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Heather Endresen – SBA: Government’s Strategic Loan Program for Entrepreneurs

My guest in this episode is Heather Endresen, co-director of Search Fund Lending at Live Oak Bank. Heather shares the ins and outs of the SBA program.

Episode Description

My guest in this episode is Heather Endresen, co-director of Search Fund Lending at Live Oak Bank. Her name probably sounds familiar as Live Oak is a sponsor of this podcast. Given the strong interest from our audience, I decided to bring Heather on the show to share the ins and outs of the SBA program as it’s highly relevant to the subject matter of Think Like an Owner. During our episode, we discussed the history of the SBA program as a government program, high-level terms of SBA debt, what companies and deals are good fits, what add-backs are accepted and which are not, risk to searchers and the worst case scenario, and the SBA programs value to strategic acquirers.

I hope you enjoy this in-depth episode on the SBA program with Heather. Enjoy.

Clips From This Episode

What's the best business you've seen?

What's the best business you've seen?

What college class would you teach?

Live Oak Bank – Live Oak Bank is a seasoned SMB lender providing SBA and conventional financing for search funds, independent sponsors, private equity firms, and individuals looking to acquire lower middle market companies. Live Oak has closed billions of dollars in SBA financing and is actively looking to help more small company investors across the country. If you are in the process of acquiring a company or thinking about starting a search, contact Lisa Forrest or Heather Endresen directly to start a conversation or go to

Hood & Strong, LLP – Hood & Strong is a CPA firm with a long history of working with search funds and private equity firms on diligence, assurance, tax services, and more. Hood & Strong is highly skilled in working with search funds, providing quality of earnings and due diligence services during the search, along with assurance and tax services post-acquisition. They offer a unique way to approach acquisition diligence and manage costs effectively. To learn more about how Hood & Strong can help your search, acquisition, and beyond, please email one of their partners Jerry Zhou at [email protected]

Oberle Risk Strategies– Oberle is the leading specialty insurance brokerage catering to search funds and the broader ETA community, providing complimentary due diligence assessments of the target company’s commercial insurance and Employee benefits programs. Over the past decade, August Felker and his team have engaged with hundreds of searchers to provide due diligence and ultimately place the most competitive insurance program at closing. Given August’s experience as a searcher himself, he and his team understand all that goes into buying a business and pride themselves on making the insurance portion of closing seamless and hassle-free.

If you are under LOI, please reach out to August to learn more about how Oberle can help with insurance due diligence at Or reach out to August directly at [email protected].

(Transcripts may contain a few typographical errors due to audio quality during the podcast recording.)

My guest in this episode is Heather Endresen, co-director of search fund lending at Live Oak Bank. Her name probably sounds familiar as Live Oak is a sponsor of this podcast. Given the strong interest from our audience, I decided to bring Heather on the show to share the ins and outs of the SBA program, as it’s highly relevant to the subject matter of Think Like An Owner. During our episode, we discussed the history of the SBA program as a government program, high-level terms of SBA debt, what companies and deals are good fits, what add-backs are accepted and which are not, risks to searchers and the worst-case scenario, and the SBA programs value to strategic acquirers.

I hope you enjoy this in-depth episode on the SBA program with Heather. Enjoy. 

It’s great to see you Heather and to have you on the podcast. She is a sponsor and an expert in SBA lending. There have been quite a few folks who are interested in having you on the show and learning more about the SBA program directly from a banker in that program. So, I’m just excited to chat a little bit about it but would love to first start with how did you get to Live Oak and what’s been your career thus far. 

Thanks. I’m so happy to be here. I started as an SBA lender in my twenties, so I’ve been doing it my entire adult life. And I started out managing SBA departments for larger banks, and then ended up meeting Lisa Forrest about 10 years ago, maybe 11 now. And I had been looking for a way to differentiate us among other SBA lenders because otherwise everybody’s really commoditized, everybody’s really got the same program. And so, we had settled on becoming specialists in acquisition lending and stumbled upon the search fund model in the first couple of years of doing that and really ended up embracing it. Went to another bank to focus just on acquisition lending in SBA, and then ultimately still needed to go to another bank that could support exactly what we wanted to do. It’s very hard to get a bank to let SBA lenders focus on a niche.

They want SBA lenders within their bank to do everything SBA for everyone. So, we found Live Oak. Live Oak is a bank that is already focused very much on the SBA program and is verticalized. So there was no other SBA lender out there that had all these verticals and was approaching the SBA business the way that Live Oak was. And we felt that we could be a vertical, even though the other verticals were all industry-focused. We thought that having this acquisition focus should be a different type of vertical and unfortunately Live Oak agreed. And let us basically establish the search fund lending vertical at Live Oak. We started out just doing SBA loans and now we do both SBA and conventional, but still with the same focus. The majority of our clients are either self-funded searchers or traditionally funded searchers and there’s a mix of a few strategic buyers and independent sponsors in there as well.

Excellent. And then I’d be curious, what attracted you initially with the search fund model that made it such an interesting niche to focus on?

