What SBA Lenders Actually Look For in Search Fund Deals

Sure, yeah, thanks. I'm Jared Johnson with First Internet Bank. I do SBA lending. Most of our transactions are what we would consider a little bit larger, so $3 to $5 million. We'll definitely work on the smaller stuff, but that's what we're trying to focus on. I've been doing SBA lending for 20 years. The last 15 or so has been focused on business acquisitions, or at least that's what we used to call it before search got so popular. Happy to be here and answer any questions.

Matt Dolsky, Byline Bank. It's my fourth year sponsoring and presenting at SMBash, so super excited to support the ecosystem. I've been with Byline for 17 years doing SBA lending. I started as an analyst and accidentally stumbled into my first search deal in 2017. Had no idea what search was, and fast-forward to 2021, it was basically all I was doing. For the last five years, my sole focus has been search. We say SBA lender, but what does that mean? I think what I actually do is walk a tightrope between what our borrowers and clients want and what is the art of the possible inside the bank. There's value in being with an institution that supports the search fund model and understands what a search deal is. If I do that walk right, I'm creating certainty for searchers at the front of the process to know what it's going to look like and get them to the closing table.

I own Pioneer Capital Advisory. We're a commercial brokerage firm. We work with business buyers, both on the SBA and non-SBA side, to be the river guide or sherpa to help them determine if their deal is SBA eligible or non-SBA eligible, what subset of banks it's going to be a good fit for, positioning it to the bank in a way they can understand, and walking them down the aisle start to finish. On the SBA side, we only get paid if the deal closes. We work with all the banks here.

We're going to break this up into three or four sections: the process and the questions searchers ask, deals and what we're looking for, the macro environment, and then Q&A.

First, let's establish the loan broker concept. A loan broker is the matchmaker, knowing the nexus of the banks and their credit appetite in conjunction with a specific deal. When I started Pioneer almost four years ago, there were lots of brokers, but they were generalists. There weren't many that just did acquisition financing. The value prop is we're simpatico with the banks. We can help you as the buyer save time in making sure your deal lands on the desk of the right banks.

From the lender perspective, loan brokers are very important. The hardest thing for most people to understand is that in SBA lending, every bank is different. We all have to follow the SBA guidelines, but each bank has their own appetite. A good broker should know what each bank's appetite is. It's not like mortgage where you can go to any mortgage lender and they'll do the same thing. With us, you could go to 30, 40, 50 banks and they all tell you no. It's not because your deal is bad, it's because the bank just doesn't like acquisition financing. So using a broker makes sense.

If we're doing our job on the bank side, we should be making underwriting and closing, not painless, but without big surprises or big changes from the way that loan broker structured a deal and brought it to you on the front end.

When should a searcher start talking to lenders? You get this a lot, when I have an LOI or sometime before that. I always think it makes sense well before LOI. You get an SBA-ineligible LOI that you have to then deconstruct. What's wrong with a phone call and an introduction? If somebody wants to send me financials and just talk about a deal, we'll talk about cash flow. If you put me and a searcher and a QoE provider and a broker in a room, and gave all of us the financials and said, come up with cash flow, I guarantee you we all are going to come up with a different number.

We like to talk to people when they're pre-LOI. For folks at early stages deciding if they want to search, or who've just kicked off a search, that's the opportune time. We can do a pre-qualification, vet you as a buyer, make sure you're financially qualified, and then you have something tangible to go to market with. The SBA guidelines have changed multiple times in the last year, whether it's rollover seller equity, US citizenship, or expansion acquisition guidelines. You want to be talking to someone to make sure your deal's going to work and that you're qualified as a buyer.

Looking at deals is probably my favorite part of the job. It starts you off on the right foot if we're looking at it and making sure the transaction works from eligibility and structure. The last thing you want to do is get a seller signed to an LOI, get them excited, then go right back and say, sorry, we have to change everything because it's not eligible.

In that first conversation, one thing I ask is why do you want to buy a business? What do you bring to an acquisition? Is it managerial skills, running a P&L, corporate development, sales? You're the exogenous variable. Outside of that, do they have a spouse? Is the spouse aligned and supportive? And what do they want to buy?

I'll run through their financial situation and see if they're searching for something they can actually end up buying. I also try to scare them out of it a little bit at the beginning because there are so many people searching for the wrong reason, or they don't understand the risk involved. I try to get them to understand the risk and how difficult it is. Even if it's not a deal they're 100% interested in, we'll go through the numbers so I can show them how we underwrite. Then they start making better decisions as they move through the process.

