Best Practices: Proceed with Caution – Consulting Agreements

Financing a business acquisition is an eligible use of SBA 7(a) loan proceeds, provided, that certain conditions are met. One of those conditions is that a seller is required to divest his/her interests completely from the business to be sold (with the specific exceptions regarding loans to purchase an employee stock ownership plan (ESOP) or a cooperative) (See SOP 50 10 6, 273). Therefore, a seller, generally, cannot remain as an officer, director, shareholder or key employee of the business. However, if the parties believe that the seller has important knowledge, experience, and skills to impart which would effectuate a smooth transition of the business to the buyer and set the buyer up for success, the SBA will permit the seller to remain as an independent consultant to the buyer for a period of time not to exceed twelve (12) months (including extensions) from the date of closing. Any consulting arrangements should be documented in connection with the business acquisition.

The general terms of the consulting arrangement should be included in the purchase agreement and the specific terms are often documented in a separate contract called a consulting agreement, which is executed by the seller and buyer at closing. Lender and its counsel should review the entire consulting agreement to confirm there are no provisions which would violate SBA’s change of ownership requirement. Lenders should be careful that any such arrangement does not permit the seller to: (i) retain control over the buyer’s business operations; or (ii) continue to share in the profits of the buyer’s business after the sale to buyer. Further, the seller should not remain as an employee of the business and receive a salary but be treated as an independent consultant and receive a set hourly or monthly rate.

Ineligible terms in a consulting agreement may also include but are not limited to: (i) responsibilities other than those required to successfully transition the business from the seller to the buyer; (ii) an option to renew the agreement past twelve (12) months; and (iii) additional payments to seller beyond compensation for services actually rendered. While there may be a few circumstances where buyer may rely upon the seller’s license for a short period of time after closing until a license can be issued in buyer’s name, the Lender should confirm that all licenses are obtained in the buyers name as soon as possible.

Occasionally, a purchase agreement and the associated consulting agreement may include an “earn-out” provision, which is impermissible with respect to an 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. An earn-out “can take a number of forms, including cash payments to the seller or an adjustment in payments to a seller’s note post-closing. SBA objects to these terms in a business acquisition since the seller will have an ongoing interest and profit from the business after the closing date and it effectively adjusts the purchase price after closing. Therefore, any “earn-out” provision should be removed from the purchase agreement and consulting agreement.

Lenders should carefully review the purchase agreement and separate consulting agreement, if applicable, associated with an SBA 7a loan to finance a business acquisition to be sure it complies with SBA regulations and ensure lender’s SBA guaranty is preserved. For more information regarding SBA compliance matters, please email us at info@starfieldsmith.com.