I think at first we were just fascinated that these young people with these great educational backgrounds were interested in small companies. That was just a new concept that we had never seen before. So I think initially it was just out of curiosity as to why was this happening what’s going on? Then realizing that they were learning this in school and that these small businesses were for a lot of them fit their goals in life and their lifestyle a lot better than the corporate path. That was very interesting. But as a banker, strictly as a banker, what we learned was it was at a lower risk profile than the non-search buyers. And for a few reasons, it’s surprisingly lower risk. The initial thought of a lot of bankers is well, ‘This is perhaps a young person. This is maybe a person that doesn’t have a lot of net worth.’ That usually is a red flag for risk for bankers.

But what we learned is their education, the energy that they’re willing to put into these businesses, and also the experience that the investors bring to the table, both in the search process, the diligence process, and the operating years actually de-risks the deal. And that’s counterintuitive for most bankers. Most traditional bankers would think that it’s better, safer, less risky for a buyer to use their own cash for the equity investment and not bring in investors. But we found that actually, the opposite is true. As long as the investors are a serial search, when professional investors have done this before, it’s actually a way of de-risking the deal to bring in professional investors. So we loved it from a lot of different angles, just personally, it was a lot more fun. They’re great clients to have, and also from a risk perspective, they make better loans. So we loved it.

That’s really interesting. I’d be curious. What other notable insights have you had over your time investing in search funds?

I think probably the biggest learning is that as long as the company is fairly simple, the searcher can do very well operating these companies based on their educational background and their willingness to learn and be coached. But the diligence and transition, I should say two things that probably represent the most risk in these deals. And again, as bankers, we just always think of where the risk is, and how we can do a better job or a good job of minimizing it so that the risk is in the diligence. And that’s where the investors can help a lot in terms of guiding searchers through that process. But that we realize as bankers, we also need to double-check and make sure that the diligence is all getting done and that we’re agreeing with it as far as green-lighting the next step.

And then it’s really important for searchers to think it through, what do the first hundred days look like? What do they need to do? What do they not need to do? What should they not do? How should they communicate to the key customers and the key employees? When will they meet them? Are they going to get to meet them just prior to close? And then what sorts of go-no-go decisions do they need to make after those meetings?

So I think the biggest learning is diligence and transition. So I know you’re going to ask me this later, but in terms of what can go wrong, most of the things that I’ve seen go wrong, come from those two areas.

So what are some ways that a lot of these SBA loan deals can go wrong? What tends to go wrong most often? And then what’s that tail risk of something that’s maybe more rare, but can be really catastrophic?

I guess a couple of examples come to mind in terms of deals that I’m sure the searcher wishes they had not closed on the deal. In one case, they struggled along for two and a half years and finally got the company to a good place, but it was a really emotionally tough two and a half years for that person. And in another case, it actually went to default. It wasn’t a loan that Lisa and I made, but it is a deal that we know about. And in both of those cases, it was using cash to accrual conversion in the cashflow numbers that they ultimately accepted. So, I find that particular area is fraught with peril. It’s just too easy to say, ‘Ah, if these were on an accrual, this is what the EBITDA would be and the deal works on this EBITDA, whereas it actually didn’t work on the cash basis EBITDA.

I think there’s just a lot to think about there. And ultimately you have to pay debt with cash. So the cash basis statements are telling you something. We can’t just throw them out and over time, whether it’s cash or accrual, things should average out over time, they shouldn’t be drastically different. And so anytime you look at a deal where it only works if we do this conversion, but it doesn’t work on a cash basis, I would walk away from that deal. If it’s a minor amount of difference, it should be supported with the quality of earnings from a really good vendor. It should not be something that a searcher would attempt to do on their own. We see it regularly. And we coach people out of that line of thinking because it’s just too risky.

You just don’t know what the EBITDA that you’re buying is really going to be. There’s not really a good answer, how to protect against this, but there are seller misrepresentations that are made. Some of them are in hindsight, looking back, it appears that the seller knew that they were misrepresenting, but often they didn’t. I’d really don’t think that they knew that they were misrepresenting. And so that’s an interesting topic. A lot of the founders are not financially trained or they’re not experts in accounting and finance. They’re very good at other things. Usually, that’s how they got the business to where it is. But a lot of times they just don’t understand the numbers. It’s the same level that financially minded people might think of them. And so, misrepresentations can happen not on purpose. They may just actually think that something is true, but it turns out that is not the case, and that’s a critical issue. So I think it’s an interesting topic, seller misrepresentation. I’ve really only seen overt seller misrepresentation once. And I know that was the case because there was a lawsuit and emails were uncovered and it definitely was over. I think more often it’s not intentional, but it does occur.

That’s fascinating to dive into SBA though. Can you give us a brief history lesson on what the SBA program is? What is it meant to do? And then, the search specific world of the 7(a) section of that program?

It’s a federal government agency in the United States, Small Business Administration. I think it was started, I might be wrong, but I think it was started under Eisenhower. And the general purpose is to encourage banks to provide debt on longer terms and with less collateral or equity than conventional lending would require. And that’s effectively what all the programs look like. If you’re going to compare the SBA program to a conventional program, you’re going to find the SBA repayment term is longer, and the collateral or equity requirements are less. And so the idea is that by opening up the access to capital to small businesses they can have a level playing field with bigger companies and they can flourish, which they have. The agency has definitely fulfilled its purpose. It’s not perfect as we all know, but it really does a great job. And there are companies that started with SBA loans.

