Sean, it's great to have you on the show. I'm going to kick things off with this question. Can a broke person really buy a business? I mean, what's the reality of that?

It's a good question. It definitely makes things harder for sure. I mean, I think it depends on how broke the person is and what kind of loan they're looking for. Because broke probably means different things to every person.

And I think one of the more important things is just kind of trying to find what your buy box is. If you don't have a ton of cash and stocks and stuff to have that liquidity for a down payment, post-closing liquidity, you can use investors, you can sometimes use seller financing as equity. But the main thing is just looking for deals in a realistic range.

If you got $50,000 to your name and you're looking at $5 million deals, even if you had an investor come up with the whole equity injection, I don't think you're going to get a bank to finance that.

Yeah. And I'm glad that I have you on the show because we're going to dive into the details of lending, which I think is super important.

So let me ask you this because we see it in the headlines. We hear other people talking about it, this massive opportunity where baby boomers are trying to get out of their business. They're trying to sell it, but oftentimes their kids don't want anything to do with it. Or maybe it's not in to sell to private equity or more institutional type investors. And that's the whole opportunity that we're talking about here.

But how does somebody make that leap from working in a corporate job? Maybe they hate the job and they're like, Hey, I want to get out there. I want to buy my first business. And yeah, you know, like you said, broke means different things to different people, but maybe they don't have millions and millions of dollars to go and buy their first company. How do they take those first steps and what can that even look like?

To be honest, you know, the archetype that you just talked about is someone that I talk to literally, I think about every single day. You know, there's a lot of people out there that, you know, have been really successful, you know, in the corporate world, maybe they kind of get stuck in some kind of middle management or they just get burned out.

And I think they're tired and they're kind of thinking if I'm putting all this energy towards something, why am I making someone else a bunch of money? When if I feel like I have the skills and interest to work hard, why wouldn't I put that towards something that I could grow and is mine?

You know, first of all, I think that kind of person is so common. And I think, you know, as you're kind of making that transition, the one thing I will say is, you know, sometimes people will want to keep their corporate job and still buy a business.

I think that can be tough. You know, realistically, I'll always listen to someone's plan. Sometimes they might have a partner. Sometimes they might have a GM that can, you know, come in. So there's always times where it can make sense. But as a rule of thumb, I think you should plan to, you know, make that full switch into ownership and be prepared for that.

You know, like I was saying in the last question, I think some of the things that are most important is just kind of maybe starting to get together some of those documents that lenders are going to look for as far as just kind of resume, updating that personal financial statement, you know, having some of those things kind of squared away and looking at your realistic buy box.

And so I do like prequalifications for really for buyers and sellers. But on the buy side, you know, most of the time what I'm looking for is, you know, there's not much you can do without a sell side business besides pretty much look at, you know, what kind of liquidity do you have? You know, what kind of business would that be able to buy?

So just kind of being realistic with what your situation is and, you know, what you feel like you can buy.

Yeah, I agree. And I want to talk about the opportunity that exists out there. And then I want to get into the details. We're going to get into like the brass tacks of what a structure could look like from a financing perspective.

But just to shed some light on this, and we were talking, Sean, you and I were talking at this ETA event is super loud, though. So it's like we're screaming at each other. So I'm glad we're in this setting.

But for the listeners out there, it's really interesting because there's so many voices out there on YouTube, Instagram, et cetera, on the Internet that say, you know, invest in crypto or do, you know, drop shipping or do real estate, but find like passive income. And you kind of alluded to it with buying a business.

I don't think you just buy a business and you're like, okay, great. It's running itself. I'm going to keep my nine to five, or I'm going to go work three hours and travel around the world and vacation. And everything's going to work out great.

I mean, if you find something like that, you could definitely DM me and let me know. That'd be wonderful. But even with like real estate, oftentimes people think, okay, yeah, my buddy, he's making $5,000 a month on real estate. He's renting it out. He's earning this passive income.

