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What usually goes wrong in the underwriting and closing process of selling a business?
Hmm, where do I even start?
Deals can fall apart for a thousand different reasons. I've put together a list of the most common landmines I see that derail SMB acquisitions, specifically from the buyer's perspective.
I've broken these into two different categories: Challenges during the underwriting process, and challenges during the post-approval/closing process.
This is not an exhaustive list at all, but these are the most common, fixable mistakes I see:
Challenges in the Underwriting Process:
- Poorly Written Business Plans Many business buyers come from prestigious business schools and know their numbers and all the business fundamentals. However, these business plans can often feel too much like sterile business school reports (or investment presentations), and not a real-world business plan written for an SBA lending institution that wants to understand how you as the buyer will operate the business and what specific value-add factors you specifically bring the the table as the acquisition entrepreneur.
Do you understand which factors drive growth in the business? Are you conveying that you understand how to actually run this business in your written plan? Addressing critical factors such as the organizational chart, a detailed competition analysis, and also what changes (if any) you as the acquisition entrepreneur intend to make post-acquisition are all mission critical.
- Lack of Financial Preparedness Being unprepared to answer financial questions can cause significant delays. For example, if you're buying an HVAC business and its revenue is down 15% from last year, you need to be ready to explain the reasons for this decline. Underwriters will scrutinize financial details, so you better know what you're talking about.
Having either an understanding of basic accounting and/or financial statements will be most helpful for you as a business buyer. If you come from a non-finance / MBA / banking / consulting background, it may be helpful to have someone on your deal team that can help with interfacing with the SBA lender bank to answer questions in a way that the underwriter can understand. There are some phenomenal resources online that you can also utilize to brush up on financial knowledge including Kahn Academy's general overview of financial statements.
- Incomplete Equity Raise Not having the equity raise finalized can halt the underwriting process. You must know who will be in the ownership group and how much each investor is contributing. Banks often require this information before issuing a commitment letter to ensure the buyer can secure the necessary funds.
Many lenders won't even bother attempting to work with you if you don't have this part worked out yet. Every bank has different requirements when it comes to this. Some banks are willing to start the underwriting process before your ownership group and cap table are finalized, but be prepared to have this information ready.
- Lease Agreement Issues If the business operates from a leased location, ensure the lease term matches the loan term. For instance, if the lease has only four years remaining but the loan term is ten years, you'll need to negotiate an extension with the landlord. Failing to align the lease term with the loan term can be a red flag for lenders. The specific requirement as defined in the SBA's guidelines is that the "lease term, including renewal options exercisable only by the Borrower, must equal or exceed the term of the loan."
Banks have some latitude to use discretion here, for example, if the business that you're acquiring has a leased location that isn't mission-critical to the operations of the company (for example - a software business where the majority of the workforce works from home). Pioneer Capital Advisory recommends as a best practice to ask the sell-side broker to validate lease terms before submitting an LOI and to validate with your SBA lending institution that there are no issues on the lease situation to ensure that you avoid any potential issues during the deal process about the lease agreement.
- Business Licensing Complications Service businesses are extremely popular to purchase right now. However, buyers often forget that many of these businesses rely on a license to operate. For businesses in trade sectors like HVAC, plumbing, or electrical services, having a qualified license holder is essential. If the seller holds the license, you'll need to ensure a smooth transition to maintain operational compliance.
Frequently, SBA lending institutions want to see that someone else within the business (not the seller) can qualify the license unless you are doing a partial change of ownership acquisition with the seller remaining in the ownership group following closing. The rationale here is that while you may be able to legally have the seller as the qualifying party without them retaining equity, they are not really involved in the business if they're being completely bought out and you as the buyer do not want to be dependent on them from an operational standpoint.
Post-Approval and Closing Challenges:
Even after securing underwriting approval, several factors can complicate the closing process:
- Landlord Agreement Delays Securing a landlord agreement is critical when buying a business that operates from a leased location. The lender wants to make sure that (1) the landlord is okay with the buyer taking over the business and continuing to run it, and (2) the lender will need permission from the landlord to access the business and take assets if the buyer defaults on the loan.
One observation from past deals that Pioneer Capital Advisory has helped buyers with is that the landlord agreement can be one of the sticking points with getting the deal closed. This is one of the top 5 items that can make or break a deal. If you are working on an acquisition where the seller is not going to be the landlord, and there is a "third-party" landlord that owns the building, it is important to get the landlord agreement form in front of the landlord as soon as possible to ensure that it isn't a point of contention with the deal.
We have previously seen the situation where in dealing with national landlords (think large national companies that own lots of investment properties), you may have to deal with multiple layers of approval within the landlord's organization and there can be lots of back and forth redlines and requested changes to the landlord agreement before the document is finalized.
- Surprise Liens or Judgments Have you checked for liens or judgments against the seller? The lender will, so if you haven't already addressed how these liens/judgments impact the deal, then your acquisition will fall apart here. The best practice recommendation that Pioneer Capital Advisory recommends is to utilize any publicly available websites to you to do initial diligence on the sell-side of the acquisition pre-LOI. For example, if the business and seller reside in a state that allows you to search for UCC filings, criminal court records, and similar for free -- do a search on both the seller individually and the entity name to see if anything major pops up. Consult with your M&A attorney to obtain their perspective on if any diligence items showing up in your findings will be problematic.
- Disagreements on Working Capital It's pretty common for both parties to "punt" the discussion on working capital until the end of negotiations, because both usually assume that it will be an easy calculation and they'll easily come to an agreement. This is a mistake.
You'd be surprised at how often there are significant agreements on what the proper net working capital figure should be. Discuss it early in the process to make sure you're at least in the same ballpark as the seller by establishing a target range. This is something that your financial due diligence provider should be able to help with. The range helps level set expectations, presenting a "best case" and "worst case" scenario for what the working capital need of the business may be. It's okay to head into the closing process with a slight disagreement, but a large discrepancy can kill the deal. Disagreements on working capital post-loan approval are one of the top 5 reasons that Pioneer Capital Advisory has observed deals dying and not getting closed.
- Down Payment Documentation Issues Adequate documentation of the down payment is crucial, especially when the down payment will come from investors. The SBA and banks require proof of funds, including bank statements and evidence of large deposits. Ensure all documentation is accurate and readily available to avoid delays.
While the SBA guidelines on down payment documentation and the duration of equity seasoning recently changed in the most recent version of the SBA's lending guidelines, most SBA lending institutions are expecting to see 3 months of bank statements from any person contributing funds towards the down payment including the month of closing and the two prior months.
Bottom line, a lot can go wrong!
As the buyer, you should be anticipating potential issues that the lender will ask about. If you haven't even thought about that specific issue and have no answer, your deal could be killed by that one mistake!
Lenders will expect you to have your plan and funds ready to go at closing. Be ahead of the game!
Upcoming Events:
- Pioneer Capital Advisory will be collaborating with Rand Larsen and Eric Pacifici of SMB Law Group to host a business buyer / ETA meet-up that will be taking place in Madison, Wisconsin on Friday, September 13th. The venue has not yet been determined, but it will likely be in downtown Madison. If you're interested in attending the event and want more details, please feel free to drop me an email at matthias@pioneercap.com
Conferences:
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As a business buyer/searcher, one of the most useful things that you can do is to attend conferences in the ETA space to learn more about what goes into operating a business after closing, raising equity capital from investors, SBA lending, financial due diligence, and much more. Below are some conferences that are coming up this fall along with the registration links for each.
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