Most SMB acquisitions involve three key financing sources: bank debt, investor equity, and seller participation. Understanding how each works—and how they work together—is essential for any deal’s success.

Debt options

The most common debt source in lower-middle market deals (SMBs) is the SBA 7(a) loan program. These loans offer terms, including 10-year repayment periods versus the typical 5 years for commercial loans.

While the 7(a) loan program typically caps loans at $5M, some banks will also do what's called a pari passu loan—Latin for 'equal footing'—which can extend beyond the standard $5 million SBA limit.

For deals larger than $5 million, operators typically turn to either commercial loans or Small Business Investment Company (SBIC) funds. These professional institutions often offer different terms and may have additional requirements beyond SBA loans.

While higher interest rates have impacted the debt market, deal activity remains strong. What we’ve seen in practice, is that buyers usually consider the loan terms more than the rates. With SBA's 10-year repayment period versus 5 years for commercial loans, the payments are more spread out, even at the higher rates.

Investor equity

Investors in SMB deals typically focus on two key elements: Preferred returns and profit participation. Most deals in this segment of the market include a preferred return of 10 to 15 percent, which means investors receive this return on their capital before other distributions occur. Using this preferred return structure, investors can potentially mitigate some of their investment risk, while still having exposure to the economic upside of the deal.

Generally, investors are most interested in the economic upside of the deal, which is where the majority of their returns will come from if an investment is successful, rather than the stated preferred return.

This risk level also impacts governance structures. Investors typically seek board representation and information rights to monitor their investments. The specific terms vary by deal size and investor involvement, but most structures aim to give investors oversight while leaving operators with day-to-day control.

Seller participation

Sellers can participate in deals through either seller notes (e.g., providing debt) or equity rolls (e.g., continuing to own a piece of the business). Recently, SBA rules have evolved to allow more flexibility with seller equity rolls, though this wasn't always the case.

Seller notes are a heavily negotiated item—some sellers are willing to take a longer-term or lower interest rate. There are also unique implications at hand when structuring the seller’s note. For example, if you can get a seller to do a full standby note for 2 years on an SBA deal, that's an advantage because it can count toward your down payment.

A seller's choice between notes and equity often depends on their outlook and timeline. Those who do not need the cash for retirement typically prefer notes for reliable income and tax savings, while younger sellers might be open to equity rolls if they believe the business has significant growth potential under new ownership and want to have continued involvement.

The SBA typically favors seller notes, preferring 5 to 20% of the deal to be financed through seller participation. However, certain structures remain off-limits, like performance-based earnouts, which can't be part of SBA-backed deals.

It’s important to note that seller financing is a form of leverage, while an equity roll is not. With seller financing, you still need to make good on repaying the amount lent, and this will come out of your free cash flow. With an equity roll, the seller is sharing the same equity risk as you – equity holders will only get distributions if the business is performing well.

404

This page could not be found.