When a small business owner looks to sell his or her business, the asking price generally includes not only the financial value and market benefits of the business but also emotional costs and returns. In many instances, an unsophisticated and eager buyer may overlook how such factors could be artificially inflating the asking price. As such, it is generally accepted that a truly reasonable purchase price can only be determined by an independent third party.
Consequently, the Small Business Administration (SBA) has included guidance in its Standard Operating Procedure (SOP) that requires a Lender financing a change of ownership with SBA 7a loan proceeds to obtain an independent business valuation from a qualified source, as defined in the SOP, if any one of the following three conditions is met:
- the amount being financed minus the appraised value of real estate and/or equipment is greater than $250,000;
- there is a close relationship between the buyer and seller (for example, transactions between family members or business partners); or
- the lender’s internal policies and procedures require an independent business valuation from a qualified source.
Assuming all of the requirements set forth in the applicable SOP are met, the business valuation is deemed by the SBA to accurately reflect a reasonable purchase price for the business. To prevent the buyer of a small business from incurring additional debt unrelated to business operations – or more practically, an overextension of credit by lenders –, the SOP provides that “[a]ny amount(s) of the loan proceeds that will be used to facilitate a change of ownership may not exceed the business valuation.” While this requirement directly prevents a lender from using 7a loan proceeds to pay any amount in excess of the business valuation, the SOP is silent on whether the borrower may pay a premium for the business above what was deemed reasonable in the business valuation.
By the time a business valuation is received by a Lender, the deal has taken on a life of its own and the buyer is often solely focused on closing the deal – at any cost. In some situations, there may be practical reasons for the borrower paying a purchase price above the valuation. For example, the valuation may not take into account brand recognition or market share or may not accurately reflect the true value of the company’s competitive advantage (e.g., technology, trade secrets and talent).
Under these circumstances, a lender may decide to move forward with closing the loan. In making this business decision, it is prudent for a lender to thoroughly document its file to explain why the lender is comfortable with the Borrower paying above the business valuation. Where there is supporting financial or anecdotal support for the lender’s rationale, such information should also be included in the file.
For additional information regarding business valuations and change of ownership transactions, please contact Katherine at 267.470.1187 or firstname.lastname@example.org.