Royce Yudkoff:

Welcome to Think Big, Buy Small, a podcast from Harvard Business School about entrepreneurship through acquisition. We’re your hosts, Royce Yudkoff…

Rick Ruback:

…and Rick Ruback.

Royce Yudkoff:

Today we're speaking to Heather Endresen, who is a deeply experienced lender of small business administration loans.

Rick Ruback:

Heather led the SBA lending activity at Live Oak Bank. Now she does something even more special and more helpful for searchers. She helps searchers find the banks that are most appropriate for them for their SBA loans.

Royce Yudkoff:

This is an important topic for acquisition entrepreneurs because the Small Business Administration Loan Program, or SBA loan program, offers acquisition entrepreneurs an extraordinary opportunity to buy a company with little or no equity, and on very advantageous loan terms. Rick, do you want to talk about a couple of the loan terms that are particularly attractive, in addition to the fact that the loan is set up to require only a small amount of equity from the acquirer?

Rick Ruback:

SBA loans are such an important part, particularly for self-funded searchers. And the reason is the large amount that the SBA is willing to lend and the fact that the loans don't have any covenants. For our listeners who are unaware of what a covenant is, a covenant is an agreement that you make with your bank that says, “I'm going to run my business in a particular way and meet particular financial terms.” Usually, those covenants are pretty binding. With an SBA loan, there's no covenants. And the SBA loans are ten years. Most commercial loans have a maturity of about five years. So, the SBA allows you to run your business, as long as you make the payments, without interference for a decade.

Royce Yudkoff:

Let's speak to Heather Endresen.

Rick Ruback:

Heather, it's great to have you on our podcast, Think Big, Buy Small.

Heather Endresen:

It is exciting to be here.

Rick Ruback:

Heather is the absolute guru of small business administration lending. Heather, why don't you tell us about your journey?

Heather Endresen:

It is great to be here with both of you. So, I started in banking way over thirty years ago, if you can believe that. I started at the bottom, while I was going to school as a teller and kind of worked my way into the SBA lending group of this small bank and ended up really loving it. And in the early years, I worked with only people who already started their business. There was no business buying back then. And then about 12 years ago, I transitioned into what I felt was like a much more exciting space, which was SBA loans for people buying businesses. And it was still pretty new. It has changed a lot over these last 12 years, and it has been a super rewarding journey because I've helped hundreds of people buy their first business. And that is just an exciting process, you know, to take someone through shopping for a business, figuring out what it's going to take to get the financing when they find something, how to look at it from the bank's perspective, and ultimately close a deal. That's a many months long process where you really get to know your client, and it's just very, very rewarding, and so that's why I've stuck around doing it so long.

Royce Yudkoff:

And Heather, Rick and I know that you've spent a lot of years as a lending officer at a leading SBA issuer, forming loans and processing that, and then, more recently, you formed your own business to help people find the right lender. Tell me and Rick a little bit about what is involved now in your role in the SBA ecosystem.

Heather Endresen:

Yes, so about a year ago, I left banking and became an entrepreneur myself, starting Viso Business Capital. And what we do now is, we're a loan brokerage for folks who are going to use an SBA loan to acquire a business. So the model that we use today at Viso is to help people shop for the right lender for their deal. You know, there's over one hundred SBA lenders out there, there's probably a good forty to fifty that really like these business acquisition deals. But when you have a deal under LOI, you're not going to be a fit for all of them, and they're not all going to be able to offer the best terms and service based on your deal, so what we do is help people save time and figure out which banks are going to be the best ones for their deal for them. And the beauty of our business model is that it's paid for by the banks. The banks are paying us for the loans at close, at their own expense, and they're not passing it on to the borrower, so the borrowers get basically a free debt coach when they come to us. And I used the same system I used before, which is educating before they have assigned LOIs, so they know how to make the offers in a way that will be financeable, and then take them all the way through the rest of the process when they're ready.

Royce Yudkoff:

The people you work with, are they typically first-time buyers of companies or is this for repeat buyers who have a lot of experience?

Heather Endresen:

It's mostly first-time buyers that are using the program. There are some folks who are coming back as a veteran buyer, either for an add-on or they've exited another business and they're starting over again. But most of the clients that we work with are first-time buyers, so they're folks that come out of your ETA programs, like at HBS, and there's mid-career searchers who learn about this possibility and kind of want to escape corporate without having to go start up a business. But the vast majority of all these people are first-time buyers, and it is a good program for a first-time buyer because a lot of the features are just much easier. There's less equity required, there's a longer amortization, and it's a pretty homogenized loan program, which I think also makes it really good for a first-time buyer because you kind of learn the rules and the way things work, and you know what to expect. Outside of SBA, things get a little more loose and creative, I guess, and so for a first-time buyer, it's kind of nice to be in those confines, I think.

