Acquisitions Anonymous - #1 for business buying, selling and operating - Let’s SBA the heck out of this deal. - Acquisitions Anonymous episode 140

Episode Date: November 11, 2022

Want to receive this listing in your inbox? Signup for our weekly newsletter:https://www.getrevue.co/profile/acquanon-----Bill D’Alessandro (@BillDA) and Heather Endresen (@HeatherEndresen), we talk a lot about the Small Business Administration (SBA) and discuss interesting topics such as why the deals are going down and the important safety considerations for this environment. Heather also imparts a great deal of crucial knowledge on cash flow and risks that we should keep in mind in the current environment.We also talk about an Outdoor B2B eCommerce Brand. We get to witness Heather's informative knowledge of this type of loan. Additionally, we learn about the difficulty of seasonality when leveraging a business.Subscribe to our channel!-----Thanks to our sponsors!CloudBookkeeping offers adaptable solutions to businesses that want to focus on growth with a “client service first” approach. They offer a full suite of accounting services, including sophisticated reporting, QuickBooks software solutions, and full-service payroll options.-----Show Notes:(00:00) - Introduction(01:06) - Our sponsor is CloudBookkeeping.com(02:33) - Guest intro: Heather Endresen(04:06) - What is happening in the market in mid-October 2022? What’s different from previous quarters?(05:45) - Who owns the larger companies in the space?(07:08) - What is the median SBA rate?(09:13) - What is the most important factor when acquiring an SMB?(12:25) - Is there room for valuations to correct, given the rate hikes decrease the Net Present Value of future cash flow?(13:23) - What is happening on the upper-quality end of this market, and how does that relate to the rest?(15:03) - In today’s environment, where the risk is higher for the Bank, does it make sense to raise more equity for high-quality deals?(16:35) - How can I know if I’m being safe from the buyer’s side?(18:12) - Seller Notes! Things you need to know as a buyer(20:27) - How to protect yourself with a seller note?(22:37) - SBA Loans & personal guarantees(26:30) - What happens in a default situation? How does the SBA operate in these cases?(29:17) - Can I choose an asset or cash to bring into the deal as coverage if the business is underperforming?(30:09) - Deal & financials: Outdoor B2B eCommerce Brand(32:34) - What is the first thing that you’d ask from a Lender's perspective?(34:21) - What is the challenge of seasonality when you’ve taken leverage on a business?(36:37) - What is the line of credit and how does it relate to the Quality of Earnings reports?(39:16) - The underbelly of SBA loans?(39:56) - How does the bank get comfortable with a Deal?(42:41) - What does SBA pre-approved really mean?(45:35) - What’s the dynamic of Live Oak Bank?(51:Subscribe to weekly our Newsletter and get curated deals in your inboxAdvertise with us by clicking here Do you love Acquanon and want to see our smiling faces? Subscribe to our Youtube channel. Do you enjoy our content? Rate our show! Follow us on Twitter @acquanon Learnings about small business acquisitions and operations. For inquiries or suggestions, email us at [e-mail]

Hey, everyone. Welcome back to another episode of Acquisitions Anonymous. I am one of your hosts, Bill Dallessandro. And today we have an absolutely killer episode for y'all. We had Heather Anderson on the episode from Live Oak Bank. Heather is one of the highest volume SBA lenders in the country. And I had the chance to nerd out with her for almost an hour on the ins and outs of how you do deal structuring when using really any loan, but especially an SBA loan. This is super relevant if you're a searcher or any business buyer. that wants to know what you can and can't do with an SBA loan. We talked about what you do. Everything goes wrong and you have to do work out on an SBA loan, how you can get more comfortable with the personal guarantee. We talked about downside scenarios, upside scenarios. I learned a whole bunch of new stuff about how to structure a seller note. I could go on and on.

I think you're going to really dig this episode. But first, if you could, please hop on your Apple iTunes or anywhere your podcast are sold. Leave us a five-star review if you like this episode. It really helps us get the word out. So without further ado, I think y'all are going to love this episode with Heather Anderson. Hey, Michael here. I want to talk to you about today's sponsor for the episode, which is cloudbookkeeping.com. So cloud bookkeeping is actually run by my neighbor, Charlie.

So I've met him in person and can attest that he's a real human being and a good person. And what cloud bookkeeping does is offer a full suite of bookkeeping services all in the cloud for you around QuickBooks. and other technologies that you're using as a small business owner. So if you're interested in getting the bookkeeping part of running a business off of your plate and focusing on running your business, Charlie and his team are one to call. They can put together a bunch of other stuff in terms of helping you manage and grow your business besides just bookkeeping, sophisticated reporting, definitely helping you get your quickbooks online set up in the right way, and a number of things around payroll as well.

well. So definitely know them and recommend them. If you want to find out more about cloud bookkeeping, you can go to their website at cloudbookkeeping.com, reach out to Charlie. I know many of you have and see if he can help you, make running your business easier and more fun by letting them help with a lot of the bookkeeping solutions. And when you call, mention this podcast. It would help us and help Charlie know that we're supporting him as well. So thanks a bunch and cloudbookkeeping.com as the sponsor for today's episode. All right, Heather, thank you for being back on Acquisition Anonymous. I think you are our first, maybe third time guest. Is that right? Third time. Yes. Thank you for having me again. Awesome. Well, every time I want to know what's up in the

world of SBA lending, I can't think of anyone better. So I'm psyched to have you back. Can you just remind our listeners, kind of who you are and what you do? Yeah. I am the co-director of a vertical at Live Oak bank that focuses on search fund lending. But what that really means is we do acquisitions. We finance acquisitions all over the country to search funds, both self-funded, traditionally funded, and independent sponsors as well. Awesome. So you are my go-to source for anything SBA. If you're a search fund, if you're doing an SBA loan, Heather is going to be, want to be one of your first calls, assuming you fit into her kind of lending box, which I think is pretty broad, is it not, Heather? It is pretty broad, yes. And I'm with Live Oak Bank, which is the number one SBA lender, and we have about 36 industry verticals. So we also have a lot of industry-specific niches we can kind of introduce you into if you happen to find a deal in one of those.

