Summary

In this conversation, Jon Stoddard interviews Heather Endresen from Vizo about SBA loans and the personal guarantee requirement. They discuss the long game in M&A, the risk involved in small business startups, and the reasons behind the personal guarantee. They also explore the default rate of SBA acquisition loans and the impact of new regulations on personal guarantees and equity ownership. The conversation covers topics such as seller notes, quality of earnings, creative ways to finance the down payment, and the challenges of private equity and VC investments. They also touch on the importance of finding a bank with industry expertise and assessing the non-financial attributes and risk of inexperienced buyers. In this conversation, Heather Endresen discusses various aspects of the loan application process and financing for small businesses. She explains the role of lender scorecards and matrices in evaluating loan applications and highlights the importance of timing when approaching lenders. Heather also provides insights into pre-approval and the timeline for receiving a term sheet. She discusses the challenges of analyzing financial statements and the pitfalls of using Seller's Discretionary Earnings (SDE) as a metric. Additionally, she explores the potential impact of rising interest rates on deal structures and suggests alternative financing options. Lastly, she addresses how to handle anomalies in business performance when evaluating a deal.

Takeaways

M&A is a long game that requires patience and relationship-building.
The personal guarantee is required in SBA loans to minimize risk for banks.
Seller notes can replace equity in financing deals, but lenders may have different requirements.
Quality of earnings reports and due diligence are crucial in assessing the financial health of a business.
Finding a bank with industry expertise can greatly benefit the financing process. Lenders use scorecards and matrices to evaluate loan applications, considering factors such as character and industry knowledge.
Timing is crucial when applying for a loan, and it's important to be prepared with a data room, business plan, and transition plan before approaching lenders.
Pre-approval provides a general indication of loan eligibility, but a signed LOI and a comprehensive data room are necessary to receive a term sheet.
Analyzing financial statements requires careful consideration of anomalies and the normalization of cash flows. Seller's Discretionary Earnings (SDE) should be used with caution.
Rising interest rates may lead to slight depressions in price multiples, but alternative financing options such as seller notes and equity investment can mitigate the impact.
Alternative financing options, such as revenue share agreements and equity investment, can provide flexibility in deal structures.
Anomalies in business performance should be carefully evaluated and normalized to assess the true financial health of a business.

 

 Watch the Interview:

Transcript:

Jon Stoddard (00:00.202)
Welcome to the top M&A entrepreneurs. Today my guest is Hender. Welcome to the top M&A entrepreneurs. Today my guest is Heather Endresen from Vizio who helps with SBA, with Vizo, who helps with SBA loans. She used to work at Live Oak Bank for six years and she did over 500 million in SBA loans. So.

Heather Endresen (00:14.029)
Viso! I'll even do it... Viso.

Jon Stoddard (00:29.278)
Welcome to the show, Heather. Oh, before we get on to Heather, if you like this content, make sure you hit the subscribe button. Thank you. Welcome to the show, Heather.

Heather Endresen (00:38.489)
Thank you, John, for having me. I'm excited to be here.

Jon Stoddard (00:42.078)
Well, I got to tell you, you know, you and I worked together six years ago, working on a loan. It didn't go through, but, uh, here we are back in circles, talking to each other again.

Heather Endresen (00:52.721)
I always tell people I play the long game. I don't win every deal and they don't all get done, but you know what, we build relationships over time and I play the long game, it always works out great.

Jon Stoddard (01:02.754)
The long game. That's what you think you should think about in the M&A world, the long game. It's not like gonna happen overnight, 30, 60, 90 days. It's the long game. I mean, I mentioned everybody goes, hey, when can I buy a business? I go, look, search funders give their searchers like $200,000 for two to three years. That's how long it takes to buy a good cash flowing business.

Heather Endresen (01:11.639)
It is.

Heather Endresen (01:22.501)
Yep.

Heather Endresen (01:27.149)
That's right. I mean, you see a few people get lucky, but it's very few. You know, it's 12 to 18 months kind of is the, is the, I guess, middle of the bell curve, if you will. But I've seen people take more than three years. And so yeah, you absolutely play the long game. I've seen deals come back around a year later and they're better the next time around. So yeah, always play the long game. It works out.

Jon Stoddard (01:49.706)
All right, I have got some questions for you. SBA recently came out, last 2023 with a whole bunch of new regulations and I wanna talk to you about that. But first, let me get into a subject about the SBA loan and that's the personal guarantee part. Five years ago when I was working on this acquisition to buy a portfolio Udemy courses, I was...

50 ish or I don't even remember what it was, but that personal guarantee was a sticking point for us And it was for my partner too had a five million net worth my net worth and it was still like whoa We're only buying a two million dollar business. Why do we need a personal guarantee on? This when it's cash flowing like 87 to 90 percent profit

Heather Endresen (02:40.949)
Yeah, so it is definitely a serious subject. Thinking about giving a personal guarantee, which sometimes also includes pledging your house, I mean, that is a very serious subject. Why do banks require it? Number one, obviously the SBA requires it as a rule, so the banks can't even make their own independent decision that every SBA loan has got to have at least one personal guarantor. And then for sure, anybody that owns more than 20% has to pass the personal guarantee.

If they've got equity of 25% in their personal real estate, they'll have to pledge that too. And that's an SBA rule as well. So yeah, it's a very serious decision to make. The reason for it is when you're doing a levered buyout of a small company, the company assets are never going to be enough to secure the loan as collateral, right? So it's basically an under-collateralized loan. And

To those of you who think the banks aren't taking any risk in that, they're only getting a 75% guarantee from SBA. So they're always taking a 25% risk piece in every SBA loan they do. So they're all kind of underwriting to minimize their potential losses. That's the only way a bank can make money. They can't really afford losses.

Jon Stoddard (03:56.866)
Let me ask you about that. Let me interrupt you and then you go, so if I'm buying a $2 million business, 25% of that is, you know, that's a much smaller, what is it, $400,000? $400,000 of, and then I'm still putting a personal guarantee on that $400,000. Is it $400,000 or is it $2 million?

