A technical change in SBA policy makes it easier to buy out a partner.
The U.S. Small Business Administration has fixed a rule that was threatening to make it difficult to finance partnership buyout transactions using SBA-backed loans.
At the start of 2018, the SBA adopted the rule, Standard Operating Procedures 50 10 5(J), that stated that in order to qualify for a loan to buy out a partner's interest in the business, the balance sheet must have a minimum equity position after the sale equal to at least 10 percent of the firm's total assets.
It's worth understanding the fix given that the old rule created confusion in the marketplace. And partnership buyouts are already complicated and difficult enough.
The problem with the rule was that partner buyouts are accomplished through the sale of stock, membership interests or partnership interests. The proper accounting of partner buyout transactions creates a negative adjustment to the equity section of the balance sheet, which typically results in a negative equity position.
To illustrate, consider a corporation with $800,000 in free cash flow with two 50/50 stockholders -- $600,000 in assets and $100,000 in liabilities. It has sufficient cash flow to support a substantial loan and a healthy balance sheet with $500,000 in equity and no debt prior to the transaction. This firm might reasonably sell for five times free cash flow yielding a value of $4 million in total, or $2 million for each owner's share.
Under the partner buyout rule at the start of the year, if one owner wanted to buy out the other, the entire $2 million purchase price would be applied to the balance sheet as a reduction of the firm's equity. In the absence of a new equity investment from the buyer, this adjustment would result in post-transaction equity of negative $1.5 million.
Beginning equity: $500,000 Less purchase price: -$2,000,000 Ending equity: -$1,500,000
Since this ending equity is less than 10 percent of the total assets, obtaining an SBA loan was impossible without a massive infusion of capital.
In the above example, the buying shareholder would be forced to invest at least $1.56 million in personal funds in order to achieve the required post-transaction equity of $60,000 (10 percent of the $600,000 total assets). With this huge investment, the buyer could then qualify for an SBA loan for the other $440,000.
In contrast, SBA minimum equity requirements for borrowers purchasing an entire business was just 10 percent to qualify for a loan.
Using the previous example, a non-owner might expect to pay $4 million to purchase 100 percent of the business. The new buyer would only be required to come up with a $400,000 equity investment (10 percent of the purchase price) to qualify for an SBA loan of up to $3.6 million.
Incredibly, an existing partner with a proven ability to run a successful company needed equity of $1.56 million to buy half of the business, and could only qualify for a loan of $440,000. Yet, a buyer with no direct ownership experience in the business only needed equity of $400,000 and could qualify for a loan of $3.6 million to buy the business.
Obviously, this made no sense.
So in April, the SBA fixed its mistake, making the partner buyout rule much more reasonable.
Under the April Policy Notice, a buying partner can now qualify for an SBA-backed loan without an equity injection, provided the business has a debt-to-net-worth ratio of no greater than 9:1 prior to the change in ownership and the continuing partner has been active in the business for more than two years.
And if both of those requirements are not met, then a 10 percent equity investment is required. The change was effective April 3. It is sensible and puts partners on a level playing field with non-owners.
I am aware of several partner buyout transactions that could not move forward at the start of the year because of the changes in the SOP. But, they can qualify now under the new rules. In one such case, the founder of a rural pest control business brought on a younger partner several years ago with the express intent to groom him to take over the business when he was ready to retire. The founder was ready to exit earlier this year, but the exit was blocked by the rule change at the start of the year.
This new adjustment will encourage lending and support responsible economic growth while ensuring our successful Main Street businesses don't die with their owners. In 2017, the SBA had a record year supporting $25.44 billion of its 7(a) loans -- its primary lending program for starting, acquiring or growing businesses.
Lending activity so far suggests another record year ahead.
The article was first published here on August 13, 2018