SBA SOP 50 10 8.1, App15.C.1 — Financial Due Diligence

C. Credit Standards 1. Financial Due Diligence The financial due diligence conducted on a change of ownership transaction is part of the primary underwriting and eligibility determination. The out-of-pocket costs associated with all financial due diligence reports may be passed on to the borrower. Any funds expended by the Applicant on the report can count toward the equity injection. a. Business Valuation Requirements – change of ownership:

i. Determining the value of a business (not including real estate, which is separately valued through a real estate appraisal) is the key component to the analysis of any loan application for a change of ownership. An accurate business valuation is required because the change of ownership will result in new debt unrelated to business operations and the creation of intangible assets. A business valuation assists the buyer in making a determination that the seller’s asking price is supported by an independent Qualified Source: a) Qualified Source: (For 7(a) business valuations): A “Qualified Source” is an individual who regularly receives compensation for business valuations and is accredited by one of the following recognized organizations and is independent of the loan production function, not involved in the approval of the transaction, and must not have the appearance of a conflict of interest: i) Accredited Senior Appraiser (ASA) accredited through the American Society of Appraisers; ii) Certified Business Appraiser (CBA) accredited through the Institute of Business Appraisers; iii) Accredited in Business Valuation (ABV) accredited through the American Institute of Certified Public Accountants; and iv) Certified Valuation Analyst (CVA) accredited through the National Association of Certified Valuation Analysts. v) Business Certified Appraiser (BCA) accredited through the International Society of Business Appraisers.

ii. For the individual performing the business valuation to identify the scope of work appropriately, the business valuation must be requested by and prepared for the Lender. The Lender may not use a business valuation prepared for the Applicant or the seller.

iii. The scope of work should identify whether the transaction is an asset purchase or stock purchase and be specific enough for the individual performing the business valuation to know what is included in the sale (including any assumed debt). The business valuation must include the individual’s conclusion of value, the qualifications of the individual performing the business valuation, and their signature certifying the information contained in the business valuation.

iv. Non-Special Purpose Properties: If the Business Purchase Price is $350,000 or less, the Lender may perform its own valuation of the business being sold, unless there is a close relationship between the buyer and seller.

v. Special Purpose Properties: A “Special Purpose Property” is a limited-market property with a unique physical design, special construction materials, or a layout that restricts its utility to the specific use for which it was built. a) If the Business Purchase Price is $350,000 or less the Lender may perform its own valuation of the business being sold, unless there is a close relationship between the buyer and seller. b) The business valuation must allocate separate values to the individual components of the transaction including land, building, equipment, and intangible assets. c) The Certified General Real Property Appraiser must have completed no less than four going concern appraisals of equivalent special use property as the property being appraised, within the last 36 months, as identified in the qualifications portion of the Appraisal Report. d) Each business valuation assignment under this section must be undertaken with a specific instruction for the Certified General Real Property Appraiser to conduct the appraisal in compliance with current USPAP guidelines.

vi. The business valuation must support the Business Purchase Price as defined in Paragraph A.1 regardless of how the debt is structured. If the amount paid for the business exceeds the business valuation, the difference must be made up by equity.

2. Underwriting a. Equity Requirements

i. The minimum equity injection requirement for change of ownership loans is based on the type of transaction. SBA requires equity injections (Applicant contribution) for change of ownership transactions to be based on the total project cost (all costs required to become operational, regardless of the source of funds, except for lines of credit and 504 loans). For Owner Buyout transactions, the equity requirement is based upon the purchase price of the business, as reflected in the purchase and sale agreement. Real estate purchased in conjunction with a change of ownership transaction is also subject to the same equity injection requirements. When separated into two loans, the Lender must allocate the equity contribution on a pro-rata basis; however, if the real estate is financed with a 504 loan, the equity injection applicable to the 504 loan must comply with the equity injection requirements for the 504 Loan Program. Loans to ESOPs for the purpose of purchasing a controlling interest (at least 51 percent) in the employer small business are not subject to the SBA requirement for equity injection. a) The following are the minimum equity injection requirements for change of ownership transactions based on their type: i) Initial Acquisition: 10%. For Initial Acquisitions, the required equity injection cannot be reduced or eliminated. ii) Business Expansion, Owner Buyouts, and ESOP & Cooperatives: 10% (a) For both Business Expansions and Owner Buyouts, the Lender may reduce or eliminate this requirement if they have determined that the Borrower has sufficient liquidity and working capital to sustain operations following the transaction. When eliminating the equity requirement, the Lender cannot include dedicated permanent working capital in this or any other 7(a) term loan request within 90 days. When a Lender waives the equity injection requirement, it is done on the basis that the business is adequately capitalized, which precludes additional dedicated working capital from being provided. However, this does not restrict the Lender’s ability to disburse a de minimis amount of excess proceeds as working capital to the Borrower that accounts for incidental post-approval adjustments to uses of proceeds. For purposes of this clarification, de minimis proceeds remitted to the Borrower shall not exceed $10,000, or one half of one percent of the loan amount, whichever is greater. Any working capital necessary to support the transaction must come from existing cash or a line of credit. To qualify for the reduction or elimination of the equity injection, the Applicant’s balance sheet must not have a negative net worth as of the last fiscal year-end. (b) Loans for the purpose of purchasing a controlling interest (at least 51 percent) in the employer for purposes of an ESOP are not subject to the SBA requirement for equity injection.

