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Getting Your Money's Worth
Those who are considering a loan for buying a business should understand SBA business valuation requirements. Valuations are to ensure the business is honestly reporting their assets, liabilities and business potential. It also helps the potential business owner ensure they are getting their money’s worth. However, not everyone understands all of the different formulas that must be taken into consideration when setting the value of a business.
Publicly traded companies like Microsoft have a set value based on how their stock is trading and what assets they hold. Smaller business valuations are more challenging to determine since they typically do not issue stock. This does not mean that a privately owned business has less value; it merely means the interest in the business is slightly different.
There is no single formula that is used to set a firm value for a business. The Internal Revenue Service (IRS) defines the fair market value of a company as the price a willing buyer who has no stake in the outcome is willing to pay for the business.There may be tax reasons, estate planning reasons and other reasons why a family member would purchase a business but this practice is carefully monitored by both lenders and the Internal Revenue Service.
The Small Business Administration (SBA) requires businesses sold to family members have a business valuation completed regardless of the size of the loan. All other businesses are required to have a certified valuation if the loan amount exceeds $350,000. The reason family member loans face greater scrutiny is because they are not “arms length” transactions and the sale price may not reflect an accurate price.
Cash flow, equipment on hand, inventory and brand name recognition are all factors used to determine the final value of a company. When these factors are combined by someone who is certified to conduct an audit of the condition of a business, they are able to determine the fair market value of a business. Businesses that have limited or no cash flow are not necessarily worthless, although they may be valuated lower.
There are three primary methods of coming up with an accurate valuation. They are an asset-based valuation, income-based valuation and market based valuation. Each uses a slightly different model and the SBA may require the use of multiple methods depending on the loan size and the industry.
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Gaps Between Venture Capital and Mezzanine Capital
Small business loan guarantees are not only for startup businesses, they are also intended for purchasing an existing business. The SBA has very strict guidelines about providing guarantees. Some of the restrictions and requirements include:
A) Size of the business - Many people are surprised to discover what business ventures are classified as small businesses. Logging businesses may have up to 500 employees and still be classified as a small business venture. Other businesses such as aircraft manufacturing can have as many as 1,500 employees and still be considered small businesses. Service businesses such as direct sellers can have as much as $7,000,000 in sales before falling out of the small business classification. There are numerous standards which are explained in the Size and Standards Table that is published by the Small Business Administration.
B) Ability to borrow funds - Those who are considering applying for a small business loan with an SBA guarantee to purchase a business must also have no other means of securing funding. This means those who are eligible for accounts receivable financing, venture capital financing or mezzanine capital financing may not be eligible.
C) Business valuation requirements - The SBA requires all business loans used for the purposes of purchasing another business will be required to undergo a business valuation. This requirement applies on all loans that exceed $350,000 or for any loans that are used for the purpose of purchasing a business from a family member. Banks can perform the valuations on some businesses with limitations set by the SBA. There have been cases when these valuations are questioned and may require additional information.
These are only a few of the primary requirements associated with SBA loan guarantees. Extensive documentation must be provided that includes cash flow statements, value of equipment or goods and any other relevant documents that will help provide information regarding the value of a company. Additional documentation that may be required is an estimated future cash flow statement and an extensive history of the business. The requirements must all be met in order for a business loan to meet the requirements the SBA has put into place to obtain loan guarantees.
On average, the SBA guarantees approximately $10 billion dollars in loans annually. They provide necessary funding for a variety of business concerns from very small businesses that provide services to larger concerns that still fall under the auspices of small business ventures. The importance of understanding all of the SBA requirements cannot be understated as a lack of understanding can make the difference between being eligible for an SBA loan and not being eligible. Those who are considering a small business loan should speak with the Small Business Administration and obtain a list of qualified SBA lenders in the area where the business is located. This can help prevent numerous problems as these banks are generally well versed on the requirements of these loans.
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Small Business Administration
- Table of Small Business Size Standards Matched to North American Industry Classification System Codes (PDF)
- SBA Loans
- SBA Loan Application Checklist