March 12, 2025
Adam Hoeksema
If you are looking to buy a small business with an SBA loan I think there is some very simple due diligence that you should do before you submit a letter of intent (LOI) to purchase the business that could save you hours of time and thousands of dollars. We offer a service to buyers that we call a Quality of Earnings “Sniff Test” where we provide this pre LOI due diligence for buyers, but there isn’t any reason that you couldn’t do this due diligence and analysis yourself. Let me outline the 3 core things that I think should be your first step of due diligence when looking to buy a business with an SBA loan:
- Do the Seller’s Financials have any Major Red Flags?
- Is the Valuation of the Business Reasonable?
- Will the Deal Qualify for an SBA Loan?
Let me dive into how I would analyze the business and answer these questions.
Small Business Acquisition Financial Due Diligence Red Flags
When I analyze a small business for sale I start by asking for the last 3 years of business tax returns. The tax returns are what an SBA lender will use to underwrite a deal so you might as well be looking at the same thing that the SBA lender will look at.
Then you will need to get those 3 years of tax returns into a spreadsheet where you can see the years side by side and notice any trends.
- Are sales going up or down?
- Are gross profit margins and net profit margins going up or down?
- Are the expenses and margins similar to industry averages?
- Are there any add backs and are they reasonable and will the SBA allow them?
With the tax return data entered along with any proposed add backs by the seller you should be able to calculate the Seller’s Discretionary Earnings (SDE).
With the SDE in hand, next we need to look at the valuation.
Small Business Valuations and SBA Acquisition Loans
Small businesses are typically valued based on a multiple of their Seller’s Discretionary Earnings (SDE). To get a baseline for your industry’s average multiple I like to use BizBuySell which is the largest platform for listing businesses for sale. They publish average earnings multiples and revenue multiples for the businesses that actually sell on their platform.
Check out BizBuySell’s Industry Valuation Multiples
As part of the SBA loan process for an acquisition the lender will need to order an appraisal of the business. This is an SBA requirement and if the appraisal comes back too low compared to the sales price you may not be able to utilize an SBA loan for the purchase.
SBA Loan Qualifications for a Small Business Acquisition
SBA lenders are going to determine how much they are willing to lend for an acquisition loan based on how much debt service the business can cash flow based on historical financials - tax returns.
The magic number is typically a debt service coverage ratio of 1.25 or above.
That means that the business should have $1.25 of earnings on the historic tax returns for every dollar of proposed debt service.
If your proposed loan payments amount to $100,000 per year, then the business will need to have shown a profit of $125,000 in the prior year.
Based on these constraints you can back into how much of an SBA loan the business might qualify for. If the business can’t qualify for $1,000,000 SBA loan based on debt service coverage ratio, then that should inform the offer that you make to the seller in the LOI.
From my perspective, the goal of pre LOI due diligence is to make sure that the offer you are making is actually financeable with SBA.
If you have a deal you would like for us to analyze through our Quality of Earnings “Sniff Test” process please feel free to reach out at support@projectionhub.com.
