About the Host
Ryan is an entrepreneur, podcast host of the show Life After Business and the co-owner of Solidity Financial. Having personally experienced the hazards of selling a business, he joined up with his friend Brandon Wood to educate others on the process. Through their business (Solidity Financial), they provide a platform for entrepreneurs called The Value Advantage™ that helps in exit planning, value building and financial management.
About the Guest
John Thwing is The SBA Guy. John is one of the busiest lenders in Minnesota and has closed over 400 SBA financed transactions. Areas of expertise include owner-user commercial real estate, business acquisitions, expansions, partner buyouts, franchise and construction financing. John regularly speaks on the topic of small business financing, presenting to industry groups, advisors and individuals interested in buying a business or commercial building, and was recognized by C-LEVEL Magazine with a 2016 Champion of Business award.
John is a fifteen-year member of the Minnesota Commercial Association of Realtors (MNCAR). He has also volunteered as a business plan judge for the University of St. Thomas MBA program and for BPA-DECA. John has been in banking for 29 years, and is a graduate of the Carlson School of Management at the University of Minnesota. Anchor Bank has funded over $28 million in SBA loans so far in fiscal 2017, and we are currently the #2 SBA 7a lender in MN/WI.
If you listen, you will learn:
- John shares how he started at his first bank in the mail department and ended up becoming The SBA Guy today.
- How the role of the SBA is to guarantee loans for financial institutions.
- Deal structures and restrictions with SBA financing.
- How the SBA tool may not be a good fit and how John helps sellers and agents recognize that.
- How cash flow is the driver of value, and banks want loans that will be repaid.
- Due diligence, determining value and prequalifying for financing.
- How SBA lenders validate 3 years of tax records for ecommerce businesses.
- Marketplaces for matching buyers and sellers.
- How hiring an appraiser is not always the best first step.
- Change of ownership is not part of the SBA loan structure.
- Qualifying buyers and looking at liquidity, transferable skills, background and expenses.
- Discuss financial fundamentals and listen to the market and your advisors.
Ryan: Welcome back to the Life After Business podcast. Today’s guest name is John Thwing, also known as “The SBA Guy.” He’s done over 400 transactions and spent the better part of his career and tenure at Wells Fargo before landing at Anchor Bank. The best part about John and his philosophy and his style is that he believes that the fundamentals come first before the deal structure because you have to know where you’re trying to go before you actually know what tools to use.
John provides us with a ton of insight about the SBA structure, the loans, how they work, when and where the lender plays with the relationship to the buyer, the seller, and the broker, and the other advisors. He provides us with some great insight on all the deals that he’s done because as a bank, you’re neutral to the process so the whole goal is to have a successful transition. He gives the analogy of being a magnet where he has to bring the buyer and the seller together to make sure that this all works because the main goal in a successful transition is for the bank to get repaid.
John’s experience shed some light on a lot of different scenarios on what equals a qualified buyer, what kind of buyers go into the SBA world to then purchase a business, and how a seller can use the SBA as a tool to finance their exit. I really hope you enjoy this interview with John. He provides a lot of good information with all of his tenure, so without further ado, here’s the interview with John.
John, how are you doing today?
John: Good, Ryan. How are you?
Ryan: Doing good. Looking forward to have you on the show. You have a lot of experience that you’re willing to share with us today. Before we even kick it off, for our listener’s sake, can you go back because you are heavy into the SBA world, but go back, how did you get into the whole lending practice and walk us through a brief overview of how you got to where you are today.
John: You bet. I started at Northwestern National Bank as a mail boy, took a year off out of college, that was my first entry in banking. Then I was in the home mortgage division, I was in the Norwest Phone Bank. I was in cash management sales selling to large corporate entities. I always wanted to get into small business. Got into small business lending in our SBA division about 15 years ago at Wells Fargo and been there ever since.
Ryan: You have a crazy amount of transactions you’ve done, it’s up more than 400 now?
John: Yup. A little over 400 transactions closed and funded.
Ryan: We got a lot of stories we can dive into today. You are labeled as “The SBA Guy.” I think as we take this interview on the high level of the functionality of the SBA down into maybe some of the stories and deal structures that you’ve seen, but to start high level, can you give us a brief rundown of the major high levels of SBA loan?
John: You bet. People tend to think that an SBA loan is a loan from the SBA. I would just like folks to know there’s really no such thing as an SBA loan. Banks make loans that are partially guaranteed by the SBA through the 7(a) Program. Then banks make first mortgages and certified development companies make second mortgages that are guaranteed by the SBA for commercial real estate.
Number one important to know, the capital end of the deal that I represent is bank capital. The SBA guarantee only comes at the back end. There are three main areas that SBA’s used for, the 7(a) Program which is general financing of all different varieties. The 504 Program, which is typically commercial real estate or long-term equipment assets and then revolving lines of credit. SBA Express Program or the Cap Line Program.
Ryan: Okay. Was there one a handful of years ago that was 90% guarantee or something like that? Because I remember when we had our company, we got one that was unique and I think we landed this SBA loan that was almost 90% or 95% guarantee by the government which is no longer around.
John: During the recession, the guarantee levels for lenders actually went up but you might be thinking of loan to values. For instance, when you finance commercial real estate or the acquisition of a business, perhaps the financing was at 90% loan to value, which is pretty common for SBA particularly on commercial real estate.
Ryan: Got it. The SBA has rules and regulations around deal structures, correct? When you and I were talking on a past phone call, it’s so much different than the normal market where pretty much anything goes when you’re doing deal structure. In your experience, in your tenure, what are the common areas that you’re seeing where they usually play within using the SBA loan as a tool?