But I think there's this big misnomer that I just want to clarify and clear up here, because if you have a rental property and your saying they're making $5 million a month, they're most likely talking about gross income, like proceeds from rent. Then you got to service the debt. Then you got to do the maintenance on the property. And then, and then, and then, and then, and then, and most likely you're probably walking away with a few hundred bucks. Maybe you're walking away with a thousand, right? That'd be great if you were, but that's just not the reality.

But I think so many people, they don't understand the financials of a business or how assets are valued or how cashflow works. So they just hear these terms or these values being thrown around out there in the marketplace. My buddy makes a million bucks here. It gets a thousand bucks, you know, dah, dah, dah, dah. And it's like, yeah, it's gross. You're talking about revenue, not profit, et cetera.

What do you see out there when it comes to like financial literacy and people misunderstanding how all this works?

Yeah, I think that's, you know, honestly an amazing point. I think, you know, exactly what you said. I think there's so many people out there that want to sell you this dream. And that's really, I think what they're trying to do is sell you.

A lot of times people have courses they want you to take or, you know, different leadership or otherwise that they're trying to kind of sell you on. I think in the reality, and I agree with the real estate thing, even real estate that I think is a lot more simple than a business.

If anyone went into, you know, owning a rental — and because most of the time the margins are very thin on that — you know, there's a lot more maintenance and tenant issues and stuff like that that I think, you know, people expect.

But even more so for a business, you know, when you're talking about passive ownership, I think that's a good goal to have. Someone that owns, you know, a plumbing conglomerate over the Midwest that has rolled up all these different things — like at that point, you might be able to replace yourself with someone you trust, and you've kind of built these systems and processes to run without you.

And I think that is the dream in a lot of ways — to, you know, be able to be there for your business and make those strategic decisions, but not necessarily be in the day-to-day grind.

But I think for most people, when you're going into buying a business, like you need to expect that it's going to take, you know, a hundred percent of your time and probably then some.

I just — I don't see many businesses that are true passively owned and run businesses. If that was the case, honestly, it's like, why would the seller sell?

If they're making an easy, whatever, 10 grand, 50 grand a month in profit — I don't know. I wouldn't sell it probably.

Yeah, exactly. I know I've heard people on the internet, they're like, yeah, I was making $2 million a month in cash in my business. And then I sold it for 40. I'm like, why would you even do that if you're making $2 million a month?

Yeah. I mean, it's — so nonetheless.

Okay. Let's put some numbers to this and let's talk about how this can actually get done from a financing perspective.

So let's say I'm looking at a business, it's doing a million dollars in profit. Okay. So we're just going to keep this really simple. And let's say there's a multiple of four on that profit.

That means the business is valued at $4 million. So $4 million. And I come to you, Sean, and I say, okay, I want to buy this company. What are my options as it relates to financing?

So the first main thing I think to keep in mind is the SBA is always going to require 10% down payment. Now, some of that could come from an investor or a friend or family, but that is generally always going to be the 10%.

The only time we can get around that is if we have a seller note that's on full standby — so no payments for the full 10 years of the note. And so that can count for 5% of the equity. But otherwise we'll be looking at 10% equity on that.

And then I typically like to see at least 10% of a seller note. It depends sometimes on a deal with that seller note, but I actually just read an article and the success rates versus the failure rates in business purchasing — the ones that have a seller note are so far away more successful than without.

It's not something my bank requires on every deal, but it is now becoming, I think, more of a requirement or at least an explanation as to why there is no seller financing if there is not.

And so I think that's something that's really important — just that the seller shares some risk as well as the bank, as well as the buyer. And so that's something I recommend on every deal.

And then seller financing can be a lot of different things. It can be that full standby to count as equity. With SBA, you can now do forgivable contingent notes, which essentially are earnouts that only can help the buyer. You can have just your traditional seller note and you can have a combination of several.

And so that's something that I think is really important to understand going into the process.

