Employee ownership deals hindered by SBA rule that puts seller debt on standby
by Bruce Dobb
The largest source of financing for the sale of small, low-margin businesses that drive local economies are bank loans guaranteed by the Small Business Administration (SBA). However, these loans don’t work very well for workers who want to buy their companies. If we hope to scale employee ownership, we have to eliminate the barriers to SBA loans for these transactions.
Last year, the SBA changed its down payment requirement, reducing it from 30 percent to 10 percent of the sale price. That move seemed like it would help sales to employees, but the reality is most worker groups can’t come up with this amount of equity. Typically, in the past, the seller essentially self-financed the down payment. But a new SBA requirement, which puts the seller’s debt on “standby,” has essentially nixed this option.
Ask SBA to waive the ‘standby’ requirement for worker/owner deals, to encourage more worker ownership.
The new “standby” provision basically says that, if the seller finances the 10 percent down payment, he or she can receive no principal payments for the life of the SBA loan—usually ten years. From the seller’s point of view, receiving no payments for that amount of time defeats the purpose of the sale, which is to access the wealth the she or he has built.
Seller on Standby
Employee ownership deals have always included seller carry-back financing. This is when a seller accepts a subordinated loan (“note”) for a portion of the sale price. Subordination allows the owner to receive principal and interest payments as long as the senior debt (i.e., the SBA-guaranteed bank loan) is paid first.
Standby debt is different. Stand-by debt is also subordinated to senior debt but principal payments are deferred until all senior debt is paid in full. Under SBA’s new regulations, selling owners are required to sign standby agreements when a portion of their note is used by the borrower (in this case the workers) for the 10 percent down payment. Under the standby agreement, the seller receives no payments on any part of the carry-back financing until the SBA loan is paid off.
Why this adversely affects employee buyers
For employee members of a newly formed cooperative or collective to put up even 10 percent for the purchase of an existing company can be challenging, especially in cases where the sale price is $1 million or more. That means that companies with 20 or more employees are almost impossible for workers to purchase. Raising even $100,000 in cash is difficult because most often employees don’t have that much in joint savings.
Understand, for a small business, meeting SBA loan requirements is basically synonymous with qualifying for bank debt: SBA-backed loans finance about 70 percent of small business acquisitions. That’s why business brokers and others who sell businesses assume that if bank debt is necessary, as it is in almost every ownership transition, then the deal has to comply with SBA rules or it won’t close.
By requiring that the 10 percent equity injection be 100 percent financed by the buyer–be it employees, investors or speculators–the new regulations have become a serious barrier to employee-ownership conversion deals. Seller debt can only be used to meet the 10 percent SBA equity requirement, if it is on full standby for the life of the SBA loan. This means no payment of seller principal on the entire note, and that’s a deal killer.
SBA guaranteed bank loans are where the action is for business acquisitions. Unhappily, this source of money is now best suited for financial buyers, speculators and bigger companies.
Beyond the SBA, other potential debt sources for small business employee buyout deals include Community Development Financial Institutions (CDFIs) like Shared Capital Cooperative or foundations. But these capital pools are not enough to finance a mass expansion of these deals. For example, in FY2018 Shared Capital loaned $2.1 million to U.S. cooperatives. Though there are 1100 CDFIs nationwide, only a handful support conversions to employee ownership. Moreover, outside of large urban areas, worker groups often don’t have access to foundation money or CDFI debt. They typically start with a request to a local bank for a loan.
Meanwhile, in FY2018, SBA’s total loan volume reached more than $30 billion with more than 72,000 approved loans. SBA guaranteed bank loans are where the action is for business acquisitions. Unhappily, this source of money is now best suited for financial buyers, speculators and bigger companies who can easily come up with a 10 percent down payment. That’s why these “commodity” buyers have a huge advantage over worker groups: they have the cash that workers lack.
How a small change could have a huge impact
Owner carry-back financing is extremely common in worker-to-owner deals. One of the largest social impact investors in the field recommends that company sellers routinely take back notes for 50 percent of the value of the company to be purchased. Just about any worker purchase of a larger company involves a seller carrying a note.
A great idea for employee ownership advocates would be to ask SBA to waive this “standby” requirement for worker/owner deals. This change would nicely complement the recent changes in SBA rules that allowed cooperatives to qualify for SBA financing.
If the standby policy were waived when owners help workers buy their company, it would level the playing field and encourage more worker ownership.
History shows co-ops are a good bet for repayment and longevity. Giving this waiver to worker groups could prevent thousands of companies from closing their doors when an owner is sick and needs to stop working suddenly. It would also give place-based economic development a shot in the arm by spurring interest from retiring owners who are seeking out qualified buyers. After all, who’s more qualified to run the company than those who have already been doing it?
An earlier version of this article was published on the Concerned Capital blog.
Bruce Dobb is senior partner at Concerned Capital, a social benefit, investment banking firm in downtown Los Angeles that specializes in saving local jobs by helping employees buy the company they work for.