John: SBA does have specific structures. Typically, there is more flexibility than people realize. It’s because many practitioners don’t really know how to leverage the program that well. For instance, in an SBA change of ownership, a business acquisition, when there’s more than $500,000 of goodwill, SBA requires that the lender not lend more than 75% of the purchase price. Definitely depending on the transaction type. With commercial real estate as well, particularly on the 504 Program, SBA dictates what loan to value you can lend to. There are areas where SBA dictates a structure. There are other areas where SBA doesn’t dictate a structure and lenders have more flexibility.
Ryan: What are those different areas?
John: For instance, in the 7(a) Program for commercial real estate, SBA does not specify or require the equity injection. Most banks and most markets will require at least 10% equity on an SBA 7(a) real estate deal, but SBA itself does not have a specific policy related to required equity. A bank can, as long as it thinks it’s still making a prudent loan could for instance do up to 100% financing on commercial real estate. They may not do that and it may be outside their lending policy but SBA does not prevent them for doing that.
Ryan: Interesting, I never knew that.
John: Similarly with business acquisitions with less than $500,000 of goodwill, SBA does not dictate the equity requirement. It’s really up to the lender's discretion.
Ryan: Let’s go into that, when you’re talking about where they’ve got some stipulations because it was some of the deals that you and I were talking about and I think a lot of our listeners play around that area where when we sold the businesses, like I said, anything goes in deal structures and we can get to that in a second but if you’re using SBA as one of the main types of financing, there’s a lot of restrictions on employment contracts and all those sorts of other caveats that people like to throw into the deal, correct?
John: Correct. I always say SBA is good at vanilla, chocolate, and strawberry. SBA is not good at Baskin Robbins’ 31 flavors. I think of it as both a strength and a weakness of the SBA program. One of the problems a lot of folks have when they’re looking at exit strategy is there are almost too many choices, there are a lot of different ways to do things. In an SBA funded scenario, it gets very specific.
For instance, you can’t have an earnout, you can’t really have any contingent payouts based on company performance over time. The seller has to no longer be an officer, owner, or employee of the business post-closing. The seller can have up to a 12 month consulting agreement. Some of those things drive a lot of clarity and fewer choices.
Ryan: Why do they do that?
John: I’ve been doing SBA loans so long that they make sense to me. From my point of view philosophically, the reason SBA has those requirements, is SBA wants to make sure they’re funding actual transitions of ownership to a new generation of owner which will extend the life cycle of the business. When you think about the whole purpose and mission of SBA, it’s to create and retain jobs and to create and retain tax basis or tax revenue. If they just recapitalize the current owner for instance, it doesn’t necessarily extend the life cycle of the business. SBA has got structures in place that prevent transactions that aren’t true changes of ownership and management.
Ryan: Interesting. That felt like you said, philosophically, that makes a ton of sense. With the experience in the people that I talk to and the people that I work with, when you get in the flexibility, like you said, you can almost be paralyzed with all the different choices and then the ripple effect of tax strategies and all the stuff that happens from the unlimited amount of options. Do you ever run into challenges with deals where people can’t get something done because in earnouts or employment contracts or consulting contracts, those are a lot of ways to push the risk back onto the seller and/or potentially net more proceeds over the course of the deal. Do you run into issues with not being able to have that flexibility?
John: Yeah. You definitely run into issues. For instance, the SBA is best at funding businesses that have some consistency over time and that are not in hockey stick growth. If you got a transaction that’s in that hockey stick growth, it’s hard for an SBA lender to catch up or keep up with value, almost very hard for a banker as well. That’s why equity players of various types are more often, or strategics, are more often going to be the funding mechanisms for those high growth or more volatile businesses.
For me personally, I’m not an attorney. In my transactions, it really does come down to fit. The SBA tool is sometimes a good fit for funding the deal and it’s sometimes not. What I do is I help both sellers and agents, recognize, “Hey, when might SBA not be a good fit?” Doesn’t mean it’s not a good deal or a good entrepreneurial opportunity, might mean it’s not a good SBA opportunity.
Ryan: I love your philosophy because you and I were talking about fit versus fundamentals, can you just dive into that and give us your overall philosophy on how transactions work?
John: You bet. A lot of my transactions are driven by what SBA refers to as a change of ownership. Business acquisitions, when someone’s buying a going concern. My buyer’s typically an individual or another closely held concern, another small business.
For me, the key issue is always fundamentals first, deal structure second. I think of the deal structure and financing as what I call flavor of capital. The key is both banks and SBA lenders are cash flow lenders first. For a bank conventionally, it first finances on cash flow and then on collateral. SBA lender first finances on cash flow, then the SBA guarantee, then varies, thirdly, collateral. Making sure that we’ve got fundamentals which would include cash flow that supports the price, cash flow that supports reasonable owner pay, and cash flow that supports some wiggle room or breathing room for our borrower, those are the three fundamental things the business has to do. Pay the owner, pay the lenders, provide some cash flow wiggle room.
Once you have that, then it really depends on what’s the strength of the buyer, how much collateral is in the deal, and how strongly does it cash flow. There are some deals that could be eligible for either conventional financing or SBA, but probably most of the deals in the market and given the multiples in the market, SBA becomes a really good tool. Because you can go up to 10 years where most banks are only going to finance goodwill or acquired business assets over 5 years.
