Frozen dollars, free dollars

Disclosure: This is my personal interpretation of how the SBA guidelines read with the new SOP that is going into effect on October 1st, 2026

Starting October 1, every dollar an investor puts into an SBA acquisition lands in 1 of 2 piles.

Frozen dollars

Pay your investor tax money and nothing else until the SBA loan is gone.

Free dollars

Can pay a pref and profit distributions starting in year one.

I’ve spent more time on this one rule in the last 3 weeks than on anything else in SOP 50 10 8.1. It’s come up on searcher calls and independent sponsor calls. It’s the open item on a file we have in closing. And it’s the reason I was up building an investor model for a buyer last Thursday night.

The rule reads simple. Picturing it on a real cap table is the hard part. So I took 1 made up deal and ran it all the way through, from sources and uses to the day the business sells, using the investor model we’ve been building for clients (grab a copy here).

It’s a long one. If you’re raising outside money in the next 12 months, give it 15 minutes. It’s a lot cheaper than finding this out from your investor after closing.

Part 1: The Rules

4 pieces of the new SOP drive everything below.

Rule 1. Your 10% gets split into 2 buckets.

Rule 2. Investor money used for the 10% is frozen.

Rule 3. Investor money above the 10% is free.

Rule 4. Passive investors stay under 20%.

Each rule is simple on its own. Stack all 4 on 1 deal and the math gets weird fast.

Part 2: Meet Sarah

Sarah is a first time buyer. She ran operations at a building services company for 11 years, and now she’s buying a commercial HVAC business in the Midwest.

It does $15 million in revenue and $1.25 million of adjusted EBITDA, backed by a Quality of Earnings report. The seller wants $5 million (4x). The lender’s valuation comes back at $5.2 million, so the price holds up.

Sarah has $275,000 of her own cash for the deal. After she writes that check, she still clears the bank’s post close liquidity bar.

Mike, her old boss, wants in for $625,000. He’s asking for an 8% preferred return plus his share of profits.

The seller will carry $600,000 of notes. And the bank will lend $4 million on a 10 year SBA 7(a) at Prime plus 2.25%, which is 9.25% all in with Prime at 7%.

Here’s how the deal gets built, one step at a time.

Part 3: The walkthrough

1. Add up what the deal actually costs

Buyers miss this constantly. Working capital, the guaranty fee and the third party reports added $500,000 to Sarah’s deal. And that $500,000 needs its own 10%.

2. Figure out the 10%

$5,500,000 (total project cost) × 10% (minimum injection) = $550,000 (Sarah’s required injection)

Sarah doesn’t already own or work in this business, so her deal is an Initial Acquisition. On an Initial Acquisition, the lender can’t reduce the 10% or waive it.

3. Split the 10% in half

Half must come from unlimited sources

4. Sarah covers her half

She writes the $275,000 check. Her half is covered, with exactly $0 to spare.

5. Decide who fills the other half

This is the decision that drives everything after it. Sarah has 2 ways to fill the other $275,000.

Path A: the seller goes on standby. The seller puts $275,000 of her $600,000 note on full standby. No principal and no interest for the life of the SBA loan. Interest can accrue (6% in the model) and gets paid once the SBA loan is gone. The other $325,000 pays normally over 10 years.

Path B: the seller gets paid on everything. She wants payments on all $600,000. So Mike’s money has to fill the gap.

Same total seller financing. Same cash from Sarah and Mike. The only thing that moved is whether $275,000 of the seller note sits on standby.

6. Sort Mike’s money into piles

Now run Mike’s check through Rules 2 and 3.

In Path A, Sarah and the standby note hit the 10% before anyone counted Mike’s money. Every dollar he put in sits above the requirement. All $625,000 is free.

In Path B, the first $275,000 of Mike’s check goes toward the 10%. That piece is frozen until the SBA loan is paid off. The other $350,000 is free.

That’s how we read the rule. The SOP doesn’t spell out how to split 1 investor’s check, so ask your lender how they’ll read it on your deal.

7. Set the ownership

Mike put in 69% of the equity cash. Split ownership by dollars and he owns 69% of the company.

Rule 4 kills that. At 20% or more, Mike signs an unlimited personal guaranty on a $4 million SBA loan for a business he doesn’t run. He won’t, and I wouldn’t ask him to.

So Mike owns 19.9%. Sarah owns 80.1%.

This is where investor conversations get uncomfortable. The bigger check owns the smaller piece. The pref is how you make that fair (more on that in Part 5).

8. Check the bank’s math

The lender measures coverage on the $1.25 million of QoE adjusted EBITDA.

Both paths clear the 1.25x floor for an Initial Acquisition with room to spare.

Look at what the standby note does for the bank, though. A payment that doesn’t exist can’t drag on coverage. Path A carries $36,637 a year less debt service, and that’s a big reason lenders like standby paper.

9. Pay the taxes first

Tax distributions go out before any pref or profit. Every investor gets them, frozen or free, every year.

$802,000 (taxable income) × 19.9% (Mike’s share) × 37% (tax rate) ≈ $59,000 (Mike’s tax distribution)

That $59,000 pays Mike’s tax bill, and that’s all it does. So I left tax distributions out of every return number below.

10. Pay Mike in year one

Mike’s 8% pref on $625,000 is $50,000 a year.

Path A: All $625,000 is free, so the full $50,000 pref goes out in cash. After Sarah’s share, there’s room for about $24,000 of profit distributions to Mike. Year one: about $74,000.

Path B: Only the free $350,000 earns a cash pref. That’s $28,000. The other $22,000 accrues and sits on the books. His profit distributions drop to about $10,000, because the share tied to his frozen money stays in the company until payoff. Year one: about $38,000.

