June 29, 2009

For 12 years, I have represented national bank and non-bank lenders as an SBA commercial loan officer in a multi-state territory of the Rocky Mountain West, specializing, for the last 4 of those years, in business acquisition finance. Presently, I am a principal member of Rocky Mountain Capital LLC, working with a variety of banks active in SBA lending to package, underwrite and source financing for buyers of small businesses. SBA is currently engaged in rewriting the rule introduced in March, that caps goodwill financing at $250,000. In the following, I advocate rules focused on targeting actual credit risks that may be associated with acquisition finance--a more reasonable and effective approach than the current arbitrary cap.

I. Goodwill Regulation: a Risk-Targeted Approach

Business acquisition lending often involves financing a large proportion of goodwill, versus hard assets--since for so many small businesses (for example, professional, services, construction; retailers or wholesalers who lease their real estate) the value of hard assets is a small part of total appraised market value--which is primarily determined by cash flow. SBA's guarantee has until now played a crucial role in business transfers, because conventional, non-guaranteed lending generally requires full collateral coverage, and goodwill has no collateral value. That prominent (indeed, essential) SBA role is consistent with the agency's long-held principle that financing should not be denied on the basis of collateral shortfall alone.

The goodwill cap adopted by SBA on March 1, 2009 sets an arbitrary limit of $250,000 or 50% of loan amount (whichever is less) as the maximum guaranteed financing that may be allocated to goodwill. This rule is bad regulation, because it inhibits all acquisition financing involving large amounts of goodwill, regardless of the quality or credit characteristics of the individual transaction. The same would be true of any rule relying on an arbitrary cap, be it $500,000, $1 million, or higher.

The basis for a rule, instead, should be defining what types of special risk may attach to financing that has a high proportion of goodwill, versus loans that do not. If there are extra risks, and we know exactly what type, then we know what the problem is that we are trying to solve. We can design rules that mitigate those specific risks, without inhibiting business acquisition lending generally.

In fact there often are particular risks associated with loans mainly for goodwill: 1) risks associated with change of management; 2) risks associated with losses in event of default, since hard collateral value may be very much lower, relative to loan amount. The first increases the risk of default; the second increases uncollateralized exposure of the lender and the agency, in event of default.

The first risk arises, not from the proportion of goodwill itself, but because goodwill is usually purchased when there is a new owner--a change in management. (Exception: a partner or employee buyout, when substantially the same management will continue). Risks of management change may include insufficient industry-specific skill or knowledge on the part of new ownership; insufficient due diligence by new ownership (key facts or risks that are not discovered); and higher than expected dependence of the business on personal character or relationships of the exiting owner--which may lead to loss of key customers or employees.

The second risk also is not due to the proportion of goodwill itself, but to the fact that purchase of a relatively large amount of goodwill is often (not always) associated with a high level of uncollateralized exposure. Exception: when the buyer or other guarantors have hard collateral to offer from outside the business--enough to substantially or fully collateralize the loan amount at bank liquidation value.

In both cases, a rule capping goodwill itself mischaracterizes the source of risk.

What should also be clear from the above, but deserves special emphasis, is that goodwill in and of itself is a positive indicator of business performance and likelihood of repayment.

Goodwill is defined by SBA as the difference between independently-appraised total market value, and tangible net worth at current appraised value of hard assets. For a given business, what elements of its history or current circumstances would have to change, in order for the goodwill component of its value to go up? The full list is long, but the most typical items are: higher, more stable or more positively trending historical cash flow; lower risk that cash flow will fail (barriers to competition, absence of customer or supplier concentrations); more productive utilization of assets; or well-supported expectation of increased future cash flows (e.g., from expansion or innovation). In a nutshell, everything that increases goodwill also increases debt service capacity.

Understanding this, it's clear that effective rules should not address the proportion or amount of goodwill at all, but should address the real sources of associated risk: change of management, and uncollateralized exposure.

II. Goodwill--Proposed Rules

A. Change of management. When financing involves purchase of a business by owners who have not previously managed that business, lenders must apply, and document in the loan file that they have applied, higher standards of due diligence and higher credit standards than for lending when change of management is not a factor.

Stronger due diligence may be shown, for example: 1) by requiring a full business plan and two years of projections prepared by the borrower (versus no business plan and only one year of projections required by SBA for real estate and expansion borrowing, for an established business with no change of management); and/or 2) by obtaining a full, detailed resume of experience and education in addition to the limited history that is typically obtained on a management resume form; and 3) by requiring that new owners demonstrate clearly-related business ownership or general management experience (not required when there is no change of management, or for a franchise with good history and management training programs).

Higher credit standards can be shown, for example, by 1) requiring a higher historical debt service coverage ratio (DSCR) for the most recent completed fiscal year, and/or 2) requiring that debt service coverage be demonstrated for a longer historical period, than the lender requires for similar loans not involving change of management; and/or 3) setting a lower maximum loan-to-value ratio (i.e, a higher combination of buyer down payment and seller carry, therefore a lower maximum guaranteed loan amount as percentage of total project costs) than for loans not involving management change; and 4) requiring a minimum level of seller financing, for example 10% of total project costs. Placing the exiting owner at risk, in a subordinated financing position, motivates the seller to provide complete information, and to actively support new ownership during the transition. It also indicates that the single person most knowledgeable about the business believes the proposed new owner is capable of operating it successfully. Documentation in the loan file would mean citing the comparison between lender's standards for financing loans involving management change versus those that do not.

B. Uncollateralized exposure. Lending with a high goodwill proportion may result in large uncollateralized exposure to the lender. When uncollateralized exposure (loan amount less net liquidated collateral value of real estate and durable equipment only) exceeds $500,000, lenders must exercise, and document in the loan file, higher credit standards than are applied to loans with less uncollateralized exposure. "Higher credit standards," for this rule, would be defined or illustrated as for the rule above, and documented in the same way.

C. As an alternative to both the foregoing requirements (A and B, above), lender may show that the business being purchased is among those that have the lowest historical default rates for SBA-guaranteed lending, and that--in the cases of professional industries such as medicine, dentistry and veterinary services--the new owner has the required professional licensing (as is already required, elsewhere in the regulations).

One key benefit to these rules is: the above or similar standards have already been put into practice by the banks which currently are the most experienced, large-volume acquisition lenders utilizing the SBA guarantee. In other words, these rules learn from and adopt best practices of the lenders who are most experienced and successful in the field. They do not change existing best practices, but acknowledge and systematize them, and by so doing will encourage and guide successful expansion of acquisition lending among the less-experienced banks. They do not inhibit acquisition lending, but encourage the prudent practice of it.

Every major national acquisition lender, to my knowledge, currently requires higher and more sustained DSCR for acquisition/goodwill loans than for real estate or hard asset lending: typically about 1.15X DSCR for real estate, often only for 1 year; but for example 1.30X in the most recent completed year and 1.20X in the previous historical year, for high-goodwill acquisition. Such lenders also exercise higher standards with regard to management experience (per the detailed resume) and demonstrated management understanding of the business to be acquired (per the business plan and projections). They typically set a minimum requirement for seller financing. They likewise make exceptions, or specify more relaxed standards, for the lowest-default industry categories.

Comments and criticism are welcomed, and may be addressed to:

Robert A. Heffner
T 406 251 5861 F 888 251 8191
Email capital.rheffner@gmail.com
Rocky Mountain Capital LLC
269 West Front Street, Suite E
Missoula, MT 59802