Heather Endresen (04:17.921)
It's two million. So, and it's actually, yeah, so it's two million. You're always guaranteeing you, the borrower, is always just looking at the total loan amount. You're guaranteeing the whole loan amount that's there. The lender is considering that, gee, if things go south, SBA is gonna cover 75% of the loss. And the bank has 500,000 exposed. Let's just say it's a $2 million loan. They have $500,000 exposed on their 25% piece.

And if the loan is lost, they're going to lose half of their 500,000, if that makes sense. And when you look at a bank's profitability model on the lending side, they just can't afford a very high loss rate. It has to be relatively low for a program to be profitable for a bank. It's not like on the investment side, where you could have some investments go to zero, but you can have some big outliers that make up for that.

Banks don't have outliers. They only get paid back their interest. If you hit one out of the park and they made the loan to you, they'd still get the same interest back as the guy that did kind of mediocre, right? Because they just pay it back. So they can't make up for losses that way, the way you could on an investment side. And that's one of the key differences in how lenders take risk and perceive the risk. So you give a personal guarantee, really to kind of...

Jon Stoddard (05:21.741)
Yeah.

Heather Endresen (05:37.833)
lessen the risk for the bank. If you didn't have the personal guarantee and things weren't going well, you're more likely to throw back the keys at the bank and say, I'm not doing this anymore here. If you've got a personal guarantee on the line, you're not going to do that. And that's what lenders have come to know over decades and decades of doing this. And so it's what makes the program work in some respect.

Jon Stoddard (05:49.111)
Yeah.

Jon Stoddard (06:01.226)
Yeah, well, SMBs are inherently risky propositions anyway, but 93% go out in business in five years. Yeah.

Heather Endresen (06:05.902)
Yes.

Heather Endresen (06:09.397)
Yeah, of startups. I mean, and that's, yeah, of startups. I mean, that's why acquisitions are less risky than startups because they perform a lot better. They're already an established business, but now we're adding leverage to that established business and we're introducing new ownership, new management, and those are all, you know, levels of risk higher than what the seller has been operating under.

Jon Stoddard (06:11.047)
of startups here.

Jon Stoddard (06:30.794)
Yeah. Is there any way, this is a thinking process that my partner, I went through. Is there any way to avoid going through the assets or getting the assets if it does go south? Like we thought about, let's put everything in a trust because we didn't want exposure to them.

Heather Endresen (06:50.809)
Yeah, unless it's an irrevocable trust, which nobody really does those, you're going to have revocable trusts usually, it doesn't protect anything. To my knowledge, you know, this is something actually that's a better question for a bankruptcy attorney than me, but it doesn't really protect anything. So what you find as a lender doing this is that people are, of course, more willing to give the personal guarantee when they are earlier in their careers.

Jon Stoddard (07:06.55)
Yeah, I don't think it's like you couldn't create a trust after you already signed the loan document with a personal guarantee You'd have to be before but then you wouldn't be able to pledge those because those are in the trust

Heather Endresen (07:17.961)
Yeah, I lost you for a second there. But yeah, if it's in a revocable trust, revocable, it doesn't prevent the SBA from going after those assets. Yeah.

Jon Stoddard (07:30.334)
Yeah. So what is the, this is this, I always have these students ask me, so, you know, I don't want to sign that personal guarantee. And I go, look, the way they write the loans and underwrite them is they, they look at really good cash flowing businesses that have been enduringly profitable. That's why their default rate is so low. What is that default?

Heather Endresen (07:50.793)
Okay, good question. It is actually, I did a whole article on this on my website, visocap.net, where I explored the default rate of just SBA acquisition loans, not all the other SBA loans. We separated out the SBA acquisition loans. I worked with my partners at Lumos data. It's the actual raw SBA data. It's about 2% total default rate. We sliced it a lot of different ways, so you can take a look at all the different slices we took.

Jon Stoddard (08:14.894)
2%.

Heather Endresen (08:19.993)
by loan size, geography, industry, all kinds of stuff. And I'm due to update that data with Lumos in about the next month. We're gonna take the data as of 930 and refresh it. I think it'll go up a little bit from last time because of the interest rate environment, but I don't think it's going to be anything dramatic. That's my prediction, but we'll see.

Jon Stoddard (08:41.63)
Yeah. Let me ask you the new regs with the personal guarantee or, uh, the equity ownership. The seller can keep 20% equity in that, but the SBA is requiring them to sign a personal guarantee. Is that correct? So I put a post on LinkedIn about this and I had 5,000 people respond to say, that's crazy. I'll never see a seller do that.

Heather Endresen (08:57.726)
Yeah, yeah. So I think

Heather Endresen (09:09.509)
It is crazy. There are things that not only will the SBA put them in the rules, but there are things that banks, underwriters will suggest and you just kind of shake your head like in what universe would this ever make sense? No one's going to do that. So this is one of those where I know no one's going to do that. I don't think it was intended to be this way. There's a kind of a long backstory to why the current rollout of SBA rules had to be done twice. You know, it was done in...

of August and then another SOP came out just yesterday, October 24th. I don't even think we've digested what came out yesterday to see if there's anything startling in that, but it had to be done to sort of correct all the misunderstandings out of the August 1st rollout. So it's kind of a messy rule exchange. Yeah, yeah, that's not gonna work. Can't do that.

Jon Stoddard (09:54.914)
When reality hits you in the face kind of thing. Well, that's not gonna work. Can you just go down to 19%?

Heather Endresen (10:03.529)
You can't make a change unless it was more than in ownership prior to an SBA loan, unless it was more than six months ago. They, that rule is to prevent you from just making a change at the last minute to comply. So there really isn't a way around it.

Jon Stoddard (10:16.83)
All right. Yeah. So no way around personal guarantee. Let me ask you about this. So I have a bunch of questions for you. Formally, 10% of the business need to be financed by both buyer, seller, and additional formulation of the five and five rule. Could part of the business with the new rules, could part of the business that the seller keeps count towards the down payment?

Heather Endresen (10:40.669)
If you're talking about seller note or the seller rolling equity, you're talking about seller note. Oh, the seller rolling equity. Uh, most lenders know they're not going to count seller rolled equity as equity. They're going to want to see some actual cash from their new buyer coming in. So I'd say no.

Jon Stoddard (10:44.159)
seller rolling equity. Yeah.

