Search Fund SBA Loans: How Investor-Backed Acquisitions Work

Why Searchers Use SBA Loans

A traditional search fund raises money from investors, finds a business and buys it mostly with investor equity and conventional debt. The investors usually end up owning most of the company. That model needs a lot of capital, and it gives the searcher a small slice.

An SBA 7(a) loan flips the math. Because SBA guarantees a large share of the loan, a lender can finance up to 90% of the project, including goodwill, over 10 years. Investors only need to fund part of the Down Payment and perhaps some extra liquidity. The searcher keeps a much bigger stake.

The same applies to independent sponsors, self-funded searchers and small investor groups. If outside money sits behind the buyer, SBA's investor rules apply.

The Rules For Outside Investors

SBA treats a passive investor's money as a non-controlling minority equity investment when three things are true:

• Under 20%. The investor owns less than 20% of the business, directly and indirectly.
• No control. The investor exerts no control over the operating business. Board control, veto rights over daily operations or the power to replace the operator can fail this test.
• No early payback. The investment is not subject to any agreement to repay it, or to make distributions to recover it, before the SBA guaranty is released. SBA treats redeemable equity of that kind as debt, not equity.

The lender must review and document the terms of every equity investment in the credit memo, including provisions that pay out when the business is sold. Expect your lender to read your operating agreement, subscription documents and any side letters closely.

That rule surprises many investors. Raise it in your first conversation, not in underwriting.

Extra Capital Can Work Differently

Not every investor dollar has to go toward the Down Payment. SBA allows additional equity that is not used to meet the Down Payment, for example cash brought in for extra liquidity, to receive standard distributions, subject to any agreements with the lender. The lender may add a debt service coverage covenant to the investor agreement or the loan so distributions only happen when the cash flow can support them.

How Much Of The Down Payment Investors Can Cover

For an Initial Acquisition, SBA requires a Down Payment of at least 10% of the total project cost, and it cannot be reduced. SBA splits sources into two groups:

• Unlimited sources: cash that is not borrowed, such as the searcher's savings or a documented gift. These can cover all of the 10%.
• Limited sources: minority investor money, seller notes on full standby and other standby debt. Together they can cover no more than half of the required Down Payment.

So minority investors and the seller's standby note share the same half. If the seller carries 5% on full standby, minority investors cannot count toward the 10% at all. More on this in investors and the Down Payment and seller notes on full standby.

If the searcher cannot bring the unlimited half, the usual answers are a gift, the searcher's own retirement funds through a ROBS plan, or an investor who takes 20% or more and becomes a full guarantor. In our experience, lenders generally treat a guaranteeing owner's cash like any other owner's cash, but confirm that with your lender before you build the cap table around it.

Who Guarantees And Who Signs

Every individual or entity that owns 20% or more after closing must give an unlimited guaranty. In a search fund deal, that is almost always the searcher, and it is why most investors keep their stakes under 20%.

A few more points come up often:

• Count ownership through every layer. Someone who owns part of two investor entities can cross 20% indirectly.
• Every owner must be eligible. All direct and indirect owners, including each person behind an investor fund, must be U.S. citizens or U.S. nationals living in the U.S., and entity owners must be organized in the U.S. That rules out many funds with foreign limited partners.
• The searcher should be the largest owner. The deal is an Initial Acquisition, and the lender's credit memo has to explain who runs the business every day.

Deals Our Clients Have Closed

Investor-backed structures are a regular part of our work. Here are a few:

Real loans we placed. Borrower and lender names are kept private. See all closed deals.

Things That Trip Up Investor-Backed Deals

1. Preferred returns and redemption rights. A guaranteed return or a right to be bought out before the SBA guaranty is released makes the money look like debt.
2. Investor control. Approval rights over hiring, budgets or the operator's job can mean the investor is not "non-controlling."
3. Fees from loan proceeds. SBA restricts paying loan proceeds to owners and other insiders, other than fair pay for services actually provided. A sponsor's closing fee usually needs to come from somewhere other than the SBA loan.
4. Management agreements. If an outside company will manage operations, the lender has to review the agreement to make sure the business is not an ineligible passive business.
5. Thin searcher salary. The operator's pay has to cover their personal obligations and living expenses. A searcher taking a token salary can fail that test.

How To Prepare

Settle the cap table, the investor terms and the entity structure before you sign a letter of intent. Show your lender a one-page summary of who owns what, through which entity, with what rights. Then get a pre-qualification letter so sellers and brokers see a financeable buyer, not just a fund that is raising money. Our guides to buying a business with partners and sources and uses help with the rest, and the SBA business acquisition loan page covers the product. This is general information, not legal or tax advice; work with an attorney and CPA on investor documents.