b. Lender’s Credit Analysis: The Lender’s credit memorandum and analysis must address the Applicant’s ability and likelihood to repay the loan from the cash flow of the business and past performance by documenting the following:

i. A description of the business, its history, industry, and management structure. The analysis must also include: a) Description of the Applicant’s industry experience and management team, including principal’s involvement in the daily onsite management of the business or how the daily operations will be managed if the principals are not there on a daily basis. b) If the daily operations are handled under a management agreement, Lenders must obtain a copy of the management agreement (unless the management agreement is part of the franchise disclosure documents for a brand listed on the Franchise Directory), review it to determine if it results in an ineligible passive business, and retain it in their loan file.

ii. Financial analysis of repayment ability: a) For acquired business, and for Applicants that are an existing operating entity, the Lender’s financial analysis must be based on the three most recent year-end historical financial information using the highest level of financial reporting available. i) Financial reporting is ordered by terms of thoroughness: (1) Audited Financial Statements, (2) Reviewed Financial Statements (including those prepared to AICPA SSARS AR-C 90 standards), (3) CPA Compiled Financial Statements, and (4) Corporate Tax Returns. ii) For both an operating Applicant and the acquired business, Lenders must also analyze the most current interim financial statement available along with the comparable interim financial statement from the previous year. b) The Lender must also obtain, review, and verify the Applicant's corporate tax returns against the tax transcripts to comply with the requirements in Section A, Ch. 5, Para. B, IRS Tax Transcript/Verification of Financial Information. c) The Debt Service Coverage (DSC) ratio must be satisfied using either the last fiscal year-end or an average of the last two fiscal year-end statements on either a historical or adjusted basis based on the transaction type: i) Initial Acquisition: 1.25:1 ii) Business Expansion: 1.15:1 iii) Owner Buyout: 1.25:1 iv) ESOP and Cooperative: 1.25:1 d) For a transaction involving the acquisition of an owner-occupied Special Purpose Property, the Lender must obtain this historical information to the extent it is available. If the purchase price is fully supported by the appraised value of the Special Purpose Property, the Lender may base its analysis of repayment on projections as provided under Special Purpose Properties below. i) For a change of ownership transaction involving the acquisition of an owner-occupied Special Purpose Property that is currently in operation, the Lender must calculate and analyze both the historical DSC of the business being acquired and the projected DSC. In situations where the appraised value fully collateralizes the loan, the Lender may rely on projections to satisfy the DSC requirement. This flexibility recognizes the specific nature of these transactions and provides Lenders with the flexibility to treat them like a start-up or new business where the property could otherwise be constructed. When utilizing projections in this manner, the DSC requirement must be satisfied within two years from loan funding. This provision only applies when the acquisition of the Special Purpose Property cannot be separated from, and is integral to, the acquisition and continued operation of the business. Examples of this type of loan include storage units and hotels where the real estate fully secures the loan. The Lender must obtain from the Applicant and analyze two years of detailed projections, including the supporting assumptions and justification for relying on projections instead of historical performance. The projections must reflect a debt service coverage equal to or greater than the required DSC per change of ownership transaction type in Para. C.2.b. of this Appendix within two years from loan funding or, for construction projects, within two years from the end of construction. The Lender must also calculate the historical DSC of the business being acquired in accordance with Para. C.2.b. of this Appendix and include it in the credit memorandum, together with an analysis of the variance between the historical results of the business and the projected results. The historical DSC is not required to meet the applicable ratio when the Lender relies on the projected DSC under this provision. ii) For the cash flow projections, the Lender must calculate the debt service coverage (which may not include anticipated cash flow from rental income from the property) and provide the assumptions supporting the projected cash flow coverage, including, as applicable: (a) Justification for revenue growth, i.e., new product lines, sales channels, and new production facilities; (b) Justification for any reduction in expenses; and (c) A comparison to current industry trends. iii) A Business Valuation meeting the requirements of Para. C.1.b. of this Appendix is required. A Quality of Earnings report is not required for a transaction involving the acquisition of an owner-occupied Special Purpose Property, regardless of the Business Purchase Price. All other financial due diligence requirements set forth in Para. C.1. of this Appendix continue to apply. iv) The Lender must document in its credit memorandum the basis for its determination that the property meets the definition of a Special Purpose Property in Para. C.1.b. of this Appendix, that acquisition of the property is integral to the acquisition and continued operation of the business, and why reliance on projections rather than on the historical performance of the business being acquired is appropriate. v) The Lender is required to input both the historical DSC and the projected DSC into the SBA Loan System. e) Historical Debt Service Coverage (DSC): i) The historical DSC ratio is defined as earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by the combined debt service post-transaction. ii) Lenders may include an addback for rent payments when the owner-occupied commercial real estate is part of the transaction. iii) The Lender is required to input the historical DSC into the SBA Loan System. f) Adjusted Debt Service Coverage (DSC): When applicable, the Lender is required to input the adjusted DSC into the SBA Loan System. i) Lender may make prudent adjustments to the cash flow of the acquired entity based on savings that can be realized through the transaction as part of satisfying this requirement. For Business Expansion transactions, adjustments may be made based on the combined entities when the acquired business will operate independently following the purchase. ii) Justification for additions and subtractions to cash flow, such as the following: (a) Unfunded capital expenditures; (b) Non-recurring income; (c) Distributions; (d) Distributions for S-Corp taxes; (e) Seller discretionary expenses; and/or (f) Ownership Compensation. (i) Adjustments made to ownership compensation must also be substantiated by a global cash flow analysis that demonstrates that the principals have the financial wherewithal to meet their obligations based upon the adjusted compensation proposed and must meet the 1:1 DSC on a global basis. iii) When using adjustments, the Lender must outline why each adjustment is prudent, necessary, and how it can be supported by the ongoing operations of the business. The justification for each adjustment or add-back must be included in the credit memorandum. The ownership compensation of the Applicant must be sufficient to support their current obligations and living expenses. iv) Adjustments to cash flow without the Lender’s supporting analysis and justification will be ineligible for purposes of determining this core underwriting requirement. g) The Lender must evaluate the Applicant’s post-closing financial projections but may not rely on them to meet the DSC requirement. This limitation does not apply to a transaction involving the acquisition of an owner-occupied Special Purpose Property, which may be underwritten on the basis of projections as provided under Special Purpose Properties above. Applicant may contribute additional unlimited or limited equity to reduce the loan amount and corresponding debt service in order to meet the DSC requirement. h) When a change of ownership transaction includes additional debt to support the purchase that is not on full standby and is structured with interest-only payments, the Lender must apply an amortization that does not exceed 10-years. This requirement does not apply to lines of credit. This requirement is to ensure that the business can service all debt associated with the acquisition, regardless of the source or structure. i) The financial analysis for all Applicants must address the following, as applicable: i) Global cash flow analysis that includes assessment of impact on cash flow to/from any affiliate business and meets a 1:1 DSC; and ii) The effect any affiliates may have on the ultimate repayment ability of the Applicant.

