Before we dive in, a quick note:

I have a business called SMB Business Plans, and my business partner Joe Thomas will be speaking at the Entrepreneurship Through Acquisition Conference at the University of Minnesota on November 15th in Minneapolis. To find out more info and reserve a ticket, click here.

What SBA Lenders Want to See for Seller Note Requirements in Business Acquisitions

When you’re structuring an SBA 7(a) loan for a business acquisition, seller notes often play a pivotal role in bridging the gap between what the buyer can afford and the seller’s asking price.

However, to ensure that everything moves forward smoothly, it’s essential to understand what SBA lenders expect when seller financing is involved. Often times, seller financing agreements are too shaky for SBA lenders to rely on. I'll show you how to structure your seller financing like a pro.

I highly recommend making seller financing a part of your deal. Besides the benefits for buyers, there are notable benefits for sellers, including the ability to defer capital gains taxes.

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Matthias Smith, CEO - Pioneer Capital Advisory LLC @SBA_Matthias Your expression when your SBA lender asks you why you skipped getting a seller note in your deal structure 6:38 PM • Jun 18, 2024 0 Retweets 12 Likes Read 1 replies

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Today, we’ll dive deep into the specifics of what SBA lenders require, how the Standby Creditor’s Agreement works, and why including seller financing might be a win-win for both buyers and sellers.

1. The Importance of the Seller Note in SBA 7(a) Loans

Seller notes are commonly used in SBA 7(a) loans, particularly for small to medium-sized business acquisitions. Essentially, the seller agrees to loan part of the purchase price to the buyer, making the deal more feasible for buyers who might not have enough upfront capital to cover the entire cost.

For the seller, it’s an opportunity to collect income for the some time after the transaction. It can also help the seller defer taxes (more on this later).

But here's where to be careful: SBA lenders are specific about how these seller notes should be structured.

At the core of these requirements is the fact that seller notes must be subordinated to the SBA loan. This means that in the event of a default, the SBA loan gets repaid first, and only after that is the seller entitled to repayment.

2. Understanding the Standby Creditor’s Agreement

To formalize the subordination of the seller note, the SBA requires the use of a Standby Creditor’s Agreement. This document ensures that the seller agrees not to receive any payments until the SBA loan has been satisfied. Without this agreement, the lender won’t approve the SBA loan.

This agreement also details other critical terms, including what happens if the seller receives payments in violation of the standby agreement. Specifically, the seller must hand over any such payments to the SBA lender within 15 days. The agreement protects the SBA’s interest and ensures that the seller’s claims don’t interfere with the borrower’s ability to meet SBA loan obligations.

3. Full Standby for Two Years

The SBA typically requires that seller notes be placed on full standby for at least the first two years of the loan term. During this period, the seller is not allowed to receive any payments, whether principal or interest.

Why?

The SBA wants to ensure that all available cash flow is directed toward repaying the SBA loan, especially in the critical early years when the business is adjusting to new ownership.

This requirement is formalized through the Standby Creditor’s Agreement, which lays out that the seller will accept no payments until the SBA loan is fully satisfied (or until the lender authorizes payments after the two-year period).

4. Partial Standby: Another Option for Sellers

While full standby is the norm, some lenders may allow a partial standby, where the seller is permitted to receive interest-only payments during the initial two years. However, no principal payments can be made during this period, ensuring that the SBA loan remains the primary obligation.

The Standby Creditor’s Agreement will specify these terms if partial standby is approved, and it will include the agreed-upon interest rate. This option can provide sellers with some post-sale cash flow while still complying with SBA guidelines.

5. Taking Action Against Borrower Collateral: Not Without Permission

Another key element of the Standby Creditor’s Agreement is that the seller is restricted from taking action against the borrower’s collateral while the SBA loan is still outstanding. This means the seller cannot seize business assets, like equipment or inventory, in the event of a default on the seller note unless they receive written permission from the SBA lender.

Why is this important? It ensures that the SBA lender maintains control over the borrower’s assets, which are often critical to securing repayment of the SBA loan. This protection is vital for the SBA’s ability to enforce repayment in case of default.

6. Aligning the Term of the Seller Note with the SBA Loan

Another requirement from SBA lenders is that the term of the seller note should match or exceed the term of the SBA loan. For instance, if the SBA loan has a 10-year term, the seller note should also be structured with at least a 10-year repayment schedule. This alignment ensures that the business isn’t overburdened with multiple large payments too soon.