Okay. Awesome. So I am going to very selfishly pick your brain about all kinds of things today that's going on. We've agreed to do to start this episode with sort of a lightning round mini interview, market update. Heather's going to tell us kind of a lot has changed over the last six months in the lending market. in the acquisitions market. She's going to talk about how she sees it from a lending perspective. And then we're going to cap it off with a deal at the end of an e-commerce deal, which I think is pretty fun. So to start, Heather, I'd love it if you could just kind of catch us up. We had you on. We're recording this in mid-October, 2022. A lot has happened. You know, the Fed has raised rates significantly. There's all this talk of recession. You know, are deal still getting done? Is it totally locked up? What's it like out there? It is not locked up. So that is the first thing. Deals are getting done. And fourth quarter is our busiest quarter historically. And that's still happening. We are very, very busy. I'm hearing other SBA lenders at other banks are also seeing the same thing. So the good news is deals are still happening. What's different that I've noticed is that they tend to be a little bit higher quality deals. So I think maybe buyers are being a little more selective.

and they're pursuing those deals that have the right characteristics, the companies that have the right characteristics. In general, the deals that I'm working on are also on average a little bit bigger. So I'm looking at deals where they're $8 and $9 million enterprise value, and they're still going with SBA financing. So a little more equity, a little bit larger deal, which also tends to be a safer company, you know, larger tends to be safer. So I think there's a little bit of a, I call it a flight to quality with buyers.

And I also, I just wonder if the conditions that we're facing are bringing some of the quality sellers to the market. I can't prove that, but it sort of feels like maybe that's beginning to happen, something that we've expected to happen for a long time, just given the demographics of the founders. Is the demographic kind of, I've heard it called like the silver title wave, like the baby boomers wanting to retire? Is that what you're talking about when you talk about market conditions bringing high quality assets or is there more to it? I think that's it. You know, we've been following that data point for many years now. And according to Barlow Research, we're now at, if you look at companies with less than 10 million in revenue, 47% of them are controlled by a founder who is 65 or older.

And that percentage has been increasing for the last 10 years that I've followed the, the statistic. So it's still increasing, meaning it's everyone's still getting older. So I would say the silver tsunami has not quite crested yet, but maybe we're getting there. And I think maybe the economic conditions are bringing some of those sellers who were willing to wait it out another year, another two years. Maybe they're looking at the situation saying, no, maybe now is the time I'm tired and I don't really want to go through a recession and a high rate environment on top of everything else. Okay. So you just mentioned the two keywords that I really want to key in, recession and high rate environment, right? So you're a lender. And when I think of like times to do a leverage deal,

I do not think of recession and high rate environment as a great time to do a leverage buyout transaction. So obviously the Fed has raised rates significantly. I think the benchmark rate is in the mid threes now, which means you're typical like what's, I don't want to paint you in a box here. like what's like your median spread for an SBA loan, like roughly? Sure. So we're, so the median is really prime, Wall Street prime plus two. That's sort of your middle of the road. There are rates lower than that.

There are rates higher than that for a variety of reasons. But that's where you're going to generally fall. And prime is right now at I believe six and a quarter. And we're probably expecting seven by the beginning of November at the next Fed meeting. So prime will move when the Fed moves at the same amount. So you figure we're probably going to have a rate increase in November and probably another one after that. I'm telling folks to model maybe a 10 to 11 percent interest rate for now. Okay.

So if I, my memory is right, I think Prime was closer to three at the beginning of the year. So we're talking about the interest rate on SBA loan has gone from five to six percent to, you know, nine to 11 percent, ish in under a year. And on a long amortization loan, a 10-year SBA loan, I think a large portion of your payment is interest. So while, you know, the math is more complicated than I'm about to make it seem, your payment has roughly doubled. I mean, roughly, right, or gone up significantly because interest rates have roughly doubled since January. I would imagine that makes it harder to pay a big number, borrow as much, service that debt. are you seeing, you know, percentage of debt to equity change over the last six months? Are you seeing valuations come down to compensate?

How has that big increase in rates affected the deals? Yeah. So it hasn't quite doubled the payment because we're talking about a 10-year amortization on these deals. So it's still increased it, not minimizing that, but it hasn't quite doubled it because you are paying a lot of these payments towards principal. The first distinction I want to make is don't think in terms of real estate when you think in terms of investing or leveraging a small business acquisition. It's very different. So the key and the largest driver in whether you're making a good investment in a small business or not really is the growth in the EBITDA that you are able to ultimately achieve or not.

It's really not about the interest rate and the interest expense that you have along the way. if you look at your ROIC or your MOIC models, you'll see that that's true. So I think what's happening is when someone finds a good deal, you know, quote unquote, you know, where they see that opportunity to grow, they see something they can professionalize or open new sales channels, whatever the plan may be, they're not as worried about the interest cost. It's just not a big impact on their overall picture. So I think that's what we're seeing happen.

