SBA's October 1 acquisition rules: earnings, equity and the $3 million test

Restaurant buyers using SBA-backed 7(a) loans will face different earnings tests for an initial acquisition and a qualifying expansion under rules taking effect October 1. The Small Business Administration published a technical update September 25 to the manual governing those transactions, including purchase-price, cash-flow and equity requirements.

The updated manual applies to applications received by SBA on or after October 1, according to the agency's issuance notice. Lenders continue using version 8 for applications submitted through September 30. The technical update replaces an earlier version 8.1 that had not yet taken effect.

The acquisition category sets the earnings test#

Appendix 15 of the updated manual makes Initial Acquisition the default category. The lender must document why a transaction qualifies for another category, such as Business Expansion or Owner Buyout. The business must be a borrower or co-borrower.

For Business Expansion, an existing business must have operated for at least 2 full fiscal years under its current ownership and purchase 100% of another business's ownership interests in the same four-digit North American Industry Classification System (NAICS) group. The transaction must also preserve at least the number of full personal guarantors required under the buyer's ownership structure before the transaction.

Initial Acquisitions require debt service coverage of at least 1.25:1; qualifying Business Expansions require 1.15:1. Historical coverage divides earnings before interest, taxes, depreciation and amortization, or EBITDA, by combined debt service after the transaction.

The lender uses the last fiscal year's results or the average of the last 2 fiscal years, on a historical or adjusted basis. Documented adjustments can recognize transaction-related savings and certain expenses. Each adjustment needs lender support; changes to owner compensation must leave the owners able to meet their obligations and living expenses.

Lenders must evaluate post-closing projections, but generally cannot use them to meet the coverage requirement. Additional equity can reduce the loan amount and associated debt service. A defined property exception allows projections, described below.

The $3 million threshold follows the business price#

For Initial Acquisitions and Business Expansions, a business purchase price of $3 million or more triggers a quality-of-earnings report, or QoE, alongside the business valuation. The lender subtracts the appraised value of owner-occupied commercial real estate included in the acquisition to establish that business price.

Buyer equity, seller debt and other financing do not reduce the price used for this threshold. A smaller SBA loan therefore does not, by itself, remove the report requirement.

The manual's financial due-diligence provisions require an independent financial professional to examine earnings reliability and sustainability for the lender. The work reconciles financial statements, tax returns and IRS transcripts. It also includes cash proof: matching bank receipts and disbursements to income statements and tax returns for the trailing 12 months and last 2 fiscal years, with a shorter scope permitted for younger businesses.

The lender must use the report's earnings findings when calculating coverage. If those findings cannot support the proposed debt structure, the loan amount must fall accordingly.

An acquisition involving a qualifying owner-occupied Special Purpose Property is exempt from QoE. The definition concerns a limited-market property whose design, materials or layout restrict its use. Its acquisition must be integral to, and inseparable from, the business purchase and continuing operation, with the lender documenting that determination. Restaurant ownership alone does not establish this status.

For that property exception, projections may satisfy coverage when the appraisal fully collateralizes the loan. The lender still analyzes historical coverage and must support projections meeting the applicable ratio within 2 years of funding, or construction completion for construction projects.

Equity has a different calculation#

An Initial Acquisition requires at least 10% equity, which cannot be waived. That percentage applies to total project costs, the costs required to become operational, with lines of credit and 504 loans excluded, rather than simply the SBA loan balance.

The equity provisions allow lenders to reduce or eliminate the 10% requirement for Business Expansions with sufficient liquidity and working capital and no negative net worth at the prior fiscal year-end. Eliminating it bars dedicated permanent working capital in this or another 7(a) term-loan request within 90 days; the manual permits a limited exception for incidental excess proceeds.

Seller debt can count toward required equity when subordinated to the lender and placed on full standby, with no principal or interest payments throughout the 7(a) loan term. These and other limited equity sources collectively may cover no more than half the required injection.