the business is properly valued. It is the responsibility of a sell side M&A intermediary, working collaboratively with other professional advisors, to educate the seller on the anticipated market value of a company before going to market.  If the valuation is overstated by 20%, how is it possible to finance a traditionally structured acquisition given an EBITDA of the company which conveys a different value?
  2. Appropriate Cash Injection by the Buyer – The higher the capital injection by the buyer the lower the debt service and higher the debt service coverage ratio post-acquisition. The typical capital injection in IBA facilitated transactions by a buyer is 15- 25% of the acquisition price.  IBA is blessed due to the high demand for our properly valued, high quality representation projects that our clients traditionally do not need to go below a 15% capital injection by the buyer in their assessment of potential successor candidates to negotiate with in good faith.   IBA is fine with a buyer delivering less cash at closing, if financing can be secured with a smaller injection, but we want them to mentally & emotionally prepare for the higher number when executing a Letter of Intent to take a business off the market for an exclusivity period to mitigate unnecessary turbulence to the deal or a need to renegotiate terms because they have failed to secure the financing they conveyed was possible.  IBA closes 80 – 90% of transactions annually where a buyer enters into agreement with our client on a LOI.   One reason this occurs is that we do not encourage dealmaking with under financially qualified parties or people trying to par out by rolling in a putt from 50 feet (https://www.sportscasting.com/what-is-the-longest-putt-ever-made-on-the-pga-tour-and-who-made-it/_.  We would much rather see the tap in from under five feet as is frequently done by our golf tournament foursomes.
  3. Necessary & Sufficient Seller Subordinate Financing – A common strategy to make debt service coverage ratios work by buyers and bankers is to try to “sell” a retiring business owner into financing a significant amount of a deal in a promissory note that is subordinate to the primary lender, commonly the one providing the SBA guaranteed loan. IBA is all about collaboration between parties in our transactions, but seller financing can be a bitter pill to swallow if the request is to place the note on full standby for ten years to a 72-year-old retiring individual by someone with insufficient signature power supporting the loan request.  In this situation, the beneficiaries are likely the buyer, who gets to conserve capital, and the bank who enters the deal with a higher equity position to collateralize their loan.   The seller in this situation may never see the payment in their lifetime, so in essence they are getting 90% of the businesses market value for use rather than for retirement, philanthropy, and to pass on while living in their family (e.g., Paying for a grandchild to go to college or helping with a first house downpayment).  A much-preferred scenario is one where the buyer has a large enough cash down payment to allow the seller to receive amortized payments commencing shortly after the sale is completed.  Insider Note: It is my opinion that a properly structured transaction should have a small seller note with a right of offset and/or escrow holdback to address potential trailing liabilities post sale.  No business buyer wants to be forced to try to collect from a seller that is living on a beach in the Seychelles.  In addition, no seller wants to finance more of a deal than the buyer puts in as cash.

The purchase & sale of a privately held company or family business is one of the most sophisticated, nuanced transactions a party can be involved in making as an investor.  Successfully obtaining acquisition financing and allocating risk between the parties are just two of the deal elements an experienced, knowledgeable, highly skilled business broker can address in a transaction.   Having the right banker on your acquisition team is also critical as a resource.  IBA works with only the “best of the best” in the SBA lending community.  If you are looking to purchase a business using an SBA loan, we would welcome the opportunity to make an introduction.  If you are a banker working in the SBA Loan space, IBA wants to provide you with quality financing project opportunities with buyers & business models that will be successful post acquisitions and REPAY THEIR LOAN.

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, legal, and accounting 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”.