Okay. So the deals you're seeing are have wide enough debt service coverage that they don't need, you know, rates to stay where they are. It's not that close to the trees anyway. Right. And that's a really important point. So we at, in my group, we have always underwritten our loans with at least a 1.5 DSCR going in. So we've always been at that other end of the scale. We've never wanted to be aggressive and have a really skinny margin, even before rates started rising.

So absolutely, when you underwrite a deal now at 10 and 11 percent, and you're still getting to that 1.5, you have a pretty good margin. So you have that cushion. We also underwrite with a seller note. So the other thing to think about in terms of debt coverage and being safe with a deal is having a subordinated seller note behind the SBA or the senior debt. What will happen if that business hits a difficult time, either because of interest rates or recession or whatever it may be, the payments to the seller note will actually get suspended rather than simply defaulting on the senior debt. And that suspending of seller note payments is agreed to because it's subordinate to the senior. So you've got, you know, the debt coverage multiple is your first kind of line of defense of kind of having a margin for error.

And your second is having a good seller note. Maybe you need a larger seller note in a deal that you're a little more worried about the future on. those are the ways to kind of structure so that you're safe. So I want to come back to this point about seller note because I think it's an important tool for buying businesses in this environment. But you mentioned a 1.5 debt service coverage ratio. Using very round numbers quickly, can you just explain what that is if somebody doesn't know what that is?

Yes. It is adjusted cash flow. So free cash flow of the business, net income. Maybe we'll add back depreciation, adjust some salaries, whatever makes sense, over total pro forma debt payments. So pro forma debt payments are going to be your SBA loan payments and your seller note payments. So you want that cash flow to be one and a half times or more greater than those payments. So for example, if the business is cash flowing $1.5 million, you don't want to see debt payments, meaning principal plus interest of more than a million dollars a year. Right.

So I would think, you know, if that sounds like you're saying, that's always been, you know, the bank's kind of margin of safety and that you haven't increased that in this environment, right? No, we haven't. So if you haven't increased it, I would think, you know, a deal being financed, you know, all else being equal, if interest rates are up, right? If you were financing right up against that 1.5 debt service coverage in a lower rate environment and now you're trying to finance up against it in a higher rate environment, you know, one of two things kind of has to happen.

Either valuation has to come down or the seller's got to put more equity in. which do you see happening more? Well, the valuation does have to come down, perhaps, and or the buyer does need to bring in more equity. So I guess we look at it as there's several levers to pull. So the valuation piece, let's take that one first. If it was kind of a plain vanilla company that didn't really have a lot of moats, it didn't have a lot of, you know, great qualities that, you know, make it really.

stand out from the crowd, well, then maybe the valuation needs to come down. You know, maybe that's the, those are the deals that are sort of on the bubble, on the margin, where maybe they're just not worth as much now. Now, on the other hand, if you have a company that has great characteristics, maybe they have recurring revenue at a very high percentage, very low customer churn, and they're positioned well. This is another thing that's important right now. They're positioned well in their industry for tough economic times.

Maybe they're countercyclical or they've got some positioning that looks really favorable. Their valuation didn't go down just because interest rates went up. So it really depends on the company that we're looking at. So if it was something that was kind of financed at the margin anyway, right up against 1.5, the valuation has to come down. And the reason the valuation has to come down for listeners is because there has to be less debt on it. If the debt is more expensive, you have to put less on it because the cash flow of the business hasn't changed in order to maintain that ratio. But you're saying it sounds like the best businesses aren't even close to that 1.5 debt service coverage ratio. So those valuations don't have to come down.

Well, that end, just how I would value those better characteristics doesn't change. Recurring revenue is still recurring revenue. And it's more valuable to me. So as a buyer. And the other thing, it is the equity piece, too. So you just may want to bring in more equity. We, in good times, the 10% equity minimum might have worked. And a lot of deals did work. I shouldn't say might have. It really worked. But now we're looking at a situation where you don't want catastrophic failure,

which would be, you know, defaulting on your debt, you know, and you want to be able to ride out any bumps or storm or whatever we're facing. It just may take more equity. And I think the nice thing about that is there's still a lot of dry powder, if you will. or equity that's interested in investing in this asset class on the sidelines willing to go into good deals. And I think maybe, maybe even more so now because of the stock market. You know, when you have other asset classes that are not performing well and you have something that might be a little more insulated from that kind of performance, you may have more equity available.

So I think if you if you have a good deal, don't be afraid to raise a little more equity. Okay. That's interesting. So you said before, Or, you know, that 10%, people are always trying to structure their deals right up against the 10% equity minimum. You're kind of implying that that's not going to get it done in this kind of risk environment. There's one thing, we're in a higher rate environment. We're also in a higher risk environment. So banks tend to risk off, right, and want a little bit more equity in deals. You know, if I'm a searcher and I'm underwriting a deal, you know, how much equity, what percent

equity should I be thinking about starting to circle even, you know, to be safe? You could still do 10%. So I don't want to get that message out that you can't and none of the deals will work that way. Some will. In some cases, I'm thinking of one right now I'm working on where there's about 11% equity, but a 20% seller note. And that sort of offset that. And it's just a really good quality company.

But yeah, I think that in many cases, the deal just may be better with 15 or 20% equity and a 10 to 20% seller note and then maybe 60% bank. debt. Maybe that's the cap stack that's just a little bit more rational in an environment where we're concerned about what the downside may be. And then also look at deals. I know everyone looks at an investment for the upside, of course, but don't forget to look at the worst case scenario. And when you look at the worst case scenario, what you're testing for is, could I at least still service my senior debt payment? You know, if the worst happens that I can dream up for this company and I can still service that debt payment, you know, then I'm probably in pretty good shape.

