Understanding the SBA 20% Ownership Rule
November 18, 2023
by a searcher from University of Texas at Austin in Seattle, WA, USA
Hey folks! I am about a month into my search and think I hit my first real obstacle. I've been speaking with a number of lenders and recently learned about the SBA's rule that owners with 20% ownership or greater must provide a personal guaranty on the loan. My search criteria are businesses with $500K+ EBITDA, meaning that my purchase price should be somewhere between $1.5M - $4.0M and thus my loan anywhere from $1.0 - $3.5M. My issue is that I do not have the funds to contribute 20% equity at the upper end of that spectrum. I intend to raise the additional equity, however I know that providing that guaranty will be unacceptable for investors. I am personally comfortable with making the guaranty.
Are there creative solutions to satisfy the 20% rule such that I can provide the guaranty without putting additional owners on the hook? Or am I stuck finding a smaller deal where I have to be largest investor at 20%? Are there other financing avenues that don't require the 20% rule? For illustration, let's assume I have $50K which means that the largest equity infusion I can make on a deal is <$250K. Assuming 90% financing, the biggest deal I could buy is $2.5M. Still sizable, but significantly more limiting than my criteria stated above.
from Harvard University in Manhattan, New York, NY, USA
Here is an example — let’s say I want to buy a business with valuation $2m, and I plan to finance it with $400k equity and $1.6m debt. You can plan to do an asset-based transaction where you show up with your own, clean and new LLC, that has its own operating agreement between you (likely the managing member) and your other partners which you can treat as effectively LPs.
How much you own of the company is then the business of your partnership — you can raise $350k which represents 87.5% of the CASH DOLLARS (1) and say spread that across 3 investors you gave 19% to each. You then put up 50k, 12.5% of the CASH but own the balance of 43% of the business. Here you came up with the CASH the SBA needed in terms of your 400k to close the deal, and yet as the only owner above 20% threshold— you yourself can sign the PG.
This works, because I have done literally this myself (different numbers and smaller sizing).
The issue however will be case by case and there will be natural resistance to huge leverage deals in my humble opinion. They may require you to take out a life insurance policy, and your operating agreement may compel other partners in the company to step up to the plate to owning/running the business in the event you are rendered dead or useless or what have you.
There are certainly ways around this issue, if you take note of the error of conflating equity ownership in the LLC making the acquisition with cash injected by each party involved. You will be adding partners and complexity and I’d expect to really get into the weeds here to get it done. Again, this is something I just closed a deal doing and my equity ownership is very different than my cash injection, in fact I have an operating partner who got equity with $0 injected (lucky him) which was approved without blinking by the bank lender….
Good luck to you.
Best,
Luke
from Carnegie Mellon University in Boulder, CO, USA