In those first conversations, I find myself thinking the objective is overstated. The numbers are talked about too much. The subjective part: what's this going to look like? How are you going to run this business? Is there a general manager? Is there a key employee? Are you getting them under employment contract? Are you throwing out any equity to them? When I go to credit committee, I spend way more time talking about those things than about cash flow. When we miss, it's because you made a bet on the wrong person, or the seller pulled the wool over everyone's eyes. My recommendation: be prepared to talk about why you're fired up about this business, how you're going to run it, who the key people are, and how you're going to keep them engaged, not just, I've got a 3.5x EBITDA multiple, isn't that awesome.

Look at the organizational chart. Understand what each person does and where you as the buyer are going to plug yourself in. You're not just buying earnings, you're getting the team. If you're using an SBA loan, unless the seller's retaining equity after closing, which involves them personally guaranteeing the debt, they're out after a year. You could be up a creek without a paddle if they're more operationally involved than they're portraying.

On searcher red flags: if you haven't thought through things like licensing and you're buying a plumbing company, that's a sign you haven't done your due diligence. There's a lot of discussion about post-close liquidity. We don't look at it as a specific number or percentage, but more of a soft discussion. When you look at somebody's personal financial statement and resume, have they earned the right to be able to borrow $4 million for a plumbing company in Omaha, Nebraska? Sometimes you can tell through the resume, personal financial statement, and initial conversations that they're just not ready for that.

When someone gets a lot of liquidity that's gifted, or they don't have much professional experience, trying to sell that background to a credit committee doesn't always go well. Getting the skills and attributes you need to be successful positions you as an easier prospect.

At the end of the day, we want these people to pay us back. We're trying to look at how they've managed their own personal life historically. We see people every day with high-wage jobs who don't save their money. Then you see the opposite, mid-level wages but they've done a really good job keeping debts and expenses low. That typically translates to the business you're buying. Red flags would be not having the liquidity, not having the ability to save cash, and not having any kind of experience in an industry they're looking to buy.

Going back to 2017, we were seeing people coming out of undergrad with no experience saying, I want to search for a business. We were like, go do something and come back. Seeing more people take that track and come back is creating much more successful buyers.

From the flip side, anyone in this room understands the self-funded search model. But if you're talking to a lender and they say, you don't have any direct industry experience in a plumbing company, I don't know how we're going to finance this, they don't understand search. Go talk to somebody else. There are lots of lenders that pretend to do search deals. You'll waste a lot of time if you don't figure that out sooner than later.

The benefit of SBA lending is the data is at your fingertips. You can look up top 100 SBA lenders, run it through ChatGPT, probe deeper with the SBA FOIA data. There's no reason to be talking to the wrong bank.

What should searchers look for beyond interest rates? Certainty of closing. Working with lenders that do bigger search fund and business acquisition deals, ones that are not collateral-focused but cash flow-focused, and that understand the first-time business buyer.

Experience in general goes far. Quite a few lenders have tried to come into the space. They have money to spend on marketing and going to search events, but they can't get deals done. You can ask, how many of these transactions have you done? How many people have you closed in this type of situation? There's not a scoreboard, but you can ask, is there someone I can go talk to? Having the right individual at the bank can make a big difference.

Confirm if the deal has been pre-flighted or pre-vetted by someone on the credit committee. Generally, you want someone with some gray hair having looked at the deal because that means it's more likely to pass muster. The more pressure-tested the deal's been, the less likely it comes back and gets retraded, leverage goes down, or additional guarantees get asked for.

One question to ask: how often do you issue a term sheet and not follow through on whatever was in it, and why? If somebody can't answer that, that's a run situation. I would never put out a term sheet that I haven't talked through with our president and chief credit officer. You'd think that would be common sense, but you see it all the time. I got a call yesterday: I spent 45 days with a lender, had a term sheet, they totally changed my deal after 45 days in underwriting. Now I'm scrambling, can you help me, by the way, I come out of LOI in 20 or 25 days. That's where you can glean how active your lender is and how likely it is they could give you a term sheet they're not going to come through on.

From the loan broker perspective, some term sheets, the moment they're signed, I could mark them in our accounts receivable aging summary because I know it's going to get approved. Others I could put on top of the toilet paper in my bathroom. Two distinct piles.

Moving to deal focus: you have the best searcher in the world on a Zoom call, but they have a deal you just don't like. What does that deal look like? There are certain industries we don't like. SBA eligibility, of course. Outside of that, debt service coverage and really understanding the business as a whole. There's a drastic difference between a business priced accurately in the searcher's mind and how it really should look. I see 3.5 to 4x multiple deals where you start digging in and there's zero management outside of the seller, who's doing five, six, seven different things. They should have some management, especially if you want to take it and grow. When you add a couple hundred thousand dollars of expenses for payroll and redo the multiple, you're way overpaying.

