On SBA 7(a) loans, it is common for sellers of small businesses to offer the buyer a promissory note to pay some of the purchase price for the business. Seller financing is favored by buyers and financial institutions. It demonstrates the seller’s confidence that the company will succeed, reduces the risk to the lender by reducing the loan amount, and allows the buyer to retain greater liquidity at the time of closing.
Under the SOP 50 10 6, when loan proceeds are used to finance the purchase of a business resulting in a new owner, the borrower must provide an equity injection of 10% or more of the total project costs. In this circumstance, only half may be financed with a seller’s note on full standby for the life of the SBA loan. “Full standby” means the seller may not accept payments of principal or interest during the life of the loan.
Full standby requirements are often not needed when the note is to be considered “debt,” rather than part of the equity injection. When a seller’s note on full standby provides more than half of the required equity injection in a change of ownership transaction, then compliance with SBA’s equity injection requirements may well be jeopardized. To avoid issues, lenders need to make sure that if any of seller’s funds will be counted toward injection, then any amounts over half should be verified through a separate note, which may or may not be on full standby. On the separate note not included as equity, the seller may accept payments during the life of the SBA loan as long as such payments cash flow and the borrower is not in default of the SBA loan.
If a lender anticipates that a borrower will use a seller’s note as part of the financing package, it should begin discussions about the repayment terms early-on to ensure those terms meet debt service and cash flow coverage ratios. To avoid problems at closing, as soon as practicable, lenders should obtain a copy of the draft seller’s note to review for compliance; then, at or prior to closing, lenders should obtain a fully executed standby agreement as well as a copy of the fully executed seller note.
Most lenders know to confirm (i) the debtor is the borrower, (ii) the seller or the principals of the seller are the payee(s) on the note, and (iii) the terms match the underwriting terms. However, there are other key components that a lender should look for when reviewing a seller’s note, including:
- Whether the standby period (discussed above) is referenced;
- If prepayment is allowed;
- If there are earn-out provisions allowing the seller to receive additional funds in addition to principal and interest under the seller’s note (not permissible);
- If there is language in the note identifying that it is subordinated to the lender’s loan; and
- Whether the note is secured by any collateral.
In addition to the seller note, lenders need to review the standby creditor agreement to ensure that its terms align with the credit memo and SBA Loan Authorization. The standby creditor agreement is a legal contract which is commonly needed by lenders when sellers are helping to fund the project. The agreement specifies the terms of the seller financing, as well as the various implications of the SBA loan being treated as “senior”. Lenders can either use their own form, use the SBA form, or modify the SBA’s form. When using SBA Form 155, lenders will need to have the seller sign a separate subordination agreement (as the SBA form does not accomplish the subordination function).
While sellers generally want to receive their full purchase price at closing, seller financing is generally favored by lenders and the SBA. The reason is simple: when a seller finances even a small portion of the deal, it minimizes the monies a buyer needs to contribute upfront, permits the borrower to retain greater liquidity, and helps to incentivize a smooth business transition.
For more information on seller notes and standby agreements, contact the attorneys of Starfield & Smith, P.C at 215.542.7070 or email us at firstname.lastname@example.org.