Ryan: There’s a lot of different ways I want to go. I think it’s such a clean philosophy in how you’re working with the structures. Honestly, what I like about it is because you’re limiting a lot of the games that I have personally experienced or seen and you’re making it true about making sure it’s actually a healthy business that can be transferred, to be honest.
John: Yeah. One of the challenges in the market is that a lot of folks that do financing, they just don’t do a lot of acquisitions. They’re not familiar with the fundamentals of how do you look at an acquisition, how do you look at EBITDA or seller’s discretionary earnings, what kind of multiples might be in a normal funding range and how do you put the deal together, and then also walk somebody through what might be the various forms of capital that’ll work and the key there is finding that common ground between the buyer, the seller and the lender. Because if it’s just the buyer and the seller agree but the lender can’t get there, it’s not going to be a deal.
Ryan: Sorry to interrupt because I think that’s all cool because interesting and different than a lot of the world that I have come from. When you have a lender like yourself involved, you’re like the referee. Hopefully, that’s not a bad connotation because I think it’s interesting because the lender has to approve the valuation and you’re driving the bus a lot, you’re making everybody dance together because in the open world, the buyer can drive so much of the process so the valuation in multiple and all that stuff is driven by two parties instead of having someone that’s in the middle of that. Can you walk through how you navigate those waters with the two parties and then also how do you and the lender actually come up with that valuation?
John: My approach is always cash flow is the driver of values, we’re going to look at cash flow. The bank tends to be the most neutral position, the bank has a profit incentive in terms of making the loan and making as big a loan as reasonably possible, because we’re getting paid interest from that balance of the loan. But the bank also corresponds to make a loan that gets repaid. It doesn’t want terms that aren’t advantageous and key up a buyer for success.
I would say most parties do look at the bank as in the middle and we tend to pull people toward us a little bit. Often times, folks in the marketplace might use me to help set expectations with the seller and I’m also helping a buyer understand that it is a healthy market and attractive companies are going to trade for pretty decent multiples.
We’re the magnet that pulls people together. Often times, people will want things that we’re probably not going to give them. I can also be bad cop. For instance, seller grade financing, in most of my transactions, we are going to expect the seller to carry a portion of the transaction, typically somewhere between 10% to 15% of the purchase price, and that helps the bank mitigate some risks, also in sense a proper transition over time from the seller.
Ryan: It is really cool because again, you got everybody working on the same playbook. Like you said, if the SBA’s whole goal is to make sure that there’s a healthy business that transfers to everybody, collects their tax, revenue, the bank collects the revenue and the seller and the buyer both win. You’re actually putting all the puzzles together instead of generally you hear some horror stories of the buyer that has intent of driving down value or not paying some of the loan dry notes caveats that are thrown into a deal.
John: One of the things I like to remind the parties, I don’t represent either party. The buyer is my client but I represent the bank, so as opposed to an attorney or an agent, who typically have a fiduciary accountability to one party or the other, my role and my accountability is actually to the bank. I always remind my customer that while they’re my customer and I want them to be happy and I want to give them good service, I have a duty to represent the bank and its depositors and owners.
That’s the other key issue, is I represent a third party and as a third party, our process is really focused on due diligence and analysis and taking what we think we know and then validating it with third party due diligence. It’s a market based approach that as much as possible is not based on how people fell but based on what the data says.
Ryan: Let’s dive into what does your due diligence process look like and how do you determine value on a specific company?
John: For me, due diligence is really two parts. In the market, you’ll tend to hear folks talk about SBA approved or pre-approved, I say there is really no such thing as pre-approved, either you’re approved or you’re not. Unless you’ve got a buyer or a seller in a purchase agreement and a financial package, you’re not approved. But people often do get what I call pre-qualified. Whether you’re a buyer or a seller, I will work with folks to pre-qualify them for financing and part of that process is making sure that buyers have some liquidity, they’ve got some cash to bring to the table and some dry powder, they’ve got a good fit from management and ownership and history point of view, so their experience fits, and they’ve got good personal credit and they don’t have any baggage.
On the seller side, I’m typically looking for hopefully good or neutral trends. I’m looking for cash flow. Typically for valuation where a broker or agent might look at seller’s discretionary earnings. I’m going to look at discretionary earnings as well but on a tax basis, then I’m going to take off the reasonable owner pay and I’m going to take the remaining cash flow and generally speaking as a rough rule of thumb, I would use a five time multiple of cash flow after new owner pay which will give me a ceiling for what evaluation scenario might look like.
Ryan: That’s interesting. There’s a couple different pieces of the process that I like. Before we even dive into a little bit more detail, what are the size deals, are there deal limit sizes from a lender and/or the SBA, what are the usual transaction size fit?
John: Yeah, perfect question. My rough rule of thumb, that five times cash flow after new owner pay, that rule of thumb really only works when you’re in the sweet spot of the SBA market. There really isn’t a lower end but the lower you go, the more the owner pay is a percentage of the deal. For instance, if the deal has $100,000 of SDE (Seller’s Discretionary Earnings) and the buyer’s going to pay themselves $75,000 salary, three quarters of the company’s cash flow goes straight to the owner. If a company’s got $1 million of SDE and the owner’s going to pay themselves $100,000, 90% of the cash flow is still available.
To some degree, I would say in general, there’s no lower end of the market in the SBA world but deals do get harder because that pay for the new owner takes up most of the cash flow. On the upper end, SBA policy limits eligibility to $5 million. An SBA 7(a) loan of $5 million would be the policy maximum that it would generally be above the credit appetite of a lot of banks.