Otherwise, just general SBA terms, as far as collateral — that one's pretty easy. If it's under-collateralized, which most of these deals end up being without real estate, they do require junior lien on any personal real estate you own that has 25% or more equity.

So that's something to consider when you're going through the process.

So slow down real quick on that piece, Sean. So when you say under-collateralized, if I'm buying a service-based business, they don't have a lot of assets. Is that what you're referring to when you use that term?

Okay. So then I want to buy this business. It doesn't have a lot of tangible assets — trucks, tractors, trailers, et cetera. So the bank needs to secure its position. So go slower through that last piece that you said, because I want to make sure the audience really understands this.

You would come to me basically and say, I need a personal guarantee that's backed or collateralized by real estate assets or assets that I own more than 25% of.

Yeah. So good point on the personal guarantee. So anyone 20% or over is required to personally guarantee in the business. So that's something to keep in the back of your mind.

But most times we're going to be under-collateralized because even if you have assets, the bank is going to discount those assets.

So if it's used equipment, it'll go down to like 50%. If it's inventory, account receivable — that's all discounted down to 10%.

The idea there is if there's a default scenario, by the time we get there, it's going to be a fire sale and this stuff is not going to be worth that much. And so if there's no commercial real estate, most times there's not going to be a full one-to-one collateral.

So $700,000 loan amount, $700,000 collateral — we're not going to have that.

And this is kind of where you get into — there's kind of two separate thoughts with most of this stuff. There's kind of your SBA rules, which every SBA lender has to follow. And then there's kind of the bank rules, which can differ a little bit.

And I think it's really important to understand which stuff is the SBA side and which stuff is the bank side. Because if a bank's saying something, it's their rule, and you don't like that, another bank may not have that same rule.

That's a really good distinction too. Yeah. Yeah.

So before the collateral specifically — so any personal guarantor that owns real estate and has 25% or more equity — that is an SBA rule. And so we would have to take a lien on that.

Say you don't own any real estate, or even if you do, we pledge it and it's still not close, then that's okay. That's under-collateralized.

It may be seen as a slight con on the deal, but that's kind of what this program is for. And as a bank, we get 75% of the loan guaranteed by the government, which allows us to get more aggressive with terms like this.

And so that's kind of why SBA ends up being attractive — is because with that guarantee, it allows us to put a lesser down payment, spread the term out to 10 years instead of probably more like five, finance more goodwill with less collateral.

All that's to say that I think collateral is important for every lender, but if you're talking about some of the other metrics, it may be slightly less important because of that guarantee.

So let me ask you this. Is it easier to get a business with tangible assets financed compared to, let's say, an internet-based business that has no assets whatsoever?

Not necessarily, honestly. Like I said, I think collateral definitely helps a little bit, but with the SBA, because of that government guarantee, I would say cash flow is king. That's really where most deals happen or don't happen.

I think when you get up to those like three, four, five, when you start getting some of those heavier deals, maybe the collateral makes a little bit more of a difference. But it's one of those things that maybe if it's on the line, kind of we're close on approval, we're close on either way, then maybe it can push it one way or the other.

But the three things that I typically tell people that I look for the most are cash flow. And so that's through the business primarily, but looking at your personal cash flow, any other businesses you're a part of, and then kind of experience. So that's not necessarily like exact experience, but just kind of telling the story of your background and why this business fits in with your skill set.

And then the last one, which I think is so important is post-closing liquidity. So you have money for a down payment, but this is funds that are left over that kind of give you wiggle room with the business, with your personal life, and gives the bank more confidence that we're not going to see any kind of issues through the transition.

Yeah, especially for just like working capital needs. So that brings up a good point because you mentioned this 10% down. What if I were to get a loan from Uncle John? I don't even have an Uncle John, but let's say I do. And he gives me $500,000. I put it down. We closed the deal.

Then I take $500,000 out of the business because I collected on some accounts receivable and whatnot. Then I pay Uncle John back. Are there restrictions on that to prevent that equity going out the door?

