For startups this is based on projections. For purchasing a business this is based on the combined profit of the buyer and seller. This ratio is a reflection of available free cash flow after paying all expenses and debt service payments.

Maximum Loan Amount

Once the DSCR is established, the maximum loan amount comes into view. The calculation is simple: EBITDA / DSCR = Maximum Annual Debt Service. However, the minimum acceptable DSCR can vary. Startups rely heavily on projections, with the loan amount depending on carefully selected DSCR values, such as 1.15, 1.25, or 1.50. For existing businesses and acquisitions, higher profitability allows for more leniency. The optimal loan amount is determined by dividing the combined EBITDA by the required DSCR values, such as 1.50 or 1.75.

Loan to Value (LTV)

While the SBA hasn’t set hard and fast rules for Loan-to-Value (LTV) ratios, many of its lenders implement internal LTV policies to manage risk. These internal policies typically cap LTV at 90% for SBA loans. In contrast, conventional lenders have a narrower window, with maximum LTV requirements typically falling between 75% and 85%. This variance in LTV policies can be a decisive factor in a financial advisor's loan application outcome: one lender might extend 100% bank financing, while another may necessitate a down payment, or require a portion of the purchase price to be financed by the seller.

Given that LTV is calculated by combining the value of the buyer's and seller's practices, acquisition deals generally bypass LTV qualification hurdles. However, LTV ratios become a crucial challenge in conventional loans when the buying advisor’s practice is valued at or below 33% of the selling practice’s value. In such scenarios, the loan agreement could breach the LTV maximums set by conventional lenders, pushing the need towards an SBA-backed loan. For SBA loans, the threshold of concern is when the buyer’s practice is worth approximately 11% of the seller's; this figure is a trigger point for exceeding conventional LTV limits, necessitating the pursuit of an SBA lender for financing.

Debt and Debt-to-Income Ratio (DTI)

Banks go the extra mile to examine the borrower's personal financial health. Some employ the same DSCR methodology used for the business, evaluating personal cash flow and debt obligations. Others use the DTI = Personal Annual Debt Service / Total Personal Income. Typically, banks look for values under 30%-40%.

Net Worth

While there is no set net worth-to-loan ratio, net worth plays a significant, yet understated, role in the loan approval process. A strong net worth, evidenced by retirement accounts, home equity, and investments, instills confidence and reduces perceived risks, especially in the case of startups. Conversely, a low net worth may necessitate down payments, even when they are not officially required.

Personal Financial Statement

Transitioning from industry stability to the individual level, it's pivotal to understand that the Personal Financial Statement (PFS) is often the first checkpoint for lenders in evaluating a loan application. A robust PFS amplifies the prospects of securing a loan since it provides a comprehensive snapshot of an applicant's net worth, liabilities, and assets.

For conventional loans, the PFS is part and parcel of the loan application. However, when it comes to Small Business Administration (SBA) loans, the SBA 413 Form is the norm. Lenders instinctively skim to the bottom of the PFS to ascertain the net worth figure—a paramount indicator of financial health. They then dissect the list to assess debt and asset details, examining the proportions meticulously.

While a substantial personal net worth can color the lender's perception positively, it's crucial to recognize that net worth alone doesn't guarantee loan approval. There are cases where advisors with hefty net worths may struggle to secure a substantial acquisition loan, while those with more modest net worth figures might succeed. It emphasizes that net worth is a nuanced consideration with no concrete personal net worth-to-loan amount ratio.

Conventional lenders typically look for a net worth that's about 25% to 50% of the loan value, not counting the advisory business's value, whereas SBA lenders apply more flexibility due to the SBA's guarantee safeguard. What's clear, however, is that lenders view personal financial assets—including retirement accounts and personal investments—as positive indicators of an applicant's financial stability, though these assets are generally non-collateral.

Lenders also weigh an advisor's professional experience in conjunction with their net worth. An advisor with extensive experience but a modest net worth might be assessed differently compared to someone newer to the industry with similar financial standing.

It's no secret that not every financial advisor manages their personal finances with the same acumen they recommend to their clients. Nevertheless, the vast majority of advisors find a path to loan approval, be it through SBA or conventional means, underscored by a variety of structured financing options. Such flexibility acknowledges the dynamic nature of the financial industry and the specialized risk assessment accorded to financial advisors, often leveraging cash flow over tangible collateral.

Leveraging Cash Flow for Growth and Stability

How DSC Impacts Approval

For acquisitions, potential cash flow becomes a critical focal point for lenders. While criteria may differ, cash flow must meet specific thresholds to qualify. The favorable terms of SBA loans, including a generally lower Debt Service Coverage (DSC) requirement and a more attractive Loan-to-Value (LTV) ratio, significantly enhance borrowing capacity for advisors. These loans can reach up to $5 to $7 million, particularly advantageous when factoring in the lower DSC benchmarks that SBA lenders often employ. For instance, while the SBA generally sets a minimum DSC at 1.15, individual lenders may opt for higher internal benchmarks of 1.25 or 1.50. Traditional lenders, on the other hand, may look for a DSC of 1.50 or 1.75, though some may show leniency regarding previous years' financial performance.

The implications of these varying requirements are profound; under the more lenient SBA guidelines, advisors can access as much as 30% more funding compared to a conventional lender seeking a 1.50 DSC benchmark, and a staggering 52% more when contrasted with lenders enforcing a stringent 1.75 DSC minimum. Additionally, even among conventional lenders, a policy shift from a 1.50 to a 1.75 DSC could facilitate nearly 17% more in available loan dollars. Such financial metrics significantly influence the lending landscape, illustrating the critical role of cash flow in securing necessary capital for growth and stability in the advisory profession.

What is directly impacting the cash flow of your acquisition?