Sometimes it's not payroll, sometimes they need equipment or to move. There are times working through the deal you discover things that add to the cost and move the needle the wrong way.

There are times searchers look great on paper, get on the phone and they're just a jerk. I have a policy I won't work with jerks. If you start being rude right away, I'm done. You're going to take over that business and run it into the ground because you'll run off all your good employees.

Things I don't like: big customer concentration where the de-risking factor, like a forgivable seller's note, still doesn't offset losing that client. Fast amortizing seller notes, sellers that want to get paid back over three or four years. Sellers with short transition plans who've been intricately involved, where the sell-side broker is downplaying their involvement. On trade deals like HVAC, plumbing, where there's not another person who can qualify the license, and people try to get fancy doing the RME thing and hiring out the license, those don't typically go well.

Hone in on industry. There are certain industries: contractors, construction, manufacturing, where you need specific experience. That's not to say we can't get comfortable with somebody. I've done many search deals for someone buying a manufacturing company who wasn't in manufacturing, but maybe they were a mechanical engineer in college. There are ways to get there, but it's more of a conversation.

Understand how involved the sellers are in the sales function. If you don't have a background in sales, business development, or marketing, and the sellers serve that function with no one else on the team that can do it, model into your projection what it'll cost to replace them.

On seller notes: a seller note is part of the purchase price paid out over time instead of all cash at closing. SBA requires a Form 155, a standby creditor subordination agreement. If you want to use the seller's note toward the equity or down payment, it has to be on full standby, meaning no payments until the SBA loan's paid off. The purpose of the seller's note is to help de-risk the transition so the seller has economic chips on the table to play nice.

If you have a key customer constituting 10 or 15% of sales, you might want a lever in the seller's note where if you lose that client, the brakes get slammed on repayment and it ultimately gets forgiven. Banks don't like the optics of a seller getting paid back at 2x or 3x the SBA bank's pace. If the bank's lending 70 to 80% of the capital stack and the seller's in for 10 to 15%, the question is how do you get credit on board.

Where people thread the needle is having a note on an eight to ten-year amortization with a bullet payment at year four or five. If you've been making payments on time, you can go back to the bank and say, the seller's note's coming up for maturity, would you be up for re-amortizing? Anecdotally, typically the answer is yes.

I like seller financing, except when it's getting paid back too quickly that it messes up cash flow. If somebody asks my preferred seller financing structure: a two-year standby followed by an eight-year amortization with a balloon after year four. That's right down center field. We'll allow faster amortization, but if it's getting paid back in under six years, we'll push back almost out of principle. If you ratchet it up too much, you can be in year three with an astronomical seller note payment.

Seller notes are almost always unsecured. Sometimes the sell side wants to collateralize it with a personal guarantee or a lien, and that gets challenging because the bank will have your full unlimited personal guarantee. Even if you're a guarantor on their note, they're behind the SBA bank.

Everybody talks about the J curve. The first two years are going to be really difficult and you're going to make mistakes. The last thing you want is to over-leverage yourself with a seller note that needs to be paid back when you're choking out the business. I'd almost rather no seller note than a 36-month seller note.

There are many ways to be creative with the seller note. I just did one that was forgivable, tied to a debt service coverage that the buyer and seller agreed upon. They factored in a salary and cash reserves before figuring out the debt service coverage, then made a payment for the next 12 months based on the previous year's debt service coverage. Whatever portion wasn't covered, they forgave. It was an interesting way to figure out how to get it to work and not overpay.

We run into people saying, there's a seller note, everything will be fine. No, the biggest problem we have on deals is the seller. I've never made a loan to an idiot. It's the sellers usually causing the problem. You don't go to jail for violating a non-compete. You may have one, but if the seller violates it, now you're suing someone you just paid $4 million.

Be leery in the LOI process if you get pushback on a reasonable non-compete. That could be the first red flag of a disaster post-closing. I had a former client going into litigation with his seller last fall.

Be careful what you agree to. I had a customer in 2021, a precision machining acquisition. The seller note prohibited him from making changes to the business, like changing ERP systems, because the seller had access to certain levels of financials. He literally couldn't change things in the business until he got the seller out. The seller is critical right up until the point you want them out. For most people, after six to nine months they've got the business figured out and want them off their back. Be mindful you're not hamstringing yourself post-acquisition.

Common SBA-ineligible structures: earn-outs are the one we see most, then usually you'll use a forgivable note. Not putting in a full 10% of the project cost. It's the project cost, not the purchase price. LOIs are often written with 10% of purchase price, then when we build in working capital and closing costs, it pushes up further. Wanting the seller to stay on for more than a year. The 12-month thing is funny because they want the seller there going through the process, then two or three months in they're asking how to get the seller out. People call me, what's that rule about 12 months, I'm going to use it to get the seller to leave.

