What on earth is a coverage ratio in financing with an SBA Loan?

When dealing with financing of various sorts you will come across the term "coverage ratio". It my be in the context of "Interest coverage ratio"  or "debt coverage ratio" or some other similar nomenclature.

Here's the basic concept of a coverage ratio. The coverage ratio is designed to determine what margin for error there is in a borrower's ability to pay back the debt.

Let's use an example assuming you are buying a business, here are some basics:

• Business Purchase Price $500,000
• Seller's Discretionary Earnings (SDE) $175,000 (Seller's discretionary earnings is the business earnings before Interest, Depreciation, Taxes, Amortization and Owner's Compensation).
• Down payment Buyer has available $100,000
• SBA Loan $400,000  financed for 10 years @ 7% =  $4,644 per month payment which = $55,750 per year.
• Salary the Buyer needs from business to pay living expenses  $100,000.

Coverage Ration Calculation  

SDE                                       $175,000

Salary needed                         $100,000

Available for Debt Service      $75,000

Amount of Debt service          $55,750

Coverage ratio is                     1.35   Amount available for debt service divided by actual debt service.

Generally speaking when seeking an SBA Loan the coverage ratio required will be between 1.25 and 1.4.

What Price is the Right Price to buy a Small Business

If you decide you want to buy a business you need to prepare yourself for the rather inconsistent pricing methodologies used for setting the asking prices for small businesses.

You shouldn't confuse the asking price for a business with the value of the business or what finance professionals call a Business Valuation or Business Appraisal. There are many ways to compute the value of a small business. The results can be wildly different and all correct. The issue isn't "what is a business worth?" as much as "what is the business value to you?". We'll breakdown the elements and suggest ways for you to go about the process of determining a fair value for a business.


For background it also might be helpful to read  "What do you Buy when you Buy a Business?" . Also, you might want to review this Case Study How to Buy a Business -  Case Study.

In this post we will discuss the elements that create small business value. As Business Brokers we have these discussions with buyers but more importantly we have the same discussions with business sellers.

The best business planning tool?

If you plan to be in business you'd better have a Business Plan. If you plan to start a small business this tool can be the difference between success and losing everything. If you think this Business Plan tool is expensive wait til you see how expensive it is to NOT have a well thought out and written business plan.

If you are considering starting or buying a business it's a good idea to have the best tools. It may cost you a few bucks but it could be a cost that saves you many, many thousands of dollars.

A good business planning tool will also allow you to compare options from a consistent platform.

I think the best Business Plan Software on the market today is Business Plan Pro . (Yes, this is an affiliate link and we get a few cents if you buy it but, hey, give us a break, we did the research).

The best part about this software is it's intuitive and you don't need an MBA to operate it. The Standard edition is all most people ever need. It's a product that has been around for many years and it's very practical and efficient to learn.

As you can see the layouts are clean and easy to understand.



If you are going to get into business you need a plan that is logical, well thought out and proven. Trust me, if you go to your banker with a professional business plan your odds of getting financing improve dramatically. A plan like the one Business Plan Pro produces will be a requirement for any SBA loans that you apply for or pursue.

Here's a few fatal mistakes a good business plan can help you avoid.

The best time to have a business plan is before someone asks you to see it! Get ahead of the curve...get your plan.

Business Buyers 7 Deadly Sins

Buying a Business - The 7 Deadly Sins

Buying a business could be the best decision for you but you need to approach the task methodically and with a clear understanding of yourself as well as the businesses you consider. Here are the mistakes many business buyers make.

We call them the Business Buyer’s 7 Deadly Sins:

Buyer Sin #1

Buyer’s failure to seriously investigate and understand their personal financial situation before they begin the process of investigating businesses to buy. How much ready cash do you really have for a down payment? Where is it? Will your family and friends really back you? What are the tax consequences of accessing the cash (401k/IRA)?