The Perfect Storm Washing Away ROI

Today we have the combination of simultaneous skyrocketed multiples, buyer-to-seller ratios, and interest rates. ROI looked very differently a few years ago when you were buying at 2 to 2.5x revenue multiple at a 6% rate. Since Covid the Fed has raised the prime rate to 8.5% (which pushes SBA loans to a maximum of 11.5%) and the valuation firms share the median revenue multiple is over 3 times. Are there other factors that more than compensate for this? Of course, but other compensating factors appeal is usually set against the back drop of a strong CAGR over the next 7-10 years.

Impact of Increased Multiple Values: The impact of a multiple going from 2.5 to 3.5 is the equivalent buyer pain of a 5% increase in interest rate. An advisor needs 20% more free cash flow to qualify for a 3x instead of a 2.5x for an acquisition. The same practice would require 30% more cash flow to purchase at 3.5x instead of 2x5.

Financial practices are now some of the most expensive types of small businesses available. The 70% of the industry who are advisors with books or lifestyle practices are getting boxed out of contention by the firms who can absorb these substantially decreased ROI scenarios today.

The aggregator model of "it's okay to over pay" because the increase in multiple difference benefit they receive doesn't necessarily apply to the typical advisor where cash flowing today is survival and more important than what any added multiple value increase may be years from now (regardless of how enticing this benefit is).

Bottom line is that many advisors struggle to make the cash flow work if they pay too much of a premium plus have all of it financed. If you're walking a cash flow tight rope at market highs then you can get under water quickly when things turn. Just ask any of the advisors who paid a big premium a few years ago and then saw their variable interest rate go up 5 points shortly thereafter.

The Broker Fee Premium: If you're paying a broker 6%-10% of purchase price or a percentage of T12 then this can be a notable impact on cash flow. Check the sellers portion of their materials and you'll see all the primary M&A advisor brokers brag to their prospective sellers that they typically get their sellers a 17% to 20%+ premium price over valuation. So your broker might be costing you 23% to 30% actual premium price than if you were able to purchase direct at valuation price. And this premium isn't accounting for financing costs. Of course, you're paying this premium because you weren't able to find it direct.

New General Rule: Here is an eye-popping rule of thumb we tested: Acquisitions where an advisor uses an M&A broker or marketplace and pays a 6% broker fee and a 15% premium price on a 3x valued practice is the same as the buyer paying 20% of the seller's revenue in an EXTRA premium price. And that's if the deal was paid in cash and not financed.

Interest Rates: About 25% more cash flow needed to qualify for the same loan amount as a few years ago. The biggest impact from interest rate increases for an advisor in acquisition mode isn't the pain in the wallet as much as the reduced borrowing capacity. Just a few years SBA loans for advisors were around 6.5% on the high side and now top out at 11.5%. If you needed about $204K profit to qualify for a $1 million loan at 6.5% you need $254K profit to qualify if rate is at 11.5%. About 25% more cash flow needed to qualify for the same loan amount as a few years ago.

Needed Amortization: About every acquisition loan for an advisor will at least amortize over 10 years. Most conventional loans are 10 year term with matching 10 year amortization just as it is with the SBA loans. However, there are lenders who offer only a 7 year term but will provide a 10 year amortization. Then another lender which can do a 10 year term with a 15 year amortization. When valuations are in the 3x neighborhood you typically need the 10 year amortization schedules to make them cash flow at or near 100% bank financing.

10 year term with 15 year amortization

AdvisorLoans exclusively offers this extended amortization acquisition loan option (at least for now anyway).

The loan is a 10 year term but payments are made based on a 15 year amortization. At the end of the 10 years there is a balloon payment. The balloon payment is made in one lump sum or if everything qualifies, be refinanced into a new note.

A 10 year term with a 15 year amortization can be utilized as a conventional loan option to either qualify for a 100% bank financed conventional loan or to lower monthly low payments to increase short term cash flow.

Three Schools of Thought for Selecting Term & Amortization

Advisors will typically view loan terms from three different perspectives. They want to pay the least amount of interest, or pay the least amount of monthly loan payment, or a combination of the two.

1. Least amount of interest paid

The school of thought for cost focused advisors. If you want the acquisition loan to cost you the least amount of total dollars then this is achieved by paying the least amount of interest dollars. The biggest impact on interest cost is not the rate but the amortization. Banks aren’t going to lower the interest rate by half but you can choose to cut your term in half. For a $1M loan at 6.5% rate on a 10 year term you would pay $362,575 in interest. But for a 7 year term the total interest would be $247,352 and for a 5 year term $173,968.

2. Least amount of monthly payment

The school of thought for cash flow focused advisors. If you want the acquisition loan to have the least amount of impact to your cash flow then this is achieved by having longer terms and/or amortization. For a $1M loan at 6.5% rate on a 5 year term the monthly payment is $19,566, for a 7 year term $14,849, for a 10 year term $11,354, and for a 10 year term with a 15 year amortization $8,711.

3. A cash flow and cost combination mindset

The school of thought held by most advisors who want the lowest monthly payment (especially in the first years after the acquisition) possible but also want to spend the least amount of total interest. This is achieved from getting a loan with a 10 to 15 year amortization schedule and then after the first year or two, or three, start knocking down the balance as quickly as you can through extra payments.

Most advisors approach acquisition loans with the combination mindset. The average lifespan of a ten year term loan for advisors is just under 6 years. SBA acquisition loans do not have pre-payment penalties. Many of the conventional lenders will allow up to 10% of the loan balance to be paid each year with no penalty. Some only have a prepayment penalty for the first 3 or 5 years. Even if you paid a 2% loan balance prepayment penalty on a chunk payment the interest savings far outweighs the penalty cost.

KEY RATIO CALCULATIONS

Debt Service Coverage Ratio (DSCR)