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In today's post, we're diving into a crucial topic for entrepreneurs looking to acquire a business: the acceptable sources of down payment for an SBA 7a loan. Understanding these sources and how they affect loan approval is essential for navigating the SBA loan landscape effectively.
What is an SBA 7a Loan?
The SBA 7a loan program is a popular financing option for business acquisitions, allowing for up to 90% financing of the total project cost. This means borrowers need to provide a 10% equity injection. This equity injection can come from various sources, and understanding these can make a significant difference in getting your loan approved.
Seller Carry on Full Standby
One common source of the equity injection is the seller carrying a portion of the financing on full standby. This means the seller defers receiving payments for a specified period, usually two years, allowing the borrower to get the business off the ground. While the SBA’s Standard Operating Procedure (SOP) theoretically allows for the entire 10% to be on standby, most lenders prefer a more conservative approach.
Typical Scenarios
- 5% from Seller, 5% from Buyer: A prevalent practice is for the seller to carry 5% on full standby, while the buyer comes up with the remaining 5%. This balances the risk between the borrower and the seller.
- 75% Seller Standby, 2.5% Buyer Injection: Another less common option is where the seller puts 7.5% on full standby, and the buyer contributes 2.5%.
Using Retirement Accounts
Another potential source for your down payment is a pre-tax retirement account, such as a Rollover for Business Startups (ROBS). This allows you to use funds from your retirement account without incurring early withdrawal penalties. However, consulting a tax professional is essential before pursuing this option to ensure compliance with all regulations.
Home Equity Lines of Credit
If you own a property, whether a rental or your primary residence, you can leverage a home equity line of credit (HELOC) to fund your equity injection. This option is viable as long as you have adequate outside income to support the additional loan payment. Lenders will scrutinize your cash flow to ensure you can manage the HELOC repayment alongside the business loan.
Investor Contributions
Bringing in an investor who takes a minority stake in the business is another way to secure your down payment. For instance, an investor owning less than 20% of the new business entity can contribute funds without overly complicating the ownership structure. This investor would be listed in the operating agreement as a minority owner, providing the necessary equity injection.
Borrowed Funds
While less common, borrowing the funds for your equity injection is possible if you have sufficient outside income to cover the repayment. Lenders will require a clear paper trail to verify the source of the funds, ensuring they meet SBA guidelines.
Importance of Post-Closed Liquidity
Lenders typically want to see 6-8 months of reserves post-closing. This liquidity acts as a safety net, ensuring you can cover loan payments during the initial months after acquiring the business. For example, on a $1 million deal with a $100,000 equity injection, lenders would expect you to have around $60,000 to $80,000 in reserves.
How Source of Down Payment Affects Loan Approval
The source of your down payment significantly influences loan approval. Lenders evaluate the strength of the borrower, considering factors such as credit score, entrepreneurial experience, and the business's cash flow. Strong borrowers with high credit scores and substantial experience are more likely to secure favorable terms.
Conversely, weaker borrowers may face challenges, especially if trying to minimize their cash investment. A solid business with robust cash flow can mitigate some of these concerns, making the deal more attractive to lenders. Lenders also consider the debt service coverage ratio (DSCR), preferring a DSCR of 1.3 or higher.
Choosing the Right Bank
Selecting the right bank is crucial, as different lenders have varying guidelines and risk appetites. Working with an experienced advisor can help you navigate these differences and match you with a bank that aligns with your financial profile and business goals.
Conclusion
Securing an SBA 7a loan for a business acquisition requires careful consideration of your down payment sources and how they impact loan approval. Whether leveraging a seller carry, retirement accounts, HELOCs, investor contributions, or borrowed funds, understanding these options and working with the right advisor can significantly enhance your chances of success. If you're looking to explore your financing options further, consider booking a discovery call with a knowledgeable advisor to chart your path forward.
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