The landscape of small business acquisitions has undergone a significant transformation, primarily driven by changes in the Small Business Administration’s (SBA) 7(a) loan program. Previously, acquiring a business with an SBA 7(a) loan mandated purchasing 100% of the company, effectively barring small business buyers from utilizing a common private equity tactic: offering the previous owner and key personnel continued equity in the business. This restriction hampered the ability of buyers to leverage existing leadership’s expertise and institutional knowledge, potentially leading to a less smooth transition. The absence of equity as part of the purchase price and as an incentive for leadership retention represented a missed opportunity to maintain continuity and stability within the acquired business.
The SBA’s initial step towards reform in 2023 allowed sellers to retain up to 20% equity post-sale, encouraging a smoother handover without requiring a personal loan guarantee. However, this applied only to equity deals, excluding the often preferred asset deals. An equity deal entails acquiring the company’s shares and inheriting all its aspects, both positive and negative. Conversely, an asset deal involves purchasing only desired parts of the business, such as equipment or customer lists, leaving behind unwanted liabilities. This initial change, while positive, still presented limitations for buyers.
A more substantial shift occurred in December 2024, with the SBA expanding the 20% rollover equity provision to asset deals. This change offers buyers greater flexibility, allowing them to choose specific assets, avoid unwanted liabilities, and retain the previous owner’s expertise and engagement. This structure, long utilized by private equity firms, provides a mechanism for maintaining continuity and leveraging institutional knowledge during the transition phase, making small business acquisitions more sophisticated and mirroring practices in larger transactions. The SBA’s rationale for this change is to facilitate partial ownership changes, allowing the formation of new entities to own the operating company, often for tax or liability protection purposes, which was previously prohibited.
This new rule provides several benefits for buyers. They can leverage equity as part of the deal, reducing their borrowing needs. The continued involvement of the seller can aid in the transition process, ensuring a smoother handover of operations and knowledge. Furthermore, it allows buyers to selectively acquire assets, avoiding potential liabilities associated with the previous business. This mirrors the practices of larger private equity firms, enabling small business buyers to adopt similar strategies for smoother transitions and leveraging existing talent.
However, even with these advancements, limitations persisted under the previous rules. Sellers were restricted from staying beyond a 12-month transition period, regardless of their willingness to contribute further. The allure of the SBA 7(a) program, with its relaxed lending hurdles, longer repayment terms, and potential for reduced upfront cash requirements through personal guarantees replacing collateral, often outweighed these constraints for buyers. Now, with the establishment of a new entity under the revised rule, these time restrictions no longer apply, allowing sellers to remain involved indefinitely as part of the new business.
Under the new rule, asset deals typically involve the buyer forming a new entity, acquiring the old business’s assets, and offering the seller a portion of the new entity’s equity as part of the payment. This structure allows the seller partial immediate cash-out while retaining an equity stake with growth potential. To avoid personal loan guarantees, sellers typically maintain their stake below the 20% threshold that triggers this requirement, unlike mid-market private equity transactions where minority investors rarely face personal guarantees. The previous requirement of equity deals often frustrated buyers, limiting their ability to avoid unwanted liabilities, a key advantage of asset deals. This flexibility also protects the buyer from legal actions targeted at the former entity.
The initial SBA rule change, despite its limitations, resulted in a significant increase in equity-based transactions advised by SMB Law Group, from 10% to approximately 40%, demonstrating the strong buyer interest in leveraging rollover equity, even within a less-than-ideal framework. However, equity-based structures also carry risks. A cautionary tale illustrates how a buyer inherited regulatory problems from the previous owner of a healthcare company, jeopardizing a substantial portion of revenue and exposing them to potential fines. Such inherited liabilities could have been avoided in an asset deal.
While the ability to structure deals with rollover equity offers advantages, it’s not without potential drawbacks. Maintaining a positive working relationship with the previous owner is crucial. If the relationship falters, it can lead to conflicts, undermining decision-making and potentially jeopardizing the business’s success. Implementing a buyback mechanism for the seller’s equity can mitigate such risks, providing an exit strategy if the partnership proves unsustainable. Without such a mechanism, buyers could find themselves locked in an unfavorable partnership, leading to internal strife, lost revenue, and potential legal battles.
A common pitfall arises when the seller struggles to relinquish control, causing internal conflict. Successfully navigating this new terrain requires careful consideration of the potential challenges associated with integrating the previous owner into the new business structure. Open communication, clear roles and responsibilities, and a well-defined exit strategy are essential for maximizing the benefits of rollover equity while minimizing the risks of potential disagreements. This empowers buyers to leverage the expertise of the previous owner while safeguarding the long-term success of the acquired business.