Yeah. So I think it's very easy from the searcher, the buyer perspective, you kind of start the capital stack at my equity, and then you just sort of assume that the rest is going to be debt. But it sounds like what you're saying is that you should really start thinking about it, you know, how much debt can I get? And then I got a bridge to 100% above that, above the senior debt. It seems like in the past, you might be able to push to 80% senior debt. But now the banks are probably going to want more like 60 to 70% senior debt. So then you can bridge up to 100 either with all equity, right? You can put in 20, 30% equity, or you can bridge that gap with some equity and some seller note. And that's what I want to get to here a little bit because I have heard

all kinds of conflicting structures and what's allowed and what's not allowed on a seller note. Can you tell our listeners sort of what you can do, right? Because I think there's a lot you can't do. There's some things you can do when you're talking about structuring your seller note. What is allowed by the SBA? What is allowed by Live Oak Bank? Like, is there a difference? How should buyers think about using a seller note? So a buyer wants to get a seller note of, you know, again, at least 10 to 20 percent.

Now, that can be on standby or they can start making payments amortizing it right away. So there's no SBA rule that says that seller note can't be amortizing right away other than a very specific situation. So I'll go ahead and describe that specific situation because it throws a lot of people off. So there is something I'll call a five and five just to make it easy to remember. SBA says 10% is the minimum equity, but they carve out this little exception that says you could actually do just a 5% equity injection if you have a seller note for the other 5% and that seller note is on full standby no payments for the life of the SBA loan. So that's a five and five.

The reason I never talk about it is we never use that for third-party buyers. The only time I would use that is for a key manager who's been running the company and buying it from their boss, the owner. So don't get confused by that. That's not a good structure for a third party. And if you think about it, why would a seller agree to that for a third party if they weren't selling it to you at too high a price? You know, just get 5% less.

So we don't use that structure. So if you're not doing the five and five, then you can amortize the note right away. And in fact, if you're not doing the five and five, the SBA doesn't say there has to be a seller note at all. They don't have a rule on what percentage it should be. So there's no rigidity there at all. The key with the seller note is really what sort of amortization schedule you're going to use and whether it affects your debt coverage, you know, too negatively for the lending. The other little trick to know about is if you want to put the seller note on a balloon payment,

maybe you want a 10-year amortization or you're able to negotiate a 10-year amortization, but it's going to have a balloon in five. Most lenders, including us, will treat that in our cash flow analysis as a five-year amortization. So beware of that. You're thinking you're going to look at it like it's a 10-year payment and we're going to look at it like it's a five-year payment and that might affect your debt coverage. But, you know, bottom line is it's subordinate to the bank.

And the thing I tell folks, the seller note is your best form of economic recourse if there is a misrepresentation in the deal, at least for small companies, where we really don't have other, you know, we might have the escrow for that for a small period of time and for a longer period of time, we'll have the note for that. So it's really important to have a note of a fair amount of size so that you would, you know, be able to sort of right size the deal if you had to eliminate that note from the cap stack. Because it's easier to just negotiate that they forgive the note than they actually cough up a wire transfer.

Well, you're going to have to sue them and that's going to be really expensive and distracting. And then you don't know the outcome. And then they still have to cough up the wire. Yep. Yeah. Yeah. Yeah. Yeah.

Yeah. Seller note is a really nice, it's kind of pseudo escrow, especially for the first couple years. Assuming there's actually something wrong. You shouldn't plan to just go screw your seller and default on your seller note. But it does provide you some nice protection in case that something had been misrepresented. So, Heather, it sounds like there's actually a fair bit of flexibility, at least according to the SBA, on what you can do, leaving the five and five scenario side. There's actually a fair bit of flexibility as to what type of stuff you can structure provided that the bank allows it. It sounds like the individual lending bank, you know, in this case, Live Oak wants a 1.5 debt service coverage ratio.

It sounds like within the bounds of what the bank is comfortable with, that's going to be your constraining factor, not the SBA. Is that accurate? That's accurate. And then there's one more constraint the SBA is going to throw at you. So in your plain vanilla seller note, it's pretty simple. But let's say you want to do a seller note that is forgivable or contingent on something. You can do that. But here's the constraint that it can't be contingent on something that is tied to net new growth.

It has to be contingent on something that the company has already, something the company's already done. It could be maintaining a certain eBadar, going back to 2019 revenue levels, or it could simply be something qualitative like, you know, retaining a key customer for two years at a certain level. And that has to be a historic level. So just can't be net new. So the SBA, what they're really trying to prevent you from doing is like a backdoor earn out. That's right. Exactly right.

Earnouts are not allowed. Roll over equity is not allowed. Any form of seller upside, not allowed. Okay. So it really needs to function more like a stability payment, assuming everything is good. You pay out the seller note. If things become not good, you stop paying the seller note. That's allowed.

But you can't only pay the seller note if, the performance gets better. Right. Then it's an earnout and that's not allowed. And that's not allowed at all. Okay. Awesome. So that is, I think that's really helpful because I've heard a lot of folks out there saying, oh, the full standby seller note is the only way to do it. And obviously sellers hate that because a 10 year standby seller note. I mean, that's equity basically, right? That's right. That's the five and five, which we just, you know, just ignore that. We just don't do it. Hardly ever. Okay. So assuming now your seller in general, of course, wants cash. But in this environment, And it sounds like a well-structured seller note can be a great way to bridge the gap where a little bit less senior debt is available.