I recently closed a transaction that was close to $4 million. There was about $800,000 of real estate in that, the bank funded over $3 million of acquired business assets. Between two and five million is where there’s going to be a lot of variation between lenders and what their willingness is and I will say the stronger the deal, the more lenders are willing to go bigger.
Ryan: What’s interesting about the conversation that you and I had about the types of deals, you were just alluding to that. Your ability based on what lender you’re working with, you do a lot in the digital online space which I find very interesting because I’ve interviewed some gentlemen on our podcast, it’s a lot of ecommerce or they’ve had digital assets. You have the ability to actually do deals in that space because of how you go about this process. I don’t want to steal your thunder but you explained what a closing is like, which is way different when there’s a lot machineries. I don’t know if you can shed some light because I think there’s a lot of people that will be interested to hear about how you guys approach that.
John: I would say that in general, SBA lenders probably don’t do a lot of ecommerce but they certainly do ecommerce. The key really is if a deal can be validated and verified with tax basis cash flow. SBA lenders are required to validate three years of tax returns through the IRS. We get the three years of tax returns from the seller. We go to the IRS. We get a tax transcript. We compare the two, make sure they match.
SBA lenders are not afraid of ecommerce in general because they’re like most other types of other service companies where there’s not a lot of tangible assets. A conventional bank lender, collateral is very important to a bank lender. But in these acquisitions, there typically is not a lot of collateral.
Even in a manufacturing company, when there are tangible assets, if it’s a nice company and performing well, typically the single biggest asset is goodwill, which of course is still intangible. A service company, for instance let’s say it’s an accounting firm or a law firm. Again, not a lot of tangible assets. Ecommerce is very similar. As long as it’s an ecommerce company, it’s got tax basis revenue, tax basis cash flow, and we can validate that through the IRS, that in it of itself is not a negative.
As a transaction gets bigger and bigger and the amount of unsecured lending that the SBA lender is doing, that’s where the concern comes in. Pretty much every lender’s going to have that concern again whether it’s ecommerce or some other kind of service business. That part doesn’t typically matter, it’s just that collateral fall and at some point most banks will say, “Hey, that’s enough. We don’t want to fund anymore.”
Those transactions are still viable because oftentimes in most transactions, sellers realize, “Hey, I really don’t have any tangible assets. I might need to carry a little more.” That typical structure of 15% buyer cash, 10% seller carry and 75% financing, as the deal gets bigger, and as the amount of goodwill gets bigger, those proportions can change. Hey, we can still fund the deal, we can still get the seller a nice chunk of cash at close, but seller’s bigger deals with more goodwill, they may need to carry a larger parentage.
Ryan: Yeah. Which I think is so cool. Everything you said makes so much sense but I think from the conversations that I have in the marketplace or people that have been in the show, there has just been frustrations because they’ve got a very viable business that does have those things and they tend to see a lot of banks that are scared of that stuff because there’s not “stuff.” I literally had a guy that said, “I didn’t have any sealing machines or stamping machines so they didn’t want to fund my deal.”
John: I will say, a lot of the issues with SBA in the market is due to the practitioners in the market. SBA tends to get a bit of a bomb wrap. Sometimes banks or bankers that don’t use SBA often, the SBA makes for a good boogie man. They can blame the stuff they don’t get or execute properly on, they can blame it on SBA.
What I would tell you is a good SBA lender that’s experienced and understands the programs of how to apply them to their client’s circumstance should be able to get out ahead of these issues and they shouldn’t ever say, “Hey, I can’t do the deal because there’s no collateral.” Now they might say, “Hey, I can’t do any more than x because we won’t do more than x unsecured.” In other words, at some point the bank’s going to go, “Hey, no more.” And between buyer cash and seller carry, you guys got to carry the rest of the weight, but you don’t really get into the SBA business without having an appetite for unsecured financing. That’s the whole purpose of the SBA guarantee so that the lender has another safety net rather than liquidating collateral, we go back and we enforce our SBA guarantee.
Ryan: I think you hit on a key point. Based on the practitioners and everything just wrapped up. When we were at imaging path before we switched, I interviewed 14 different bankers and everybody’s got their different kind of pitch. They either are totally sales, total underwriter, combination of everybody in between but knowing how that lender, how much exposure and experience they have with SBAs is huge. Because we were going on a road where it seemed like a very good fit but then you realize that they’ve only done five SBA loans. Maybe because like you said, it’s such a detailed process that you want to make sure that someone actually understands how to do this and do this well.
John: It is, from my point of view, key to have a credible SBA specialist. Most good commercial bankers are willing to say, “Hey, SBA is not really necessarily my thing.” A good SBA lender, if you have other funding mechanisms that work, I also work with some very, very strong borrowers, very strong buyers, where SBA is not their only option. In those scenarios, SBA may be a choice, conventional commercial bank financing might be the choice, and what I call personal funding might be a choice.
In other words, they can write a check, they can leverage personal assets like either liquid securities or personal real estate. Probably a third of my clients fall into that category, where really my role is to help them differentiate and choose from different funding options. The typical commercial banker might not have that same skillset to be able to differentiate conventional SBA and personal funding choices for buyers.
Ryan: Because it’s about the deal structure, getting it done and done the right way. Let’s take it a notch deeper in some of the weeds because you have some very good thoughts and advice on what kind of buyers are out there, what kind of sellers are out there and how you match. Can you give us a little bit of an overview of the types of deals, is it midmarket mainstream, family transitions and then where are these buyers that are looking for SBA loans and where are the sellers, what is the landscape of the market and how do you actually match it all together?