I know FedEx is one of them. There are some big companies that were starting with SBA loans, where they’ve done a study and the taxes that they’ve paid more than pay for the program. And the other little interesting point to note is it’s effectively a zero-subsidy program. It’s not a giveaway. It doesn’t actually have a hard line item in the federal budget. So the fees that the customers pay and the banks pay because we pay fees also effectively paid for the program. It’s a success as far as a public-private partnership, it’s a big success. And a lot of folks don’t realize that it doesn’t even cost anything in the federal budget. So it’s a great program and it doesn’t exist in every country. Most other countries don’t have a federal or a government program that helps support small businesses. So I think we’re very fortunate to have something like that.

Yeah, absolutely. And then, what’s special about the 7(a) part of the loan program. So why have I searched funds focused on that particular section of the program?

The 7(a) program is the only part of the SBA program that allows funding of business acquisitions. So there’s another program called the 504 program, but it’s only for owner-occupied commercial real estate acquisitions or refinances, and long-term equipment, that’s something with a useful life of greater than 10 or 15 years. So the 7(a) program is the only program that’s really available to fund business acquisitions.

And so it wasn’t meant to be used in the way it is, or has a search model taken the loan and may be done their own modifications to make it work for their situations and deals?

I would say no one at the SBA sat down and said, ‘Hey, this would be a great program for this search fund model.’ So yeah, sort of just kind of has happened is that the searchers have found it, and found it while this is a very useful program and vehicle to get my deal done. If I follow the SBA rules and guidelines, which are fairly rigid, as we all know. But I honestly do not think that the SBA, the agency, the folks that operate in and work within the agency are very familiar at all with the search fund model. I don’t have that sense at all. I think that they’re not really aware, and I will say that there has been political pressure eased off after COVID because they didn’t want to reduce access to capital, but there has been political pressure about the SBA and folks that were a bit SBA has not been too fond of the fact that there are high net worth investors that are effectively participating in the SBA program. So it definitely wasn’t intended for this purpose, but it’s working based on the way the rules work today. It does work well for the searchers.

And so let’s go over those rules. So in broad strokes, what are the general parameters of a 7(a) loan that searchers need to be aware of?

It’s a 10-year amortization in terms with no prepayment penalty. You can put as little as 10% down, there is a little clause in there for 5% if the seller will carry the other 5% on standby for the full 10 years. We don’t recommend using that structure for searchers or third-party buyers. We think that structurally makes sense for a key manager buyout. So let’s just go with 10% minimum equity, which is still very low. It’s a great way you can lever up the company with that 10-year term and that 10% equity. And again, that accomplishes the goal of the program, which is longer terms, less collateral, less equity. The other side of it is the SBA SOP is agnostic to collateral. So it says, if you have real estate with equity of 25% or more, you have to pledge it as a personal guarantor on an SBA loan.

You can’t leave real estate equity on the table, but if you don’t have real estate equity to pledge, that doesn’t make any difference in the decision. We still can do the loan. It’s still a perfectly good loan. So that’s kind of an interesting point that all banks are not the same on that. Live Oak embraces that we are a cash flow lender. And if you don’t have collateral, it doesn’t change our decision. But there are a lot of banks who are more collateral-focused on smaller companies, and they would not do a leveraged buyout, a searched deal without some kind of real estate collateral. So the good things are 10% equity, 10-year term. You don’t really have to have collateral. The business doesn’t have to have assets, could be a service business without any, and it still qualifies. So that’s all great. It’s just, it’s a little more challenging is in order to be eligible, you have to buy out 100% of the company, the seller can’t roll equity.

And none of the key employees that might own a little bit of equity can roll either. So that can be challenging because you might want to keep those key employees kept by out a hundred percent. You can’t get creative with earnouts or any kind of seller upsides. That includes warrants, a true earn-out, nothing like that. The seller can’t get any upside. They have to be bought out in full, and that price is sort of final. And then the seller has to exit within 12 months. So let’s just see how to find a seller that’s a great salesperson for whatever else they might do that they want to stay on, you can’t, they have to exit. So, some of those go counterintuitive to risk in a deal sometimes. And I get asked often, why does the SBA have these rules to which I laugh? Because I don’t know.

I don’t know that they know these rules have been around for a long time. These are not new rules. All I can guess is that the SBA was concerned at some point that maybe there might be straw buyers, that the seller was getting cashed out with an SBA loan, but not really leaving the company and still running it without any skin in the game later on. I don’t know exactly, but those are the rules. So it’s a little rigid. As far as that is concerned. There are a couple of things you can do, and those are forgivable seller notes. You could have a note that is contingent on some form of performance. As long as the performance is something that the company’s already done. It’s not based on net new growth. In other words, and you put that note on standby for a period, you test the metric.

If it’s earned, it begins amortizing. If it’s not earned, it gets discounted. That’s a forgivable seller note. So that’s about as creative as you can get. You could also do an escrow hold back. And a lot of deals do have a short-term escrow hold back that’s based on usually some sort of a transition issue that needs to be performed on. So those are the only two kinds of creative things you can do. Otherwise, it’s a straight 100% buyout with that minimum 10% equity.

And then what types of companies tend to be good fits for the program? And then which ones do you tend to avoid?

So we see a huge variety of industries, very niche companies, which we love all the variety that we see. The things that don’t fit, and this just has to do with the debt period. It wouldn’t matter if it was SBA or some other form of debt or companies with sales concentrations, where you have one customer that represents more than 20% of sales.