You can use sub-debt from your seller and still try to keep your equity down in that 10 to 15% range, if possible. Yeah, absolutely. It does two things. You know, it keeps your senior debt down. And it helps the lender when they see that the seller's giving, you know, demonstrating that confidence in the deal. They're demonstrating confidence in you. running the company, which is really, really important. They know better than anyone, of course, and it's demonstrating their confidence in their company going into the situation. So nobody wants,

you know, to find that you've been sold a business that the seller knew was headed into difficult times. A seller like, that's not going to carry a note. That's at least the way we think, right? So if a seller is willing to carry a sizable note, that gives everybody some more confidence in the deal overall. Yeah. And that sizeable note is a junior note. So the seller is willing to carry subordinated, bank gets paid first, kind of essentially unsecured or at least second lien secured position. So he's got to feel like, seller's got to feel like the buyer is not only going to be able to make the bank hole, but also make him whole and also, you know, grow the business. That's exactly right.

Yeah, it's a great level of alignment. So we got some great questions on Twitter. One that I wanted to mention, Dave Rekuk asked, downside protection. A lot of people, when they talk about SBA loans. Whenever I talk to somebody, the scariest thing is a personal guarantee. Right. And SBA loan requires a personal guarantee. It is what it is. It's just part of the package. I think a lot of people, it really freaks them out.

So we talked about kind of forgivable seller note as one way to kind of protect your downside. What do you say to people who are really uncomfortable with the PG? How, how as a buyer signing a PG, you know, what actually happens in work out? Like, at what point does the bank take your house? You know, like how do you, how should you think about downside as a personally guaranteeing buyer? Yeah, it's always a, it's a tough subject, but it's an important one because no one should sign that if they don't understand exactly what they're getting into going in. So what happens in a default situation? First of all, I will tell you this.

SBA loans are very generous on giving lots of runway to try to correct things. So if we have a borrower who is communicating with the bank, this is across all banks. The SBA sort of requires banks to give, you know, deferments and, you know, all kinds of things to kind of help the situation because the last thing the bank or the SBA wants to do is shut down what might otherwise be a viable business. That's not what anybody wants to ever see happen. So there's lots of opportunities to correct things and including kind of a short sales situation. So that can actually happen. Maybe the business is viable, but it's over levered. And it can be sold.

and I've definitely seen some of those happen. So lots of things that can be done before we get to the ultimate bad situation, which is default. We can't make the payment. So what happens there is if you've pledged real estate, if real estate you owned it at the time of the SBA loan and you pledged it, it does get liquidated. I know some people have heard the notion that it doesn't.

Unfortunately, that's not true. It does. There will be a notice of default filed and all the process. will be followed there. Some people will file bankruptcy to delay that. Some won't. Bankruptcy is not necessary, but it, you know, maybe for some people it may be the better choice to just consult your own counsel. And then ultimately, the bank has got a decision and the SBA in their liquidation groups. They're going to look at how much the loss is, you know, after they've liquidated any business assets, which, by the way, usually there is not much that comes from liquidating business assets

in a default situation. But they'll try to liquidate everything. Whatever the losses that's left, they're going to look at the personal guarantor and whether that person has the means to pay any of that. That means other assets, you know, liquid assets. If they decide, no, in my experience, most people do not. If they, if they've gotten to that point, they wouldn't have gotten to that point if they had more cash to put in earlier.

So often the cases that they don't. And so the SBA does something. that's called an offer in compromise. So if you want to Google that, there's wealth of information out there about what that looks like, but it's basically a negotiation. And it's either going to result in a one-time lump sum of a small amount, whatever the person's means are. Oh, interesting.

So it's kind of still on your tab if you ever want to borrow a day. If you want to borrow again, but it's not like you'll be pursued any further. And you as the borrower, you've pledged a bunch of collateral, you know, house, you know, stock portfolios, all that stuff. Do you have a choice as to which assets get liquidated? Can you say, don't take my house? I can satisfy the loss with this stock portfolio. Here you go.

Yeah. So the first thing is the bank, the SBA will never pledge anything, have anything pledged other than real estate. So they would never take a pledge of the stock portfolio or any other cash. So it's not pledged, but you might have it, right? So they could pursue it, but not through a direct pledge. And yes, you could. Absolutely.

That's the whole point of communicating with the bank. when things are bad is offering something. You know, if you have, you want to, you don't want to sell the house, but you have, you know, cash that you can offer instead, you negotiate that. So, so it is possible, you know, to avoid things if, if you've got other assets that you might be able to kind of bring into the situation. Yep. Okay. Cool. Well, we've talked a lot about what might go wrong, which I know you really like to talk about what Micah write a lot of times, right? Right. So I'd love to segue us a little bit into an example, right? So we've, we've, we've, brought a deal today. It's a, it's kind of an interesting one. I'll put it up on the screen if you're

watching us on YouTube. So I want to read this deal and kind of, Heather, get your take on it it from a lender perspective. So I'll read the deal here and then we'll kind of get your take. So this is a B2B e-commerce brand in the outdoor living products vertical, which I take to mean furniture as I read this. So it does $5.3 million in revenue. It does about one and a half million of EBITDA slash cash flow. And they are asking $6.9 million for it. So back of the envelope, that's about a 4.6x multiple. And it says the business has been around since 2010, 12 years in business.

It says that it is primarily a B2B business. So it says the brand has significant accomplishments in the niche space of outdoor living furniture. As a thriving B2B company, they've taken on some major clients, including big box giants, such as Target, Home Depot, Lowe's Walmart, and the shopping channel. They've spent more than a decade cultivating the support and appreciation of these major retailers, and they know their customers love the brand's outdoor and gardening products, which are made of decay-resistant wood.