Buyer Sin #2

A Buyer’s failure to understand how much money they need to live on, month-to-month. This is often called your “burn-rate”, which needs to be absolutely as accurate as possible, by month, for at least 1 year.

Buyer Sin #3

A Buyer’s failure to understand the difference between profits and cash flow. Profit is what the books say the business made. Cash flow is what cash, the owner, can actually use. You can’t spend profits, you can only spend cash. You can have a lot of profits and no cash.

Confidentiality in the Sale of Small Businesses

Business sellers and buyers often look at confidentiality requirements in different ways. However, in the end, they both have the same interests.

The reason to maintain confidentiality is to protect the business from the possible negative impacts of  a sale.

Read more here............

What Does Patricia Kluge Bankruptcy teach us about business ownership?

A messy business failure can always be learned from. The Patricia Kluge bankruptcy has lessons for small business owners with partners, both known partners and unknown partners.

I once heard a wise man say, "Pick your business partners twice as carefully as you pick a spouse..because a spouse can only take half of what you have."

If you are going into a partnership in a small business make sure you set up the proper buy/sell agreements so that you don't wind up with a partner you don't want. How could that happen?

You and you partner are 50/50 with no buy/sell agreements in place. You've known your partner since high school and trust him completely but..... after you two are in business he goes thru a divorce and his wife winds up being your 50/50 partner. Now what? But wait it could get worse...she remarries and now you have another partner, kind of. You get the picture.

Get your buy/sell agreements in order before you go into business with a partner. A good business attorney can help you avoid a terrible situation, one which we see way to often out in the real world. You'll even find businesses for sale solely because of partnership issues that weren't planned for at the beginning and now selling the business is the only way out.

Here's a good video post regarding buy/sell agreements.

Want to Know How a Business Appraiser Looks at Small Business Value?

Factors that Increase or Decrease Business Value

By: George D. Abraham

CEO & Chief Appraiser

Business Evaluation Systems

There's a range of key factors that can affect the value of a business.  While some of these factors are outside of the owner's control, steps can be taken to make the business as valuable as possible. Start planning well in advance and consider inserting an exit strategy into your original business plan. Then start implementing the factors that increase value and eliminate the factors that decrease the value.

Financial Statements

Just how good are your financials. Are they minimal or do they show an in-depth look at your business.  Can you easily track the flow of revenue and expenses flowing from the invoice to the financials to the tax returns?  Can your track the sales of your top 5 customers? Can you easily prove all of the perks you receive from the company?  Today's accounting software easily lets you do all of this and much more.  When a buyer is interested in a company, the ease at which the owner can prove the financial performance of his or her business has a direct impact on value. Incomplete or inaccurate financials tells the buyer that no one is watching and tracking the Company's performance and therefore the future performance (of real importance to the buyer) is unpredictable.  Value is created or destroyed by the ability to see the Company's future.  The longer the buyer can see that the Company will perform in the future as represented, the more secure they are and less risk is perceived.  To the contrary, when the future is a guess, risk is increased and value is decreased. 

Ever wonder what an Accredited Investor is? And why it matters......

Under the Securities Act of 1933, any company that sells securities must register with the SEC or file for an exemption if they so qualify.  The Act provides companies with a number of exemptions from federal registration requirements.  One of these exemptions is that the company may sell its securities to Accredited Investors.   Selling securities to Accredited Investors is deemed to be an exemption because the assumption is that Accredited Investors have the skill and knowledge to evaluate and determine the risk of the investment.

The term Accredited Investor is defined by the Securities and Exchange Commission (SEC) and is used to describe investors who have achieved a level of financial sophistication that eliminates or diminishes the need for protection that some government filings may provide. 

An Accredited Investor is:

Do you know yourself? Do you know your clients? What Kind of business owner are you?

I had a chance to meet with John Warrillow recently. He's the author of an excellent new book that talks about business owners and how they think. It's titled Built to Sell

If you have a dream of selling your business or growing your small business into a bigger business that one day can be sold, this book should help you.

