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🟠 Self-Funded SBA Acquisition Structuring Explained

80/10/10 structure, step up pricing methodology, and key self funded terms

This is the SMB Scoop. The weekly newsletter to help you find, buy, operate, and invest in cash flowing small businesses.

In today’s issue, expect to learn about the self-funded acquisition model from both the entrepreneur and investor perspective:

  • ❓ What’s a self funded SBA acquisition?

  • 🧱 80/10/10 deal structure

  • 🆙 Self-funded step up pricing/valuation methodology

  • 📖 Key terms (the step up multiple, liquidation preference, preferred return, CEO salary)

What’s a self-funded SBA acquisition?

An acquisition entrepreneur seeks to acquire a profitable, cash flowing small business funded mostly through an SBA 7(a) loan with a purchase price between $1,000,000 and $11,000,000. Self-funded search is part of the entrepreneurship through acquisition (ETA) family.

This is different from a traditional search fund which is a popular model for graduates of top MBA programs.

The benefits of a self funded search are significant to the acquisition entrepreneur. An aspiring business buyer is able to use a lot of debt as a percentage of the total purchase price under the SBA 7(a) loan program and ultimately own a majority of the company’s equity and cash flow distribution after investors are paid back their investment (plus a preferred return), and most importantly retain functional control of the business.

Small business investors are underwriting base case investment opportunities at 35%+ IRRs and 3-4x MoM (multiples of their money). The preferred equity structure encourages a fast return of capital to the investor, allowing for faster recycling of capital into other investments.

But how do you come up with the equity?

Acquisition entrepreneurs typically lack the personal funds to fund the equity required to buy a sizable company making more than $750,000 of EBITDA. For example, a $4,000,000 purchase price, there would be approximately $400,000 of personal or investor equity needed (pro-tip: you can further reduce the equity capital needed in an SBA 7(a) deal by including a seller note on ‘full standby’).

Many early and mid career professionals don’t have $400,000 of liquid capital available to make such a purchase, or are in a situation where this would be too much risk for them to bear personally.

This equity need has created opportunities for both acquisition entrepreneurs and investors - a win win situation. Acquisition entrepreneurs can get access to capital outside of their own. Small business investors have increasingly been investing passively into these self funded acquisitions. Small business as an asset class is an alluring investment opportunity given its high returns. And has been notoriously difficult to directly access without active hands-on involvement…until recently.

When I acquired my first business with an SBA loan in 2017, investor involvement was basically impossible structurally (the landscape has changed dramatically…will discuss more another SMB Scoop edition). I liquidated my life savings to fund the equity infusion. Now, acquisition entrepreneurs have access an experienced and value-add investor network. I would have raised investor capital to support my acquisition had it been a viable option back then.

80/10/10 self-funded SBA structure

The 80/10/10 self funded structure is a popular way to structure an SBA financed deal. This means your capital structure is comprised of 80% senior debt, 10% seller note (subordinated seller debt), and 10% equity. Individual deals may have more/less of each component.

  • Senior debt (70-80% of enterprise value) - senior debt provided by an SBA lender.

    • Interest Rate: Variable floating interest rates can range from Prime + [1.0% to 3.0%]. With Prime at 8.50% as of the most recent July 2023 hike, you’re probably looking at an all-in interest rate of 10%+ in today’s market.

    • Amortization: 10 years

    • Personal Guarantee: required of buyer

  • Seller note (10%-15% of enterprise value) - the seller agrees to accept a portion of the purchase price in a series of deferred payments. They do this because it allows them to increase.

    • Interest Rate: 5.0% to 8.0%

    • Amortization: negotiated but anywhere from 4 to 10 years.

    • Personal Guarantee: negotiated, but it is a common position and request brokers & sellers require the seller note be personally guaranteed by the buyer. Buyers try to avoid providing one because it cuts against many of the arguments of having the seller note in the first place (long-term alignment with seller)

  • Equity (5%-15% of enterprise value)…Two options:

    • Personal equity - if you’ve got the cash on hand to fund the equity need, this is an attractive route for many. First of all, you don’t have to find, negotiate, or manage any investors. Second, there are tax benefits of electing to be taxed as an S corp and you can be more aggressive with personal/business expenses.

    • Investor preferred equity - Acquisition entrepreneurs raise capital through their personal network (friends and family) or by small business investors. I created the SMB Junction Capital Connector as a distribution platform to solve this capital raise issue so check it out if you’re an entrepreneur needing to raise equity (for a good deal).

The ‘self-funded step up’ methodology

The purpose of the of the self-funded step up is a valuation & investor pricing methodology. It’s really a negotiation of how much ending cash flow distributions investors are entitled to (and inversely how much carry the acquisition entrepreneur ends up with).