iii. Spread of pro-forma Business Balance Sheet (current business balance sheet adjusted for all changes in assets and liabilities as a result of the SBA loan, other debt, any required equity injection, and use of loan proceeds);

iv. Ratio calculations (based on the pro-forma Balance Sheet and historical and projected Income Statements) for the following financial ratio benchmarks: Current Ratio, Debt/Tangible Net Worth, Debt Service Coverage, and any other ratios the Lender considers significant for the business/ industry (e.g., inventory turnover, receivables turnover, and payables turnover, etc.) including discussion of Lender’s comparison to industry trends;

v. Analysis of working capital adequacy, at a minimum, over the next 12 months;

vi. Assessment of collateral adequacy adjusted in accordance with Paragraph C.3.c., in this Appendix below to offset risk of default;

vii. Insurance Requirements, including: a) Life Insurance – on whom and how much. If life insurance is not required, provide justification. b) Business hazard and liability insurances.

viii. Explanation of and justification for the refinancing of any debts as part of the loan request, along with supporting documentation, in accordance with the debt refinancing requirements in Paragraph A.3.a. above, including a written explanation for any late payments over the past 12 months.

ix. Lender’s rationale for recommending approval, including a discussion and analysis of the following: a) The factors demonstrating the Applicant does not have credit available elsewhere on reasonable commercial terms in accordance with Section A, Ch. 1. Para. H. b) When 50 percent or more of the loan proceeds will be used for working capital, Lender must explain in its credit memorandum why this level of working capital is necessary and appropriate for the subject business; c) Competition; d) 90+ day delinquencies; e) Trade disputes; f) Federal, State, or local citations which would preclude the Applicant from normal business operations; g) Discussion of any liens, judgments, bankruptcy filings, or pending litigation, including divorce proceedings; h) If the application involves a franchise (as defined by FTC), the Lender must review any credit information provided, such as the number of failed franchisees and cash flow projections provided by the franchisor; and i) Discussion of other relevant information