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 businesses. The following blog article has been provided by Joseph Cowles of MeadowsBank (https://www.meadowsbank.bank/):
SBA 7(a) and 504 Financing for Business Acquisitions and Owner-User Commercial Real Estate Purchases
The primary benefits for borrowers who use the SBA 7(a) and 504 loan programs are usually the lower equity injections (less money down) and the longer-term financing (lower monthly payments) than typical conventional financing. These benefits help businesses hold onto their working capital and keep their operating expenses low.
The SBA 7(a) loan program is the more diverse of the two loans, as it can be used for business acquisitions, owner-user commercial real estate purchases, and generally any other business purpose. The aggregate SBA allowance for borrowers who use 7(a) financing is $5,000,000.
For business acquisitions, the 7(a) loan is typically a ten-year adjustable-rate loan, and the down-payment is usually around 20% of the purchase price plus the soft costs. The lender will usually require a blanket UCC filing on the business assets and look at placing a lien on outside collateral that has at least 25% equity. There is no prepayment penalty in this loan, which makes the product user friendly. Borrower’s can refinance or pay off the loan at any time (within the ten years) with no penalty.
For owner-user commercial real estate purchases, the SBA 7(a) loan is typically a twenty-five-year term. The rate can be adjustable (more common) or fixed, depending on the lender and other factors. The lender’s financing structure is typically 90% of the purchase price plus soft costs (subject to appraisal) on general-purpose commercial real estate and is decreased (typically 5% to 10%) for start-ups, special-purpose commercial real estate (I.e.: bowling alleys, swimming pools, hotels, movie theaters, golf courses, amusement parks, and other types of commercial real estate that have a single usage). Lenders are required to place a lien on secondary collateral, if available, if they are financing more than 85% of the appraised value of the commercial real estate. A seller-note can be used in some cases to decrease the borrower’s injection. There is a declining three-year prepayment penalty (5%, 3%, 1% of the original loan amount). However, the borrower can pay up to 20% of the principal amount each of the first three years and incur no penalties.
The unique benefit for borrowers who use the SBA 7(a) loan program for commercial real estate purchases is the speed to close. There are preferred SBA lending partners (PLP) around the country that can approve credit underwriting and financing in-house, which can make this process much quicker than having to submit to SBA for final loan approval. The most time-consuming element of closing a SBA 7(a) loans is the time it takes to order and receive third-party reports (appraisal and environmental). If there is a tight purchase and sale agreement deadline, lenders can sometimes order the third-party reports on the front-end of underwriting and collect the fees from the borrower up front. These fees will be credited towards the down payment at closing.
For business acquisitions and owner-user commercial real estate purchases that are combined in one loan, the 7(a) loan typically has a twenty-five-year term, if the commercial real estate purchase is higher than the business acquisition. If the business acquisition is higher than the commercial real estate, the lender may split the purchase into two loans: 1. The business acquisition with the SBA 7(a) loan, and 2. the owner-user commercial real estate purchase with the SBA 504 loan.
The SBA 504 loan program is more specific than the SBA 7(a) loan program. The proceeds of the loan can only be used for the purchase of owner-user commercial real estate and heavy equipment. If the loan is for commercial real estate the term of the loan can be up to 25 years. If the loan is for heavy equipment the term of the loan is typically ten years. The useful life of the heavy equipment must be at least ten years, as well.
In the SBA 504 loan program, there are two participating lenders. The first lender is typically a bank who usually finances 50% of the purchase price. The second lender is a Certified Development Company (CDC) who usually finances between 30% and 40% of the purchase price, depending on the subject commercial real estate (general-purpose vs. special-purpose) and the length of time in business (more or less than two years). There is 5% added to the borrowers down payment and subtracted from the CDC’s loan amount if the commercial real estate is special-purpose or if the business is considered new.
The key benefits to the SBA 504 loan program are the maximum loan size potential and the financing interest rate structure. The CDC can finance up to $5,000,000 on the second mortgage (30% to 40% of the purchase price) and the bank will usually finance at least 50% of the purchase price on the first mortgage. The SBA 504 loan program can offer approximately double the purchasing capacity on commercial real estate than the SBA 7(a) loan program.
At the closing of an SBA 504 loan, the lender will fund the CDC’s portion of the total financing. The CDC will typically fund their portion 60 to 90 days later. The government must sell debentures on Wall Street to generate the funds used for these loans by the CDC’s. During this 60-to-90-day interim period the loan is interest only and the interest reserves are built into the loan amount to cover this “interest only” period. Once the CDC finances their portion of the loan, the 25-year-term financing commences (CDC’s can also offer 20-year term financing at the borrower’s request). The rate on the CDC loan will lock once the CDC’s 504 loan has funded and is locked for the life of the loan. The rate locks once per month, once the government debentures are sold on Wallstreet to fund all the 504 loans that are pooled together around the country. The bank loan is usually fixed for at least three to five years and will adjust after that period.
The prepayment penalty on the first mortgage of an SBA 504 loan can vary between lenders, whereas the second mortgage by a CDC has a ten-year declining prepayment penalty.
The two primary underwriting and closing concerns for lenders who offer SBA 7(a) and 504 financing are the debt service coverage (to ascertain if the borrower can afford the purchase) and the value of the business and/or subject commercial real estate (to make sure the borrower isn’t paying too much).
A financial package and application will be required by the lender and the CDC to determine that the business can cover their expenses, the borrower can pay their bills, and there is a remainder of profitability.
SBA loans can be used for startup businesses. In this case, the borrower will have to prepare a thorough business plan and solid projections that are backed up with accurate assumptions (the methodology and data used to derive the numbers).
The SBA 7(a) loan program offers two primary benefits to lenders. There is only one loan to capture the maximum loan to value and the government guarantees 75% of the lenders loan amount. The SBA 504 loan program does not offer a government guarantee to the lender on the first mortgage, but the lender can participate on much larger commercial real estate purchases and heavy equipment loans than with the SBA 7(a) loan. Lenders also have the potential to finance more loans by partnering with a CDC on the SBA 504 loan.
In summary, if a project is a business acquisition or has a tight timeline to close, the SBA 7(a) loan program can be quicker to close than an SBA 504 loan. If the project is a large commercial real estate purchase, the SBA 504 loan program has the capacity for larger projects than the SBA 7(a) loan. The primary benefits to both loan programs are the less money down and the longer term and amortization than conventional financing, and there are no balloon payments.
If you have questions relating to the content of this article or financing the acquisition of a business and/or commercial real estate, Joseph Cowles would welcome the opportunity to answer them. Mr. Cowles can be reached at (541) 521-7881 or jcowles@meadowsbank.bank.
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”.