Upcoming Event

For those of you in the Madison area, and for anyone who will be at Rice this fall: I'm moderating a panel called "So You Bought a Business, Now What?" at the Rice Business Acquisition and Entrepreneurship Conference on October 16th. If you're going, find me. I want to hear what your deal looks like on the other side of October 1st.

Missed the webinar?

Chris Barrett of Midwest CPA and I ran a session on the new guidelines last Wednesday. 132 of you showed up live. The recording is now up on our YouTube channel, and it covers the equity injection changes, the coverage test, and the loan term math in more depth than I can fit here.

​Watch the replay here​

Your QoE Now Works for the Bank

There are 31 days left before the rules change.

Most of the conversation I've had with buyers over the last two weeks has been about the down payment. Half of your 10% has to come from you personally, in cash you didn't borrow.

This new rule is going to reshape who can buy a business in this country.

But the change that's going to catch people flat footed on their own deal is somewhere else. It's one subsection of Appendix 15 that says any acquisition priced at $3 million or more now requires a Quality of Earnings report, and that the report belongs to your lender. Not to you.

I've read that section a dozen times since the SOP dropped on August 14th. I'm still not sure the market has priced it.

Let me walk you through it.

A story from this week

Two partners (the buyers in this deal) are acquiring a manufacturing division that's being carved out of a larger family owned group. Purchase price is right around $7 million. (Details changed on this one for anonymity, as always).

Their bank is racing to pull a loan number before September 30th so the deal gets underwritten under today's rules. To do that, the bank needs a business valuation and a Quality of Earnings report formally engaged before the number is issued.

So the buyers went and did the responsible thing. They hired a QoE firm a few weeks ago. Wrote a check for $20,000. Sat through 90 minute management interviews. The report is nearly done.

Here's the problem. That report was engaged by them, for them. If the loan number doesn't get pulled by September 30th, the deal falls under the new rules, and the new rules say the report can't be used.

If that happens, they'll spend an extra $20k on the new report, plus delay the deal and potentially annoy the sellers with a second set of interviews.

What the rule actually says

Straight from the source:

And then the most important line:

This is stronger than what most people are repeating.

The SOP goes past saying your own QoE won't satisfy the requirement. It says the required report may not be prepared for you at all. The professional standards world takes that language seriously. Scope of work, intended user, and reliance are the three things every engagement letter defines up front, and the SOP just told the profession that you are not the intended user.

The sell side QoE sitting in the data room is dead on arrival for this purpose too.

Does your deal even need one?

Three tests, and the order matters.

Test one: what kind of transaction is this? Initial Acquisitions and Business Expansions are subject to the requirement. Owner Buyouts and ESOP or Cooperative deals are exempt, and the SOP says why: the existing owners already know where the bodies are buried.

That exemption is worth understanding, because it creates a genuine structural difference between buying 100% of a company and buying into one alongside a seller who stays.

Test two: what's the business purchase price? Not the loan amount. Not the total project cost. The purchase price, measured before you apply a dollar of equity, seller debt, or any other financing source.

You cannot structure your way under $3 million. A $3.4 million business with a $600,000 seller note and $340,000 of buyer cash is still a $3.4 million purchase price. It needs a QoE.

Test three: is there real estate in the deal? If so, subtract the appraised value of the property from the contract price first. A $4.2 million deal with a building appraised at $1.4 million is a $2.8 million business purchase price, and it falls under the threshold.

That real estate carve out is the one legitimate lever in the whole test, and it isn't a loophole. It's just how the SOP defines the number.

The part that changes your deal team

Here's my actual concern, and it isn't about cost or timeline.

Today, when you commission a Quality of Earnings report, you get a phone call. The partner walks you through what they found. They tell you the things that never make it into a written report: that the owner's son is on payroll at $140,000 and does nothing, that three of the top ten customers haven't ordered since March, that the December revenue spike looks like channel stuffing. That conversation is often worth more than the document.

Starting October 1st on any deal at $3 million and up, that conversation happens with a credit analyst at a bank.

I keep coming back to this. You're taking a member of the deal team away from the buyer, and I think the buyer's independent financial diligence is fundamentally important. If the QoE provider is giving qualitative feedback to an underwriter instead of to you, is the buyer going to learn those same things? I have no idea, and I've asked around enough to be confident the answer doesn't exist yet.

There's a version of this where it works fine. Banks share the findings, buyers get the report, and the change is mostly administrative. There's another version where a buyer closes on a business with a customer concentration problem that the lender's QoE flagged in a paragraph the buyer never read.

Ask your lender now, before you're under LOI, whether their policy is to share the full report with the borrower. Get the answer in writing. Some will say yes immediately. The ones who hesitate are telling you something.

