SBA Loans for Franchise Buyers: What You Need to Know
Aaron DiGregorio, Senior Vice President, Live Oak Bank
The Small Business Administration (SBA) is a government agency that serves as the primary resource for government-backed business loans. While a bank provides the financing, the SBA guarantees a percentage of the loan amount, enabling the lender to provide more favorable terms than some conventional loan options. For example, small business owners utilizing an SBA loan may obtain capital with less equity than a conventional loan would otherwise require. Lenders can provide loans through the SBA guaranteed programs to small business owners across the country they otherwise would be unable to lend to due to a lack of collateral and liquidity, among many other credit risk factors. Remember that the SBA guarantees a percentage of the total loan amount and does not provide capital. Banks vary in their appetite, capacity, and procedures within the parameters of the SBA's guidelines. As a result, specific term offerings should be negotiated between the borrower and an SBA-approved lender.
What is an SBA 7(a) Loan?
The most common SBA loan program is 7(a), which can be used for starting, acquiring, or expanding businesses. SBA 7(a) loans enable small business owners to preserve monthly cash flow by offering extended terms compared with conventional financing. For leasehold transactions, the full amortized term is 10 years compared to five to seven years, and when real estate ownership is involved, the term can be extended to 25 years. This program also enables borrowers to preserve cash required up-front by minimizing the cash equity requirements to as low as 10% for new business buyers. Conventional loans, by comparison, will traditionally require down payments of around 25-30%.
How Does an SBA 7(a) Loan Differ from Conventional Financing?
Unlike conventional financing, which relies on tangible collateral in the event of a loan default, SBA 7(a) loans are cash-flow based, focusing on the business's ability to repay the debt using a Debt Service Coverage Ratio (DSC). DSC is calculated by dividing the business's Net Income, Interest, Depreciation, Amortization, and any other non-cash expenses, as well as wages paid to the owner(s) in Officer's Compensation by the overall loan payment. Lenders will typically want to see this ratio at 1.25x or higher and will adjust for any personal income requirements a borrower may have from the business.
The Benefits of SBA 7(a) Loans for Franchise Operators
SBA 7(a) loans use a cash flow analysis that enables lenders and potential buyers to take a simplistic approach to a transaction in determining "Do the ends justify the means?" Said another way, historically, does the business generate enough free cash flow to satisfy the loan payment while enabling the borrower(s) to continue living a healthy lifestyle? Through SBA 7(a), businesses can be looked at through a cash flow lens even when collateral is unavailable, opening the door for new owners seeking financing.
The SBA 7(a) program also enables existing business owners to leverage their current cash flow against a new transaction, thus minimizing the up-front capital required to close a deal. This preservation of liquidity becomes incrementally impactful to franchise operators looking to scale and grow through multi-unit ownership, whether by acquisition or new store development. Lenders will typically want to see some skin in the game in the form of cash equity. This minimizes the initial leverage points in scenarios where an existing franchise operator with sufficient cash flow no longer must adhere to the 10% down for new transactions.
When Small Businesses and Franchisors Should opt for a 504 Loan
Another popular SBA program is a 504 loan; however, this product is geared solely toward small businesses looking to finance the acquisition or construction of owner-occupied commercial real estate. Unlike 7(a) loans which provide total project financing under a single loan umbrella, 504 loans are composed of two loans: the lender and Certified Development Company (CDC), a non-profit organization aimed at deploring capital on behalf of the SBA with state and regional specific ties, with the borrower's equity comprising the remaining third portion. In most instances, the lender provides 50%, the CDC 40%, and the borrower brings the remaining 10% of the total project. However, if the transaction is associated with forming a new business and/or a special purpose property, the borrower's equity requirements increase to a 50-30-20 breakdown.
There are many misconceptions surrounding SBA financing, driven mainly by the borrower's experiences with banks that do not specialize in SBA lending or are not preferred SBA (PLP) lenders. The amount and type of financial information required under the SBA are the same as a conventional loan. However, non-PLP lenders typically lack the expertise to navigate specific nuances of government-backed loan programs.
When choosing the right SBA lender, ensure they have a proven track record in navigating the SBA process. Preferred Lender Program (PLP) lenders can underwrite, approve, and close loans without SBA review, significantly expediting the funding process.
Aaron DiGregorio, Senior Vice President, Live Oak Bank