In fact, their products sell in such high volume for the B2B clients that they have a 100% repeat order rate. That's pretty impressive. This has enabled them to push more aggressively for D2C sales through their Amazon platform, where they now offer 120 skews, which give customers plenty of variety when it comes to selecting the right products for their homes. I will keep scrolling down to just hit some of the most important parts here. All the products are functional, well-designed, attractive, and proven sellers. They are packed unassembled, RTA, which means ready to assemble, was easy to follow assembly instructions, IKEA style, I assume, inside the package, shiftful anywhere in North America

using a network of 3PLs, 120 skews, and they're launching new ones every year. They specialize in one-of-a-kind skews. The business was ideally positioned to benefit, not just from the rise in demand for outdoor living products, I assume during COVID, but the rise in the use of online means to buy these heavy products. From the start, their products were manufactured to offer homeowners a major advantage by creating outdoor living and small format storage and gardening products because they're made of decay-resistant wood. Their high-volume movers on Amazon have an average order size of $350.

Sales are strong throughout the year. They pick up considerably from March through July, and then again, at the holidays, these products are highly appealing for consumer shopping on Ryan from mid-range. would dismay resistant products for the home. It says they got two employees, and I have got to assume that most of the stuff is made in China. So Heather, you know, I kind of bring this deal to you. You know, what are some of the first questions you're asking as a lender?

Yeah. So the first things I'm thinking is this is probably a COVID tailwind, this current EBITDA, and I want to know historically, it's been around 12 years so we can really look back and see what happened before COVID and what happened since, I'd be worried now about discretionary consumer spending affecting them. So I would think that's going to flatten out to possibly shrink a little bit. I am a little concerned about manufacturing of anything in China just because of the geopolitical situation in the world and shipping.

So, you know, ocean shipping. So that would concern me lead times. And anytime we've got a deal where there's manufacturing. overseas, we're asking about whether there's alternate domestic suppliers in a case like this, I'm going to guess maybe not. So that might be a worry of mine. Two employees also kind of catches my attention because it feels like it could just evaporate pretty quickly. And that would concern me. A 4.6 doesn't sound bad on a 1.5 million EBITDA, but again, all those other factors, you know, and not knowing what the historical numbers are, I'm getting

a guess it's a little rich. Yeah. Okay. So I want to key in a little bit on your thoughts as a lender on kind of COVID bump trying to underwrite the last two years, right? Here we sit in in late 2020. Essentially the last two and a half years have been highly anomalous, right? And it's been anomalous in different ways for every industry, right?

You mentioned for this one, you know, a lot of people bought outdoor patio stuff over the last two and a half years because everybody wanted an outdoor living space, right? So you've probably got some weirdness or one-timeness on the revenue line, right? You've also got, if this stuff is heavy and it's coming from China, the freight situation has been bonkers, especially in 2021. It's been, you know, through the roof from $8,000 containers to $40,000 containers and now back again. So there's some really strange stuff going on on the cost line, too. So how is a lender, do you possibly, you can't go back in underwrite 2018, right? How do you possibly get comfortable with what this business is going to be like going forward?

This one's tough because of all those reasons. I definitely would think that the demand for this product is going to reduce for the fact that people aren't trapped in their homes anymore. They're back to doing other things. And they might just not be spending as much. Freight costs, yes, it went it went up. It went down. but, you know, it still feels like freight is going to be volatile going forward. So just a hard to, it means not stable, you know, so anytime a lender looks at something and says, gosh, it's not been stable and I can't really, I don't have visibility into the future very well.

It's very hard to put leverage on. And I like to make that point because it doesn't mean it's not a good company to invest in. It just may not be a great company to put leverage on because leverage is, lasts a long time and is stable. You have to pay us every month. Yeah, yeah. Regardless of what's going on. Yeah. So those are the kinds of things. And then seasonal, I heard that in there too. And so it's hard to structure debt around a seasonal business as well, right? We've got a lot of things to think about there. They're going to have to still make the minimum payment, but they're also going to have to make their operating, their fixed operating

cost. This one doesn't have very much with two people. But, you know, in other situations, we're going to look at what's the low period of the seasonality and what happens with their cash position during that period of time. A lot of times that means we're going to have to supplement that with a line of credit. And we have to do a lot of discussion during diligence to figure out what that right amount is on a line of credit. You never want to go into a deal, into buying a business and have to ask for additional working capital within the first year. That sends up red flags at a bank. And so you want to do it right the first time. And with a seasonal business, that can be challenging to figure out how to do it right. Yep. Because when you've got, if you sell a bunch in the

summer, you've got to do a load up of inventory, you know, in January. You got to probably pay your supplier, you know, unless you've negotiated really great net terms, you know, there's going to be a cash outlay. and the double whammy, right, is the cash outlay is during your slow period, right? So you don't have a ton of cash flow coming in and you've got to lay out this big amount of cash. And as you mentioned, the debt payments are the same every month. So, Heather, would you look at it and say, you know, the 1.5 debt service coverage ratio is out the window. I, on an annual basis, I need a, you know, what a different debt coverage curve or a coverage ratio in the low period, right? I got to make sure I underwrite you just to the low period and I don't even care about the high period.