What we as lenders do is look at the worst-case scenario. We backed that customer out of EBITDA, and we see if you could still cover the debt. And if not, then that’s not a good loan because that could happen. You could lose that customer, especially during a transition. The transition really increases the risk of a customer concentration. So customer concentration is probably the biggest issue, also project revenue, which I also like to call lumpy revenue. So a contractor that’s doing more, a new construction or big projects, one-time projects that are not recurring, but project revenue could apply to a lot of different companies. I’ve seen technology companies with too much project revenue. So it’s really breaking down the mix of revenue and seeing how much of this revenue is just, I have to bid and win it one time. And then I don’t get any more recurring revenue out of that customer.

That type of business doesn’t pair well with debt. It might still be a good company, but it just might not work with a term loan because term loan, you have to pay every month. And if the cash flow is lumpy or cyclical or seasonal, those things don’t pair well with debt. That’s just the way to think about it. Those are the biggest issues. There aren’t too many ineligible businesses. It basically has to be for-profit obviously no non-profits, but the biggest issues we see are just down to the quality of earnings, or is it a project or lumpy, or do we have sales concentrations or bigger issues like that?

Gotcha. And then you’ve mentioned the transition being a challenging time for searchers. What are some of your recommendations for searchers as they get into the business for smoothing that transition with the seller and entering this new company?

I think a really good communication with the seller prior to close, obviously. We see it go really well, where there’s already a very well-established relationship with the seller, but just really clear communication. I think the discipline of having a detailed 100-day plan is a good one because he won’t forget. You can stay on course. You’re going to have a lot coming at you when you close on a deal. I think everyone describes it as just drinking from a fire hose. There’s a lot going on. So having a plan that you can kind of refer back to and say, ‘Oh, yes, I need to get that done. I need to get to this next.’ I think that’s just a really good discipline. We bankers love it. Of course, we want to see that you have a plan and that you’ve thought through everything. And I think it helps with the seller too. I think, to sit down and review that plan carefully with the seller and have a game plan that he’s part of, or he or she is part of, is really useful in terms of getting through that initial period.

And I just think, be careful not to change too much. I remember a story when Lisa and I were first focusing on acquisition loans and a lot of our clients were not search funds in those days. They were, I would call them folks that were sort of buying a second job. They may have had a career in a bigger company taking their 401k funds or whatever other savings and buying that next stage of their career, which was always interesting. But, this kind of goes back to my earlier comment about why investors are good. These folks were on their own when they did their diligence. And when they closed on their company, they were left to their own devices. And we did see some situations where they needed some changes way too fast and made some quick decisions to implement things that they thought would improve the company that actually got them in trouble. I think that it’s not doing anything too quickly, I think the first 6 months or so, I would just want to see searchers focused on just learning the business, everything that they can possibly learn about it, and then decide what their next move is because it might be different at that point than what they thought they were going to do when they were on the outside and just looking at the business.

Yeah. So within that 100-day plan, what items or goals do searchers sometimes put on that you feel are too ambitious and perhaps too aggressive for the first 3 to 6 months?

Some kind of major system implementation that’s going to really change the way the workflow takes place and kind of disrupt the staff and the way they do things you don’t want to do that you need to get to know exactly what the workflow is, and what the strengths and weaknesses of your staff are before you do things like that. So I think system implementation or any major operational change, acquiring, making a big CapEx investment before you really know if that’s the right thing to do. I think those things can all wait at least 6 months so that you’re sure, like I said, most often the initial thought has changed a little bit after the company has been, you’ve been operating the company for a while. I think it’s just big CapEx and big systems issues. Also, you have to see how you’re going to get along with the staff.

I think there’s certainly some turnover that’s likely to take place. They may not like the changes that you represent, even if you haven’t made any yet. And you may find that I think it’s a joke amongst serial acquirers that every seller always says, the staff is fantastic, but everybody can’t have a hundred percent fantastic staff that can’t be true. And it isn’t. You may get in there and find that you need to upgrade. You have to do that very carefully. Of course, any kind of people change. So those are some of the things that I’ve seen that there’s just a lot of variables and you have six months to marinate before you make big decisions.

So what about the 6 months after that first 6 month period? So that 6 to 12-month range, what other, few things that you tend to urge or push or encourage searchers to start trying or start implementing in their companies now that they have a little bit of understanding of how the internal process works and how their team is set up?

I wouldn’t say we push or urge, but we certainly have those ongoing conversations. And that 6-month mark is the point they’re telling us that ‘I’m ready to do what I talked about back here, but I’m going to do it just slightly differently. Or I’m going to prioritize it maybe a little bit differently.’ So I think it’s not that we would, we’re not really directing or urging them. Usually we each got a pretty good understanding of where they see the opportunity. And obviously, we’ve agreed with that or we wouldn’t have made the loan. I think the important thing is to just stay in contact with your lender because things may not go as well as you want. And you want to make sure we know what you were doing and why you were doing it. But also you may find that you need to adjust your line of credit or you need to borrow for some CapEx that’s going to make sense.