Confusingly, the term ‘step up’ has also been used in the traditional search fund world for many years as a way to compensate initial search capital investors. The intent of it was to compensate for the added risk of providing capital before an acquisition had been identified. This is entirely different from the self-funded step up so don’t mix up the two.

Below is an example of how to calculate the investor ownership in an example $1.4M EBITDA acquisition. Investors are providing 16% of the enterprise value (or total cash need) as investor equity to purchase the business. Multiply the 16% times the self-funded step up (2.0x) to get 32%, which is the expected ownership of distributions after the investors have been paid both the liquidation preference (return of capital) and the preferred return.

Self-funded step up multiple

Market: 1.5x to 2.5x

Self-funded step ups range from 1.0x to 3.0x depending on a variety of factors: competitiveness, business quality, deal structure, growth prospects, etc. I would peg the mid point of market self-funded step up to be 2.0x assuming a close to ideal structure of debt and equity.

Liquidation preference

Market: 1.0x

A liquidation preference of 1.0x means that the equity investors are entitled to receive their initial investment before the common shareholders receive any distributions. Investors with a liquidation preference have a priority claim on the company's assets over other the acquisition entrepreneur who will hold common shares.

I would view this as an absolutely standard term. If a deal proposed no liquidation preference, I would avoid using the self-funded step up methodology and assess this deal from the ground up.

Preferred return

Market: 8-14%

A preferred return, also known as a "hurdle rate" or "priority return" is the rate of return that investors are guaranteed to receive before any profits are distributed to the acquisition entrepreneur (the common shareholder). This is necessary in order to align incentives and provide a base floor of return for investors. Given general interest rate increases, there has also been an increase in the preferred return rates offered.

Acquisition entrepreneur / CEO salary

Market: $60K to $125K

Salary is probably the most dicey term that I rarely see negotiated (to the benefit of acquisition entrepreneurs). I’ve seen upwards of $250K attempted by some aggressive acquisition entrepreneurs. A $150K acquisition entrepreneur salary on business that generates $450K of EBITDA of makes no sense as both an entrepreneur and an investor. The goal is for the acquisition entrepreneur to pay their rent/mortgage, food, child care, and not much more.

The acquisition entrepreneur’s primary focus should be either growing the business and paying back investors as quickly as possible through cash flow. As an investor, I want that acquisition entrepreneur to be highly incentivized to pay back my initial investment, however that is my personal preference (other investors aren’t as focused on return of capital). I like this mindset because as an investor, I can recycle that invested money into more opportunities once the capital is returned.

Any salary paid above what is minimally necessary and appropriate directly reduces investor returns and increases investor risk. I’d recommend taking a wholistic approach looking at CEO salary vs EBITDA, assessing it as reasonable or unreasonable on a case by case basis but knowing that size of company impacts the ability to pay a higher salary.

To be clear, EBITDA should include the cost of the new CEO salary

Criticism

This methodology is not perfect. In fact, I think this type of passive investing requires a higher level of sophistication than public equities because there are many ways in which an acquisition entrepreneur could hypothetically take advantage of investors even in the initial structuring phase. Slight changes in the 80/10/10 structure can lead to distorted economics resulting in bad deals for investors.

Ex: $250K salary instead of $100K salary is $150K of incremental cash flow annually that should have done to investors who funded the acquisition in the first place.

Ex: No liquidation preference

Ex: Poor minority protections (ability for acquisition entrepreneur to unilaterally increase their salary or change the operating agreement)

Investing like in these opportunities is highly risky and should only be for accredited investors and then some. You need to know how to vet a financial model, understand deal specific risks, understand a complex operating agreement, quickly identify any red flags with the acquisition entrepreneur or company. Otherwise, it may be an expensive learning experience.

Take-aways

Most of this is my personal perception of what market terms are today given the deal flow I’ve seen and deals I’ve invested in so far through my personal network & through the SMB Junction Capital Connector. On a deal by deal ‘out of market’ terms may be completely justified while ‘in market’ terms may not make sense given the company/operator profile.

The self-funded search model allows an aspiring entrepreneur buy a company and retain well over a majority of ownership while putting very little to no capital into a multi-million dollar business.

The model requires using heavy amounts of SBA debt, as outlined above in the 80/10/10 structure, in order to achieve outsized economics to both the acquisition entrepreneur (entitled to 70%+ of the distributions) & investors (generating 30%-40%+ IRR passively).

When a deal is aligned between the acquisition entrepreneur and investors, it really works: An exception company bought, and many multiples of an investors money returned to them, while creating significant wealth for the acquisition entrepreneur.

Please respond with any questions you have or topics you’d like me to address in future issues.

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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…]