Rick Ruback:

Heather, can we take a step back? You explained this when you kindly came to class this year, as you've done for the last decade or so, but first of all, small business administration is SBA, right?

Heather Endresen:

Yes.

Rick Ruback:

Tell us a little bit about what the small business administration is and does, and why they lend money.

Heather Endresen:

Yeah, so it is a government agency. I think it's been around since the '50s, and they have other things that they do, like AA certifications for minority-owned businesses. There's a lot of other things the SBA does, but in regard to the loan programs, what they do is they lower the risk for the banks so that banks will be encouraged to lend to small businesses, because obviously the more banks lend to small businesses in this country, the stronger the economy, the more tax revenue, it's good for the entire ecosystem. So, they do that, they reduce the risk by guaranteeing a percentage of the loan that the bank might make. So if the bank is going to be making a $1 million SBA loan, the SBA is going to guarantee 75% of that. So, they make a $1 million loan, they're only at risk on $250,000. It is a pro rata risk situation, not a first-in-last-out kind of situation, but let's just say there's no collateral and the loan goes bad right away. Hopefully, this never really happens, but the loan goes bad right away, so the bank is only going to lose $250,000 and the government, the SBA, is going to step in and take the other $750 off the bank's books. So, they're able to lend with lower risk.

That guarantee also does something else that's really important: it gives the banks more profitability in this program, or faster profitability is a better way to say it. So what happens is, most of the participating banks are selling the guaranteed portion, that's $750,000, in a secondary market to investors. The investors are taking, you know, very little risk because it's the guaranteed portion. The only risk they're taking is pre-payment risk, and so they're paying a premium for that, because the note rate is so much higher than where treasuries trade, and the banks are getting those premiums, they’re taking those into income. And so, it's really important that people know that because of that, the program is one of the most profitable loans that a commercial bank can offer, and that's why we have so much competition and so many lenders out there that are eager to work on your loan. It's very profitable. It's one of the great public-private partnerships I think that I've ever seen, in all the different mechanisms that it kind of encourages banks to lend.

Rick Ruback:

Yeah, that's really helpful. And for the borrower, what are the limits? What's the deal for the borrower? So, if I'm going to go out and buy a company, what are the limits on the SBA loan? What does the SBA loan require of me?

Heather Endresen:

There's no minimum loan size that the SBA dictates, but what you find is banks will set their own minimums because it's expensive to process. There's a lot of compliance that has to go on for a bank to put one of these loans on the books. So, you'll find banks will set the minimums at around $250,000 or $350,000. They won't want to go much below there, especially for business acquisition, because it's pretty time-consuming. So that's the lower limit. The upper limit is five million, and we've been stuck at that, I think since about 2009. And there's a lot of people talking like, “When is the SBA ever going to raise that limit?” And they really should consider doing that because there is kind of a no man's land forming when the deals are too big for SBA, but too small for conventional. And the answer to that is, it won't get raised until Congress does it, it needs to be done by Congress, so who knows? But that's currently the upper limit, it's $5 million, and it's kind of per personal guarantor. It's a little more nuanced than that, but the way to think about it is, you know, if I'm personally guaranteeing a $5 million loan, I'm tapped out until I pay it off. If I pay it off or pay it down, I can free up more availability. If I personally guaranteed a $1 million SBA loan, I have $4 million of runway left. That's how the $5 million works.

Rick Ruback:

And tell us a little bit about the personal guarantee, because you snuck that in and that's sort of one of the amazing parts of this and most interesting parts of this.

Heather Endresen:

Yeah, I was hoping nobody would notice the personal guarantee part.

Rick Ruback:

You just slid it in there!

Heather Endresen:

That's the hardest part about the whole deal, is there's a lot of good things about an SBA loan but the hardest part to get comfortable with if you're thinking about doing it is that you have to give a personal guarantee if you're going to own more than 20% of the business. And at least one person always has to personally guarantee every SBA loan, so if it was widely held cap table, still one person would have to personally guarantee, and it would usually be the operator. So that personal guarantee is a full, unlimited personal guarantee for the whole loan amount, regardless of the fact that the SBA is covering some of it for the bank, you're guaranteeing the whole thing as an individual. You might even have to directly pledge real estate collateral, if you have personally owned real estate that has 25% or more equity and you own it just yourself or your spouse, that has to be pledged. So, the personal guarantee is something you have to take very, very seriously. It really is very meaningful, obviously. Outside of that, you know, the rest of the terms are actually pretty favorable and pretty friendly to the borrower, but yes, there is a full personal guarantee on the line.

