Equity Injection Rules for Advisor Acquisition Loans

In conversations with advisors about financing their acquisition loan the topics of interest advisors ask about usually revolve around if there is a cash down payment requirement, something seller financing related, and for equity buy-ins also about seller guaranties and grantor agreements. This article covers the cash down payment requirements for acquisition bank loans.

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What is an Equity Injection?
An equity injection represents the borrower and in a way also the seller's "skin in the game" for an acquisition loan. It indicates the infusion of either cash or assets into a deal to reduce the leverage of an asset or equity purchase. This injection can come from the buyer as a cash down payment, or a seller can contribute equity by providing a promissory note for a portion of the purchase price. Equity injections can therefore be satisfied through the buyer's down payment, with a seller’s note, or in some combination.

Conventional Loan Equity Injection
While a borrower’s personal financial situation and credit profile have influence, the primary equity injection criteria from conventional lenders focus on the Loan-to-Value (LTV) ratio. Typically, conventional lenders cap LTV at 75%, although some may extend to 85%.

For acquisitions, LTV is calculated by combining the value of the buyer's and seller's practices, resulting in most conventional acquisition deals meeting the LTV requirement. If a $1M value practice acquires a $1M value practice then $1M loan/$2M value = 50% LTV.

When a $333,000 value practice acquires $1M value practice then $1M/$1,333,000 = 75% LTV. In this case an equity injection (down payment and/or seller financing) is not required based on LTV but the lender may have other reasons they may want to see "some level" of injection (5%-10%).

Rule of thumb if both practices valued at same multiple, the buyer’s value needs to be at least 33% of the seller’s value (or visa-versa) to meet a 75% LTV.

SBA Loans Have New Rules for Equity Injections
The SBA significantly changed their equity injection requirements for loans involving a change of ownership in November 2023. Let's break down how SBA equity injections now work in advisory acquisitions, partner buyouts, and equity buy-ins.

An important contextual emphasis is that the SBA is deferring more and more decisions to the individual lender's internal policies. While the SBA has their rules and procedures, each SBA lender has additional policies which they stack on top of the requirements of the SBA. This means not all SBA lenders approve the same loans or even approve in the same way. One SBA lender may require an equity injection while another does not for the same loan for a host of reasons.

Expansion Acquisition
For an established advisor looking to acquire, not needing a down payment or required seller financing can make all the difference, and this is feasible, as long as certain criteria are met. If the target acquisition meets the following three conditions, no equity injection is required:

1. The target business operates in the same industry as the acquiring business.

2. The geographic location of the target business matches that of the existing entity.

3. The ownership structure of the acquiring business is precisely replicated in the acquired business.

By fulfilling these conditions, advisors bypass the 10% equity injection requirement. However, if any of the three conditions are not met, the standard equity injection rules for non-expansion acquisitions will apply.

Non-Expansion Acquisition
The SBA mandates a 10% equity injection for non-expansion loans involving a change of ownership. This requirement applies to the total project costs rather than the loan amount or purchase price, and the 10% equity must originate from outside the selling business's existing balance sheet.

For advisors these acquisitions refer primarily to those deals where the buyer's ownership structure is different and don't qualify to be considered an "expansion" by the SBA rules. The first two requirements of an expansion loan (same industry and client footprint) are met with most advisor-to-advisor acquisitions. The third expansion requirement of the buyer's ownership structure being the same can get triggered if an advisor is partnering with another advisor for the acquisition or if using a different entity for the acquisition.

Even so, the SBA provides a path for the buyer to not have to make a 10% cash down payment in the full standby note option.

10% Equity Injection Required

1. Equity Injection If Cash Payment: The equity injection can be paid by the borrower in cash, preferably wired to the lender at or just before the loan closing. The money can come from savings, investments, a Home Equity Line of Credit (HELOC), or as a gift (with a gift letter as proof). Lenders usually require the most recent account statements for verification.

2. Full Standby Note: The SBA made a big change to the full standby seller note. Now the seller can finance the full ten percent of the equity injection requirement. No principal or interest can be paid during the first two years standby period. The loan cannot have a balloon payment in order to qualify (i.e. the loan after the standby period must have a period of time where principal and interest payments are made to fully pay the loan) This option enables the borrower to purchase a business with no money down.

3. Partial Standby Note: A partial standby is where interest only payments can be made for the first two years but not principal payments. The seller can finance up to 7.5% in a partial standby note. The SBA requires 2.5% to come from a source other than the seller. Adequate cash flow has to support the partial standby option. As in the case with the full standby note, the loan must fully amortize after the interest only period and cannot balloon.
   

Equity Buy-ins
When a non-partner buys into a partnership by acquiring less than 100% of the shares. This is treated with SBA loans in the same way a partial partner buyout loan is handled. A seller promissory note option to contribute towards the equity injection requirement is not allowed. This loan requires a ten percent cash injection unless two key requirements are met:

10% Cash Injection Required Unless:

1. A Maximum Debt-to-Worth (equity) of nine-to-one (9:1). This is determined based on the business balance sheet over both the most recent year and quarter. To determine the debt-to-equity ratio, divide the total debt of the business by its total equity. For instance, if a business has $900,000 in debt and $100,000 in equity, its debt-to-equity ratio would be 9:1 and eligible for 100% financing. A business with $1,000,000 in debt and $10,000 of equity would be a debt-to-equity ratio of 100:1 and require a cash equity injection

2. Any remaining owners of the business who have twenty percent or more in equity, are subject to the SBA guarantor requirements. This includes the personal guaranty and the property collateral requirements. See more about Equity Buy-ins.
   
   

Partner Buyouts
When it comes to Equity Injection for Partner Buyouts, equity injections are applicable in both Complete and Partial Partner Buyouts. Neither allow for a seller promissory note option to contribute towards the equity injection requirement. For changes of ownership between existing owners and for partial changes of ownership: When required, cash contribution can be either an amount sufficient to reflect a debt-to-worth ratio of no greater than 9 to 1 on the pro form balance sheet or in the amount of at least 10% of the purchase price of the business, as reflected in the purchase and sale agreement, whichever is less. For partial changes of ownership, SBA will measure percentage of ownership post-sale for the purpose of determining who is required to provide a guaranty. See more about Partner Buyouts.

Complete Partner Buyout
A complete partner buyout is when an existing shareholder is purchasing 100% of the equity they don't own so that after the transaction the buying partner owns 100% of the equity of the entity.

10% cash down payment requirement unless two conditions are met:

1 - The borrower must have been active in the operations of the business and has been a ten percent or more owner over the last two years. This needs to be attested to by both the borrower and seller.

2 - A Maximum Debt-to-Worth of nine-to-one (9:1). This is determined based on the business balance sheet over the most recent year and quarter.

Banks have to be able to document both requirements.

Partial Partner Buyout
The partial partner buyout is when a borrower is purchasing less than 100% of the equity.

10% cash injection unless two key requirements are met:

1. There is also the same nine-to-one maximum debt-to-worth condition.

2. Any remaining owners of the business who have twenty percent or more in equity, are subject to the SBA guarantor requirements. This includes the personal guaranty and the property collateral requirements.