An equity injection represents the borrower and in a way 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.

Equity Injection With Conventional Loans

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.

Understanding the New SBA Equity Injection Rules

The SBA equity injection rule stipulates a ten percent equity injection on loans that lead to a change of ownership. This rule applies to the total project costs and not the loan amount. The 10% equity must come from a source outside the business's existing balance sheet.

Change of Ownership Loans

These loans entail acquiring a business, assets, or equity, where the ownership is entirely transferred from the seller to the buyer. These loans include new business purchase loans, expansion business purchase loans, and complete and partial partner buyouts.

In terms of Equity Injection for a Business Purchase, there are three ways to meet the equity injection requirement: 10% Cash, Full Standby Note, and Partial Standby Note. If choosing a Standby Note, the borrower will have two loans: an SBA loan with the lender, and a promissory note with the seller.

For changes of ownership resulting in a new owner (complete change of ownership): At a minimum, SBA requires an equity injection of at least 10 percent of the total project costs, (all costs required to complete the change of ownership, regardless of the source of funds) for such transactions.

What are change of ownership loans?

A loan resulting in a change of ownership is when you are purchasing a business, assets or equity, whereby 100% of the ownership transfers from the seller to the buyer.

These include:

A new business purchase loan
An expansion business purchase loan
And complete and partial partner buyouts.

Expansion Acquisition Equity Injections

Business Expansion Loans

Business Expansion Loans do not require an equity injection. When an existing business starts or acquires a business that is in the same 6-digit NAICS code with identical ownership and in the same geographic area as the acquiring entity and they are co-borrowers, SBA considers this to be a business expansion and not a new business.

Expansion Acquisition

When an existing business purchases another established business.

There is no down payment requirement for one business purchasing another business if three conditions are met.

1 - The target business to purchase is in the same industry

2 - The target business to purchase is in the same geographical area as your current business

3 - The exact same current ownership structure will be applied to the purchased business.

If all three of these conditions are met then no equity injection is required. If all three conditions are not met, then the ten percent equity injection rules apply.

Non-expansion Acquisition Equity Injections

Equity Injection If Cash Payment

The equity injection can be paid by the borrower in cash, preferably wired to the lender a week or two 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 statement for verification.

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.

This option enables the borrower to purchase a business with no money down.

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.

Partner Buyouts &
Partial Equity Buy-ins Equity Injections

Partner Buyouts Loans

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.

Complete Partner Buyout

A complete partner buyout is purchasing 100% of the equity owned by that partner. For the complete partner buyout there is a 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 part of the equity owned by a partner. The partner who is selling will remain on as a partner since they are selling just part, and not all, of their equity.

This loan also requires a ten percent cash injection unless two key requirements are met.

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

Calculating the 9:1 Debt to Equity Ratio

The 9:1 ratio for equity injection in SBA SOP for partner buyout loans is a measure of a business's financial health. This ratio compares the business's debt to its equity, which represents the amount of capital invested in the business by its owners. A lower debt-to-equity ratio indicates that the business has more equity and is less reliant on debt, while a higher debt-to-equity ratio suggests that the business is more heavily indebted.

Calculating the 9:1 Ratio: To calculate the debt-to-equity ratio, divide the business's total debt by its total equity. For example, if a business has $500,000 in debt and $100,000 in equity, its debt-to-equity ratio would be 5:1.

Interpretation of the 9:1 Ratio: The SBA considers a debt-to-equity ratio of 9:1 or higher to be indicative of financial risk. When a business's debt-to-equity ratio exceeds this threshold, it may be required to inject additional equity into the business to demonstrate its financial stability and reduce the risk of default on an SBA loan.

What is an equity injection?