Is that how a bank might look at it? We will do that. Yep, absolutely. We will look at some deals that way. The other thing about the outlay for the inventory, as you mentioned, let's just say the lead times get longer. We've all talked a lot about supply chain lately and all kinds of different deals. And so we can sort of say worst cases, our lead times get a lot longer. So now when are we having to lay out that cash earlier?

we're having to hold that inventory longer. All of those things will ultimately compress the margins. And I think inventory is a really interesting topic in a lot of businesses right now for that very reason. You can already see that the sellers are starting to carry more inventory for all those reasons. And so the buyer has to really be smart about, well, what does that mean about my future margins then if that's a permanent situation? We at one time thought maybe that was a COVID blip, but now we're seeing maybe the that holding more inventory is a permanent situation for a lot of businesses. Which kind of requires, if you're going to maintain a higher level of inventory,

it's not a huge cash delta. But you have to ramp to a higher level of inventory. That eats a ton of cash in the meantime. Correct. And even maintaining it, I mean, ramping for sure, it's exponential at that point. But maintaining a lot of inventory is expensive. It's warehouse space. You need to invest in maybe better inventory management systems.

so you're controlling it better. You have the risk of obsolescence, you know, something when, you know, out of model or whatever it might be. So there's just greater risk in carrying more inventory. That's why the world went to just in time in the first place. But now it looks like, you know, with de-globalization, that's not really going to be something we're going to be able to sustain. Interesting.

So you mentioned a line of credit. So for me, you know, when I think of, you know, okay, I'm going to do an SBA loan. That's my senior debt. I've probably, maybe I got to. seller note behind it, as we've already discussed, I kind of would assume a line of credit in addition to all that would sort of be off the table. Your cap stack's already pretty loaded, but you're shaking your head like, oh, no, it's totally possible. How does that work? Like, how does the bank get comfortable with that? How is it structured? Yeah, good question. That's an important one. So,

we always provide a line of credit at close. It's available immediately after close. So it's not funded at close. That's the key here. But there's always going to be a line of credit available in all of our deals. So how we do it is it's not considered part of the deal financing if it's not funded at close, right? So there's still usually going to be networking capital included in the deal. So there's that piece is on the balance sheet. There's some liquidity there. But we want to have a line of credit available for the regular operating needs. And it should be a revolver. It's not something where they should draw it down and, you know, use it as permanent it working. Right. So we're analyzing, you know, in each deal, what is the cash cycle of this business?

You know, what are the different expectations we can have around seasonality, around inventory, all of those things. And that's how we're coming up with the right size of the line of credit. And this is a good time to plug the quality of earnings providers for small deals. They do help a lot in determining the working capital needs. They help determine the right amount of networking capital in their work. And they also show us kind of the variance so we can see the size of the line of credit that might be needed. Because once again, we want to, we want to err on the side of maybe too big of a line of credit than ever too small of a line of credit because you don't want to come back to the well and ask for more, you know, shortly after closing a deal. So quality of earnings

providers can be really helpful in getting the lender on board with the line of credit need. Interesting. So it's going to be less about debt service coverage rate. ratio, that's going to be about the funded debt at close. And it's going to be more about kind of what is the cash conversion cycle here. What are the payment terms from suppliers? How fast is it sell? Payment terms from customers, seasonality. So it's almost separate from the month to month debt service coverage. Absolutely. Yep. It is definitely a separate analysis. But an important one. And also, we will even factor in growth. So if you've got growth plans, that can impact what size line of credits you're going to need as well.

Okay. So I think it's worth me saying, and I don't know, Heather, tell me if this is just my experience, but in talking with you today, this strikes me as a significantly higher level of sophistication than many SBA lenders in the country have. You know, I've talked to more SBA lenders than I can count, and a lot of them will say, oh, like, no seller note at all, or it has to be full standby, or no line of credit. or no line of credit. It seems to me as you talk, or cap at $5 million a hard max.

I know Live Oak does kind of that plus loan on top of to upsize the SBA facility. It seems like, and you did not pay me to say this. It seems like, am I right in saying that the lender that you choose for an SBA loan can significantly impact kind of your options for deal structuring? because there's like a base level of what you've got to do, but the creativity level is much greater than I'd sort of expected to hear above and beyond kind of your vanilla SBA loan. Yeah. Well, thank you for saying that because that is really our value proposition is that we want to be

part of the deal team, meaning, you know, another set of eyes, not just the second set, but another set of eyes to really help you think about the deal and what is the right way and the best way to structure it. I think you find a lot of SBA lenders in the space today. were busy doing real estate loans for most of their career. That's where the SBA volume has been done in owner-occupied real estate. And a lot of them are still learning, to be honest, how to do small business acquisitions. And they're not doing a very sophisticated analysis.

And they're applying a real estate mindset on one hand, like loan to value. And on the other hand, even worse, I think, is they're applying, here's what the SOP says, the standard operating procedure of the SBA. Here's what the rules say. The rules aren't designed to keep you safe. The rules are, I don't even want to say what they're designed to do because they're very tangled up kind of government rules, you know. But just because the rules say so doesn't mean it's a good idea.

And within those rules, you can still be somewhat creative so that you can structure things in a way that's safe and sound for you and for the bank and, you know, for you to really focus on what you're buying the business for, which is developing out your growth plan or your professionalization plan for the company, not being distracted by worries about your debt. Yeah. Awesome. And, you know, the thing that comes to my mind is, you know, as a seller, right, you generally think of the bank as a buyer relationship, right?

The buyer brings their bank, arranges their financing. But I'm thinking about it, you know, from the seller side, bringing a creative lender, you know, like a Live Oak Bank to the deal is likely to help you get more total consideration as the seller because things are on the table like you can put a seller note on it. You know, the buyer doesn't have to use working capital out of the SBA at close financing. They can get a line of credit, so which leaves more proceeds available to you, the seller. So it seems to me like seller should care about bringing a savvy lender to market also. What's the dynamic there. Like, are, are, are, is live looks usually brought by the buyer and they can't talk to the seller?

