May 18, 2016
Best Practices: Clarification of 25% Contribution in a Partner Buyout
by Ethan W. Smith and Neal Patel
As stated in the SBA Standard Operating Procedures (SOP), if the purchase price of a business includes intangible assets in excess of $500,000, the borrower (or seller, in the form a two year seller standby note) must contribute at least 25% of the purchase price of the business for the application to be processed under the lender’s delegated (PLP) authority.
As explained in an article published by Starfield & Smith in November 2015, the SBA clarified whether the value of the purchasing owner’s existing ownership in the business can be used to satisfy the 25% contribution requirement, or whether the purchasing owner must put “new” money into the transaction. The following clarification from the SBA was paraphrased in the article:
“[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.”
Although the intent here is clear, the specific verbiage related to “pro forma balance sheet equity” has continued to create challenges for lenders attempting to process these loans under their delegated (PLP) authority. It appears that rather than using the term “pro forma balance sheet equity,” the SBA was simply referring to “pro forma equity.” Therefore, in accordance with SBA’s stated interpretative intent, lenders must ensure that the purchasing partner’s equity is at least 25% of the value of the business on a pro-forma basis if they want to process the loan under their delegated (PLP) authority.
Business appraisers will typically provide the 100% Pre-Sale Stock Value of the business in this scenario. To calculate the Gross Pro Forma Stock Value of the business, the lender should first add any new tangible assets added to the business as a result of the loan, such as working capital (cash). Next, by subtracting the new SBA loan related to the partner buyout from the Gross Pro Forma Stock Value, the lender is able to determine the Net Pro Forma Stock Value.
Table 1 below presents an example where a 25% partner is buying out a 75% partner’s ownership interest, resulting in 100% ownership vesting in the purchaser:
The business appraisal reflects a Pre-Sale Stock Value of $1,000,000, which includes all assets and liabilities pre-sale (for purposes of this example, the value of the interest being purchased is assumed to include $500,000 of intangible assets). In addition to financing the partner buyout, the lender is also financing working capital (cash) and closing costs. Working capital is added to the Pre-Sale Stock Value to calculate the Gross Pro Forma Stock Value (closing costs are not added to the gross pro forma stock value, as closing costs do not increase the value of a business). Next, subtracting the total new SBA loan from the Gross Pro Forma Stock Value allows us to determine the Net Pro Forma Stock Value, which, when divided by the Gross Pro Forma Stock Value, provides the Pro Forma Stock (Equity) Percentage.
In Table 1, the purchasing partner does not retain 25% equity in the business (primarily due to the working capital/closing cost loan being factored in).
As reflected below in Table 2, the borrower must contribute a total of $31,250, thereby reducing the Partner Buyout portion of the loan, to meet the 25% contribution requirement.
As seen above, 25% ownership in a business prior to a buyout does not automatically translate to the purchasing partner retaining 25% pro forma equity post-buyout. Lenders must pay careful attention to the ways in which new debt will affect the pro forma equity of the purchasing partner in a business, which may impact lenders’ ability to process loans under their delegated PLP authority.
In addition to the scenarios presented in the tables above, other scenarios may lead to further questions. For example, the appraised value of the business may be higher than the purchase price; the purchasing partner may have more than 25% ownership in the business; the appraised value may be less than the purchase price but the purchasing partner has more than 25% ownership; the buyout amount may be less than $500,000. These scenarios, among others, will each have a unique effect on the Pro Forma Stock (Equity) Percentage of a business, and must be carefully reviewed by lenders to ensure that all SBA requirements are being met for PLP processing of such loans.
For more information regarding SBA requirements for partner buy-outs, contact Ethan at firstname.lastname@example.org, or Neal at email@example.com.