Jon Stoddard (10:58.922)
All right, so with a seller note, what does that, could that look like? I mean, how much, how big could that be? And it could be as small as possible, but could you say 49%?

Heather Endresen (11:11.821)
Well, what the SBA did with this rule change is it said that under certain conditions of the seller note, the seller note could actually replace all of the 10% equity requirement. So SBA has always had this 10% minimum equity requirement. And they used to let five, yeah, they used to let the seller note stand in for 5% of that if it was on full standby. And then this new rule came along and said,

Jon Stoddard (11:28.778)
Yes, from the buyer, yeah.

Heather Endresen (11:38.337)
doesn't even have to be on full standby for the life alone. As long as it's on full standby for 24 months, the seller note could replace all of the 10% equity. So you could actually have a zero equity down situation. But I always say stop right there. But here's the big caveat here. No lender's going to do that unless maybe, a couple of circumstances, unless maybe it's an inside key manager buyer that's getting maybe a below market.

Jon Stoddard (11:53.154)
But, yeah.

Heather Endresen (12:07.717)
price because they've helped build the business. Okay, maybe. And the other scenario where I think maybe they would do it is someone who's got not much liquidity, but they're pledging real estate that maybe fully secures the loan. So the lender's getting something, it's just not cash. But outside of those two scenarios, I honestly can't think of any case where a lender's gonna say, sure, we'll do this loan with you the borrower, the buyer. No.

Jon Stoddard (12:35.062)
100%. Yeah. I feel like a, do a bunch of seller. Yeah. That, that standby, you know, I always thought that standby after 10 years was just kind of crazy. I don't, I just didn't think anybody retiring would go, I'm going to start getting paid my seller note after SBA pays off in 10 years.

Heather Endresen (12:52.141)
Well, here's my take on it. You would do that if you think you're getting paid 10% more than the actual value of the business. And I think there's been a few deals that were engineered that way, you know, to just, okay, sure, you'll pay me 10% more, I'll carry that as a note, and I don't care if I ever get paid back. So that's something to be cautious of, but that could happen.

Jon Stoddard (13:00.788)
If we're yet.

Jon Stoddard (13:16.158)
Yeah, but that's, this is always the scenario I see with a lot of students. They'll, they'll definitely go out and they're ambitious. They go out and they get an LOI sign and it's a, the valuations is usually a little bit too high. I said, look, I tell them that the SBA lender, it's like a roadmap. I mean, no, like it's guardrails. You're not going to be able to outbid people overpay for this.

position because it's not going to be financeable.

Heather Endresen (13:47.309)
Yeah, it does have to pass a business valuation as well. So if you tried to overpay and you bring that in, maybe the business valuation comes in low and the deal falls apart there. So that could happen too.

Jon Stoddard (14:00.334)
Yeah. And what do you do in that case? Can you, do you, you see these entrepreneurs, they go back and renegotiate or they just lose the deal and it moves away?

Heather Endresen (14:08.717)
Both of those things happen, depending on how flexible the seller is and what other options they might have. But what I see that causes renegotiations more often than business valuation, it's not usually that. It's usually findings in the quality of earnings report. These are small companies. They don't have great accounting methods. The more complex the accounting that they need to be doing, the more likely there's probably something that they're not doing quite right.

Jon Stoddard (14:10.463)
Yeah.

Heather Endresen (14:36.497)
and the QoV provider comes along and can spot those things and kind of iron them out. And that usually reduces EBITDA somewhat. And so then you got to come back to the price if that happens.

Jon Stoddard (14:44.684)
Yeah, yeah.

Jon Stoddard (14:48.758)
Yeah, I don't think I've ever seen where they go, so, oh man, I think it improved EBITDA. Have you, huh? Ha ha.

Heather Endresen (14:53.137)
I have, I have. I've seen it like three times.

Jon Stoddard (14:58.802)
I will tell you this though, I would say eight out of 10 times I see businesses, the SIMs, I asked for the financial report cards, three years income statement, two balance sheets and the same day, 12 months apart, rarely eight times out of 10, they are not balanced books. They're compiled, but they're not balanced. When you go into this, what do you recommend to the buyer going, oh, you need to do...

bring a forensic audit in there, a CPA, and they need to balance the books, or you just go to a quality of earnings and.

Heather Endresen (15:32.837)
I really like the quality of earnings. I'll give you my history lesson on this. As a senior person in this industry that's grown tremendously, I've been doing this 12 years. Six years ago, which doesn't mean that, does not that long ago, there were no Q of E providers for small deals. Everybody had to do their own diligence. And believe me, there were a lot of mistakes. Now you have, I don't know how many, 10? Really pretty good.

Jon Stoddard (15:51.415)
Now there wasn't.

Heather Endresen (16:00.697)
choices of vendors for Q of E at pretty reasonable price points. Why wouldn't you do that? And I like them better than you're bringing in your CPA, nothing against CPAs, but if it's an accountant that doesn't do forensic accounting Q of E work all day every day, they're just not as good at doing this. They're not as good at spotting things. And maybe I haven't seen that industry before. And so it's just a huge value add. And I just strongly.

Jon Stoddard (16:21.23)
Yeah, yeah.

Heather Endresen (16:30.213)
Most banks don't require it though.

Jon Stoddard (16:32.318)
Yeah, so you have 10. I only know about two or three, like a guardian and a couple others. I mean, you got a list of 10 that you could share we could put in the notes.

Heather Endresen (16:41.541)
I have, well, I don't want to play favorites on here, but I have my top three I give out to my clients. And so I, and I've done the most work with those three. And then I do have, I think I have at least seven others that I don't know them all as well as my top three, but I probably know the top five or six pretty well. So yeah, there's quite a few. Yeah.

Jon Stoddard (17:01.334)
Yeah. And what range would somebody expect to spend to get that done? How long does it take? And can you put that back into the price or is that right out of the pocket?

Heather Endresen (17:14.948)
So it's usually 8,000 to 15,000 depending on complexity and scope of work. And it usually takes two to three weeks, also very much depending on how responsive the seller is. And by the way, hot tip, bad accounting leads to really long Q of E because the seller can't answer the questions and can't give the information sometimes. And then, yes, you can roll the cost into your SBA loan. So it's part of your transaction costs.