Because they're buyer's fiduciary. Like, how does it kind of work, you know, or sure, if you're taking a business to market, should you go and be like, Heather, I want you to be the bank for the buyer I don't know. And, you know, how does that work? Well, you're touching on a subject. I'm, I'm, I'm, I'm thinking in my head, how am I going to just say it? I'm going to just say it. So here, so it's kind of a, yeah, this is sort of the underbelly of the SBA business. my practice with my partner Lisa Forrest is a buyer-focused practice. We get all of our business as a buyer advocate and on the buyer deal team. We don't get our business from brokers or sell side.

Most of the SBA world does get their leads there. And I'll tell you, I'm not going to say it's all bad. It can be good like you described. It could be like, hey, let's bring a good lender in. But unfortunately, what it's become is this. The sellers, brokers, often not all, are getting paid a referral fee from the bank for the buyer's loan. So it's not necessarily a relationship that is aligned with the buyer, if you know what I mean. So it, unfortunately, that is most of the deal volume is done that way.

And I think it's sort of does the buyer. I think it does everybody a little bit of a disservice because it doesn't bring the alignment that would bring about these more creative solutions and kind of really thinking things through and structuring things in a sound way. And it creates a lot of friction and it wastes a lot of time. So I'm a big advocate of if you're a buyer, this is the reason we have the channel the way we do. If you're a buyer, select your bank on your own, not through the seller's broker.

The seller's broker is representing the seller. and when you negotiate, you are on different sides. I mean, you can be collaborative, and there are great brokers out there. So I don't want to say that they're all not good. They are of many very good ones and very, you know, high integrity. But there are others who are just looking to get the deal sold at the highest price. And again, maybe they're applying a real estate mindset rather than a safe and sound kind of quality approach. So buyers, I'd say buyers beware.

And, you know, select your deal team, whether it's your lender, or your lawyer or your QV provider such that they're aligned with you in terms of their interests and that they can provide quality feedback to you on the deal. It's really important. That's really interesting when you think about the incentives at play, right? So if you're buying a business, right, and seller has already got a bank, it's SBA pre-approved, which you've said on prior podcast is not a thing. But if it's if it's SBA pre-approved, well, that really means is seller has a relationship with bank or seller broker has a relationship with bank and they're going to make a fee on you borrowing from that bank. That's what that really means.

So you as buyer, I mean, I would think, you know, especially in a competitive process, you may have the ability to bring a more creative bank, more creative lender and say, no, no, no, this is my lender. But because my bank is part of the deal team and they're going to give me a line of credit after close and finance a little bit differently, I might be able to pay more for the, the same asset, you know, assuming it's still pencils, right? Because if you've got all of the other people bidding against you using sellers lender, right, who may not be as creative, they're only going to be able to go so high, right? Or they might not be able to use a seller note or they might not be able to, you know, you have a line of credit after close. You could use as buyer and a line

bank, you know, as a weapon to win the deal against the other bidders, is how I'm thinking about it. I don't, you can definitely use an aligned bank as absolutely on your side. to win a deal. And I think instead of it may, meaning that you could pay more, it means greater certainty of clothes, to be quite honest. This is the key, right? So if I'm aligned with the seller's broker, I am, I have less incentive to ask hard questions up front, right? I don't want to make him mad or, you know, whatever. I don't want to disrupt that relationship. So I'm going to let my underwriters do that. And that's going to be four to six weeks down the road. And this is a lot. And this is a is a very common experience for a lot of borrowers. So I have the salesperson, I'm not really

vetting the deal too hard up front because of that relationship. If you work with a buyer's lender, that's the opposite. We don't want to waste our time. We don't want to waste our buyers' time. We're going to ask all the hard questions at the front so that now we know we actually do really like this deal. And if we win this LOI, we will get it funded. So something that we do is we pre-vette pre-LO deals for our buyers. That's part of our process. They're bringing us pre-LOI deals. They put it together in templates that we taught them how to put together. And we're giving them feedback. So it's very different from if I'm a seller's lender where I wait for something to be under LOI before I really spend much time on it. I'm actually spending time before that to make sure it looks like something that

is going to be a fit for us. So I think that's an advantage. Absolutely. Awesome. That makes a ton of sense. Well, Heather, I got to wrap this up because we could go on all afternoon. But I want to give you a chance at the end. How can people, if they were entertained or interested or their interest is peaked by this episode, what's the best way to get in touch with you and start a conversation with you? Just reach out to me at Live Oak Bank on our website and register for our office hours or send me an email, Heather.enderson at Liveoak bank. It's liveoak.

Awesome. And you guys, I think you have office hours occasionally, right? We have an office hours every Wednesday. and every Thursday it's four buyers, and we walk you through the frequently asked questions on Wednesdays. And on Thursdays, we actually walk you through the templates, the cash flow model, the M&A questionnaire, and the deal memo that we use to pre-Vet deals. So yes, you're welcome to join us any Wednesday and Thursday. Awesome. And where can people find you on Twitter? We've got a lot of Twitter listeners. I'm Heather Anderson on Twitter, at Anderson, Heather, I believe. And yes, I love

Twitter. I love talking to you all there as well. Awesome. Well, Heather, thanks so much for being with us. You are now my three-time favorite guest, number one, two, and three. No offense for other guests, but I love learning, nerding out on all the deal structuring stuff. So thank you for being here. It was really great. Thank you very much.