Royce Yudkoff:

You know, Heather, just focusing on the personal guarantee, or PG, for a moment more, Rick and I often see at the small end of loans, even when you go for a conventional bank loan, a non-SBA loan, that a conventional bank will ask for a personal guarantee and generally drop that requirement as the loan size gets larger. And we've always thought that that's because what the bank is really concerned about is the key man risk, that things go poorly, what's to stop the entrepreneur from giving up and walking away from the whole thing? And the answer is, the personal guarantee stops that. So, would it be fair to say that if you're buying a smaller small business, that you're likely to be asked for a personal guarantee, whether you have a conventional bank loan or an SBA loan, but as you get to a larger size acquisition, the conventional bankers will usually drop that requirement, but the SBA loan is very fixed on that, from $250,000 to $5 million, you're always going to have that PG. Is that a fair description or would you disagree?

Heather Endresen:

That is totally fair. Yep, that's right. Small business, in general, you can assume it has a lot of key man risk. I think that's the way banks look at it, and that's generally correct. And so, whether it's an SBA loan, or you are able to get a local bank to do a non-SBA loan, which is not easy to do for a small deal, but if you are able to do that, they're still probably going to have a personal guarantee for that very reason. And up market, where you might have some conventional lending, you know, the business is more professionalized, there's a management team hopefully in place, and therefore, the key man risk is less and the personal guarantee is less important to a bank.

Rick Ruback:

Royce, the SBA loans just seem sort of magical and yet some people are very hesitant to take advantage of that magic, mainly because of the personal guarantee.

Royce Yudkoff:

Well, Rick, as you and I always discuss, signing any personal guarantee is a subject for sober consideration, but there are ways to minimize this risk if you decide to go ahead with an SBA loan. And I'd say the first of those ways is to make sure you're buying the kind of enduringly profitable business we describe across all our episodes. These kinds of businesses aren't a total guarantee that something bad won't happen, but they stack the odds in your favor. What are some of the other things that we've talked about that make it less risky to sign a personal guarantee?

Rick Ruback:

I think it's helpful for our listeners just to think about the challenges that a loan provides, any loan, but particularly an SBA loan. Suppose you buy a business for a million dollars, you pay $4 million for the business, you get a seller note for say a million dollars, and you take, I don't know, what do you think, Royce, a $2 million, $2 .5 million SBA loan?

Royce Yudkoff:

Yeah, two and a half million.

Rick Ruback:

Okay, so two and a half million and interest rates are a little higher now. So, let's say 10% for easy math. So, at two and a half million dollars, we're just going to do this math roughly, even though we're finance professors, at two and a half million dollars, you take two and a half times 10%. So that's $250,000 a year in interest payments, right? And there’s some amortization, so maybe there’s $300,000 a year, your first year. We could work it out, but it's around between $300 and $350, something like that, right, your first year's payments. And so, if you think about your business, your business has a million dollars of pre-tax profit. And, of course, you pay your interest and principal out of that pre-tax profit. So, your cash flow would have to fall below one third of the cash flow that the seller was able to generate before you get in trouble with the SBA.

Royce Yudkoff:

That's a lot of headroom and a lot of protection, and also increases the odds that you're not going to get in trouble. It comes from the SBA's long amortization period, long repayment period, compared to what commercial banks will offer, that allow the annual repayments to just be not that big.

Rick Ruback:

And compare that to a commercial loan where if your profitability falls by two thirds, you're going to have lots of covenant violations, lots of concerns. The bank can recall the loan. None of that will happen if you have an SBA loan, as long as your cash flow doesn't fall below a third of what you bought it at.

Royce Yudkoff:

You know, I agree with all of this and I think there's some additional cutting and trimming you can do to increase your safety in using an SBA loan. One of those is that you don't need to keep this loan for the full ten years. In other words, as you start to pay down the loan and perhaps the cash flows of your business grows due to your hard work, your amount of debt relative to the value of the business will go down and you can eventually become eligible, maybe by year four or year five, you can become eligible to refinance this loan out and replace it with a conventional bank loan, which has no personal guarantee. The terms won't be as good as the SBA loan, but one of the things you can chuck is the personal guarantee. So, you can think about it as something you're working on for four or five years, not a full ten years.

Rick Ruback:

But Royce, one of the things I think is interesting with that example you gave is that when you could refinance to a commercial loan, you've got so much headroom because your business has grown and you're so much further away from defaulting on just those interest and principal payments that the personal guarantee is like the scent of a problem, not a real problem.

Royce Yudkoff:

I knew you would say that because we're finance professors and that's a true fact. But of course, some people are just uncomfortable having a personal guarantee, but totally agree, those later years, the risk has just been reduced. The world would be a better place if everyone listened to finance professors.

Rick Ruback:

Yes, especially our families, you know, but anyway.

Royce Yudkoff:

Especially our families. Two more quick things on this. You know, one risk reducer is you can choose the amount of SBA debt you put on the business. While the SBA will go up to 90 or 95% of the value, and there's a lot of good reasons to take as much SBA debt as you can, you can clip it back and replace those dollars with investor money that you bring in or a seller note, which makes the likelihood of having a deficiency to the SBA lower.