So it gets, and most of these vendors that have, you know, been serving the space that is typically funded by SBA loans, they're very friendly to that process and they'll submit their bill to closing. You might have to pay them out of pocket if the deal breaks. That's the risk that you face.

Jon Stoddard (17:59.422)
Yeah. You know, have you ever seen the, you know, business sellers, they get really emotional about the financials and they reluctant to give numbers out. And have you ever seen that kill a deal and just go, come on. I mean.

Heather Endresen (18:14.753)
Yeah, I have. I've seen it kill a deal in so many weird ways, but yeah, sometimes they just are offended at being asked these questions, or it makes them uncomfortable that they don't really know the accounting that well, so they're not really understanding the question or why this is such a big deal or whatever. And so yeah, they are emotional about the entire transaction. You go into it knowing that this is their life, life's work usually, this is their baby, their employees, their customers.

And depending on the personality, sometimes it's just, they're not cut out for it. And it can be, you know, they blow up and kill the deal.

Jon Stoddard (18:51.694)
Yeah. Let's talk about the down payment, which is there's a lot of creative ways to do that today. You know, some perfect world, somebody comes in, they've got a network, the million dollars, and they're trying to buy a $2 million business. They need to be 10% down, which is $200,000. But I have done a number of interviews where the buyer does not have that $200,000 and they'll go out, maybe borrow it from somebody else.

or raise it from investors.

Heather Endresen (19:23.417)
They're not supposed to borrow it if they're getting an SBA loan. So they should be raising it as equity from investors to comply with the rules. And what I find fascinating is that I've been lending for over 30 years, all to small businesses at no point in time, other than the last five years, has there been this much equity capital interested in small business? You just, you know, it's abundant. It's it. And I know people say, well, the terms aren't

Jon Stoddard (19:47.746)
Yeah.

Heather Endresen (19:52.205)
you know, easy. Well, they're not, but you know, they're more expensive than debt. But I think in most cases they're pretty fair. And it gives people the ability to do this that don't have the cash. That's amazing. You know, that's really an incredible opportunity.

Jon Stoddard (20:06.582)
Yeah, here's the downside I see this is because these private equity, MBA, BC types are coming down and looking for an alternative asset class to invest in. And they bring all these complicated term structures in. I want liquidation preferences, participating preferred. I want a 12% coupon. I want a 1.5 to 2X step up. Like you're talking to a guy who wants to buy a $2 million HVAC company where it's only growing 5 to 10% a year. This guy wants a.

20 to 30% IRR. I go, yeah, I don't know how that's gonna work.

Heather Endresen (20:41.257)
It doesn't work if the company can't grow. And I do think some people, it could be taken advantage of if they don't understand maybe what they're getting themselves into. And it is a bit the wild west. The terms that I see for equity investors are all over the place. There's no kind of standard terms. So you do need to have good advisors. And that's the thing, when you come in to buy a small business, you're not gonna be an expert in...

legal accounting, raising equity and operating a business and know that industry. I've never met anybody like that. So you have to build up a deal team of advisors who can help you with all of those things. Whatever your weak points are, you bring in experts and they help you with that. But still, to me, the good news is there's still equity capital very interested and there's still a wide variety of different terms that you could negotiate depending on the deal.

And I think it's helped many people that would otherwise not be able to be buying a business, do it and do it successfully.

Jon Stoddard (21:44.502)
Yeah, I've seen a lot of that. I used to be in the startup world. We raised some money for a startup. And what happens is a lot of portfolio companies, two of them would be great. Maybe they rocket ships, but most of them are going to be dogs and some of them are going to be lifestyle businesses. But trying to buy one of those companies with an investor's tentacles inside there is very difficult.

Uh, that's what kind of scares these, you know, I just want to buy an essential landscape in business. And you're really bringing a surgically implanted cancer into my business with those types of terms. Yeah.

Heather Endresen (22:25.509)
So here's the good news if you're going SBA. There's a lot of bad news going SBA. We talked about that already, the personal guarantee and all that, but the good news is that SBA does not allow the investors to have undue control in the operating agreement. So they really can't have much teeth in that. So they can't fire you. Like on a non-SBA deal, the traditionally funded search deals, they fire the CEOs if they're not performing. There's a lot of things they can do there.

Jon Stoddard (22:31.255)
Yeah.

Heather Endresen (22:55.245)
control over certain decisions that the CEO can make. In SBA, they are not allowed to have that kind of control. So you still have the majority ownership because none of your investors are gonna own more than 20% because they don't wanna give a personal guarantee. So that's in your favor and they can't have that control over you. So they really can't be too much in your face. What you really want in an SBA deal is investors who give you fair terms or reasonably fair terms and might also be value add to you.

you know, beyond the money, their network, or they've got some industry experience and they'll take time to advise you on questions and ideas that you have. That's the best scenario. And I do see that play out a lot. I'm sure, you know, the negative plays out too, you know, where the investors are not so great to have around, but you know, that's like, you've got to choose wisely if you're going to bring in investors. You've got to interview a lot of them and you've got to choose wisely.

Jon Stoddard (23:51.255)
Yeah.

Yeah, agreed on that. Um, I gotta ask you about the life insurance requirements. What, what is that for the SBA? And why does that sometimes take longer to get that written than sometimes the SBA loan?

Heather Endresen (24:00.908)
Okay.

Heather Endresen (24:07.081)
Yeah. Okay. So the rule is the SBA says if you don't have real estate collateral, which most of these deals don't, or if it doesn't fully cover the loan, the uncollateralized portion of the loan has to be covered by a life insurance assignment. So you get this life insurance policy and you assign it to the bank. Interestingly, this August 1st revision of the SOP said that banks don't have to do that exactly that way.

if they don't do something similar to that on their conventional loans. So some banks actually who do this kind of lending conventionally said, oh good, because we don't do that in our conventional loans and we don't wanna have to keep doing it. So now you have, some banks have to do it and some banks don't. It's changed a little bit. And why does it take long? There are some that get it fast. And I have a particular broker that I refer most to my clients too, who always come back to me and say, that was the best price.

and they've never had a problem with the timing of it. So, I'm happy to make those referrals as well, but you do have to get it started early because they wanna take a blood test and they need to look at medical histories and there's a lot that goes into their underwriting of life insurance. Like, are you gonna live? Are you gonna live? Yeah.