If you're a business owner, or hope to one day be a business owner, this book is important for you...if you are an advisor to business owners this book is critical!

What kind of business owner are you? What kind of business owners are your clients?

• Mountain Climber
• Freedom Fighter
• Craftsperson

Take the time to figure it out, it could be worth a lot of money to you one day soon.

Give it a read, I'll bet you'll be glad you did.

Click here for the link to the book.

Thinking about buying a business? Here's a way to figure what is possible

If you want to own your own small business there are really only two ways to get into business. You can start a business from scratch, often called a start-up. Or you can buy an existing business from a business owner who is ready to sell their business.

There is much written about starting a business. The biggest problem with a start-up is in the time it takes a start-up to become cash flow positive and unfortunately many never become cash flow positive and they fold.

Buying an existing business is often a good choice. If you do it right you can be cash flow positive immediately and financing for purchasing a business is often very favorable. In a previous post I wrote about "Why would someone sell be their perfectly good business?" and it talks about why business owners choose to sell good businesses.

If you want to buy an existing, profitable, business you need to answer a couple of questions about your situation before you begin your search.

First, how much money do you have available for a down payment before borrowing any money from any banks, credit cards, etc. It will be very, very difficult to buy a good business without a down payment.

Second, what's the minimum amount of money you need to make from the business to live on once you buy the business.

If those two numbers are reasonably close to each other you have a decent shot at buying a business.

Here is a "typical" deal:

Business earnings (Seller's Discretionary Earnings)  $75,000
Selling Price of business   $200,000
Down payment    $50,000
 Earnings/Salary you need  $50,000
Get an SBA Loan for $150,000
Annual Payments for your SBA Loan $20,500 (10 years @ 6.5%)

Business earnings $75,000 - $20,500 (debt payments) = $54,500 to you the new owner.

Also, when thinking about your down payment there is a mechanism to use you 401(k) funds to buy a business without incurring early withdrawal penalties nor tax obligations.

If you want to be in business for yourself it's always a good idea to get informed and look at all your options.

Why would someone sell me their perfectly good business?

Often small business buyers wonder about this. There is an all too frequent buyer attitude that says "If it is a good business they wouldn't be willing to sell it to me!"
Here are some reasons we see business owner want to sell:

1. Divorce of husband and wife owners
2. Partnership disputes
3. Owner health issues
4. Kids don't want the business and the owner has gotten to retirement age.
5. The business has gotten bigger than the skills of the owner
6. The business needs professional management
7. The industry is changing faster than the owner wants to change (in this case the owner is always convinced the market is wrong and he is right).
8. The business is totally debt free and the owner doesn't want to take on debt to grow.

There are many other reasons that make sense to the seller, even if it doesn't always make sense to the buyer. the tricky part is, because confidentiality is so important it takes some work to locate a good business to buy. Finding a good business for sale and buying it from a seller who has a good reason to sell could be a formula for success in a business acquisition.

Holiday Reading Ideas for a Better Business

My New Year's resolution (well, one of them anyway!) is to provide more tools for small business owners to start or buy a business, then grow it profitably and sell it! As part of that I am kicking off the New Year with a specific book recommendation. Although I can't say I agree with everything in this book it is loaded with ideas that might help get you focused on creating a business that you run, instead of a business that runs you.

Making Money is Killing your Business contributes greatly to the argument that running a business by the seat of your pants is not always a great idea.

A core and unique concept of the author Chuck Blakeman is that a business should throw off money and time. If you start thinking about your business this way I think it will change some of your decision making. In an earlier post, 'Tis the season...  I warned about creating an atmosphere in your business where you are cynical about your business and you lean on an "it's me against the world" view of ownership.

This book gives clear ideas and examples of how to mange that natural tendency.
Don't get hung up in the references to a specific industry. Analyze the concepts and I think you'll be able to apply improvements to your business quickly. Good luck and let me know what you think about the book.

