Lessons learned from failed SBA financing
October 29, 2021
by a searcher from University of Virginia in Red Bank, NJ, USA
I’m early in my search so some of these lessons below might be obvious to grizzled veterans, however I wanted to share my story so that other new searchers (and prospective searchers) can learn from my experience. Plus I think we need to share more failure stories as a search community; we’re already really good about sharing and celebrating successes (which is amazing!)
Context: Less than a month into my search I stumbled across a fully remote company in the accounting & bookkeeping space. While it was smaller than my target SDEs, it was growing really fast...like a 40%+ CAGR over the past 3 years. The owner also had a good team in place so they weren’t working full time in the business. I was highly interested in the fully remote model and the growth was super exciting to me. I was in a fortunate situation where I could take a risk on a smaller deal with significant growth potential so I acted quickly. After hitting it off with the seller, we were under LOI in about a week.
Small note on price…. While the business was growing fast, we priced the deal based upon 2021 performance and exit run-rate. It was on the high end of the range even for 2021 performance, but I felt like it was justified given the growth. If I could continue even half the growth rate for the next 3-4 years, then I would be getting a bargain.
Once I knew this had legs I reached out to two different banks. First was a recommendation from the Broker and the second was a referral from a mentor of mine. This mentor told me (twice) at the very beginning “Make sure the banker says the deal will cash flow. Get him to confirm it in an email”. From my (inexperienced) perspective this deal was a slam dunk…. With a SDE ratio of ~40%, how could it not cash flow? However I followed his advice and shared the revenue and SDE numbers with the banker and he tentatively confirmed that it looked OK, however he said they would underwrite using EBITDA + add backs, and he asked me for those numbers. I told him that in my mind SDEs = EBITDA + add backs so we should be good...and I left it at that. (Note: I had not received any tax returns at this point; I was using the P&Ls in the CIM).
Fast forward 3 weeks and my deal is on life support because both banks are declining to underwrite the deal saying that the valuation is not supported by the historic cash flows of the business. I mean DUH… of course the historic cash flows aren’t sufficient. This is a fast growing business! However, it seems that banks are hesitant to lend capital (even partially guaranteed capital) to fast growing companies.
Here are my lessons learned:
Banks love tax returns and they don’t care about your QoE
I definitely underestimated how much banks care about tax returns. Despite the fact that most small business owners try to reduce their taxable income so they pay less, the tax return is the gold standard for bankers. So much so that despite the fact that we had almost 10 months of operating history in 2021, Banker #1 would only use the 2020 tax return in underwriting. I mentioned that I was going to bring in a 3rd party firm to do a proof of cash to validate 2021 performance and his response was “I need to see a 2021 tax return”.
Banks don’t care about addbacks like you do
Who doesn’t love a good addback? Brokers, sellers and buyers understand the value of add backs. They may disagree on the specific type and value of add backs allowed, but all are in agreement that they are a legitimate part of all deals. Banker #1 didn’t even discuss add backs. Banker #2 asked for the add backs, but I got pushback on ones that were specific to me as a buyer (e.g. health insurance...I’m covered by my wife). His feedback was that they always try to value a business without taking the specific buyer into account. That 40%+ SDE ratio I talked about previously? Wrong assumption.
High growth is a hindrance to SBA financing
Never did I imagine that one of the biggest strengths of this deal would be its biggest weakness. I assumed that everyone would think that growth is good and get excited about it. As it turns out, high growth is a negative in underwriting. Banks want to see a consistent trend over 2-3 full years before they get comfortable as they are taking a weighted average of the cash flow. While they will weigh the current year heavier, they won’t underwrite a deal using only 1 year cash flow or a run rate.
Heres what I would do differently:
Take seriously all advice from advisors
My mentor gave me the best advice right at the beginning: “validate the deal cash flows with the bank first”. I didn’t take that advice seriously enough and I was sloppy assuming my calculated SDEs = EBIDTA + add backs. I should have spent more time here.
Share the tax return with your banker early
I actually got the tax returns fairly early, but instead of sharing them with the banks immediately as a sniff test, I sat on them and I spent hours completing loan applications, putting together projections, Personal Financial Statements, and writing a business plan. I wasted probably 10 days by not sharing the tax returns first.
Push the broker on valuation
To be honest, I’ve hardly interacted with the broker on this deal. The deal was posted on their website and they set up the initial seller meeting, and thats the extent of our interactions. I negotiated the price, deal construct and got the signed LOI without them. In hindsight I should have asked the broker how they arrived at the list price and then just listened to see if they actually had a solid point of view. With anything fast growing I think you have more opportunities to push back, but I didn’t push back enough. I wish I would have discussed valuation more with the broker.