Jon Stoddard (25:19.622)
Yeah. Are you going to live the next 10 years and run in this business? What about the change of ownership? What happens in there? What are the terms and conditions if the change of ownership happens? Like, Hey, I grew this thing. I saw some big opportunities. I'm doing some acquisitions. I'm now, it was 2 million now it's 6 million and I got somebody who wants to buy the business.

Heather Endresen (25:42.725)
So you can obviously sell the whole business and that's easy to understand. Let's just say you wanna do sort of like a recap and have someone buy into the business. They can't really get an SBA. Yeah.

Jon Stoddard (25:52.542)
Yeah, like a recap with 11.25%, let's say in three years, it drops down. We got new government, we got, you know, more tightening of the, not tightening of the, but loosening the belt and the interest rates lower. And you do want to recapitulate.

Heather Endresen (26:07.117)
Yeah, so SBA is not great with recaps. They don't really have a program for partial buy-ins where they can't really fund somebody to just kind of buy in a small piece of a business. You'd have to do kind of partner buy-outs. You might be able to finance that SBA depending on who you'd be taking out of the cap table. And it's interesting, there's kind of a question now around SBA to SBA refinances. That was previously almost impossible to do.

And the SBA changed the rules a little bit to make it slightly easier now. So that's going to be really interesting to see how that plays out. So if somebody got into a deal and the bank priced it pretty high because it was higher risk at that time, and now it's three years later, they're doing well, but they're not big enough to get a conventional loan. But they'd like to go to another SBA lender and get a better rate. They used to not be able to do that. And now.

it's a little bit easier. They could do that. So we'll see how that kind of opens the floodgates because a lot of folks, you know, whether they're struggling or not, they're really not happy with the high interest that they're paying at the moment. Yeah.

Jon Stoddard (27:14.678)
Yeah. What is actually, are you seeing with the 11.25, which could go up any day? I mean, a lot of private equity guys, the hedge fund guys are saying the feds lost control, the interest rate. What's happening? What's the effects down line to getting a loan with 11.25 plus the two to 5% closing costs stuff?

Heather Endresen (27:42.657)
Right. So your total project, you know, the amount you've got to finance is going to be bigger than just the 80% of the purchase price. The simplest way I can describe it is, you know, from a year and a half ago, where rates were to where they are now, I always have this rule of thumb is how many turns of EBITDA can you finance under an SBA loan? And I used to say, back with the low rates, it was 4.25. So if you had a million dollar EBITDA company,

It could hold an SBA loan of about $4,250,000. Now it's about $3.75.

So that's the difference. That's the simple difference. Yeah. So you've got to make up that gap either with equity or maybe a lower multiple, but no one's gotten lower multiples. The multiples have stayed the same. So the way most people are actually getting there is with seller notes that have more flexible terms. So standby for two years or interest only, something that doesn't have much impact on debt service.

Jon Stoddard (28:49.406)
Yeah, I'm seeing a pretty wide range of seller interest rates, like six to eight percent. Is that what you see too?

Heather Endresen (28:57.569)
That is what I see. I don't see as many six anymore. I see more like eight most of the time. Yep.

Jon Stoddard (29:01.398)
More like 8%. Hey, I have to read this. If I go to sba.gov 7A, it says, I'm gonna read it, the interest rate, lenders and borrowers can negotiate the interest rate, but it may not exceed the SBA maximum. I know you're not responsible for the SBA.gov, but what's that saying there? Or is it just being ambiguous and not real?

Heather Endresen (29:23.257)
Well, there is actually a maximum. There is a rate that SBA says lenders can't charge more than this. So if it's variable, that rate is prime, Wall Street prime plus three. If it's fixed, I don't know the answer, because it changes. You'll have to look that up. But there is also a cap on the fixed as well that moves around and you have to look that up to figure out what that is. But they do actually have a limit, so they won't let.

Jon Stoddard (29:39.702)
Hahaha

Heather Endresen (29:52.365)
banks do what they would consider taking advantage of the borrowers.

Jon Stoddard (29:57.606)
Yeah. Let me, let me ask you about this. You're used to work for Live Oak Bank and they had their rules and their investment thesis, but now you're free agent. You can pick a lot of different stuff. How do you see deals where there's a lot of real estate to deals where it's a, you know, a service based company to deals that I get to software, just all of its IP.

Heather Endresen (30:25.421)
Okay, so I'm gonna put software and service companies almost in the same bucket, and I'll take real estate first. Banks love real estate, SBA loans. It's not only 75% guaranteed by the government, but it's probably close to fully collateralized by the real estate. So they love them. They love them for one other reason that a lot of people don't know about, and that is the secondary market premiums are much higher. Their profit margin, in other words, is much higher.

because the term of the loan is longer. So most banks are selling the guaranteed portion of their SBA loan in a secondary market and they're getting premiums. So, yeah, on a 25-year loan, the premium's much better than a straight business acquisition deal, which is only a 10-year loan. So there's a lot of reasons they like that loan better. They'll price it accordingly, and they'll actually go a little skinnier on the DSCR as well.

Jon Stoddard (31:04.046)
25 years, usually on a mortgage.

Heather Endresen (31:22.445)
So that's always going to be their kind of cream of the crop deal, SBA deal. Now let's take the service company. Service company, it's not going to be probably collateralized by anything or, you know, just a UCC. But, but I, you know, I try to remind people lenders don't care about equipment collateral really. They're depreciating. They're not going to be there or they're not going to be worth much of anything if, if they do go into a liquidation. So they're not really very useful that way.

Jon Stoddard (31:35.134)
trucks, you know, trucks, yeah.

Jon Stoddard (31:42.466)
Those are depreciating assets anyway.

Heather Endresen (31:52.585)
So they're just going to look for a good DSCR margin, a low customer concentration situation, and a good operator that looks like a winner as far as running it. That's going to be your basic business acquisition. Now software, yeah, it's got intellectual property. Again, I'm not sure the banks would know how to value that and what they would do with it on a liquidation basis, because if the company failed, what's it worth?

