Founded in the 1950s, the U.S. Small Business Administration has for many years assisted in the establishment, and growth of small businesses, and the exit of business owners. The specific loan program created to provide such loans is the 7(a) program. In the early years a SBA loan was obtained by contacting the federal government, proving a business had been declined 3 times by banks, and then getting a direct loan from the federal government. Such “direct loans” today are made by SBA only for helping businesses after disasters. The model that has existed for recent decades is the “indirect” loan model, where the small business gets a loan from a bank (or other lender), and the bank goes to SBA for a loan guaranty. Typically, the SBA reimburses the bank under such a guaranty for 75% of any amount it losses (85% on loans under $150,000). These loans can be as large as $5,000,000, a ceiling increased from $2,000,000 in the Jobs Act of 2010 during the Great Recession. With the increase to $5,000,000, the use of the 7(a) loan program for ESOPs became more viable. SBA loans are capped at 10 years, fully amortizing, when used for any purpose other than real estate acquisition, for example, an ESOP. The SBA program does not allow banks to default a SBA loan Borrower based upon financial covenants, only for lack of repayment. Interest rates are typically up to prime rate + 2.75%, adjusting quarterly. One-time upfront fees of up to around 2.77% of the loan amount are paid by the Borrower to the SBA, and these fees are income to the SBA, intended to fully cover the pay-outs on guarantees, thus the SBA 7a program is designed to operate at no cost to the U.S. tax payers, other than the overhead of running SBA. One unique aspect of SBA rules on ESOPs, the SBA does not allow banks to utilize the expedited “PLP” processing program, every SBA ESOP loan must be approved by the bank, and then submitted to SBA and re-approved by SBA. All SBA guaranteed ESOP loans must be direct to the ESOP, guaranteed by the company. If the ESOP owns less than 100% after the ESOP loan, then every 20%+ owner must guaranty the SBA loan personally, and collateralize the loan to the best they can with their personal real estate. If no one owns 20%, still one person must guaranty and collateralize the loan. When the ESOP owns 100%, however, the requirement for personal guarantees and collateral go away. To be eligible for a SBA loan a business must meet the definition of “small”, and that definition can be rather generous. If a business has net worth under $15,000,000, and 3 year average net profit under $5,000,000, then it is “small” and eligible.
Most, if not all, SBA loans that have funded ESOP transactions have resulted in ESOPs owning 100% of the company upon loan settlement. If such a 100% transaction is for a company where an ESOP already exists with material un-leveraged ownership, the overall level of debt to go to 100% ESOP ownership might be modest relative to the cash flow of the business. When financing a 100% purchase in a single stage, the levels of debt can be challenging, and best addressed by significant subordinated seller financing on cash flow friendly terms. Another aspect of seller financing when acquiring 100% is that SBA also has a rule that all SBA loans be to adequately capitalized companies. In a business sale, including a sale to an ESOP, the business is deemed to be worth the purchase price (a valuation report is required), and thus equity must be injected, or else there is no capitalization to meet the SBA requirement. Such required equity is typically created by the Seller holding Seller Notes that are subject to a SBA Form 155 Standby Agreement. If a Seller note pays interest-only during the life of the SBA loan, it generally can count as “equity”, thus creating equity capital in the purchase transaction. Not all of the seller financing needs to be subject to this interest-only restriction, other portions of seller financing can pay-out faster.
One of the most challenging aspects of making a transaction comply with SBA requirements is that SBA requires all owners (including holders of stock options or warrants) must sell, and as a seller they must therefore exit any role in the business, other than: holding seller debt, and being a consultant under an agreement no longer than 12 months. Key managers that a business relies upon, thus may be required to head to the exits on loan settlement day. SAR holders and phantom stock holders, both before and after the sale, are not considered “owners”.
Many employees have been assisted in their ownership dreams by the support of SBA, but to SBA-finance an ESOP transaction is complex, where requirements of SBA, IRS and DOL can all intersect. With good planning and the requisite skill set, the process should go smoothly.
Author: Ted Lauer - tlauer@accessnationalbank.com