John: Sure, you bet. A couple of things. There are a couple of different marketplaces. There is the change of ownership market place which is generally business acquisitions, the 7(a) Program is the primary tool there. Business advisers, business brokers, attorneys, accountants, those are all the market makers so to speak. The market makers will vary depending on is the business listed and publicly marketed, i.e. with a broker or is it more of an inside deal where you got current insiders buying in or we’ve got some known person buying and there’s no agent or intermediary.
SBA is a good tool for both of those situations. Oddly enough for me, the deals that are marketed and that are bought by an outside third party through an agent tend to be the easiest because they’d been on the market and the seller has experienced the marketplace. For me, one of my toughest transactions tends to be family transactions.
Ryan: Because it’s family.
John: Well, because it’s inside and because there’s been no exposure to the marketplace or marketplace norms around both value and structure. Often times when we get an inside buyer, I show up at the first meeting and I go, “So what do you think?” And then they’ll look at me like, “Oh, I don’t know. I thought you were here to tell us.”
Ryan: I cannot get paid enough for this.
John: I’d say, “Hey guys, I’m not an agent. I don’t represent you or your interest. I am never going to be the first one to say a number. Once you tell me number that you’re thinking I’m happy to give you my feedback about that number. But I don’t want somebody at some future date saying, ‘Hey that SBA guy told me my business was worth this.’ I’m not an expert on business valuations. I am an expert on funding businesses in price ranges that makes sense to lenders. Two different perspectives at the same question.
Inside transactions tend to be hard, and again, whether it’s an acquisition of going concern or even commercial real estate because there hasn’t been an exposure to marketplace norms or pressures. That’s when I usually steer people back to their CPA, or their attorney. The other dynamic that you often see is people say, “Let’s hire an appraiser as a first step.” For my point of view, that’s not always the greatest idea. In general, appraisers do better work when they know what two parties in an open market think.
In other words, the first comp in an appraisal is the purchase agreement or the terms of the sale of that particular business or building you’re trying to value. If you just say to an appraiser, “Hey, what’s it worth?” And they don’t have the context of what the buyer and the seller think, I say it’s like sending them into the woods without a map or compass. They’re feeling their way around without that first data point, which is what would people think now.
What I typically advise folks is they should start to look at things like cash flow. Start to do some research about what a normal multiple in their industry might be. And then start to think about what can the company afford going forward and have some idea of what do we think might be a fair price to both the buyer and the seller before they go to an appraiser or even a lender or at least have a starting point.
Ryan: I can just visualize those scenario where you’re just walking into just a bunch of loose stuff. You nailed it when you said there needs to be at least one data point for you. Everybody is going to have some sort of benchmark and a foundation to work off of. Let’s, for a second, assume that they’ve got some sort of exposure and they’ve worked with someone to actually build “exit plans,” selfless plug. I think the family always thinks that the kids or the inside management has to have money. I think this is where your expertise can become very crucial because you can make things happen that most people I don’t think actually are nowhere possible because most of the comments I hear are: My kid doesn’t have any money, my manager, I don’t pay him enough to buy outright, I want to give up my cash flow in order to let him buy me.
Let’s say they had some sort of rough idea on the time frame and/or the cash flow that’s available and some agreement on the multiple. How do you actually help them structure that on the inside?
John: Sure. One of the things to know is for instance, in third party transactions, we typically always want to see buyer cash coming into the deal. But for instance, on inside transactions, whether it’s a current minority shareholder or a family member or just current management, because those people already take their living out of the business, they already know the customer base, they already have a built in vested interest in the deal. In those transactions certainly, we are willing to think of or require less cash from the buyer. Lower levels of cash is pretty common for inside management or family buyers and for good SBA lenders, that won’t surprise them. It could create a challenge or it might not.
The other thing is I always focus on what I call a range of outcomes. What I like to help people do is understand number one, what is the valuation scenario that makes sense and to me that same scenario makes sense for an outside buyer or an inside buyer. Based on any particular buyer, outside or inside, how might a deal come together? One thing that people always say to me is they go, “I don’t want to waste your time.” Because their information might be incomplete or they don’t feel like it’s strong enough or they don’t have other data available. I always remind them, “Hey, I would never close a deal if I wasn’t willing to invest time on the frontend to figure it out.” And I go, “Believe me, no matter what deal I see, I’ve seen worse deals.” Because sometimes people are kind of shy. I’m like, “Believe me, I’ve seen something worse. Don’t be shy.”
I always think the ability and willingness to engage in the process, and to produce some decent financial information, both on the buy side and on the sell side. And then somebody like me can come in and say, “Hey, SBA might be an option or conventional financing might be an option. Or hey, you might not be viable for financing at all but there may be a way to structure this internally to get it funded without a lender.”
Ryan: What happens when you’re doing internal transfer like that and you actually want the seller to stick around? Because if you have to have a cut of ownership like that or cut of the actual involvement, is there major stipulations that you have in a transfer like that?
John: Yes. On any kind of inside transactions, let’s say you got a number of current shareholders and they’re going to buyout either senior manager, or they’re going to buy out all the current owners except one or two. Any exiting owner has to sell 100% of their interest. In other words they can’t get money and still be an owner. As of day of closing, they can’t be an owner, they can’t be an officer, they can’t be a key employee. They are eligible for up to a 12 month consulting agreement and I typically recommend that those consulting agreements be unfunded, in other words there not be a minimum contractual amount, typically set up on an hourly compensations rather than annualized.