While I’m really disappointed, most of it is my fault. However, I did learn a ton so it wasn't all a waste. I feel much more prepared for the next deal.
Hopefully this will be helpful to someone.
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA
1) "Bank Loves Tax Returns" - I think the better way to state this is Banks are typically required to get tax returns (and for SBA loans they must get them), but that does not mean they fully rely on them. If the tax returns are prepared on a cash basis and the financial statements on an accrual basis, some lenders will go with the accrual based financial statements instead. They obviously have to justify why they are using them over tax returns, but I see plenty of SBA lenders flip between using the tax returns and accrual based financial statements. If you have a QofE, that will make it easier for the Bank to rely on the financial statements.
2) "Banks Don't Care About Add-Backs Like You Do" - I would not say this is completely true. All standard add-backs are typically used like officer salaries, retirement, one-time expenses, auto, etc., but some expenses are almost impossible to verify to add-back. Those expenses typically include travel, meals & entertainment, and other expenses they say are for personal use in line items not really used for personal use but there is no way to verify them. The other thing to keep in mind is that there are some adjustments that may have to be made that would reduce EBITDA. Banks will make adjustments for the new owners salary, future Capital Expenditures deemed needed, etc., which can reduce EBITDA. I typically find if an add-back can be justified as one-time or a legitimate seller expense that will disappear, the lenders will add it back. If it cannot be verified, they will not do so.
3) "High Growth is a Hindrance to SBA Financing" - SBA Banks do not have an issue with quickly growing companies if the purchase price makes sense. In fact most lenders would prefer to lend against companies that are growing versus those that are stagnant. However, the issue you can sometimes run into with SBA financing is that if the price set for the purchase is based on the most recent EBITDA or projected EBITDA versus historical EBITDA, it can be hard to get the business to value out. SBA lenders require a business valuation, and that valuation usually weights out multiple periods to come up with the value. If the company is growing too quickly and the price being paid is too high, the valuation might come in too low. In addition, SBA Banks typically want to see at least two full tax years of cash flow hitting a minimum DSCR of 1.15x, even for high growth companies. If the debt you are looking for today does not work historically and only in the current period, that is going to be a challenge to get done with an SBA loan. However, if you bring more capital to the table, get creative with seller financing, or do a combination of those items, there are often ways to make the deal work and meet the Bank's expectations.
4) Two Banks are not enough to make a determination on what the market will provide. We are a Commercial Loan Brokerage Shop and we have over 50 SBA specific banking partners because every Bank does things differently and looks at differently industries differently, and some will not lend into certain industries at all. It is important to understand what the market will bear and position your deal the right way on the front end to have the most success.
I totally agree with talking to advisors and we are here to help anyone trying to figure out the best way to structure their transaction to have the most success. We will do a free review on any transaction and provide you feedback on the issues we think you might have and help you to structure it the right way so it qualifies for the financing you are looking for. I can be reached at any time at redacted Again, I am sorry about your experience and I hope your next one is better.
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA
I can tell you most serious SBA lenders will add back any reasonable justifiable add-back they can verify.
There is also flexibility in what is used in determining historical cash flow. I have gotten deals done where the historical tax returns do not meet the debt service coverage requirement but the financial statements (accountant prepared typically) on an accrual basis do. I have also seen banks use quality of earnings over financial statements. You need to find Banks willing to work under those circumstances.
On transactions where a business is experiencing quick growth and the price is based on current revenues and EBITDA, it is always a bit more challenging to get financing done. Lender's will have to be cautious about what the historical cash flow looks like. Usually if we can get the ratios to work with both a TTM and a YTD, and the DSCR in the previous year is reasonable (even if below requirements), there is a good argument to be made. Often I see seller notes used when the cash flow is tight to get over the hurdle. But even if the lender gets comfortable, it does not guarantee the valuation firm will get comfortable. I have seen a number of valuations come in short recently and some firms have been conservative, especially in companies growing coming out of Covid. There appears to be an assumption being made that growth may not continue and 2021 growth might be a by-product of the pandemic. We all asked valuation firms not to penalize companies too much based on 2020, but I think we are seeing those same firms being cautious about not assuming the growth in 2021 will continue.
I certainly wish you luck with your next deal and if we can be of any assistance, please let me know. We help to streamline the paperwork and manage the lending process. I can always be reached at redacted Happy Halloween everyone.