Best Practices: Considerations for Complete Change of Ownership

Financing a business acquisition is an eligible use of SBA loan proceeds, provided, that certain conditions are met.  SOP 5010(5)(K) states that a business acquisition must result in a 100% change of ownership, and the seller is required to divest his/her interests completely from the business (i.e. a partial sale to reduce seller’s interest in the business is not permissible).  The seller cannot remain as an officer, director, shareholder or key employee of the business.  If the buyer believes the seller’s experience and assistance is important in order to successfully transition the business to buyer, the buyer may hire the seller as a consultant for a period not to exceed twelve (12) months (including extensions) from the date of closing.  Lenders should be careful that any such arrangement does not permit the seller to: (i) retain control over the borrower; or (ii) continue to share in the profits of the borrower’s business.

If the parties agree to have the seller act as a consultant to the borrower post-closing, they should negotiate an independent consulting agreement and execute it at closing.  Lender or its counsel must review the entire document in order to confirm there are no provisions which would make the loan ineligible, such as options to renew the agreement past 12 months, or to provide additional payments to seller beyond compensation for services actually rendered, such as to cover healthcare costs, car payments or country club memberships for seller and/or his/her family multiple years post-closing.  The borrower must obtain all licenses for operation of its business, so the principal(s) of borrower, and not the independent consultant(s) should be the qualified company representative on the licenses.

Many times a seller note is included as part of an asset or stock/membership interest purchase transaction.  A seller note can count as equity injection, but only if it is on standby for the term of the loan (i.e. no payments before the SBA loan is paid in full).  Further, the seller financing can only count towards half of the required equity injection for the change of ownership transaction.  Sellers may secure the repayment of their seller note with a pledge of collateral.  It is important for the lender or its counsel to obtain and carefully review drafts of the seller note, security agreement, guarantee(s), and pledge document(s), if applicable, to confirm that seller note and collateral are deeply subordinate to the lender’s loan payments and Lender retains a first and prior lien and control over the collateral securing the SBA loan.

Occasionally, an asset or stock/membership interest purchase agreement may include an “earn-out” provision, which is generally impermissible with respect to a SBA loan used to finance a change of ownership.  An “earn-out” is defined as a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings.  SBA typically objects to this type of structure since the seller will have an ongoing interest and profit from the business after the closing date.  Therefore, any “earn-out” provision is contrary to the complete 100% change of ownership requirement under the SOP and should be removed from the purchase agreement.

This article covered a few of the most common issues that arise in financing a change of ownership with a SBA loan.  Lenders should carefully review the asset or stock/membership interest purchase agreement and any associated agreements between buyer and seller to be sure the change of ownership is effectuated in compliance with SBA regulations and the SBA guaranty is preserved.  For more information regarding SBA compliance matters, please email us at info@starfieldsmith.com.