🟠 Personally Guaranteeing Debt: With Opportunity Comes Risk

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This week’s topic is: Personal guarantees (PGs) in small business and real estate.

PGs are a big concern for both aspiring entrepreneurs and existing owners who are considering the use of personally guaranteed debt to acquire a small business (self-funded SBA acquisition structuring explained).

Many people are unwilling to consider a personal guarantee out of principle (“I will never take a PG”).

Others don’t give it a thought, they’re PGed up to the gills.

Who’s right? As with many things in life, probably somewhere in the middle for most of us.

I think it’s a personal decision and depends on a number of factors including:

• current net worth

• amount of debt you’re PGing

• quality of business

• personality

• risk seeking/aversion

• age

Summary of today’s newsletter (8 considerations):

• 🔍 The Data Behind the SBA PG

• 🧠 The Psychological Weight of PGs

• 🏠 Low Yield + Lots of debt = Bad (Real Estate)

• 💼 With SBA, the biggest risk in the first year

• 🚫 The Risk Magnifiers

• 🌈 The No-PG Rainbow

• 🛡 Shielding Against PG Risks

• 💰 The Net Worth Perspective

1. 🔍 The Data Behind the SBA PG: The apprehension behind personal guarantees stems from the fear of a 'complete loss' or bankruptcy.

But is this fear justified?

I’ve heard from various sources & charts that the default rate for large SBA loans >$1M is around 2%.

So I wanted to figure out if I could verify or at least get close to this claim to get a real sense of the real historical complete loss, people’s #1 issue with an unlimited PG when buying a business.

First, let’s look at the Charge Off rate chart provided from the SBA. See the 7(a) Regular line item. I don’t have access to this raw data set but here’s the output.

Source link

Second, let’s take a look at a set of publicly availably SBA 7(a) loan data (2010 to 2019 dataset and 2020 to present dataset). The results, assuming my filtering of loans & calculations are correct, suggests a 2-5% charge-off rate over the entire life of the loan. Below is a chart on the cumulative charge-off rate of SBA 7(a) loans.

I consolidated these two files into one excel file with the output here.

Charge-off is an SBA administrative action whereby a loan is reclassified from “liquidation” to “charge-off” status, and the outstanding balance of the loan is removed from the SBA’s accounting records. In other words, it takes a LONG time to get to a charge off. More information about SBA charge-offs procedures at this link.

You might notice that the charge-offs for 2020-2023 are basically non-existent. I’m not sure why. This is possibly due to the types of loans included or that the SBA staff have access to a more current view of expected write-offs that they aren’t including in the data sets. Either way, just another data point.

The take-aways:

• Charge-off rates decline significantly as you get a larger loan. This is one of the main reasons I’m a have the mindset that larger is better - all else equal. The data supports it’s less risk of a complete loss.

• The SBA charge-off rate is in the range of 2-5% over the life of the loan.

If you have a better source of data or better way of looking at this data, please let me know.

2. 🧠 The Psychological Weight of PGs: It's not always about the numbers.

Even if a real risk isn't looming, the mere existence of a PG can amplify periods of struggle.

The mental toll is real if you let it affect you.

I experienced this first hand as an owner. The PG weighed on me during my early operating years when we were making many big one-way door decisions.

It gave the monkey on my shoulder already telling me “I’m not good enough” additional ammunition to lob at me during times of uncertainty.

The monkey said “If you fail, I’m going to take not only your past, but your future down with you”.

Heavy to carry the burden of not only letting yourself down, but your wife, child, family, and those who have helped you along the way.

Even when I had gotten past the danger zone and into safe territory with my business, I could still feel the monkey there on my shoulder. Gnawing on my ear.

3. 🏠 Low Yield + Lots of debt = Bad (Real Estate): I believe real estate is an underappreciated trap for many who believe prices never go down and have been tricked into thinking they’re unstoppable by the real estate trends of the last 5 years.

Don’t be fooled.

In the past few years, real estate has been underwritten with extremely low debt service coverage ratios (not much room for failure).

Making it more challenging is if you made a purchase with expensive hard money or even senior debt with a balloon payment expected 3-5 years after purchase, you will be forced to refinance those great terms.

It’s happening now.

I’m expecting lots of turbulence in the real estate market over the coming years with real estate developers & extremely low cap rate purchases that now look to be very underwater.

For added flexibility, always opt for longer amortization and fixed-term arrangements.

Cautionary story of buying highly leveraged, low yield real estate assets:

4. 💼 With SBA, the biggest risk in the first year: The initial year post-acquisition is crucial.

If done right (say, buying at 3.0x-4.0x EBITDA), and buying at 2.0x debt service coverage ratio, by end of year 1, you will have generated enough cash to pay the next 12 months debt service (principal and interest).

This is the power of buying a high yielding business that generates lots of cash in excess of debt payments (25-33% unlevered returns).

Your risk goes down significantly the longer you consistently generate cash.

Your SBA loan doesn’t require a balloon payment after 3-5 years.

Unfortunately, the interest rate has impacted SBA loans. Most SBA loans are variable rate loans meaning they are linked to the prime rate. We’ve seen the prime rate increase from 3.25% in 2020 to 8.50% in July 2023, with loans priced at around prime plus ~2.0%, you’re looking at an all-in interest rate of ~10.5%.

But many of us think it’s worth the risk:

5. 🚫 The Risk Magnifiers: Tread cautiously if your business has customer/supplier concentration or hefty working capital requirements.

Hunter Durham is sharing is story on Twitter of going through bankruptcy after buying a number of business.

He’s bringing light to what happens when a complete loss occurs which we rarely have the opportunity to see in public. I’m glad he’s sharing his story.

There’s many things to learn from hearing his story:

6. 🌈 The No-PG Rainbow: 

For those who will always be in the ‘never PG’ camp, there are many alternative paths to entrepreneurship through acquisition

• traditional search funds

• independent sponsor model

• seller financing

• bootstrapping

• conventional debt

7. 🛡 Shielding Against PG Risks: You can do many things to mitigate the PG risk.

Ensure you're investing in the right business type and at the right price. This is obvious and most important. Buy a high quality business and you are setting yourself up for success.

Consider raising more equity or directing more cash to the balance sheet.

Always plan for downside scenarios

Buy from a seller with integrity.

Move to Texas. Seriously. In the State of Texas borrowers are not able to pledge their primary residence as collateral for an SBA loan due to the laws in the State related to Homestead. A homestead is defined in Texas as the place of residence for a family or individual and is secure from forced sale by general creditors.

Get a home equity line of credit in place:

Risk of a PGs is a spectrum.

8. 💰 The Net Worth Perspective: A logical assumption would be that individuals with high net worth would find PGs less risky since they have a backstop of cash & assets for a rainy day.

However, reality paints a different picture.

High net worth individuals, wary of losing even a fraction of their wealth, often steer clear entirely of PGs.

Those willing to accept PGs will have access to more types of capital (SBA) and likely higher upside (through more ownership). One of the costs to this access & upside is the likelihood of complete loss does goes up.

Looking to…?

• invest passively in SMBs? Join Accredited investors only…check out the SMB Junction Capital Connector investor network to get in the flow of off-market deals (self funded, independent sponsor, private equity)

• raise equity capital? Submit your deal under LOI for free to the SMB Junction Capital Connector to get intros to value-add accredited investors

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The SMB Scoop 

Ben Tiggelaar

Things I’m currently working on: www.bardocapital.com, www.smbjunction.com, [acquisition made in June 2023 to be announced…]