The nice thing about an SBA loan compared to a conventional loan is that you could shrink the EBITDA by making investments and in order to grow it. Whereas if you have a conventional loan, you have covenants that are tested quarterly. And if you shrink the EBITDA too much, you’re breaking the covenant. Now you have a problem. So you have handcuffs when you’re in a conventional loan that you don’t have in an SBA loan. And an SBA loan with no covenants, you can spend as much as you wish. I have a client right now who is at zero EBITDA on purpose because he’s invested in the sales force, that he’s got a very good plan and he’s got the cash to continue to fund that zero EBITDA kind of situation. And we’re watching that with him. It’s fine. He makes his monthly payment. He tells us what he’s doing. He stopped breaking a covenant. And so he has that freedom to make the investment. So I think that’s interesting, but you should tell your banker when you’re doing that because we don’t want to get a quarterly financial statement and be surprised. They go, ‘wow, this was a million dollars of EBITDA. Now it’s zero.’ You know what happened? We want to know what’s happening before we get that financial statement.

Right. Of course, I’d also love to chat about add-backs. So, within the deal process of looking at this company and trying to figure out what is the EBITDA that we’re going to borrow based on you mentioned cash to accrual being a challenging point, what add-backs broadly are accepted within your program? And then what is maybe more highly scrutinized or ones that are just not going to be accepted?

So definitely cash to accruals. It can be accepted, but it’s very tricky and needs to be very careful as we take it. Market rent adjustment is very normal so that a lot of the founders will own the real estate. They might be paying themselves above market or below market. So you want to normalize that to what you’re going to be paying. So that’s an adjustment that we see very common add back is the seller’s salary, of course, but don’t forget to deduct yours. So a lot of brokers seems that you see, I use seller’s discretionary earnings, and that includes the salary. That’s not really EBITDA because you need a salary and you need at least a market salary as well. We need to kind of assume what a normal person expects to be paid, to be assuming these duties we’ll add the sellers, but deduct yours.

And then the seller often is not always, but often has family members who are maybe the spouse or adult children who might be on the payroll that aren’t really doing anything. We’ll take those because we can verify them with W2, but just be careful that they’re really not doing something. I did see a deal once, where there were some large add-backs and they weren’t family members yet the seller claimed they weren’t doing anything. And we said, but then why, who are they? Why are they getting this money? Oh, they’re friends and we just didn’t buy it. We just thought I can’t believe that you pay your friend $300,000 to do nothing. Be careful, but we will take those salaries that are folks that aren’t really effectively working in the business. Auto leases, a lot of sellers will have auto leases for themselves and perhaps some family members, okay, those are not necessary, we’ll add those back.

And then it starts to get gray when it gets to all these other personal expenses. And so those tend to be meals and entertainment and travel, which the sellers will often say, ‘these are personal meals.’ They’re not business lunches and dinners and their personal vacations, they’re not business trips. How will we ever know what they were? We don’t, we’ll never know if it was a necessary trip for the business or if it was personal, same with the meals and entertainment. So we just can’t verify that. So we wouldn’t take those. And frankly, they shouldn’t be so large that the deal only works with them. The deal should still work. If we take out some of these fluffy expenses and don’t use them in our model. So our general rule is any add-backs that are only documented by credit card statements, we don’t accept those. Because we just can’t verify whether they’re business expenses or not.

It’s interesting, you know, that there’s just so much of it that goes on. And in really, almost every small business, I rarely see a small company that doesn’t have some amount of sellers, personal expenses running through it. I recently just looked at a deal where it’s a founder buying, he’s a strategic acquirer, so he’s not a searcher. He founded the initial business and he runs a lot of personal expenses through. And we found that he had a tax lien a few years ago, and we had to ask him for an explanation. And of course, it was an audit-related to his personal expenses where he paid significant penalties and he still does it. It didn’t stop him. He’s still doing it. So it’s interesting. But I think the key is that we know that they’re there, but a deal shouldn’t only work because of meals, entertainment, and vacation expenses. We should be able to use those other add-backs and still get to a place where we’ve got the debt coverage that we want to see. And then if those extra expenses really, if the seller is being honest with you about them, and you do realize those in EBITDA, great. You have that much more EBITDA when you step in.

Certainly. Yeah. So with meals and entertainment being, no-go what other types of add-backs will you not accept? I remember we chatted about PPP loans, not being accepted for instance, but what are some other ones that are, you just will not accept?

Yeah. PPP should not be in the earnings for sure. Although you still see some seams with them in there. Some others that you can’t accept are sometimes this gets really muddy to try to verify too. Sometimes a founder will be expensing things related to another business that he started. And instead of accounting for it properly, like making a loan to that other business, he’s just running the expenses of the other business through this company. Can’t verify that he can’t really know that’s what is really happening. It’s too much of a mess to really add back. I’ve seen add-backs related to hobbies. When a couple that comes to mind, someone was into car racing and put his mechanic on payroll and other expenses for the hobby. How it’s pretty tough too, we didn’t end up accepting that I’ve seen people who literally put their groceries all through the office and that’s tough.

So I think, you know what, when you see it, you just see some kind of weird stuff. That’s you have to just think about it. Can I ever one, verify this with something other than a credit card bill, because we’re not going to sit through years of credit card statements. And number two, is there some proof point that I know definitively says this was not a business expense related to this business? And a lot of those are just, you just have to take somebody’s word for it. There is no proof point, and that’s when we have to take the word for it, or we have to take a credit card statement. That’s where we generally draw the line and we won’t accept them.

Yeah, that makes sense.