Yeah. Yeah. So this was kind of along the lines of some of the new SBA rules in terms of investors, because even though he's your uncle, I would still see that, I would say, as an investment. So the SBA does allow debt to be used as equity, but mostly it's going to be through personal loans or a HELOC.

And even then, it's not the most attractive, but it can work, especially for a HELOC or something like that. But when you get into other people giving money, for your down payment, what that really would end up looking like, I think, more is more like an investor.

And so the big thing with investor and what the SBA clarified is that they don't want any set repayment schedule, because then that invested equity looks a little more like debt than true equity. And that's what they want to stay away from.

If you gave your Uncle John 15% or 18% ownership for a couple hundred grand, that's kind of the more traditional, I think, what SBA is looking for. But yeah, that's a good question.

Do you guys ever require people to pledge their kids as collateral?

No. I mean, really, the only thing we look for in collateral is real estate. Maybe some other banks will want to tie up stock accounts. That one I've seen. I've seen vehicles, although that's just a nightmare and not worth it.

Typically, you'll just have to put a junior lien on real estate, and that's about it from the personal side.

All right, that all makes sense. So let's go back to the seller's note. What does that actually look like? Meaning, do I go to the owner and say, hey, I want to buy your business, but say that going back to that $4 million example, I say, can you give me a million dollars in a personal promissory note? What does that look like, Sean?

Yeah. And that's where it's really just a total negotiation with the seller in terms of what kind of buyer and seller come up with. I think, especially from the bank side, the thing that I always say is to try not to have balloon payments, which everything comes due at once, and to try to amortize it as long as possible, because we still have to account for that debt.

Some people want to think like, oh, well, if it's a seller note, that's different. So I can give basically the max amount for the business through the loan, but then also have more as a seller note. And that typically doesn't work because we're still going to account for all that debt regardless of where that sits.

And so that's why I think it's important to structure it the right way and to try to extend the amortization of that seller debt as long as possible to give yourself still the best chance of getting the deal approved.

Yeah. I mean, because ultimately you're looking at total debt service, including the seller's note when you're looking at qualifying for the SBA loan, right?

Yeah. And that's in the SOP. In the SOP, it states that as the underwriter, you're supposed to account for any current and future debt.

So I think there are some banks that differ on what that actually looks like. The way we do it is even if it's on full standby for, say, two years, we're still going to account for that debt because we're trying to be as conservative as possible. And in that third year, we can't necessarily be like, oh, well, the buyer's definitely going to grow it by 20% by then. We kind of have to just be conservative and look at where it's at.

Will the SBA ever allow a seller to take a first position when it comes to their debt structure?

No, definitely not. Definitely not. Yeah, the SBA is going to always be in first on something like that. And they'll have the seller basically sign a standby agreement that basically says they can't really go after the buyer while this principal for the SBA loan is being paid off.

So they're definitely behind the SBA. And that's just the position that has to be with these types of deals.

How does the SBA look at earnouts overall with deals? They frown upon it. Is it dirty, not a clean way to do it, or it's an OK structure to use?

Yes. So that's something they've somewhat recently clarified. So what they call it is a forgivable contingent note. And the reason they don't use the earn out word is earn out can go both ways between a buyer and a seller. They're only interested in things that help the buyer.

And that could be around gross profit, revenue, a key customer, really anything that they want to tie that to. But they don't want it to go both ways because say it's like a million dollar deal. And so the SBA is going to guarantee 75 percent or 750,000.

If the business becomes way more successful than they had originally planned and all of a sudden the business is now valued much higher, they're paying the seller out more. The SBA is only going to guarantee the original portion and they don't want that ballooning up after close.

So you can do an earn out basically, but it needs to be structured to where the only benefit is removing purchase price, not adding to it.

How does valuation play into the purchase price and how much does the SBA get involved with valuation and scrutinize it?

Yeah, yeah, definitely. So one of the things that every SBA lender has to order on a business acquisition is a business valuation, and it should match the purchase price or be above it. Now, there are times with the SOP, technically, if the business valuation comes in low, there are ways to still get the deal done.