Matthias Smith, CEO - Pioneer Capital Advisory LLC @SBA_Matthias One of the common questions that I receive from business buyers is on seller financing While not an SBA requirement, most banks want to see the amortization of sellers notes match the same term/amortization of the SBA 7(a) loan which is 10 years if you're buying a business… https://x.com/i/web/status/1818026601898205529 3:51 PM • Jul 29, 2024 0 Retweets 4 Likes Read 3 replies

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By matching the terms, the seller note helps reduce financial pressure on the business, allowing it to focus on repaying the SBA loan first. The Standby Creditor’s Agreement plays a role here by ensuring that the seller note is structured in a way that doesn’t put undue stress on the borrower’s cash flow.

7. Interest Rates on Seller Notes: Keeping It Reasonable

While the SBA doesn’t mandate a specific interest rate for seller notes, lenders will expect the interest rate to be reasonable. Typically, seller notes carry interest rates in the range of 5% to 8%, but this can vary depending on the specifics of the deal.

The Standby Creditor’s Agreement will document the interest rate, especially if a partial standby is involved where the seller receives interest payments during the initial two years. A fair and manageable interest rate helps ensure that the business isn’t financially strained by the seller note.

8. Seller Financing’s Tax Benefits: Deferring Capital Gains Taxes

For sellers, one of the often-overlooked benefits of providing seller financing is the ability to defer capital gains taxes. When the seller receives installment payments over time rather than a lump sum at closing, they can spread out the recognition of capital gains, potentially reducing their tax liability.

According to IRS Publication 537, sellers who use the Installment Sales Method can defer taxes on the portion of the sale proceeds received in each year, which might allow them to stay in a lower tax bracket. This strategy can make seller financing more attractive, as it reduces the immediate tax burden and allows the seller to manage their taxes over time.

9. Debt Service Coverage Ratio (DSCR): Protecting Cash Flow

A critical metric in SBA loan underwriting is the Debt Service Coverage Ratio (DSCR), which measures the business’s ability to cover its debt obligations with its operating income. A seller note that isn’t structured properly can negatively impact the DSCR, making it harder for the business to meet its obligations.

The Standby Creditor’s Agreement helps protect the DSCR by ensuring that payments on the seller note are deferred, giving the business more room to focus on repaying the SBA loan. This is especially important in the early years of ownership, when cash flow may be unpredictable.

10. Seller Notes Can Count Toward Buyer’s Equity

In some cases, seller notes can count toward the buyer’s required equity injection for the SBA loan, but only if the seller note is fully subordinated and placed on full standby for at least two years. This flexibility can be a huge advantage for buyers who might not have enough cash on hand to meet the SBA’s equity requirements.

The Standby Creditor’s Agreement ensures that the seller note meets these requirements, allowing it to be included as part of the buyer’s equity contribution.

11. Documentation is Everything

When it comes to seller notes in SBA deals, documentation is key. Every detail of the seller note—its subordination, standby provisions, interest rates, and repayment schedule—must be clearly outlined in the Standby Creditor’s Agreement. Without this, the SBA lender will not approve the loan, and the deal could fall apart.

Make sure that everything is thoroughly documented to avoid any delays or complications during the loan approval process.

Wrapping It Up: Seller Notes, Standby Agreements, and Tax Benefits

Seller notes are a valuable tool in SBA-financed business acquisitions, but they need to be structured carefully to meet SBA guidelines. The Standby Creditor’s Agreement plays a vital role in protecting the SBA’s interest and ensuring that the business can focus on repaying the loan.

And for sellers, there’s a major bonus—deferring capital gains taxes through seller financing can make the deal even more appealing.

Whether you’re a buyer or seller, understanding how to structure the seller note correctly is crucial. By working closely with your lender, accountant, and legal counsel, you can ensure that the deal goes smoothly and benefits all parties involved.

About Pioneer Capital Advisory LLC

Pioneer Capital Advisory LLC is a boutique commercial loan brokerage firm that helps buyers of small to medium-sized businesses navigate the SBA 7(a) financing process. Our firm has successfully closed deals for buyers across a wide range of industries, including HVAC, background check companies, landscaping, and much more. Importantly, we are paid by the SBA lender banks after closing, not by the buyer directly, making our services both valuable and cost-effective for buyers.

Disclaimer: The information in this newsletter is for informational purposes only and should not be considered legal or financial advice. Business buyers are encouraged to consult with their legal counsel and accountant to ensure the proper structuring of their transactions and to fully understand the tax implications of seller financing.

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