But it is our favorite topic lately. Sorry, it’s our favorite topic lately, because there are a lot of deals on the market where for a variety of reasons, taxes being one of them, but sellers are really feeling like now’s the time to sell. In some cases, they haven’t really cleaned up their books. The best practice is you tell a founder, clean up your taxes and your books for at least a year or two before you plan to sell. So you can really optimize the value of your business. What you have is most of the deals on the market have not done that. And therefore there’s a lot of entertaining facts to look at out there that at least the stories about them are going to have entertaining. They’re not generally stuff that we can accept.

So as a seller, you mentioned cleaning up books, I assume that goes beyond just simply making sure that they’re correct and easily accessible. Do you also mean that there should be some strengthening of a company’s balance sheet or some other cleaning up within the business that a seller should do prior to selling? Could you go into that just a little bit?

A lot of the founders are not interested in spending a lot of money on accountants or bookkeepers or any of those services. And so I think best practices for them to go ahead and have a third party, take a look at their books and advise them what they should clean up. Number one is, reduce or eliminate the amount of personal expenses that are running through your business. If you do that, you’re effectively proving to a buyer that those really were personal and work necessary in the business. If you keep doing it, if you keep spending that way, all the way to the time of sale, you have bankers like us and buyers who are skeptical as to whether that’s really in EBITDA or not. So if I have, as a founder, I would clear that out and not do that. And for at least a year or two, to prove what the true EBITDA of the company actually is.

And then other cleanup items just might be more granularity in the P and L. So we can, some things might have been lumped together that maybe shouldn’t have just generally better accounting practice. So that a third party can step in and really understand the costs associated with the different business lines that a company might have the margins if they have several different business lines or product types, but just so there’s some granularity. So someone can come in and really understand and analyze and really put for the founder to put their best foot forward of what the business is capable of.

Certainly. Yeah. That makes sense. Are there certain quirks or different sets of rules that they need to be aware of or careful of as a strategic using the SBA program or is it fairly straightforward and it’s really pretty similar to how a search or might use it?

Yeah. Great question. It’s actually a more flexible program for strategics than it is for first-time buyers, if you will, searchers or otherwise. The first-time buyer has to meet that 10% minimum equity requirement. The strategic, and that falls under the business acquisition section of the SBA’s SOP with a strategic buys and a company, as long as it’s truly in the same industry, and they’re going to be operated effectively as one business, it’s considered a business expansion under the SOP. It’s not under the business acquisition sections under business expansion. And that means that there’s no 10% equity requirement. There’s no minimum at all. So it’s up to the bank at the end of the day whether they’re willing to do it without any equity, but I will tell you, I’m doing one right now. It’s a managed service provider and buying another one and they help to repeat that a few more times.

And they’re able to buy it with zero equity. They’re effectively contributing the equity or the cash flow of the existing business. So, from a bank perspective, it’s still a very safe deal because if we combine those two companies, we’ve got plenty of cash flow. And also the strategic has that advantage that a first-time buyer would never have, which is being able to eliminate redundant expenses. So the EBITDA that the strategic is buying is actually larger than anyone else would be buying. And so they could pay a higher multiple, or even if they don’t pay a higher annuals, they’re just simply getting a better value. So I think it’s a great program for strategics and we’re hoping to reach more founders and existing company owners to get the word out about how great the program is for strategic acquisitions and what a great time it is to grow by acquisition for a small company. Searchers have certainly latched on to the macroeconomics that is driving this to be such a great time to buy a small company, but strategic they’re busy running their business. So they may not have realized what a great opportunity we have now, but it’s a fantastic program for strategics with zero cash injection required.

Do they also have the lifetime limit as well as the strategic?

They do. So everyone still has that $5 million cap per personal guarantor. And I get asked this a lot too if there is a partnered search where there are two personal guarantors and it’s a $5 million SBA loan, do they get another 5 million? No, if you’re both personally guaranteeing one $5 million SBA loan, you’re both tapped out the way the SBA rules work. So it’s still 5 million. Live Oak has a companion loan program where we will go an additional 3 million above the 5. So we’ll do a total of 8 million in debt with our companion loan, but the SBA is still capped at 5 for strategics and for everyone.

And do the same general guidelines apply for recurring revenue and avoiding project-based revenue and that sort of thing to those still apply, or do they change a little bit given that they already own a business in that industry?

It is a little easier for strategic. So let’s say strategic wants to buy a company that has a 25% customer concentration. That’s easier for strategic to do because when we combine the companies, maybe that 25% turns into 18% and we’re not so worried about it. So again, they could take more risk on that deal than a first-time buyer might be able to do. But otherwise, the same principles apply. It’s just that we apply them to the combined company cash flows rather than just the target on its own.

So what else about strategic 7(a), I asked you about that you’d be excited to share? I’m making a note here.

Just let me think. Yeah, I think for the strategics, I think it’s just simply a great time for them to grow this way. It might be an easier way to grow than organically. And a lot of founders just may not be aware that there’s this funding available to do it, but I also think it’s a great opportunity for searchers. A lot of searchers don’t use their full 5 million on the first deal and they have plans to grow by acquisition. And absolutely it’s a great way to do it. The one thing we like to point out to our searchers when they’re starting is if that’s your plan, if you plan to grow that way, just let your banker know. Let us be part of that from the beginning. You don’t want to get an SBA loan and close on a deal. And 6 months later, come back with a new, another deal that your bank wasn’t expecting.