Not so much. But the software company usually has that holy grail of recurring revenue, recurring income, if it is subscription-based. And so that is easier to underwrite. They look for customer churn and all those good metrics that you look for in SaaS. And if all those are pretty good, they might underwrite to a skinnier DSCR than they would that service business, because it's

looks like more stable cashflow. Whereas the service business could lose a customer or two, or something could go wrong and they could suffer a downturn, much more easily than something with recurring revenue.

Jon Stoddard (33:02.398)
Yeah. When you say easier to underwrite, can you impact that a little bit when the for software, you know, difference between it's only been in business three years versus something to five years, um, with a low churn rate, let's say given it's a low churn.

Heather Endresen (33:18.781)
Yeah, no lender really loves only in business three years and there's a change of ownership. Nobody, no matter what industry it is in, that's gonna be big first red flag you have to get over and you may not get over that. That's always tough. But if it's software, if you've got a lender that can understand the software, here's another challenge. And at Live Oak, I was very lucky. Live Oak had a whole technology fund and we had internal experts you could go to and say, is this good software?

you know, I'm just a lender. What is this, you know, what does this thing do? Yeah, right. They've given you this beautiful deck and this roadmap and does it mean anything? And so we have people that could say yes and they could talk to our credit folks and say yes or no. The problem with software is if you go to a lender that doesn't have that, they're gonna be suspicious that it's not good. They don't know. They, you know, they don't know what they don't know. So, and that goes across a lot of industries.

Jon Stoddard (33:50.947)
Do people need this or is this just going to always be a TAM of 5 million bucks? That's it.

Heather Endresen (34:16.833)
it's always better to go to a bank that has some industry expertise in the type of business you're looking at than not. I see.

Jon Stoddard (34:24.886)
How do you as a buyer find that? Like, how do you like, now I know Live Oak Bank has the software and you could do that, but what if they specialize? And one of the issues I had when I was like six years ago talking to you guys, I was trying to buy that portfolio of courses on Udemy. And then they're like, wow, this is, the guy's been around for plus five plus years. The margins are great, but we don't understand this Udemy because Udemy hasn't really been around. I don't know what the real reason was, but it was

I mean, to us, it was a good business. To you guys, it was a higher risk. Yeah.

Heather Endresen (34:58.465)
Yeah, right. And this goes on, especially now that I broker loans, I see very interesting dynamics, where one bank understands a business, the other bank is asking kind of naive questions or arriving at conclusions that aren't really right. So your question was, how do you find out if the bank has expertise? First of all, you can't really ask the salesperson. I hate to say this.

Jon Stoddard (35:23.95)
No, they're not gonna- The first thing they say, yeah, we'll do that long.

Heather Endresen (35:26.953)
Yeah, please take everything. And I was a salesperson, so I'm allowed to say this. Take everything they say, it's a little bit of grain of salt. So I have a way that I help my clients do that, and I help myself do that. And that is through my Lumos data partnership. I've got access to the database, and I pull up the NAICS code of the business and see which lenders have done the most deals to that industry. And then we reach out and see how they feel about that industry, you know, after doing deals.

Sometimes it leaves a scar, right? Sometimes they've done a lot in industry and something hasn't gone right and they said never again.

Jon Stoddard (36:01.442)
Yeah, that's one bit, one spitting twice shy kind of thing with bankers. No, yeah, yeah.

Heather Endresen (36:05.141)
Right. Yeah, you got that too. So it's a little bit of work and a little bit of digging to figure out who's really got industry expertise. And that is part of what we do at Vizo is keep track of all of that. What are a bank's particular likes and dislikes down in the weeds and things like that. So we can really match up quickly to the right lender who will hopefully be asking the right kinds of questions.

Jon Stoddard (36:30.474)
I think that's important. So I just want to get into the subject where a lot of, I tell people, my students like, look, is the deal financeable? Cause we start at what's, okay, if you're going to buy this $2 million business, let's go to the SBA site. And if you borrow 90% of it or 80% of it, what's the monthly and yearly payment, what's the debt service coverage ratio? And is it passed?

Do you look at only deals above 1.5 or I know some banks need to see 1.75? And then I see some go 1.25.

Heather Endresen (37:10.141)
Right. So you know what I do? I see that whole wide range, 1.25 to 1.5 and higher. I have built a tool that helps me and helps others kind of decipher that. It's what I call a non-financial scorecard. So it takes the top 10 attributes of a business and we decide, we customize it to the business and we score them 1 to 10 on risk. You know, is this a high capex or low capex? Is it, you know,

recurring revenue are all project based. And we do this and we weight them and we come down with a composite score. And then I have a little chart below that sort of suggests that this is a low risk business that's probably a DSCR of 1.25, but you're probably paying a higher multiple, you know? And it gives you kind of suggestions of multiple DSCR. And then at the other end of the spectrum, here's a really higher risk business. And maybe that one does need to be at a 1.75.

DSCR with a bigger seller note and it sort of suggests those things. So I think it's all a matter of those other characteristics of the business. We talk too much, I think, about DSCR and these financial ratios. Yes, they're important, but the reason I built the scorecard is because we've got to focus on the non-financial attributes as well to kind of decide if we have a really solid low risk business or a little more of a risky business that we're getting into.

Jon Stoddard (38:33.294)
Yeah, let me give you some context to my next question. I interviewed a searcher for a search fund and I asked him the question like, wait a minute, I'm trying to understand. You got a fund that's gonna give you money to go buy this business. You just got out of Harvard and you have zero experience running a business, any business, why are they doing this? Well, it's because it's a business, it's low risk, it's been around for 15 years and a monkey could run it.

Yes.

Heather Endresen (39:04.621)
Well, don't tell the seller that, I hope, but please don't. Yeah. Well, okay. That's true, right? And this is something that I've experienced firsthand watching folks like that get into companies and be successful. And honestly, some of them be very successful. I have a whole batch, I would say, or group of folks that I helped buy the business and they were like that. That was what their resume looked like generally.

Jon Stoddard (39:06.306)
Don't tell the seller yet.