M&A Due Diligence from Seller Perspective

Here's an article that shows how M&A Due Diligence preparation can dramatically improve a seller's position.

What is an "S" Corporation?

An S Corporation is a form of business classified for federal income tax purposes as a corporation that has elected to be taxed as a pass-through entity, in a manner similar to a partnership or sole proprietor.  Unlike a regular corporation, or a C corporation, an S corporation (both names derive from sections of the Internal Revenue Code) generally is not subject to federal income tax.  Instead its income is reported on the tax returns of its shareholders, and they have the responsibility for paying the tax.  If there are losses suffered by the corporation, they also pass through and are reported on the shareholders’ income tax returns.

               Because only the shareholders, not the corporation, are taxed, S corporations avoid the problem of double taxation associated with C corporations.  This is the biggest draw for creating an S corporation, particularly for closely held corporations.

               Shareholders in an S corporation, like shareholders in a C corporation, generally have limited liability arising from corporate matters, even though they pay taxes as if they were partners or sole proprietors.  In addition, when the corporation is eventually sold, there can be reduced taxable gains, as compared with the sale of a business operating as a C corporation.

               On the downside, the limitation on classes of stock in an S corporation provides less control over the company and the value of its stock.  Potential outside investors likely will not be attracted by the pass-through tax characteristics of an S corporation, nor by the limit on the number of shareholders.  Although corporate taxes are avoided, there is still a requirement for filing an informational tax return every year for a corporation with more than one owner.  Finally, if avoiding formalities is an important consideration, it should be noted that, like any other corporation, an S corporation must follow the requirements for having regular meetings and keeping company minutes. 

               The balancing of the advantages and drawbacks of S corporation status in any given case is sufficiently complex that it is advisable to seek professional advice before making this important choice.  

Note: This article provided by Craig Welscher a Houston, TX based attorney. You can contact Craig through www.welscherlaw.com

When buying or selling a business....timing matters... a lot!

I am often asked when is the "right" time to buy or sell a business. Unfortunately the answer is complicated. When I'm asked that question my response is "as compared to when?".

Below is an example:
Mary wants to buy a business and John thinks he wants to sell his small business.

The Biz: In 2009 John's business struggled like many businesses. He was down about 30% in gross sales and earnings. For 2009 his sales were $600,000 and earnings $100,000. John wants to know if he can get his business back up to earnings of $125,000 can he sell it for more money in 2011 (he'll need full year 2010 results to get credit for any increased earnings).

The buyer: Now there's Mary. Mary has $100,000 for a down payment and she need's $60,000 per year in salary from the business to live on.

Let's quickly figure how much Mary can afford to pay John for his business:

Mary has $100,000 for down payment
Current interest rate used for Mary's loan 9%
Biz earnings today- Mary's salary of $60,000 leaves $40,000 ($100,000 - $60,000) left for debt service.
An SBA lender would, today, loan Mary about $197,000 based on the available $40,000 for debt service.
So Mary can pay John $197,000 + her down payment of $100,000 = $297,000.

What if John's earnings increase to $125,000 but interest rates 18 months from now are 11%
Then the bank would likely loan $237,000, add that to Mary's down payment of $100,000 = Selling price of $337,000.

So even though John's earnings increased 25%, his selling price only goes up about 11% because of the increase cost of financing caused by higher interest rates.

So when the right time, hard to say? If John waits, what happens if his earnings stay at $100,000 but interest rates increase? Then his selling price would drop!

Usually the best time to sell is when earnings are up and interest rates are down, but that doesn't always coincide with the events of the buyers and sellers lives.

Should I find a job or I buy a job? Eight important questions.

Many people get fed up with working for someone else and consider starting a small business or buying a small business. If you are considering being your own boss please give consideration to the following questions. Can you ask yourself these questions and answer them honestly? I'm serious, can you answer them honestly?
1. Are you really as smart as you think you are?
2. Are you willing to work harder for yourself than you do for someone else?
3. Can you live with a high risk/high reward life?
4. Can you make good decisions with limited information?
5. When you're wrong can you admit it, correct it and move on?
6. Can you resist the urge to spend like a fool in good times so you'll have reserves for the bad times?
7. If the toilet needs to be cleaned will you do it?
8. Which would you rather have, a big image or a big bank account?

