The changes that the Main Street Employee Ownership Act made to the Small Business Administration’s lending rules for ESOP transactions are now in effect. The revised rule makes an SBA-guaranteed ESOP loan potentially more attractive for sellers who want to sell their companies to an ESOP but do not qualify for conventional bank financing for cash flow or collateral reasons.
Qualifying small businesses eligible for an SBA-guaranteed ESOP loan can use the loan proceeds to cover the purchase price and some or all of the ESOP transaction expenses. The loans can also now be made to the company and then re-loaned by the company to the ESOP. Another significant change is that the selling shareholder can stay on with the company as a shareholder, officer, director, or key employee after the sale – even if the ESOP buys 100% of the company.
The SBA has two tests to measure whether a company qualifies as a “small business” and a company can qualify by meeting either of them. The first test is based on annual revenue or number of employees depending on the industry. For example, a construction company cannot have more than $36.5 million in annual revenue; a cabinet and countertop manufacturer cannot have more than 750 employees. The second test looks at whether a company has a tangible net worth of over $15 million and average after-tax income of less than $5 million for the past two years.
In addition to being unable to secure conventional financing and meeting the “small business” requirements, other key points of the MSEOA and the SBA’s rules are:
- The ESOP must acquire a controlling interest of at least 51% of the company;
- The SBA ESOP loan can be made directly to the ESOP or to the Company to re-lend to the ESOP; if the Company re-loans the SBA loan proceeds to the ESOP, the terms of that loan (the “inside loan”) can be different from the terms of the SBA loan;
- If the SBA loan is made directly to the Company rather than the ESOP, it is eligible for the SBA’s “Preferred Lenders Program” and will be processed by the bank alone rather than by SBA, streamlining the process;
- The maximum loan amount is $5 million and the maximum amount the SBA will guarantee is $3.75 million;
- The maximum loan term is generally 10 years and the interest rate cannot exceed Prime, LIBOR or the SBA’s optional peg rate + 2.25% (for loans under 7 years) or 2.75% (for loans of 7 or more years);
- Any remaining shareholders other than the ESOP must provide an unconditional personal guaranty; and
- If the SBA loan is not fully collateralized with fixed assets, personal real estate must be pledged to secure the guaranty up to the shortfall in collateral.
With the new MSEOA rules on-line, companies that are good ESOP candidates but need help financing a shareholder buy-out may find an SBA loan to be a workable solution.