Rick Ruback:

That's right. That's right. It's a max, not a min. You don't have to take all of the debt you can, but there's certainly reasons why you want to because the more debt you raise, the less equity you'll need to raise, and the less equity you need, the less you're sharing any gains you get with your investors.

Royce Yudkoff:

And now let’s go back to our conversation.

Royce Yudkoff:

We've been talking about this sort of sober consideration in an SBA loan, which is the personal guarantee. Should we ask Heather about what the favorable attributes are, like, why do an SBA?

Rick Ruback:

Yeah, the joy, the ten years, the no covenants, all that stuff.

Royce Yudkoff:

Yeah, give us all the appealing aspects of the SBA loan relative to a conventional loan, and why people should be interested in that.

Heather Endresen:

There's so many good comparisons. One is just the limited amount of equity. That's a really big plus of the program, that the SBA will allow lenders to lend up to 90% loan-to-value, but the new SOP even goes beyond that. There are loans being done now at 95%, even higher, a little bit higher than that, if there's a favorable seller note in place to account for some of the equity requirements of SBA.

Rick Ruback:

So slow down. So, if I buy a business – Royce, you're the math guy here on these numbers anyway -

Royce Yudkoff:

Thank you, Rick.

Rick Ruback:

If I buy a business that has $1 million of EBITDA – earnings before interest, taxes, depreciation, and amortization – and I buy it for $4 million, how much can I actually borrow against that? Can I borrow 95% of that?

Heather Endresen:

You could. Under the new SOP, the SBA updated it last fall and they said that seller notes could stand in for more of the 10% equity than they used to allow, so technically, the SOP now says you could have a seller note that stands in for all of the 10%. However, there are no lenders, no banks that really want to do that, so they don't go that far.

Rick Ruback:

So that means, if I bought a business for $4 million, is my math right, I only need $200,000 of actual equity?

Heather Endresen:

That's correct, you could do it that way.

Royce Yudkoff:

Because at the maximum amount of borrowing, Heather, the SBA would lend you up to 90% of that, so 3.6 of the 4, you'd have a seller note for $200,000 and then you'd have your own equity for $200,000, and that totals the $4 million, and that's how much an SBA loan would permit, but it would permit that.

Heather Endresen:

Correct, as long as the seller note, in that case, was on a two-year standby and had no balloon payment after that, standby meaning no payments. So there's some conditions on how that seller note would have to be structured if you're not going to put the full 10% equity in.

Royce Yudkoff:

Right, so the interest would accrue for the first two years and not be paid in cash, and then be paid in cash.

Heather Endresen:

Correct.

Royce Yudkoff:

And then, I suppose, just to round this out, if you weren't seeking such a big SBA loan as a percent of the purchase, then they'd have less requirements on the seller note, they’d have less limitations on the seller note.

Heather Endresen:

Right.

Royce Yudkoff:

Okay, I got it.

Heather Endresen:

Then you're wide open to what kind of amortization and terms you would want to put, if you're putting at least the 10% down. So yes, that's the first big advantage of the SBA program, is the amount of leverage that you can get. Now, keep in mind that you don't want high leverage if your multiple isn't reasonably low and the business isn't reasonably stable, right? So, it's not like everybody should run out and go for the maximum leverage. That doesn't always make sense, but it's nice that it's available when it does make sense. You know, occasionally I'll see a deal where the purchase price is low threes, you know, as a multiple of EBITDA, or even a little bit below the threes, in the twos. Then you can sort of see where a higher leverage loan might make sense, at least from a debt coverage perspective.

Royce Yudkoff:

And Heather, this compares to a conventional loan where, generally, a bank making a conventional loan would want the loan to be about half the value of the company. It would never go up to like 90% or 80%, right? That's the compare and contrast that Rick and I should be thinking about?

Heather Endresen:

That's right. There's one other rule of thumb I like to use with my clients, just kind of back of the napkin math, and that is, at today's rates, on a 10-year amortization, assuming a 10% seller note over five years, you can afford about 3.75 times adjusted EBITDA in SBA debt. It could go up to four if the business is more stable, but the simple rule of thumb is 3.75. So if I'm looking at a million dollar EBITDA company and I'm going to go with the plain vanilla structure of 10% equity, 10% seller note over five years, how much SBA debt can I get? About $3.75 million. You'll have good debt coverage and lots of lenders who will be able to lend if you use that rule of thumb. It's a good place to start when you're thinking about deals and how much you can pay, and how much equity you might have to bring in.

Rick Ruback:

Yeah, yeah, yeah, but let's go back to the other example where I'm putting in only 5% equity. I'm going to buy this business for $4 million, I'm going to have a seller note which is going to accrue, and I'm only going to put in $200,000 of equity. So if I make $1 million, I'm borrowing....what did you say, Royce, 3.6?