If you answered yes to at least 7 you have a chance to succeed. Now go back and take the test again. Remember be honest with yourself, it could make you wealthy or it could make you broke.

Due Diligence when Buying a Small Business - Part 4

In a previous post, Due Diligence Part 3, we talked about how to deal with tax returns, in Due Diligence Part 2 we talked about Sales Tax issues. Here in Part 4 we'll talk about a background check you might considered getting when you are in the due diligence process of buying your small business. Do diligence is not just about investigating the small business accounting, it's about the entire business..

A business background check might turn up nothing, which is probably good. Or a business background check could turn up everything from tax liens, lawsuits with suppliers or customers or even criminal activity. Basic background checks can be very inexpensive and are available online. One possible source is Background Now.

Due Diligence is supposed to give you comfort, if you check everything and there are no deal killers you can complete the purchase of your small business and sleep a lot better.

SBA Loans have new underwriting policy

A few days ago the SBA came out with a new lending policy to be used when buying a business. Business brokers are very excited about this change since it will facilitate more financing for small business purchases. About 15 months ago the SBA made a draconian change in their underwriting that eliminated business acquisition financing for goodwill in excess of $250,000. This 2008 policy change effectively dried up SBA lending for buying a business sales. Small business financing is a unique problem since the loans are usually not large enough for lenders to make much profit.

SBA loans are a very important part of the small business financing options. The newly released SBA business loan policy allows up to $500,000 in goodwill financing or if the buyer puts up at least 25% in equity the goodwill limit is uncapped.

This policy change is important because the goodwill value in the transaction is an indication of a highly profitable business.

SBA loans are back and business buyers and sellers will be more able transfer business ownership to retain jobs and help their communities grow.

When buying a small business - Allocation of Purchase price is important!

Allocation of Purchase Price is done for tax purposes when buying the assets of a small business. The allocation is important because it effects how the person buying a business and the person selling a business will be taxed and what deductions are possible.

Always do the allocation of purchase price before closing the transaction, it's real money! Business brokers should be able to provide you details and the appropriate IRS form 8594.

Here are the issues:

1. Buyer wants shortest depreciation schedule for acquired assets.
2. Seller wants tax treatment at capital gains rates, not ordinary income
3. Buyer wants to write up value in hard assets so buyer can deduct more in depreciation
4. Seller does NOT want to write up assets because it triggers depreciation recapture and tax at ordinary income rates
5. Goodwill and intangible assets are 15 year write off for buyer and cap gains rate for seller.

A good allocation of purchase price can reduce the total amount paid for a business after tax, and after tax is all we really care about, right? Same issue for seller, a good allocation of purchase price can maximize the after tax benefit to seller.

For buyer the difference is WHEN they can deduct the price, for the seller it's the difference between cap gains rates and ordinary income! Big difference!!

Talk to your business broker about how to address this issue in any offers.

Due Diligence for Buying a Business - Part 3

Assuming you've read Part 1 and Part 2 here we go with Part 3.

Sales Tax and Due Diligence in a small business purchase: Make sure the seller provides you with the Sales Tax Reports for at least 3 years. Double check those with the reports filed with the state. It is pretty unusual for small business owners to over-report sales and pay taxes they don't owe ,so this is a good source for determining the minimum sales level. If the sales tax reports and payments are not up to date seek legal advice on what effect that could have on you if you purchase the assets. In some states the sales tax "chase" the assets and you could be in for a surprise when the tax man shows up for old taxes on the assets you just bought.

If you are working through a business broker they probably already have the sales tax reports an can provide them to you in due diligence. But as always, trust but verify. Cross reference with the official state reports.