All owners have to exit. If it’s a third party transaction and we’ve got an outside owner coming in, in that scenario all current owners have to exit regardless of their ownership percentage. Again, if it’s current partners, any remaining partners have to remain proportional to their pre-purchase level. If you got four partners, and you got two that are exiting but the two that are staying, one wants to be majority and one wants to be minority, but they were equal before, I can’t fund that deal. If they were equal before, they got to be equal after as well. SBA won’t fund what they refer to as creeping control. Transactions that change the power dynamic and ownership dynamic, SBA says no, we don’t want to be part of those because we don’t want to be involved in deals that…
Ryan: You want to make sure that it’s constant and you can project the future. Because if you would change the power dynamic like that, it puts more risk on whether or not you’re going to get paid back.
John: More risk and also, it’s not that changes of ownership proportion are wrong or unhealthy. It’s just that that’s not a part of what SBA wants to be involved with. In other words, we don’t want to annoyingly be a party to a conflict or a takeover.
Basically, whatever that ownership percentage was before, it’s got to be the same after. I will say sometimes, the end result someone wants isn’t supported by the current structure. When these things are a dialogue overtime, someone like me can say, “Hey, guess what? At the end of this year, you should make a change to your ownership structure which tease you up for an SBA buy out six months or a year from now because then your end result will be what you want.” That’s one of the other things people don’t always recognize. Sometimes, it’s going to take two steps to get to your end result rather than just one.
Ryan: Let’s expand on that. There are some cool things that I’m working on with internal transfers. You answered my question when you said because you have to have to that immediate cut with the SBA when it’s finally financed. There’s a couple of internal transfer compensation structures that I put in place because it all matters about how much that seller wants to net at the end of the day.
Let’s say that I have $500,000 EBITDA and that internal key man or family member wants to buy it, you put a compensation plan in place. If you go from 500 to then 600 to then 700, that growth goes into buying non-voting shares of the business so they can contribute in ownership over those future few years. When it hits a certain EBITDA or certain controlling share or the seller collects enough distributions, then essentially, you just “refinance” with an SBA and then the final step happens. Like you said, that’s the first foundation but then you can at least work on that structure before you actually get the rest of the financing done.
John: Exactly. When internal transactions are the preferred outcome, people should, in my opinion and probably yours, people should start earlier, they should start to have the discussion earlier, they should start to paint the picture of what does the end result look like and know that it’s like a planning a game of chess, you’ve got to make a few moves to get to your end result. That younger generation, whether they are family or nonfamily, part of their compensation rather than being dollars might be shares or quasi shares or some other form of ownership in the company or capital to make an equity contribution when the actual transaction happens. Some kind of deferred compensation structure that puts either shares or dollars aside from the buyer downstream is oftentimes a good way to go when you’ve got an inside buyer.
Ryan: To tie it to growth so that way you don’t have to fund it out of your own cash flow. I remember the conversation, it was always with my dad, “Why should I give you part of my cash flow that I already have?” Just like, I don’t know. If you can tie that additional stock or cash bonuses or deferred comp to growth for a future funding, then everybody wins. No one loses in the situation.
Ryan: I want to go and flip the switch for a second and talk about the buyers that are out there. Because I think in the range that you play in, because it’s all associated with seller’s discretionary earnings, it’s a lot of lifestyle buyers, correct me if I’m wrong at any point, but how do you find those buyers? Where do they come from because if I’m selling, a lot of it has to be the right fit.
From the conversation you and I had, you do a lot of due diligence on the resume because you and I were having a conversation, on my particular situation, if you’ve got a guy that’s making $500,000 at Honeywell and he quits and goes and buys a company, he’s no longer making $500,000 or anything like that. How do you structure that? What are the qualifications and how do you make sure that it’s the right fit?
John: A couple of things. I’ve been doing this a long time. I’ve been an SBA lender for 15 years. The quality of buyers has continued to increase over time. I would say we’re in as good of a market in terms of buyer quality as I’ve seen. For me, a good buyer is someone who has liquidity and can measure it to the kind of transaction they’re trying to pull off. Depending on how big a deal you’re going for, you should have dough to put into the deal, you should also have dry powder on the sideline. In other words, we don’t want to you putting your last dollar in.
Good buyers also have transferable skills. In other words, they’ve got good business skills and they can demonstrate those; they’ve managed people, they’ve managed processes, and they’ve managed money. Good buyers also have good personal credit and hopefully no baggage, no significant legal or financial issues. Getting key issues on the buy sides is also just cost of living. Total household expense becomes very important. Folks who have very high income but also have a high expense level, and that expense level will be continuing when they buy a company, that’s a hard starting point.
Ryan: That guy from Honeywell that needs to $500,000 and wants to go buy a small print shop. It’s only net of $500,000.
John: If a man or woman is making really good money but doesn’t have to spend a lot to live, in other words they got fairly small mortgage, their cars are paid off, their toys are paid off, all those kind of things, then that’s somebody that to me is well positioned for an acquisition. If I have someone who’s both high income and high household expense, that person is actually fairly poorly positioned. Again, the business has to do three things: has to pay the owner, has to pay the lenders, has to have wiggle room. The more the owner takes out as a percentage of that total salaries discretionary or EBITDA or cash flow, the less there is to support that.
For me, my best buyer is someone with a conservative lifestyle. They’ve stashed money away, they’ve paid down debt and they can reduce their total household income when they make this acquisition, they can live on a fairly modest salary until the business is performing well and they can either bonus or distribute more cash to themselves.