And the reason for that is that the bankers might feel like that’s too fast. How was the transition gone? But if you’ve convinced us before you even close the first deal that you have a good strategy in mind with these roll-ups and that you have even a pipeline of targets that you’ve identified and the timeline that you think they might get executed, then we’re prepared. Then we’re saying, okay, we’re on board with that. We’ll be happy to look at the next one as soon as it’s ready. And we certainly have, Lisa and I have a number of clients who have definitely done a few roll-ups. Some of them will do some small ones with cash, not even use financing, just seller note, and cash. And then maybe a little bit larger when they’ll come back to us and get some more financing.

We love that strategy and we love supporting it. It’s not as easy as it sounds. I think a lot of folks think they might be able to do it faster than ultimately it turns out that they can. And again, that goes all the way back to the transition period on your first deal is like drinking from a fire hose. There’s a lot to take in a short period of time, and you really, probably aren’t going to have time to go look at other deals during that time. But it’s interesting to see that when a searcher becomes a CEO and starts operating that company, that often the roll-up deals that occur from getting to know their competitors, it’s a little more of an organic way of finding the deals. Now that you’re in the chair, you’re in the industry, you have employees, you have clients in this space that might lead to some discussions that lead to an acquisition. So those are always interesting as well.

Yeah. I’ve talked with a number of searchers who now acquired companies who hear from competitors or local companies like them calling because they found out that they acquired this company and they want to sell their company as well. We talked earlier about risks to searchers, but I am curious, what does the worst-case scenario look like for a searcher where the company defaults and this personal guarantee now is looming overhead? What does that look like for a searcher when everything goes to zero?

Yeah, it’s a tough subject. So first it’s a very low default rate, so I like to start with that. The default rate, especially if the deal is structured properly with a seller note, with good debt coverage, plenty of margin, not customer concentrations in a state where if you lose one customer, you won’t be able to pay your loan. So all of those things, if we do a really good job, we’re very careful that the default rate is extremely low, but it’s a small business and things can happen. Still, there are instances where things just do not go right. First, is there are salvageable situations sometimes. So you may be underwater with the amount of debt that you have unable to pay it, but there’s still a viable company there if it was delivered. So there are opportunities. If, you know, communicate with the bank, do something like a short sale, actually sell the company to someone else who will either not have debt or a much lower amount of debt.

And the bank only loses part of the loan, but it’s not all fully charged off. It’ll be a partial loss. That’s one option. But at the end of the day, however, it happens if the bank takes a loss and these are leveraged buy-outs without a lot of collateral, there’s almost never, I very rarely see a levered buyout, SBA loan that is fully collateral covered. So the collateral is almost never going to pay it off. So at the end of the day, the bank is going to liquidate all the collateral. That’s attached to the loan, and that’s going to be business assets, which frankly, at that point, there really is almost never anything left or very little, and any real estate collateral. So talking back about that pledge of real estate, if you did pledge real estate, and you were required to pledge it, the SBA will liquidate it. That will happen. They’ll foreclose on it and liquidate it.

So then they end up with a loss of some amount and the SBA is going to cover 75% of that for the bank. And the bank’s going to actually take the other 25%. So always keep in mind, the bank has money that is at stake, we will lose if the loan does not go well. So that’s our incentive, obviously, in addition to just being good citizens, that’s our incentive to make sure we make good loans. But that loss let’s just say, I’ll just make up $100,000 that’s lost after liquidations. And you’re the personal guarantor. You need to come back to the bank and the SBA and enter into what’s called an offer in compromise. And you can Google this, there are some good blogs out there that kind of describe what this process is, but it’s a negotiation and it is to clear the $100,000 off your record.

One for once at all, if you can either enter into a 5-year paid plan, that’s going to be based on your income and your means, or you’re going to be entering into a one-time lump sum again, based on your means. So the question is if I have assets, is the SBA going to want them? Well, yes. In that negotiation, they’re going to look at your personal assets. Your retirement accounts are exempt. So they’re not going to be trying to raid the retirement fund. But if you have other assets, then the negotiation gets harder for you because you need to pay more than someone who doesn’t have those assets. If that makes sense, they’re not directly attached to the loan, they’re not collateral, but when you’re in that negotiation, that’s what the SBA is going to be looking at, your means. Do you have the means to pay more than what you’re offering? So it’s a negotiation, there’s often some percentage of $100,000 loss, the bank, they’re not going to get the full a hundred thousand dollars or at least almost never. But how much they get, what percentage of that $100,000 is based on what your means are and what you’re offering. So that’s the simple answer. And once you do that, it’s over. Then that’s the final settlement and the SBA and the bank will not come back after you for anything further.

Have you seen any searchers who have gone through that process and then come back later and wanted to acquire a different company with an SBA loan?

They can’t, unfortunately. So unless for that example, unless you did pay the full $100,000 back, you will not be eligible to borrow from SBA again. And that’s with any government loan. So, if an individual had the bank or the government had taken a loss on a VA loan or an FHA loan, the same thing. If there’s still a net loss, even if it was for many years past, you can’t be eligible for another government program, unless that loss is fully satisfied. So that’s probably the worst that happens is that you’re shut out of all government loan programs after that.