Royce Yudkoff:

3.6 in senior from the SBA, yes, and then $200,000 in seller note, but that's on standby, so 3.6.

Rick Ruback:

Right, so 3.6. So, let's do the math. I have $1 million of income. What's my interest on $3.6 million these days?

Heather Endresen:

About ten and a half, we'll say ten and a half.

Rick Ruback:

Ten's so much easier to multiply.

Heather Endresen:

Sorry, okay, ten, ten.

Rick Ruback:

So, it's like what, $360,000?

Heather Endresen:

Well, no, that's not the way payments are calculated in SBA. They use mortgage amortization method.

Rick Ruback:

Ah okay, so they're equal payments over the ten years.

Heather Endresen:

Mm-hmm, correct, so it's P and I.

Rick Ruback:

So, it's going to be a payment like $400, $425,000, something like that, right?

Heather Endresen:

Yup.

Rick Ruback:

When I first started teaching finance, we used to teach people how to do those things, now they just have calculators. So, you get $1 million, you take out $425,000 that I pay the SBA, and that means I have $575,000 in profits. I have to pay my taxes on that, of course, but it's a pretty good income.

Heather Endresen:

Yeah, exactly. That's why it works.

Royce Yudkoff:

Particularly because the entrepreneurs' equity that they've put in is only $200,000, and they're making $575,000 a year.

Heather Endresen:

That's right. As long as, you know, you do your diligence and that is the cash flow that you're really getting, I think that's part of the challenge here, is making sure that the EBITDA is what you think it's going to be. But absolutely, the economics are fantastic.

Rick Ruback:

This is magical. $200,000 and I get to triple my income in my very first year and then I don't have to put another $200,000 in and I get that $600,000 every year, and if I grow, it gets even better. The other thing that's so special about the SBA that I don't think we've talked about is covenants. Do you want to talk a little bit about that?

Heather Endresen:

A typical conventional loan will have covenants and they will be financial ratios that you must maintain, and if you don't maintain them, you are in default. Even though you're making your payment, you know, you're paying the bank, you're still in default because you've exceeded the maximum leverage ratio they may have set for you or the fixed charge coverage, which is sort of the cash flow coverage ratio, that they may have set for you. Sometimes they'll even have a liquidity minimum, you have to keep X amount of cash on this balance sheet at all times, etc. So, it creates some confines, which can not only result in a technical default when you're still paying, but it also limits you in terms of what you can do, obviously, with the cash that is coming in. You may want to spend more on growth but your covenants won't let you, so you have to be more conservative with your spend, and things of that nature. So that's what covenants are. The best thing about the SBA loan covenants is there aren't any because the SBA doesn't want the participating lenders to declare technical defaults and, you know, for example, shut down a small business that employs a lot of people in a community because of a technical default. The SBA doesn't want to be in that business, and so they won't allow a lender to declare a technical default. Therefore, there are no covenants. The only kind of, sort of covenant there is that you've got to provide quarterly financial statements and annual tax returns, but that's not really a financial covenant.

Rick Ruback:

That's it?

Heather Endresen:

Yep, that's it.

Rick Ruback:

And if you put your commercial banker hat on just for a second, covenants are usually set, in my experience, so it's about a 5% bump. If revenue dropped by 5%, you would hit your covenant. Is that about right?

Heather Endresen:

That's about right. It depends on the deal going in, how conservatively levered it is. But they don't give you much room, so yes, a small downturn can result in a technical default of a covenant breach.

Rick Ruback:

Yeah. And Royce, I wonder what your experience is, but mine, from our board work together and others, talking to our class guests, is I would get the sense that maybe half of the people who have conventional loans feel constrained by their covenants? Maybe more?

Royce Yudkoff:

Yes, I agree with that, Rick. I think that, first of all, it's something that they always have to keep in mind as they make business decisions, you know, how much they're going to invest or spend on the business. They have to be very watchful of those covenants, and I think over half the time, the covenants are tight enough that that's a real priority in how they make decisions. So, this is a big benefit to have this long period in which to pay off the loan and no covenants, just being required to make the payments.

I have a question, Heather, which is, you've described to us that mostly you're dealing with first-time buyers, and you've described in response to Rick's questions that a buyer can finance up to 95% of the purchase with a small note from the seller and a big SBA loan. And so, in Rick's example, they're buying a $1 million EBITDA, or pre-tax profit, business for $4 million. They're putting up $200,000, they're making like, $500,000 or $600,000 after loan payments. These first-time buyers that you deal with, where do they come up with the $200,000? That's a tiny amount to put up relative to the purchase of the business, but $200,000 is, you know, a goodly amount of money. As you look at the population of borrowers you've dealt with, where do they get that piece of the cash need for the transaction?