What has to be in the report

This is not a light document, and if you've only ever seen a two page "quality of earnings summary" from a regional firm, adjust your expectations.

The SOP requires the analysis to reconcile four separate sets of books down to one normalized earnings number: the accountant prepared financial statements, the tax returns, the internal financial statements, and the IRS transcript data.

It requires a Cash Proof, which the SOP defines as a reconstruction of cash receipts and disbursements that ties bank statement data to the income statement and the tax return for each period under review. It has to be performed on a trailing 12 month basis and on the last two fiscal years. Its stated purpose is finding unreported income and undisclosed expenses.

It requires every add back and adjustment to be identified and documented, and the SOP names the categories it cares about: non recurring revenue or expenses, above or below market owner compensation, related party transactions, deferred maintenance, and accounting methodology differences between cash basis and accrual basis reporting.

And it requires an assessment of revenue quality: customer concentration, contract continuity, and whether the existing revenue and margins are likely to survive the sale.

That last requirement is going to be uncomfortable for a specific kind of seller. If a CIM claims 99% recurring revenue and there isn't a single signed contract behind it, the QoE now has to say so, in writing, to the lender.

I watched exactly that happen on a deal this month. Sell side QoE, commissioned by the seller, and it came back showing the recurring revenue claim didn't hold. That was before the rule even took effect.

Sellers with clean accrual books will sail through this. Sellers running cash basis books with heavy personal add backs are going to feel it.

Where the QoE actually bites

Almost everyone is bracing for the wrong impact.

The panic I keep hearing is about debt service coverage. The hurdle goes from 1.15x to 1.25x, it has to be met on historical numbers, and now the lender is required to use the QoE earnings figure in that calculation. So buyers assume the QoE is going to blow up their coverage.

Run the math on a normal deal and that mostly isn't what happens.

Take a $3.5 million acquisition, no real estate, priced at 3.5x on a broker's adjusted EBITDA of $1 million. Total project cost of $3.6 million with working capital and fees. Ten percent down is $360,000, so the loan is roughly $3.24 million.

At today's Prime of 6.75% plus 2.75%, that's 9.50% on a 10 year amortization. About $155,000 of annual debt service per million borrowed, so call it $503,000 a year.

Now the QoE comes back at $875,000 instead of $1 million. A 12.5% haircut, which is a completely ordinary result when somebody actually ties the bank statements to the tax returns.

Coverage on the new number is 1.74x. It clears 1.25x with enormous room.

The problem is somewhere else entirely.

The SOP says the business valuation must support the purchase price regardless of how the debt is structured, and if the amount paid exceeds the valuation, the difference must be made up with equity. It also refers, in the equity injection section, to the value "supported by the Business Valuation and Quality of Earnings report."

So the appraiser is now working downstream of a verified earnings number. At the same 3.5x, a $875,000 earnings figure supports $3.06 million of value on a business you agreed to pay $3.5 million for.

That's a $437,500 gap, and it has to be filled with equity at the closing table.

Three ways to fill it, and you should know all three before you sign an LOI:

Re-trade the price to $3.06 million. Cleanest outcome, hardest conversation, and the one your broker will fight hardest. It's also the honest one if the earnings genuinely weren't there.

Put the gap in as a seller note on full standby. The SOP explicitly contemplates this: additional limited equity sources may be used when the sales price exceeds supported value, and those funds must be on full standby. No principal, no interest, for the life of the SBA loan. Ask yourself whether your seller will really agree to $437,500 of frozen paper on top of everything else.

Write a bigger check. For most buyers this is theoretical.

The point is that the coverage test is a floor most deals clear. The valuation is a ceiling, and the QoE is now what sets it. Price discipline on the front end just became the whole game.

The timing mechanic, and why September matters

If your lender is processing under delegated PLP authority, the business valuation and the QoE must be formally engaged at the time the SBA loan number is issued. Formally engaged means a vendor is retained and an engagement letter is in place. The reports themselves can land afterward, before closing, with the credit memo updated once they arrive.

Which is the whole reason the last month before October 1st looks the way it does.

The loan number is the gate. Once the number is pulled, the deal is underwritten under the rules in effect at the time, even if it closes in November. The Titanic is going down, the lifeboat is right there, and the only question that matters for the next 31 days is how you get in the boat.

Two things you should know about that boat.

PLP authority is bank specific. Not every lender has it, and not every lender with it will use it aggressively. Some banks hold approval until underwriting is fully done. Others are willing to pull a number preemptively and cancel it if the deal dies. Those banks exist, we work with some of them, and they are fewer than you'd hope.