That’s not very good. 

Like I said, I hate to talk about it, but it’s a good topic because people do want to know, but it really does not happen very often. And I think it does go back to the very beginning that we’re talking about what could go wrong and diligence and being sure that the EBITDA that you think you’re buying, that you’ve checked it out three different ways. And that’s really the EBITDA, just being really careful about risk will really keep you out of that situation, I think.

The cases that I can think of, and there are just very few in recent memory, were not surprised operational issues in the business, which could still always happen. They were in hindsight things that could’ve been fixed in diligence, or you could have either paid less for the company or just walked away from the deal. Had we discovered that in diligence. And that’s where the value, I think of a good banker, that’s focused on acquisition deals comes in. We see a lot of transactions, lots and lots of them. Then we see what happens afterward. And we talk to our CEOs and we hear the good, the bad, and the ugly. And we try to bring those learnings to the front end every week. So if there’s something that we realized could have been caught, could have been better on something, we’re going to bring that information to our searchers, who haven’t yet closed the deal, and try to make sure that would never happen again.

And that’s an interesting point because most SBA lenders are not specialists in acquisition. Lisa and I have very few competitors who spend all day every day doing acquisitions. Most of them are commission salespeople, and they are focused on any and every SBA loan that they can get booked, as you might imagine, a salesperson would be. And that often means a lot of real estate loans, which are totally different. They’re two existing companies and it’s very a simple kind of cookie-cutter cash flow. So if you don’t work with a banker that has a significant amount of experience doing small company acquisitions, and the same is true if you don’t bring in investors that have that experience, you might be missing out on some insights that would prevent you from making a mistake or taking some risks that you otherwise wouldn’t want to take.

Certainly, yeah. Moving into some closing questions. What college class would you teach? If it could be about any subject?

It would be economics, but it would be dispelling the myth that there is such a thing as pure capitalism or pure socialism or pure communism. I think people are very confused about that. And here we are talking about a government program for entrepreneurs. So that, to my point, it’s a mix of everything in this country. And I would teach that.

That’d be a fun one. What strongly held beliefs have you changed your mind on?

What I’ve changed my mind about, that is related to search, is the career path for folks that could do anything, which I think there are a lot of these searchers that I’ve met, right? They’ve mastered education. For sure, they’ve gone to great schools and they’ve done fantastic things. And a lot of them also were military veterans that did really truly amazing things. And they have the kind of this, the world is their oyster. They could do anything, almost they want to in business. So the view I changed is that I never thought that being a small business owner would be the best thing for someone to do, but I definitely have changed that just from seeing the success and seeing the freedom that people have in exploring these companies and being their true selves in terms of how they want to live their lives and what they want to pursue.

So I’ve got a 23-year-old and a 19-year-old, and I think I’ve changed totally what I tell them that I want. Of course, they’re going to do what they want. Of course, they’re not going to do what mom wants, but what I would want most for them, what I think would be the most exciting path career-wise in life would be to be an entrepreneur in a small company, whether to buy one or to start one. I think I didn’t think that way 10 years ago at all, but I definitely do now.

I love that what’s the best business you’ve ever seen?

This one’s super hard because I am seeing some really interesting businesses. And frankly, when they do fantastically, well, they just pay us off. And I don’t get to hear about what happens after that. I’ll go with one of the best deals that I’ve seen recently, a client at the beginning of COVID sort of March 2020 found an e-commerce company that the founder just was running another business. He really didn’t have time for this one. He moved, wanted to move to a different part of the state when he sort of unloaded at the worst possible time, but the best possible time for our clients. And it has just been a home run. He also entered into a lease option on the real estate that ended up being about a million dollars below market because of what happened with real estate prices. So I think it’s just a timing issue with us. The one that comes to mind is the timing can be everything.

It would have been a great deal without the COVID bump, but he had the nerve to go ahead and close the deal around that time, which was a nervous time for everybody. And we have the nerve as a bank to go ahead and lend. And we didn’t exactly know that everyone was going to start shopping online at that point. And yet they did. That’s just one in recent memory. But as far as the best business I’ve ever seen, I’ve seen so many great, interesting companies, founders that have found just amazing ways to deliver a product or service very efficiently and in a way that their customers love. I’m excited. Every day I open up new deals and to see what some of these small companies are doing, I can’t pick the best one. They’re all pretty interesting.

I’d be curious. What’s the most nichiest business you’ve seen that was perhaps a business or industry you’d never heard of before?

They get these all the time. But the one that comes to mind right now is mobile phlebotomy. And that was, they contract with law enforcement. And I guess if you don’t have a service, you can call out for, if you’ve got a suspect that you need a blood test, the officer would have to normally take them to a hospital and stand around and wait for the blood to be drawn and then take them back. Mobile phlebotomy service can just come out and take care of it. Apparently, they also do cadavers. So it’s a very interesting business. And occasionally we see some really interesting services that you would not know existed.

That’s fascinating. I love that answer. That’s awesome. Thank you so much, Heather, for coming on the podcast. It’s been so much fun to have you and chat about the SBA program and all these different tactics entrepreneurs can take. And then I love the mobile phlebotomy. That’s just fantastic.

Yeah. Thank you so much for having me. I hope that the information is helpful to those that are thinking about using an SBA loan for an acquisition.

I’m sure it will be. Absolutely.

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