Heather Endresen:

That's a great question. So, there's options there too, which is really nice. Some of them, of course, more the mid-career type of searcher, might have the cash. And if they don't have it in savings, they are also able to sometimes use what's called a ROBS, R-O-B-S, and it is where they can use their IRA money and directly invest it into the business without any tax penalties. So sometimes you have that scenario, but you have over half, I would say, of my clients like to tap into value-add equity investors. Sometimes they also use friends and family, but I'd say more often, it's usually value-add equity investors who are serial small business investors. This is something that has really evolved a lot over the 12 years that I've been in the space, the availability of those types of investors and the amount of equity that's interested in the space has really, really grown.

So, the SBA does allow a client to use a little bit of their own money, and lenders like to see some of it coming from the person who's personally guaranteeing the loan. But then the rest of it could come from investors, and so you know, typically, the investors are not going to personally guarantee. They're going to stay below 20% ownership. But what's really nice about this, and I just did a Twitter poll asking people if they had investors in their cap table, were the investors value-add or not? And over 65% said “Yes”. Some of them, you know, they were extremely value-add. Another 25% said “No” but they benefited from having the capital, so that was obviously of value to them. And 10%, I guess, didn't have the right investors and said that they were not helping at all, and they were actually detracting. But the beauty of it is, I guess what I'm trying to illustrate there is, bringing in the right investors into these deals de-risks the deal. So yes, you do give away a little bit of ownership but what that 65% of that poll tells you, and my anecdotal experience tells you, is you actually could improve the performance of the business by having the right investors in your cap table, so a lot of them tap into that for that very reason.

Royce Yudkoff:

You know, Rick and I send out from our Entrepreneurship Through Acquisition program at HBS, probably twenty to thirty graduates a year who go out to buy businesses. And overwhelmingly, you know, because they've just graduated from an educational program, they don't have much capital of their own, and so they routinely do what you've just described: they will raise money from a set of investors, many of whom are serial investors in small firms, just like you say.

Heather Endresen:

As things have evolved in this marketplace, a lot of the investors now, they bought a business a few years ago and maybe sold it or sold a majority interest of it, and so they're back investing. I find that the ecosystem seems to be very addictive. No one ever really leaves, they just come back as an investor, so it's great.

Rick Ruback:

Heather, when you were in class just a few months ago, we had a long discussion about how the personal guarantee actually works. Since that is the item of fear for most people, given the tremendous benefits in the SBA, tell me a little bit about how that actually works. So suppose I have my loan, my business is chugging along, and then something catastrophic happens. COVID, or yeah, let's take COVID. COVID happens and suddenly I have to close my doors. What happens? Does the SBA come and throw me out in the street? How does that work?

Heather Endresen:

So even with COVID, or whatever other issues might occur, the bank is encouraged to give a borrower at least six months of payment deferrals, whether it's interest only or a full payment deferral, to try to right the ship. If it can't be righted and there is a default, you've got that personal guarantee on the line. And so, this is what it looks like. The SBA and the bank will liquidate any collateral, so any business assets, but there's usually not much left, and any real estate that was pledged directly to the loan, they will liquidate that. Then they'll come up with, “Okay, now we still are losing money, we didn't get the loan fully repaid, and now the personal guarantor needs to settle.”

And that settlement process is called an “offer in compromise”, or you can look up the term, SBA OIC, and there's a simple two-page form where you disclose your assets and you begin a negotiation with the SBA. And they will negotiate based on your means, so regardless of what the size of the loan loss is, you're only able to pay what you're able to pay, so if you don't have a lot of assets, your settlement amount, you can expect it will be fairly small. If you have a lot of assets, you can expect it will be maybe the full payment. And sometimes the SBA will actually, instead of a lump sum settlement, they'll go for a five-year pay plan. But it's a back-and-forth negotiation, so it's not as though you get to walk away, you did give a personal guarantee.

Royce Yudkoff:

Let's imagine that the loan that was not recovered by the bank and the SBA, that there was still $200,000 owed to the bank SBA by the now defunct company, and you, the guarantor, has net assets of $100,000. Does that mean the SBA and bank will say, “Well, we're owed $200,000, you have $100,000. We'll take all of that and we'll write off the rest of the loan.” Is that how they think about it?

Heather Endresen:

Pretty much.

Royce Yudkoff:

So, the offer in compromise is kind of like, “We'll just take all your assets until the loan is either paid or you've given us all your assets, and we'll write off the rest”, is the way a borrower should think about it.

