Modeling for Investor Distributions with SBA Debt

searcher profile

April 12, 2022

by a searcher from University of Florida - Warrington College of Business Administration in Boynton Beach, FL, USA

Hey all,

In a deal with conventional debt, there are often distribution limits or excess cash flow recapture provisions - essentially forcing the business to pay down senior debt first with any excess cash flow.

In SBA deals which are covenant-light, you may only need to satisfy a DSCR requirement. Above which you are free to pay the capital stack in reverse order, from most expensive to least (likely paying back preferred equity first). And this assumption can make a huge difference in modeled IRR - do preferred investors start getting their capital back in year 1-2 or do they only collect a coupon until exit?

Curious if anyone has worked through this question and can share any market insights. Thanks!

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commentor profile
Reply by an intermediary
from The University of Chicago in Chicago, IL, USA
Your point is correct that IRR will increase using the CF as proposed. My software has this feature. It allows users to choose what to with excess cash flow after debt service. I had researched this subject when I wrote the software. The answer was ... do not use excess cash flow to pay down based on cost of capital. Keep liquidity in mind. Everyone said, pay down LOC first b/c you can re-borrow against the LOC easily for a rainy day. What to do if there is excess cash after paying down LOC? I have implemented a paydown order. It is based more on seniority of the dent than the cost of capital. Such built-in paydown order can be overridden.
If there is traditional preferred, there is coupon and pre-determined % participation in the waterfall. I don't know how IRR increase will help by pre-paying this stack, and more likely, you can't pre-pay beyond coupon.
If the capital stack is structured like a typical PE deal where the PE-GP has carried interest beyond a hurdle rate to the LP, then the PE-GP (in this case you as the searcher is PE-GP) will benefit by using the excess cash flow to pay the LP b/c it will improve the IRR to LP, which in turn will increase the $ value of your carried interest. However, most PEs I have talked to have said that playing such games with sophisticated LPs is unhealthy in long run. PEs prefer to pay down LOC with excess cash, keep some liquid reserve and then, if there is excess cash flow, pay down the Term Debt rather than use the excess operating cash flow to repay LPs. Above comment does not apply to proceeds of a portfolio exit.
So, in short, I agree with your premise of enhanced IRR. However, imo, it does not apply to traditional "preferred" or mezzanine. It does work with carried interest structure, but entrepreneurs may not do so to maintain future relationship with investors.
(Note: In most of the deals I have worked on, the IRR enhancement is marginal, may be few points..)
commentor profile
Reply by a searcher
in Alpharetta, GA, USA
Peter it’s very simple - as you noted the docs are cov light. As long as you make your monthly loan payment on time there is no restriction on what you do. Obviously you’re giving a personal guarantee, so if you choose to make distributions which weaken the business liquidity to a point where default becomes a possibility, then you are an idiot and there’s not much to be done for that. In brief, the personal guarantee is the best defense that the SBA has and that is why they require it.
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