What the buyer needs to do in that situation is basically why they're okay at overpaying for the business based off the third party report. But technically, the SBA made it a little easier on those business valuations.

So say like you're buying a million dollar business and like they're putting in 200,000 equity. So then there's like 800,000 loan. Technically with the SBA's rule, it only has to come in over that 800,000 number, but you would still need to justify why you're willing to kind of overpay for the business.

There is some leeway with that, but at the end of the day, it's, I would say, best practice to hopefully be in that range. And that's where like getting the right kind of EBITDA number that you and the seller agree on up front and then putting a multiple on that that's reasonable is so important.

Most deals with SBA can only trade between about three and probably about four and a half times the EBITDA. And so when you get much above that, unless you're putting a bunch of money down, it can be hard to get that financed.

Yeah. When I'm looking at deals to buy companies and we build out our discounted cashflow model and we do other valuation models to one of the big parts of determining the final value is accounting for risk. So key man risk, single channel risk.

Concentration. Yeah. Concentration risk, all the different types of risk factors.

How much do those play into the SBA's lending decisions when it comes to a business? In other words, if I want to buy a business and I'm like, Sean, I know this company, I love this business. It's $4 million. But then you start diving in deeper and you're like, wow, you know, the, the owner, when he leaves, he's been like the main character of the company as all the sales contacts, et cetera.

It's going to be detrimental. And all their leads are coming from this one architecture firm or whatever it may be. And so there's just a lot of risk factors spread throughout the business.

Does the SBA kind of turn a blind eye to that or do they get into those type of risk factors and does that ever impact their lending decisions?

So definitely impacts it. And that's where I'd kind of come back and have that differ between the SBA and the banks. So the SBA has their rule sets when it comes to like credit and stuff. I think there's like, you know, some bare minimum standards that banks have to follow, but for the most part, the SBA gives banks some leeway.

And so I think that's more of a bank decision and what the bank's comfort level is more so than the SBA. But I know for me personally, and I think any good SBA lender, like we're asking those questions. We're asking what the seller's involvement is.

If it's a relationship heavy business, is that only the seller that holds those relationships? Is there a GM that's staying on that holds those relationships? Has the seller kind of been slowly backing away and they're not really as involved. And so the team kind of more sustains and runs itself.

If there's concentration risk, what does that look like? If there's a contract, how sticky is that contract?

If there's a lot of risk, that's when we might look at one of those like contingent forgivable notes. But yeah, all those things, for sure we're diving deep into and any good lender should look at things from those angles to make sure that our backside is covered as well as your guys's.

Yeah. That's why if you're selling a business and you're listening to this, that's why it takes time to prep your business for sale. I mean, it's one thing to turn your financials around, improve your gross margin, make some adjustments with your pricing, et cetera.

But the other things like eliminating key man risks by getting people moved around in different positions, documenting processes, having SOPs — that takes time. And that's why it has this like runway when it comes to selling a business. So thanks for pointing that out.

Okay. Let me ask you this as it relates to industry risk factors, does that play a part or does the bank not really get into those types of criteria?

So I think that totally depends bank to bank. Some banks are really industry heavy. And so you come to them and they're like, oh, it's a commercial landscaping, like recurring revenue type model, whatever.

Then they're like, oh, we definitely want to fund that. Or they might say, we definitely don't want to fund that.

For my bank personally, we're not really industry bullish or bearish, I guess I would say. We don't really do much with trucking, which is a huge industry. It's just very cyclical and it's going through a little bit of a downturn. We also can't really do much motels, hotels.

But other than that, for me, it's way more important just about deal specific type stuff. And so looking at each deal on its own merit, from the sell side, from the buy side, and kind of looking at it through those lens.

So I would say, at least for me, I'm mostly industry agnostic. I feel like I've done deals across the spectrum. And I don't think I've ever had pushback in any call that I've had with my bank about being in a certain industry.

