Why Your Business is Not Worth a Premium: An SBA Loan Perspective

This is especially true as it relates to SBA 7a lending for business acquisitions. The SBA has some of the best rates around, if a given buyer can 1) get comfortable with the personal guarantee clause, 2) accept the SBA first-lien position and 3) find a business with the cash flow to support the requisite debt service. Number three is perhaps the most critical piece of the whole equation, especially as buyers and sellers consider business value. Without the ability to service the debt, the deal is dead on arrival. Unfortunately, most small business sellers completely misunderstand how value is calculated.

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What is the Debt Service Coverage (DSC) ratio?

Debt Service Coverage or DSC is a simple equation. It’s the annual free cash flow (FCF) of the business divided by the annual gross cost of debt service (SBA interest + principal and any subordinated seller notes). The rule of thumb for SBA lenders is, at a minimum, a 1.5 DSC ratio. That is, the annual cash flow must be at least 150% of the expected annual debt service.

Keep in mind that Free Cash Flow (FCF) can be very different from EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). In fact, actual cash flow from a Statement of Cash Flows (corroborated by the tax returns) is what the SBA loan underwriters will most likely demand to see. Where there is more DA that EBIT, true cash flow can be more easily obfuscated by silly non-cash add-backs. We have seem multiple deal failures because a buyer based their valuation assumption on EBITDA in a business with large non-cash add-backs.

Your business value is most often determined from a very calculated process. Synergistic premiums and earnouts need not apply.

When it comes to buying and selling businesses that fall within the purview of the SBA, your company’s value will be based on a very calculated process–a process that will ultimately hinge on the numbers you provide to the buyer and the buyer’s lender.

Many a seller may try to rationalize in his/her mind a valuation that falls outside of the normal bell curve. It’s the corporate equivalent of the illusory superiority — the logical fallacy that causes people to think they are smarter than the average. The fact of the matter is, most businesses will be average and most are worth what they are worth and do not venture far out of a tight range.

Annual Debt Service Coverage for SBA loan piece.

Seller note — Debt Service Coverage component

Fully negotiable, but with max terms set by and subordinated to the SBA component.

Considerations in DSC Sensitivity Analysis

There are multiple moving parts to this calculation, many of which, if moved, can adjust the relevant DSC ratio. However, most are ancillary and work in the buyer’s favor to ratchet the value down, not the other way around.

  • Rising Interest Rates — LIBOR and the Federal Prime Rate are both expected to have multiple stages of increase in the coming months. This will impact the ability of any business to service the debt and underwriters will base their DSC calculations on assumptions that the SBA rate will get above 8% and beyond.
  • Working Capital Needs — Every business will have typical working capital needs. Some will require more, especially those which are highly seasonal with less predictable cash flow during certain times of the year. In addition, the debt service may negatively impact the need for working capital. A simple Current Assets less Current Liabilities may not suffice.
  • Annual Cyclical Revenues — Companies dependent on seasonal trends (e.g. online retail and ecommerce) will find their SBA underwriters to be a bit more critical with their DSC sensitivity.
  • Personal Add-Backs — Sellers can often be overly liberal in calculating their Adjusted EBITDA or AEBITDA. Mark-to-market or other reasonable adjustments should be made to ensure the cash flow can handle and service the debt.
  • Seller Note — The size, term and rate of the seller note directly impacts the DSC calculation. As such, it is a critical component in determining the overall ratio and the ability of the target company is servicing the total DSC, which will include both the DSC and seller note.

While most SBA lenders have a hard-and-fast rule for 1.5x DSC, most like to see north of 1.7x. The aforementioned sensitivity table shows how the various annual debt service stacks against the cash flow. In this case, we assume cash flow and EBITDA are synonymous (again, which is not always the case).

Show Me the Equity!

Yes, there are more private equity groups than ever. Yes, more private equity groups have vast amounts of dry powder and liquid capital for making lower middle-market deals of this size. And, as we have discussed before, many private equity groups today are acting more like strategic acquirers. That is, they are looking for good fit bolt-on and tuck-in targets for a larger platform play. Unfortunately, that does not mean that 1) they want to overpay either or 2) they want to put in more equity than their lenders may require.

An ultimate premium will need to come from more equity from the would-be buyer. Any underwriter with a good process will cap the amount of serviceable debt by a very specific amount. That means that any potential seller premium brought by a synergistic buyer must be derived from more equity. More equity means “more money down,” “more cash at close” and “more skin in the game.” Premiums are a zero-sum-game in that the seller only wins (in his/her mind) when the buyer loses. Value was not actually exchanged for value. If you want buyers to pay more, you will have to convince them to cough up more equity. It’s that simple.


In many cases, sellers hold unrealistic valuation expectations. I have found that the smaller the business, the higher the likelihood that the owner thinks his/her business is worth more than what the market would ever pay.

If like everyone else, you are seeking a premium when selling your business, there are several considerations which you will have to consider. Firstly, size matters. The smaller you are, the less likely you are to capture a large delta from true fair market value. Where buyers have smaller pocket books, particularly with individual buyers, the aforementioned rules will absolutely apply. Large premiums come to small companies typically only when they own some other controlled asset (IP, business model or relationship) that the buyer could leverage for much greater scale. Second, run a process. Most sell-side M&A; advisors who run a controlled process can capture more of the value for the seller than the buyer–especially if they are able to bring multiple buyers to the business at the same time. Finally, understand that a buyer premium can only come from more equity, which you can gauge on ability to pay based on the buyer(s) which you have at the table.

For those looking to perform their own analysis of the above, you can find the Debt Service Coverage (DSC) calculator here.

Nate Nead
Nate Nead
Nate Nead is a private equity investor and the Managing Principal at Investnet, LLC. Nate works with middle-market companies looking to acquire, sell or divest business assets.