Heather Endresen:

That's right. I mean, I think there are some assets that can be left off the table, like retirement assets…

Rick Ruback:

If we go back to our earlier example – and I bought this business for $4 million, I've put up $200,000 of equity, and the rest through an SBA loan and some seller note. And the business had been earning $1 million and I had to pay $425,000 or so in annual payments to the bank and the SBA. And suppose somehow, I can no longer do that. So first you give me six months. And by the way, I guess that means that the profitability of the firm has to drop by more than half, because it was a million bucks, and I only have to pay $400,000, so the business has to fall in profitability by more than 50% for this problem to happen. But then, if disaster happens, because we can't deny that disasters happen sometimes, they're just pretty rare, and the SBA says, “Okay, you need to give us that $3.6 million you borrowed”, and I'll take the role of the borrower, I say, “I don't have any money. All my money was the $200,000, and I invested it in the equity, and that's gone, so I don't have any money. I don't have any assets.” And the SBA says, “Well, let me see your house.” And we say, “Well, you know, I got a big mortgage on my house too, I don't really have a lot of equity in my house.” I might be a renter, I may not have a house, I have an old car. In that case, I might end up with not having any payment on my personal guarantee, is that right?

Heather Endresen:

Yeah, if you don't have any assets, but let's just say that you do default, you don't have any assets, you may end up with that five-year pay plan. So, they may look at your resume and say, “Yes, but you can go out and you're probably going to go get a job and you're going to work, and so we want something.” So I think that's generally how that can shake out if you don't have any assets for the SBA to recover at that point.

Royce Yudkoff:

That’s the compromise part, that even in that case you’ll pay something.

Rick Ruback:

You know, we have a class guest who took a personal guarantee in his loan and he talks about the fact that at the time of his acquisition he had no assets and so he viewed the personal guarantee as not much of a constraint. And that's not a bad view.

Heather Endresen:

I agree, that is not a bad view. It's a much harder decision if you're later in life and you have a lot of assets because you're going to probably end up paying the whole loan back no matter what. If you have no assets, yeah, it's not going to be as painful as for the person who does.

Rick Ruback:

And the SBA doesn't filter borrowers based on the assets they might have. They care about the quality of the business.

Heather Endresen:

That's right. I mean, they may care about your resume, you know, the fifty-year-old might have a better resume, but other than that, no, you're kind of on equal footing with the SBA, which is wonderful.

Royce Yudkoff:

Well, Rick and I see this all the time because the students we send out, our former students, usually don't have a lot of assets, and many of them do qualify for SBA loans, and it's just what you're talking about. They don't feel like they're taking a lot of risk.

Heather Endresen:

I agree with them. It's a great opportunity for young people to explore.

Royce Yudkoff:

Heather, if part of our audience is interested in pursuing SBA and would like to learn more, what's the best way for them to get in touch with you and learn more about the details of how this works?

Heather Endresen:

Yeah, so my website is visocap.net, V-I-S-O-C-A-P.net, and I hold a Zoom session every two weeks. You can sign up for it there, where I start with all the Frequently Asked Questions, show you what it takes to qualify, what all the different banks are looking for, and provide you with tools and templates so you can begin assessing deals from a lender's perspective. So, that's the best way to get in touch and to get started with working with us.

Royce Yudkoff:

That's great, that's super helpful. And you know, I like the notion that you figure out how much you can borrow from a lender, like in an SBA situation, or it would apply to a conventional loan, at the time you're making an offer on a business, so you can figure out how much equity you'll need. And back to Rick's example of if you get $1 million of cash flow, how much of that you have to spend on servicing the loan. It's good to do that work before you make the offer on the business rather than later.

Heather Endresen:

Absolutely, get those templates and practice what the math looks like and you'll make offers that are definitely financeable, and you'll have a real clear path for what you need to do for your equity as well.

Rick Ruback:

Wait a minute, something just slipped by here. So what you're saying is the way the process should go is, I look for the company, I find the company, I send the seller an indication of interest and we roughly agree on a price. But then, before I send the letter of intent, what I should do is reach out to you and say, Heather, I was thinking about...

Heather Endresen:

Yeah, make sure it's financeable.

Rick Ruback:

So do that before you make the offer. That must mean you get a lot of inquiries. Is that okay?

Heather Endresen:

It's okay. We have a team of four right now and we have a really great system that we are able to respond to people on their pre-LOI debt consults, that's what we call it, very efficiently. So when they use our templates, they've come to our Zoom session, it's actually very efficient for us to assess deals and give people feedback before they submit their LOI. So we prefer to do it that way and we love to work with clients that want that additional information before they submit.

Rick Ruback:

So, I guess the obvious point is that before they make their LOI, maybe early on in their search, they should learn about the templates, learn about the SBA, attend one of your sessions, and then be ready once they're ready to make the offer to get pre-qualified for the loan.

Heather Endresen:

Absolutely, it's really just setting yourself up for success, you know, starting out that way and knowing that the bank looks at deals differently, sometimes differently than you might as an investor. The bank just wants to not lose money. They don't necessarily care what your, you know, multiple on invested capital might look like in five years or your returns. They have a different way of analyzing the cash flow and looking at the deal and so it's really helpful to learn about that and understand that before you start making offers.