Heather Endresen (39:32.093)
and they've already exited at a great multiple and they're now investing or buying other companies. So, you know, the proof is in the pudding. You have to see it to believe it, but I understand why a lot of people are skeptical and especially banks. It was not easy. If you imagine, you know, going to Live Oak Bank six years ago and saying, we want to lend to this guy or this gal and they'd look at the resume and, you know, go, oh my goodness, what are you, are you guys crazy?

But they let us try it, they let us do it, and it worked really, really well. So it does work.

Jon Stoddard (40:05.71)
I got to tell you, I was looking at the prior regs of the operator that you guys scored. Character, reputation and credit history of the applicant, experience and depth of management, strength of business, past earnings, projected cashflow, future prospects, ability to pay the loans, sufficient invested, potential for long-term business, nature and value of collateral, effective in affiliates and unrepayment loans. Some of those are subjective and objective.

brought it down to just three. Applicant's credit report, cashflow, and equity or collateral. Is that true?

Heather Endresen (40:43.55)
I don't know where is that scorecard coming from, from a particular lender or?

Jon Stoddard (40:47.046)
Yeah, I was on a website that it was like the new regs, the prior regs to the new regs. Yeah.

Heather Endresen (40:51.305)
Oh, oh, reg. Okay. So, I mean, I don't look so much at the regs. Yeah, the SOP kind of just has guidance. And I think maybe they went too granular to the point, like, you can't really govern that stuff. Like you said, how do you govern something that's subjective?

Jon Stoddard (40:54.727)
or SOPs that you call them, yeah.

Jon Stoddard (41:05.066)
I didn't like his post on Facebook. I'm gonna score that a zero. What, you know.

Heather Endresen (41:08.137)
Yeah, right. Right. So I think that was what that was. But I think what's more important to people who are trying to get a loan is the lenders do have scorecards like that, so to speak, or they have matrices. A lot of them have these matrices where they're building all these scores and you don't even know it. You're talking to your lender and they're going, oh, bad on character or whatever, you know, doesn't seem to know this business very well or whatever. So one of the

try to coach my clients on is we start with a data room and we put a business plan together and a transition plan together. And I have sort of a methodology there. I don't want folks to go to the bank too soon because when you're sort of getting your act together on the loan and on the deal in front of the lender, they are judging you. They're not telling you that. But, and also you're sitting in their pipeline for a long time and it's coming up in meetings and credit folks are asking, well, what's going on with that one?

You don't want to be the one that's sitting there for an extra month because they can't get the Q of E done. Why do you need the bank to see all that? Because they're going to form opinions about that. There's a time to go to the bank and there's a time not to. We try to prepare people for that and go to the bank when we're ready and we have the answers to their questions and we're buttoned up and we know what to tell them about certain aspects of the business. Too many people don't do that.

Jon Stoddard (42:11.606)
Yeah.

Jon Stoddard (42:29.674)
Let me ask you about the timing of that. I've seen some people go, Hey, I went to the SBA. I'm a pre approved for a million dollars. Well, you don't even know what the business is throwing off cash at it. You don't have the LOI. I don't like, I don't see the purpose of that, uh, to how long it takes to send. If I put everything in the data room, how long should I wait to get a term sheet?

Heather Endresen (42:54.945)
Okay, so let me take the first one, this pre-approval. This is kind of born out of brokers asking for something and buyers not knowing kind of what the broker wants. I will tell you, a broker friend of mine recently schooled me on this because I was even doing those generic letters of support and he said, we don't want those. We want a pre-call letter to this deal. So I do offer that to my clients, but then you've got to fill out my templates.

Jon Stoddard (42:59.243)
Yeah.

Heather Endresen (43:22.573)
and send it in and I've got to review all of that. There's a lot of work and you don't even have an LOI. And I will give a pre-qual letter specific to that deal with a dollar amount that it appears to qualify. I'm not gonna be able to do that on every deal. That's, you know, and no lender is. So, you know, that's what brokers really want though. They don't really want that generic letter of support. So for whatever that's worth. Now you get a signed LOI, your next question, and you put everything in the data room, how quickly can you get a term sheet?

This is where it depends. If when you say everything's in the data room, I agree that this answers all the bank's questions, and we don't have any really big outstanding questions, you should be able to get a term sheet in three to five days. And most of my clients do. But sometimes we need to hold back and wait on that data room, sometimes all the way till Q of E. I have some cases where I can tell the Q of E is going to fairly significantly change things. We need to get.

pass that, see if we can renegotiate, and then go to a bank. And it's going to be much cleaner if we do it that way. So it really depends on the state.

Jon Stoddard (44:26.822)
Oh yeah, I agree with that because like I said, 80% of the businesses I've just seen in just in the last week, they're not balanced books.

Heather Endresen (44:35.161)
Yeah. So what are you looking at? Yeah, you don't know.

Jon Stoddard (44:37.57)
Like, you know, like that income statement on the, even on the income statement, that's a theory. That's not what's the cash in the bank. So, and it's not balanced. None of those numbers on the net encounter on the balance sheet match the numbers on the income statement. So you need to call it earnings. Yeah.

Heather Endresen (44:52.685)
I looked, yeah, you do. I looked at one recently and what was standing out to me was they took in customer deposits. 50% of each order was a customer deposit. And so let's go look and see how much is on the balance sheet and the customer deposits were the same dollar amount every quarter, never changed. So that tells you something's not right there. That's impossible for that number not to change. And the same kind of thing was happening with inventory as well. So you. Mm-hmm.

Jon Stoddard (45:11.726)
Hmm.

Jon Stoddard (45:18.978)
Yeah, anytime I see the same exact number that's unrelated, like, okay, you inflated it's on an Excel spreadsheet. So you inflated the number to make your expenses look low or your revenue higher. Yeah. Something's going on.

Heather Endresen (45:30.137)
something's going on. Yeah, and we're not gonna know until we get a Q of A. Yep.

Jon Stoddard (45:34.783)
Yeah. What do you do with SDE? Because I always see brokers coach the seller to put lots of line items in the SDE, make it look bigger to make the multiple look.