The lifeboat has a hole in it if you change the deal. If you modify the loan after the number is pulled, adding a guarantor, restructuring the cap table, changing the loan amount, it goes back through. And when it goes back through, it goes through under the new SOP. Get your cap table settled now, not in October.

One more piece of the September dynamic worth naming. If your lender is a publicly traded bank, September 30th is also quarter end. Valerie and I both spent years inside that machine, and the drumbeat in the last two weeks of a quarter is real. Right now those two incentives point the same direction. Use it.

What happens to the QoE market itself

A few open questions I've been chewing on, and I'd rather give you my honest guesses than pretend I know.

Price is going to move, and I'm not sure which way. Buyer commissioned QoE work in this market runs $15,000 to $25,000 for a deal in the low single digit millions. I've seen $20,000 quoted from a regional firm and $60,000 from a national one on the same engagement. Once the bank is the client, the bank has the negotiating leverage, and a Live Oak or a Huntington ordering hundreds of these a year is going to push on price. The counter pressure is capacity. Every acquisition at $3 million and up in the 7(a) program now needs one, all at once, from a finite number of qualified firms.

The provider panels don't exist yet. Each bank is going to develop a list of QoE providers it works with. Those lists don't exist publicly. Which means the same deal, same financials, same buyer, could produce a different normalized earnings number and therefore a different supported valuation depending on which bank you take it to. I have no idea how wide that spread will be. I'd like to.

The deliverable isn't standardized. The SOP describes what the report must contain, but "Quality of Earnings" is not a defined term of art with a single professional standard behind it the way an appraisal is. Expect the first quarter of this to be messy.

I'd flag one more thing. The SOP says the out of pocket cost of the required financial due diligence reports can be passed on to the borrower, and that anything you spend on those reports counts toward your equity injection. That's a genuine piece of good news, and it's easy to miss. On a $3.5 million deal, $20,000 of QoE cost is about 5.5% of your required injection.

What I'd do this week

If you're under LOI at $3 million or more and your lender has PLP authority, the only thing that matters is whether the valuation and QoE get engaged before September 30th. Call your lender today and ask, in those words, whether they intend to pull a loan number this month and what they need from you to do it. If they can't answer clearly, that's your answer.

If you're under LOI and the loan number won't happen in time, stop optimizing for speed and start renegotiating your LOI. You need diligence period language that survives a lender ordered QoE, and you need a price adjustment mechanism if the normalized earnings come in materially below the marketed number. Your attorney will know how to write it. Most LOIs signed this summer do not contemplate any of this.

If you're pre LOI and shopping above $3 million, add $20,000 and three to four weeks to every deal model you build. Then go ask the seller one question before you write an offer: are your books on a cash basis or an accrual basis, and are they prepared by a CPA? The answer tells you most of what you need to know about how a Cash Proof is going to go.

And regardless of where you are, consider commissioning your own scaled back diligence anyway. Not the SOP report, which can't be prepared for you. A separate, narrower engagement focused on the things you actually need for your own decision making and for the closing table: the net working capital peg, the add back schedule, and the customer concentration picture. It costs less than a full QoE, it protects you in the negotiation, and it means you're not learning about the business secondhand from your lender's credit file.

SBA is holding office hours through September. If you have a question about how this works in practice, that's the room to ask it in.

The 60 second version

• Any Initial Acquisition or Business Expansion with a business purchase price of $3 million or more needs an independent Quality of Earnings report starting October 1st. Owner Buyouts and ESOPs are exempt.
• The $3 million test is measured before equity, seller debt, or any other financing. You cannot structure under it. Real estate is subtracted at appraised value first.
• The report must be conducted for the benefit of the lender, and the SOP says it may not be prepared by or for the borrower or seller. Your QoE and the sell side QoE both fail.
• It requires a Cash Proof tying bank statements to the income statement and tax returns, on a trailing 12 month basis and the last two fiscal years.
• The real risk isn't your coverage ratio. It's the valuation. If the QoE earnings support less value than your agreed price, the gap gets filled with equity or a full standby note.
• Under PLP, both the valuation and the QoE only need to be formally engaged when the loan number is issued, which is the whole reason the next 31 days matter.
• Modifying the deal after the loan number is pulled sends it back through under the new rules. Settle your cap table now.
• What you spend on the required reports counts toward your equity injection.

The valuation used to be a box the lender checked after you'd agreed on price. Starting October 1st on any deal at $3 million and up, somebody independent is going to reconstruct the seller's cash and hand the number to your bank before the number is handed to you.

Price your deal like that's already true, because in 31 days it is.

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​
​

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.

Thanks for reading. Feel free to reply directly to this email with any questions or thoughts.