Ryan: Do you actually interview the buyers in a professional interview like when they’re trying to get a job style? How do you guys go about that?
John: No, not at all. What I would say is in general, my typical process is I get introduced to buyers from advisers in the marketplace that send folks to me. We usually start with a brief conversation, 15 minutes to an hour depending on the level of questions and the curiosity of the person. Then I’m collecting a fairly basic financial package of their personal financial statement, their personal tax return and their resume. Then we’re just having a general conversation. What tends to happen is I get to know them as we look at deals. In other words, I’m not usually moving forward with somebody on the very 1st deal we talk about, it might be the 5th deal or the 50th deal. As we talk about deals, I get to know them and their background and their experience and their story and then I can help.
Right now I have a client I’m working with, it’s the first deal we’ve worked on. He happens to have 20 years experience in the industry that he’s buying in. Financially, he’s not quite as strong a buyer but form an experience point of view, he’s super strong. The other thing in my role is that mix of what is the mix and is it the right mix. Any particular buyer might be stronger in experience, they might be stronger in personal liquidity, they might be stronger in a low household expense. Part of my job is to help position them as a well-qualified buyer to the bank so that when an underwriter looks at them, they go, “Yup, that’s somebody we would like to place a bet on make a loan.”
Ryan: All that makes so much sense too because when I was talking to another individual who’s in the market for that situation, everybody is always so concerned about their income and I’m like, “Actually you’re using the cash flow of the business to buy it. You need to have everybody have skin in the game which is probably very much associated with your different percentages but you’re not going to be making any money because that’s going to be your new job. You have to have everything fall in line with what is going to be and not what is.”
John: Yeah. I did a transaction recently, kind of an interesting story where two buyers, married couple, both good incomes, already owned investment real estate, they were getting into the group owned business. That’s an industry that we’re active in. Similar health care businesses tend to be pretty well staffed. There are some regulatory and licensure related roles and the staffing tends to be pretty good. They actually came to me originally and their business plan was one of the two of them were going to quit their job and run the business full time. I looked at the staffing in the business that they were buying, I looked at them and their experience and they’re both in good well-paying jobs where they also have flexibility. I said, “Hey guys, why would one of you quit your jobs? This deal is actually stronger if you two both maintain your outside income and you just act as support to the existing staff that’s already there and staying.” That’s what they actually had wanted to do but they thought that one of them would have to quit.
I would say we are typically an owner operator model in the SBA world but the scenario varies based on the transaction and the buyer and what the company needs. Part of my role is to help say, “Hey, what’s the right solution?” And to ask questions. The other thing that tends to take buyers a little bit of time to figure out as they get to know the business is what is the go forward staffing model. Hey, can I just buy it myself and just replace the owner? Or do I also need to hire somebody? Are there other FTE that’ll be leaving or is the owner working more hours than I really want to? Or can I really replace two people? If the owner’s absentee, maybe I can replace both the owner and a manager, for instance? Understanding that go forward business or ownership and management model, is really key to understanding cash flow.
Ryan: Totally, totally. With the deals that you’re involved in, is it mainly from the buyer side that you’re getting involved in? Or when someone’s going to exit their business, usually they’re hiring a broker and an investment banker and then they go to you once they find that buyer. How do you usually find a deal, is it mainly the buy side or is it mainly the sell side?
John: Yes. It’s funny. I would say most of my “leads” come from folks that represent the sell side but interact with the buy side. That would typically be intermediaries of various types. Actual agents, advisers, accountants, attorneys, any kind of advisory role but typically it’s someone who’s acting as an adviser or agent to the seller but they’re the first point of contact for a potential buyer and that buyer gets sent to me. I also certainly have just unaffiliated buyers that reach out to me directly, get pre-qualified on the buy side. And then they’re out in the market just shopping in general and looking at any number of different sources for a potential transaction. From my point of view, the key really is that fit and marriage.
I see good buyers and good sellers where I’m not interested in them together though. I like the buyer, I like the seller but they don’t go together.
Ryan: Alright, tell me the story. You’re thinking of one in particular while you said that. I got to imagine.
John: Mostly it’s experience. In most of my transactions, transferrable skills are the primary explanation or background on the buy side. In other words, most of my buyers do not have direct industry experience in the exact business that they’re buying. But, as business get more specialized, for instance, if you’ve got a highly specialized manufacturing company, or a highly specialized commercial sub-contracting company, we’re not likely to fund a general buyer with good general business skills into a highly specialized business. The more specialized the business becomes, the more it’s important that there would be a really good fit between the skillset required and the buyer. Businesses for instance an industrial distribution company, I got a whole lot of potential buyers that could fit into a company like that and maybe not have any specific industry skills. The other big underlying question is what is the continuity that’s remaining? Key question I’m always going to ask is if it’s a consulting business with one owner and one guy, even if it makes great money, you better be a copycat of that guy or it’s going to be hard to buy and it’s harder to transfer that business.
The more a business has people in various roles that have continuity with customers, with vendors, with employees, etc., the more transferrable that business. That’s the other issue is, what’s the continuity within the business that’s staying and how much is it going to hang on the buyer and they’re experience to carry the deal forward.
Ryan: You touched on a couple really cool point because I don’t know if you’re familiar with the [00:57:02] built the seller value builder system. We hear that some of that stuff at our firm and one of the thing is the whole hub and spoke, and you’re talking about the specialization of maybe that engineering manufacturing firm. Let’s say in that situation, I was the owner, I actually had a president because I worked myself out of that hub and spoke but I became more of the investor and you no longer needed that because you might now have a general manager that’s doing all the work. Does that open the marketplace a little bit more for the buyers?