11. Run it forward 7 years

Here’s Mike’s cash for every year of the hold, tax distributions excluded.

The gap never closes. It widens. Path B pays Mike $36,000 less in year 1 and $58,000 less by year 7.

12. Sell the business in year 7

By year 7, EBITDA is about $1.64 million. Sarah sells at 4x for about $6.6 million.

The sale pays off the SBA loan. That’s the day Mike’s frozen money thaws and his accrued pref gets caught up.

Path B actually pays Mike more at the exit. With the SBA loan gone, his accrued pref ($154,000) and the profit distributions held back on his frozen money ($150,123) finally come out. The residual is bigger too, since there’s no standby note to pay off.

(Both paths also carry a $100,000 reserve the model holds back in year one. It’s in the cash line, along with the $304,123 the company held for Mike in Path B.)

13. Add it all up​
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On paper, Path B pays Mike about $17,000 more. He just waits 7 years for $304,000 of it, and that’s why his IRR is lower.

Part 4: What Sarah’s deal teaches

The cash gap is bigger than the IRR gap. 2.5 points of IRR sounds like nothing, and Path B even wins on total dollars. But Mike collects $349,000 less while he waits, and his profit distributions get cut in half.

For a lot of individual investors and family offices, that annual check is why they said yes.

Path B leans hard on the sale. Mike only gets caught up because the business sold. So I reran the model with Sarah holding all 10 years.

Path A pays Mike about $1.13 million over the hold. Path B pays about $598,000. His frozen $275,000 sits the whole decade, and his IRR drops to 19.7% versus 22.8%.

Standby costs Sarah real money. This is the part people skip. The note accrues at 6% for 7 years and all of it gets paid at the sale: $413,498 on a $275,000 note. Sarah walks away with about $3.03 million at the sale in Path A and about $3.29 million in Path B.

That’s roughly $251,000 less at the sale. She gets most of it back along the way, because Path A carries $36,637 a year less debt service and about $181,000 more of that cash reaches her during the hold. Net, standby costs Sarah about $70,000 of her own upside to keep her investor paid and her raise closable. I think it’s usually worth it. Just know the price before you ask.

More buyer cash is the other lever. If the seller won’t do standby, Sarah can shrink the frozen piece with more of her own money.

Part 5: Paying your investor when the step up won’t fit

A buyer I talked to last week wanted to give his investors a 2x step up to make up for the lockup. The instinct makes sense. If they can’t get cash for years, give them more of the company.

Run that on Sarah’s deal and Mike owns 139% of the company. Smaller investors hit the wall too. Someone who puts in 12% of your equity dollars lands at 24% on a 2x step up, and now they’re a guarantor.

So the ownership lever is mostly gone. The pref has to carry the load.

Here’s what the pref rate does to Mike’s return in Path A, everything else held constant:

Every 2 points of pref adds a little over 1 point of IRR. And it never touches his 19.9% ownership, so he stays clear of the 20% guaranty line.

Now the exit multiple, same Path A setup:

A full turn of exit multiple moves Mike’s IRR a bit more than 4 points of pref does. Show that to the investor who’s nervous about paying 4x going in.

Part 6: Your operating agreement is now an underwriting document

2 more pieces of the SOP change how you paper the deal.

First, your lender has to review every investor’s terms and write them up in the credit memo, including what happens when the business sells. (Para. C.2.a.ii.b.iii(b), p. 352) Your waterfall, your pref, your exit terms and any drag along or tag along rights are underwriting now.

Second, free dollars are only as free as your bank lets them be. The lender can require a coverage covenant, in the loan agreement or your investor agreements, before anything beyond tax distributions goes out. (Para. C.2.a.ii.b.iii(d), p. 352)

I set that test at 1.25x in the model, and Sarah clears it every year. On a tighter deal she might not, and then Mike’s free dollars wait too.

We have a file in closing right now where the operating agreement is the open item for exactly this reason. It needs distribution language the lender will sign off on, and the loan docs can’t be drawn until the cap table and investor terms are final.

Start that work after the commitment letter and it can eat weeks of attorney time.

Part 7: What to do before you raise a dollar

Here’s the order I’d work it in.

1. Build your real total project cost. Working capital, guaranty fee, QoE, valuation, closing costs. Your 10% comes off this number.
2. Make sure you can cover half the 10% yourself, in unborrowed cash, and still clear your lender’s post close liquidity bar.
3. Ask the seller about standby before you sign the LOI. Offer interest that accrues at a real rate, and show the seller the number they’ll collect at payoff.
4. Model how much investor money ends up frozen, and show your investors that number up front. They’ll find out anyway.
5. Keep every outside investor under 20%, and pay them for the lockup through the pref.
6. Keep redemption rights and puts out of the investor docs for as long as the SBA guaranty is in place.
7. Have your attorney draft the SBA distribution language now, alongside the investor docs, so the operating agreement is ready before the lender asks.
8. Ask your lender 3 questions early: How will you read the frozen and free split on my deal? What distribution covenant will you require? Do you want to review the operating agreement before or after the commitment letter?

Thanks for reading!

If you're working on an acquisition, or are in the pre-LOI phases, you can book a short, informal call here to meet our team and learn how we can help you.

For pre-LOI buyers ready to explore opportunities: Schedule a meet & greet call​

Already have a deal under LOI and need financing help: Schedule an LOI consultation​

Independent sponsors on a non-SBA deal (pre-LOI): Schedule a financing call with Rafael​

Independent sponsors with a deal under LOI: Schedule an under-LOI call with Rafael​

Until next time,

Matthias Smith

President, Pioneer Capital Advisory

​www.pioneercapitaladvisory.com​
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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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