Rick Ruback:

And then the really great thing about reaching out to you is that, instead of having to reach out to a half dozen banks and go through the SBA process with each bank, they can just reach out to you. You're like the common app of SBA, right? I just reach out to you, I do it once…

Heather Endresen:

That's right.

Rick Ruback:

… and you manage that whole process.

Heather Endresen:

We do, we manage that whole process. We work with all the big SBA lenders. We have details on their credit preferences so we know exactly how to match your deal to the right lender and save you time from going to the wrong places. And then, we also hold the banks accountable, not only to service but also to, you know, giving the best interest rate for the deal, given its characteristics.

Rick Ruback:

Oh, that's tremendously helpful.

Royce Yudkoff:

Heather, Rick and I have asked you a bunch of questions during this interview, which has been great. We like to close by asking whether you have any questions for us.

Heather Endresen:

And I do because I would like to know, what is your favorite success story that you know of where somebody started out as a first-time buyer with an SBA loan?

Royce Yudkoff:

We know loads of those people. Rick, I don't know if you want to kick off on this, or you want me to.

Rick Ruback:

Sure, well, we just had on our very first podcast guest, Geoff Duckworth, and Geoff bought a business using an SBA loan, and his business was great. Interestingly enough, he had been living on the West Coast, decided to move to the East Coast, had had a condominium he had purchased along the way, and he took the profits from the condominium and that turned out to be his equity investment, the rest seller and SBA loan. He ran the business, had a great return, decided to move on and go do other things, so sold the business. The business thrived, he's thrived. Life's really good for Geoff.

Royce Yudkoff:

Well, I think this is a good note on which to wrap up. Heather, Rick and I are really appreciative of you taking the time to join us on Think Big, Buy Small, and we know our paths will be crossing again because you're so active in this space, so thank you very much.

Rick Ruback:

Thank you, Heather.

Heather Endresen:

Well, thank you very much for having me, and it was great to talk with both of you today.

Royce Yudkoff:

Rick, this was a very enjoyable conversation and a great exploration of the benefits of SBA financing. You and I see a lot of searchers self-fund and then use SBA loans as a key part of their acquisition. What are some of the patterns of those searchers that are typical of who uses this and why?

Rick Ruback:

Well, I think they all buy smaller businesses. As you know, the SBA has a limit of $5 million in their 7a program and so generally you're buying businesses where, you know, $5 million is sufficient debt financing. If you needed $10, the SBA wouldn't be a great place to go. Although some people do do add -ons. Some lenders will allow you to do some subordinated lending underneath that. And there's always seller notes.

Royce Yudkoff:

Yeah, and I'd add to that that these are often searchers who have very little net worth when they do their search. They might be early career searchers or for whatever reason don't have much capital, which further insulates them a little bit from the personal guarantee risk. And what they will typically do is sell off 20 or 30% of the equity in the business they buy to some investors. The fact that they're able to use this attractive debt means that the returns on equity are very high and they can offer the kind of returns that will attract investors in small companies while only giving the investors a small minority of the equity ownership. So, you get this wonderful situation where this searcher, who puts a lot of effort into finding and buying the company, but often no capital, ends up owning about 70% of the business.

Rick Ruback:

Yeah, that's what makes the SBA very special. And again, if you had covenants, I think that'd be very hard to do.

Royce Yudkoff:

I agree. Next week, we're going to be speaking with Alexander Wallace, who left a good job in a large insurance company to become a self-funded searcher in his native New Zealand. We're going to talk to him about what it's like to bring searching approaches to an entirely new market.

Rick Ruback:

I'm really interested in this conversation because we record Alexander just as he's beginning his search. And that's a moment of both unbounded optimism and enthusiasm and also a little bit of edge around the journey and, you know, you’re taking your first steps.

Royce Yudkoff:

It's just so interesting to see how that unfolds.

Rick Ruback:

And Royce, I think now is a good time to ask our listeners to send us in some questions. Our last episode of the season is going to be us answering the questions that we hear from our listeners. Listeners, please send your questions. Our e-mail is rickandroyce at hbs dot edu.

Royce Yudkoff:

You’ve been listening to Think Big, Buy Small. We’re your hosts, Royce Yudkoff…

Rick Ruback:

…and Rick Ruback.

Royce Yudkoff:

Katie Zandbergen produced today’s episode. 

Rick Ruback:

Our audio engineers are Mari Shear and Craig McDonald. If you have any questions, comments, thoughts, feel free to just e-mail us – rickandroyce, all one word, at hbs.edu.

Royce Yudkoff:

We’ll be back next week with another episode of Think Big, Buy Small.