I think we try to really look at each deal on its own and assess the risks and strengths and weaknesses from there.

Yeah, I think that makes sense. So you've seen a lot of these deals come across your desk, I'm sure. And is there a common theme or trend or item that kills deals from your experience?

In other words, it's easy to understand the criteria up front, right? You can lay it out like, okay, Steve, at least 10%. It's got to be structured like this. There's a valuation range, all that makes sense.

But then as the deal starts going through underwriting, are there certain things where like this always kills deals over and over again? I see it over and over again. And if so, what is that?

Yeah. So I have an underwriting background. So most of the deals that I get killed, I kill myself early. I know my team well, and I know how to kind of underwrite a deal pretty well. And so it's pretty rare that I throw something. I mean, I usually know exactly what my team is going to say.

I mean, I could almost like play their part in a call. And so typically, by the time I get a deal into underwriting, most of those concerns I think are alleviated or maybe not totally alleviated, but I feel pretty confident we're going to get the deal done.

But I think to your point, the thing that I see most often that makes things difficult is aggressive ad backs from the seller.

So what ends up happening sometimes is we're showing like an SDE number based off really aggressive ad backs. And then on top of that number, we're paying the max price. So we're paying a 5x or a 6x multiple on top of already very aggressive ad backs.

And so I think it's just important to try to go into it understanding that banks are going to be really conservative on ad backs.

And so when you're looking at a business, the things that we're going to look for is interest, amortization, depreciation. Those are obvious ad backs. Seller's salary is an obvious ad back, although we would want to put in a buyer's salary as well and kind of make sure that is also in there and kind of against the seller's salary.

But then when you get into things like travel, meals, entertainment, stuff like that, it's just really hard to verify those were truly not business expenses. If you fixed up your basement and it was $75,000, or put in a pool or something, that's a lot of money.

And so one-time stuff like that, if we can get backup, easy to add back. That's no problem.

But at the end of the day, it has to either truly be a personal expense or a one-time expense, and we need the backup for that.

And so that's something that I think more often than not can be very difficult because with the landscape that we're in right now, there's so many buyers and so many searchers that I think there's a lot of competition on good deals.

And so a lot of times, if you're not working with a lender already, you may get into an LOI, but then you might take it to a lender and no lender can get it done because it's not really in the SBA's wheelhouse from a cashflow perspective.

Yeah. And I agree. In SDE, we could do a whole conversation on that, a whole other episode, because I know when I've looked at deals and companies to buy, sometimes it's like, okay, we're going to add back this legal expense. We're going to add back this travel, entertainment, all the things you mentioned.

But going back to the legal side, it's like, sure. Sometimes there's this one-off lawsuit, but also there are some things where it's like, yes, I know it's kind of one-off, but it's not really one-off because every three years you are probably going to get a lawsuit or whatever it may be. So it's just a normal and recurring part of doing business.

So I think if you're not careful, the seller of course wants the highest multiple on the highest profit possible. So they're going to add back things that they say, yeah, these are non-recurring or these are perks for me. And it's like, not really, because you would either have to pay those out anyways, or it's just the cost of doing business.

It's just the risk factors that happen in business.

Yeah, exactly. And I'll see someone say like, oh, well, this is an add back for a software, but you don't have to use the software. And it's like a recurring expense every year that is pretty integral to the business.

It's just like, well, that's not really an ad back. That's not really what we're looking for.

Yeah, absolutely. So this has been really helpful, Sean. Like I said, we could go on and on and on on this topic and perhaps we'll revisit it in the future. I know there's a lot of interest in this space, especially among my community here.

So I really appreciate you coming on the show and sharing your perspective.

Yeah, no, I appreciate you having me. I'd encourage anyone that's looking to buy a business to either follow up with myself or someone like me, but just to kind of get your deal team early. I think it can help give you the best chance of approval and success.

Yeah, absolutely. Well, I appreciate it and I look forward to further conversations on this.

Awesome. Thanks, Steve. I appreciate you.