Heather Endresen (45:49.141)
Okay, I am so against SDE as any kind of metric. I'm just against it because forget the ad backs. I'll get to that. But even if you have a clean, no ad back deal and you're gonna add in the seller's comp but you're not gonna take a salary for replacement comp and you're gonna pay a multiple of the salary that you're gonna need, that doesn't make any sense. Right.

Jon Stoddard (46:10.946)
Yeah, it's gonna run itself. It's gonna run itself, yeah. Yeah.

Heather Endresen (46:13.497)
Right, it's gonna run itself. So you have to deduct, I mean, maybe the seller's taking a huge salary and you're gonna deduct a smaller salary, that's fair. That's fair. But you have to deduct a replacement salary or replacement salaries. So that's one of the common pitfalls too. Sometimes you have a number of exiting sellers, maybe the spouse or maybe they have a partner and you're gonna need more than one salary to replace them all. So you've gotta.

Jon Stoddard (46:37.59)
I think the IRS requires a nominal salary.

Heather Endresen (46:41.385)
Right, they do, they do. But yeah, but you just gotta look at what market would be for you to spend your time running this company. And you're not gonna pay four times your salary. Who's gonna take a job and pay four times their salary to get the job? That no one would do that, so. No, so I don't like SDE at all. Adbacks, oh boy, jeez. I mean, every small business, I've seen almost everyone.

Jon Stoddard (46:58.459)
I don't know. Yeah.

Heather Endresen (47:09.221)
They're playing games with the taxes, right? They want to pay for personal expenses through the business. And I think we've all just come to accept that. But it can go too far. You know, it can just...

Jon Stoddard (47:19.106)
Yeah, yeah, like I'll just give you a perfect example. Just this yesterday had somebody reached out on Facebook, hey, our account, since an attorney's fees ad backs, I go, do you think you'll use them next year? Yes, okay, they're expenses.

Heather Endresen (47:31.777)
Yeah, right.

Heather Endresen (47:36.361)
Oh, I've seen things like, you know, oh, well, this software didn't work out for us. So you can just add that back. We didn't like it. You know, just things that... Yeah. We made a mistake on this, doing spending money on that. So you won't have to. I mean, you're going to make mistakes too, I guess. Yeah. So some of the ad backs are just kind of silly. And I don't know why brokers don't do a better job of just, let's start with at least a reasonably clean, defensible set of ad backs. Let's just start there. Please.

Jon Stoddard (47:43.678)
Yeah, you take the R&D tax credit. I don't care, but it's not an ad back.

Jon Stoddard (48:05.142)
Yeah.

Heather Endresen (48:05.977)
Can we?

Jon Stoddard (48:08.254)
Yeah. So with the interest rate going up, if it keeps going up, what are we likely to see?

Heather Endresen (48:17.317)
Oh, if it keeps going up, I think we are likely to see a slight depression in price multiples, although that's a tough one to predict because why would a seller sell if they have to go much below four? If they're giving, they'll just hang on, right? So they're not going to want to do that. So I think the more likely is more flexibility in seller notes or, and I don't mind this at all, raising more equity from investors. There's all those investors that want to be in these deals.

Jon Stoddard (48:30.926)
They'll just hang on, right?

Heather Endresen (48:46.361)
They're not all bad and the terms aren't all exorbitant and the capital is there. So you can keep your leverage lower by, bringing in some more equity. I don't think people are gonna stop doing the deals though. Like you said earlier, this asset class is kind of like the last asset class that's attractive at the moment. Everything else has kind of got some pretty bad cracks in it at this point in time. So there's a lot of attention on this.

Jon Stoddard (48:56.31)
Yeah.

Jon Stoddard (49:10.498)
Well, I'll tell you there's a type of investor that's looking for an RSA, kind of like BooPoo's does, but it's revenue share agreement that you can come in to bring the down payment and they'll just get paid out of the top line. Yeah.

Heather Endresen (49:18.729)
and

Heather Endresen (49:26.117)
Yeah, okay. I mean, there's a lot of solutions that equity could bring if we have continuing rising rates. And like I said, fortunately, we're at a point where there's a lot of equity interested in the space. So I think that's positive.

Jon Stoddard (49:43.742)
Yeah. Well, that was fantastic. That was something that covered me. So I appreciate that ever Heather. I still mess up all the time.

Heather Endresen (49:52.162)
Good.

That's right. I mean, these are, like you said, they're small businesses. There's stuff that goes wrong and you can't predict it.

Jon Stoddard (50:03.226)
Oh, so wait, I'm gonna cut that little part out, but so where does somebody go if they want this little tool or want access to figure out if this deal is financeable? Where do they go?

Heather Endresen (50:15.129)
So come to my website, viso, V-I-S-O, cap.net, and you can fill out our little web inquiry form and let me know that that's what you want. I'll invite you to my Zoom sessions. I do those every two weeks, and I'll give you all the templates that we use.

Jon Stoddard (50:32.606)
Yeah. Let me ask you another question. How do you score or look at businesses that have anomalies? Whether it's, let me give me a perfect example. I have a friend, a student looking at a cargo business that does right around 6 million, but last year they did 12 million and it's coming back down to 6 million. How do you score that? And the opposite, what if it's like a really bad year? One bad year.

Heather Endresen (51:00.485)
So the story needs to be laid out there in a way that we can kind of track. And then you sort of adjust that year and say that was one extra order and that is not going to happen. We're not going to expect it to happen. And we just take it out of the cash flow there and sort of try to normalize it. If that big order hadn't happened, what would we have looked like? What is the rest of the margin? And that's not hard to deal with. It's people that want to want to sell on that.

bonus year and that's not going to work.

Jon Stoddard (51:32.758)
Yeah, yeah, no, that is actually overseen. They're trying to give a multiple and last I go, that's not what you're doing in 2023. We can clearly see that, yeah. Yeah. Well, Heather, thank you so much for being on my show. I appreciate it.

Heather Endresen (51:40.23)
No. Yeah, right. Exactly.

Heather Endresen (51:47.981)
Thank you for having me. It was fun and always great to talk to you, John.

Jon Stoddard (51:53.602)
All right, thank you. Let me stop this, but give me a few seconds to...

Heather Endresen (51:57.017)
Thank you.