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November 4, 2015

Best Practices: Change of Ownership Challenges

by Ethan W. Smith

SBA lenders sometimes face challenges when underwriting change of ownership loans. Specifically, lenders that are using an SBA 7(a) loan to finance a partner buyout (where one existing owner buys the ownership interest of another owner resulting in 100% ownership vesting in the purchaser) with intangible assets that exceed $500,000, may have difficulty in properly structuring their loan, especially if they want to process the loan under their delegated (PLP) authority.

SOP 50 10 5(H), Subpart B, Chapter 2, Subparagraph IV. H. 7. b. provides:

If the purchase price of the business includes intangible assets (including, but not limited to, goodwill, client/customer lists, patents, copyrights, trademarks and agreements not to compete) in excess of $500,000, the borrower and/or seller must provide an equity injection of at least 25% of the purchase price of the business for the application to be processed under delegated authority. (Seller equity is defined as seller take-back financing that is on full standby (principal and interest) for a minimum of 2 years.)

Often times when this scenario arises, lenders question whether the purchasing owner’s existing equity in the business can be used to satisfy the 25% “equity” requirement, or whether the purchasing owner must put “new” money into the transaction. Lenders generally agree that in order to give credit to the purchaser for its existing equity, the lender must have an SBA-compliant third party business valuation performed to substantiate the value of the purchaser’s existing equity in the business.

SBA has provided additional clarification for this situation by providing guidance to NAGGL which states:

[The lender must determine whether] the business valuation [was] done pre-sale or proforma… [W]hile the purchasing partner may have 25% equity pre-sale, the additional leverage will alter the proforma balance sheet, which may result in less than 25% equity. If less than 25% proforma, additional investment by [the purchaser or seller] (to restore the 25% equity position) is necessary to avoid LGPC processing. If the proforma balance sheet contains equity of 25%, then there is no specific requirement in the SOP for “new “equity. The equity contribution of the borrower is his/her already invested capital equal to or greater than 25% to allow PLP processing.

Therefore, in addition to obtaining a business valuation to determine the value of the purchaser’s existing equity in the business, the lender must also analyze the business’ balance sheet on a proforma basis to ensure that the purchaser will maintain its 25% equity post-closing. Lenders that fail to properly assess and credit the equity of the purchasing owner in this situation risk improperly processing their loans under their delegated authority, thereby risking their loan guaranty.

For more information on processing change of ownership transaction under delegated authority, please contact Ethan at esmith@starfieldsmith.com or at 267-470-1186.