John: It does. I would say, as a general rule, oddly enough, the bigger the company gets, and the more continuity there is in the employee base, the less of an issue it becomes. I recently closed a relatively large transaction. I’m not a super specialized business, but where my buyer had really great business skills but none related to this particular industry, he was a great buyer. As a business gets bigger and as the infrastructure and the hierarchy of people gets bigger and the continuity, what’s the tenure of different people, then that issue tends to go away. A lot of the businesses I fund, the seller started as some kind of technician. In other words the seller did the work. Overtime, they turn into a business owner. Some business owners remain at heart technicians and those are the businesses that are harder to sell and transition. Some business owners over time go from being technicians to being professional business owners. Those are the businesses that are easier to sell and easier to transition to a wider variety of buyers because the owner has morphed into a professional business manager rather than a technician.
Ryan: You just quoted The E-Myth right there. I love it. If there was a couple things, John, that you’d leave our listeners with that you’ve either touched on or you want to reiterate or you want to bring and leave them with, what would it be?
John: I think really key is always working with experienced advisers. And again, whether that’s me, whether that’s your banker and whether that’s your accountant, your attorney, working with folks that are experienced and proven, and that have some skillsets around the transition of a business or the acquisition of commercial real estate, or for instance a construction financing, whatever it may be.
To me, that credibility of your team. I always say these transactions tend to be the financial super bowl of both the buyer and the seller. When you’re recruiting a quarterback for your financial super bowl, rate and term shouldn’t be your number one driver. To me that’s just really key issue.
The other thing is fundamentals. I always think the ability to have a discussion about financial fundamentals always leads to that outcomes. Again, whether it’s regarding a going concern, whether it’s regarding a potential real estate purchase. The ability to talk financial fundamentals, do we have cash flow, do we have value, do we have liquidity, is the basic building blocks.
I’d say the last thing is just the ability to listen to the market and hear what your advisers say regardless of what you feel. Advisers are going have some marketplace norms and marketplace norms are just that. They’re a way to look at the transaction. Doesn’t mean you have to do it, but those advisers have that experience to give you some context. Whether you’re a buyer or a seller, relying on the advice of those pros I think really helps deals come together.
Ryan: Listen to the norms prior to actually having to do the deal because then you can change stuff if you need to.
John:You know where you’re going. It’s like a sea voyage. It helps if you know where you’re going. It helps if you have previsions. It helps if you have a map and compass. You leave port and then you got to adjust as you go to the weather conditions but the key is we want to get to that destination but the destination got to make sense.
Ryan: I love it. John, what’s the best way for our listeners to get in touch with you?
John: Best way to get in touch with me is [email protected] or 612-505-9751 on my cell.
Ryan: Thanks for coming on the show, John.
John: Thanks, Ryan. I appreciate it.
Ryan: I hope you enjoyed the interview with John. Here are some of my take aways and some of my thoughts on John’s ideas and thoughts in the interview. One of the main things that really hit home and I think should be highlighted is the transferability of the business has to be there. When you have a bank involved, that is financing a deal like this for 10 years, their main goal is to get paid back and get their interest. They want to make sure that this is the healthiest possible transfer that they possibly can.
The only two ways to make that transfer possible is to make sure that the buyer is extremely qualified to continue that cash flow over the next 10 years to pay back and service that loan. To make sure that the resume, the skillsets, the quality of that buyer is extremely important and actually can be even more important than the actual funds that are available for the purchase.
The other way to make that transfer even more applicable is to make sure that you build yourself out of that company, to make sure that you become an investor, and not just a worker.
As John and I were talking about in the interview, go from technician in the E-Myth world to entrepreneur which is you running a business but then become an investor. Work yourself out of that business because it’s not only going to make you more money in the end but then it’s also going to open up the range of buyers that are available to you because if you got to specialize business where they need to know your stuff, the only way to actually open up that market is to replace yourself and then it allows the buyer to come in and then become an investor, not just a worker. I think it’s extremely important to apply that because the bank is the one that has to make sure that those funds continue to flow.
One of the other things that I thought was really important that I want to highlight that John was saying was fit versus fundamentals. The fundamentals have to be there. Because this is so as he said, vanilla, chocolate and strawberry, whatever it was, we need to make sure that there’s cash flow. Pure and simple. Because the cash flow funds the deal, services the debt and provides the lifestyle for that potential buyer. That has to be there. Making sure that the SBA is a tool is extremely important.
I guess this is one of the third take aways, making sure that your lender understands this. I cannot stress it enough. I worked with way too many lenders and interviewed 14 plus banks and everybody’s different that’s sitting across the table from you but then also every one of those lenders, even if they are a good fit, might not do this and might not see the SBA as a tool and might only see it as a potential commission. Making sure that your lender has the ability to do it but then also can say no because they don’t want a commercial loan versus a no deal is actually applicable. The quality of the lender and the skillset but then also making sure that the cash flow and everything is there is super important.
I hope you enjoyed the interview with John. I think demystifying this SBA and getting rid of the boogie man feel because it is just a tool and it is the right tool for a lot of different situations and doing the prep work ahead of time. I guess if there’s one last take away, it’s that it is a total possibility for internal transfers. If you get the stuff setup correctly and you have a compensation structure or growth strategy that allows for that insider to buy in prior to the financing, that structure will then allow more sellers distributions and more net proceeds and teeing it all up to make that SBA financed loan that much easier when the time comes.