On the macro environment and SBA policy changes: four or five years ago SBA was pushing smaller loans. They made no guarantee fee for smaller loans. A lot of banks went wild approving everything small. Unfortunately, many of those banks failed or were acquired due to defaults. Then guidelines got too loose. Some changes were good. Having a seller roll equity or retain equity was great. Now changing that rule so they cannot roll equity, they have to retain equity and guarantee for two years, was silly.

The latest big one: originally you had to be a US citizen or have a permanent green card. A month or two ago they changed it to full US citizen, every single person with any ownership. That was the craziest thing I've seen. I'd be curious to look at loan portfolios with LPR borrowers and see how they perform. Most of our clients with just a green card were some of our best borrowers. The American dream was to come here and buy a business.

A lot of us have been trying to speak with SBA and get them to understand what search is and how it's benefiting the whole ecosystem. I haven't run into anyone successful with that yet. Hopefully we can lobby them a little.

The US citizenship thing sucks. One of my first banks was First Bank Financial Center. The lender I worked under had a huge gas station portfolio: first-generation Indians coming over and buying a gas station, then a nephew comes over, gets the green card, rinse, wash, repeat. The irony is the people working for them were people with high school GEDs. It was the biggest lever for creating American jobs. Where we're going, I don't know.

I have concerns about the perception of the self-funded search community with SBA. We need as an ecosystem to do a better job telling the search story. I'm super proud of the search portfolio we have at the bank and its performance. Search loans that are SBA-backed provide liquidity predominantly for the baby boom generation transitioning their businesses, who may not have a next generation to take over. It's providing an exit and retirement for them, but also saving and retaining jobs for employees. There've been misconceptions at SBA about what search actually is. One thing I'm convicted to do coming out of here is do my part. There might be a new SOP, the standard operating procedure, in the coming months. In the meantime, I'll keep telling the story of self-funded search deals because it's a really good story.

Q&A: Are there other avenues searchers are turning to because of SBA difficulties?

I haven't seen too much. You have a lot of seller carry notes, which is how things were done before SBA got popular. If somebody came along willing to do conventional lending at a certain dollar amount, they could be successful, but there's always risk. The reason banks use SBA is because of that guarantee. If you do $5, 6, $7 million loans and it goes bad and you're completely on the hook, how many can you do before you're done?

Up to $5 million, there's not a viable alternative that gets you a 10-year amortization with up to 80 or 90% financing. Some local community banks, if you're buying a manufacturing or distribution company with hard assets, you might entice them with operating account deposits and squeeze out a five or seven-year amortization with 20% down. But you can't get to the same leverage or down payment bar as SBA. When you're looking at companies close to $2 million of earnings, options open up: SBIC funds, private credit lenders. We have a division at Pioneer that Rafael heads up along with my colleague Pablo.

What's the largest customer concentration you've gotten approved, and what structure or conditions?

Ever would be tough to answer. I had one in the last two months with 40% customer concentration for a manufacturing company. We're going to dig in: who that customer is, how long, payment histories. We'll ask a dozen questions about that customer to understand how durable it is. At 80% concentration it becomes undoable. 30 to 40% range won't kill a deal if we get satisfactory answers.

People forget there are companies with one income source, like government contracts. We've done deals with multiple government contracts, all military-based. I just did one with contracts for IT, training, and call center, all military-related. We look at how long the contracts are, how do you get out, does the buyer have qualifications to retain them, do they need to do a stock purchase. There are times that makes sense versus 40 or 50% concentration with a brand new customer driving the revenue jump and that's why they want to sell.

What we're trying to understand is how to mitigate risk. Is there something to get us comfortable that it's a low likelihood they leave, or if they left, how would the business look? Somewhere between 30 to 40% works, give or take.

Final question, 30 seconds each, tell me one thing you've never said at an ETA conference.

I like doing weird deals. If something comes to me in an industry I've never worked in, I kind of want to do it just so I can say I did another industry.

Lots of people who think they want to buy a business really should not. Running a business is super stressful. My wife called me on having gray hairs that I didn't have four years ago. Pressure test, is this what you want to be doing?

Social media is big in the self-funded search space, and I find I spend so much of my time on internal stuff. Somebody has a deal in closing, and they want to waive a lease requirement because of a parking lot, these little things that pop up every day are most of what my time gets spent on, along with poring over 35-page credit presentations and figuring out what I want to say. It's much more boring than it looks on LinkedIn and Twitter.