The following article is part of our series exploring how the $10 billion allocated to the SSBCI program under the American Rescue Plan could be used to expand the number of employee-owned businesses. Here, the authors propose using some SSBCI funds to create a “Down Payment Investment Fund” to overcome the financing gap for employees who cannot raise the 10 percent equity contribution required by deals financed with SBA loan guarantees.
We were celebrating the signing of a “Letter of Intent” (LOI) at a recent client meeting. The LOI is the first step for employees to purchase the company they work for. It gives them exclusive rights to purchase the company for a specific time by taking the company “off the market” while the employees try to arrange financing. Very exciting stuff—over 100 employees wanted to purchase a business valued at $4 million.
The employees would need a bank loan to buy the company. Business brokers I work with estimate that 75 percent of all their deals that need bank financing use an SBA-guaranteed loan. Banks seek that extra protection when they don’t have a long track record with a new borrower. Additionally, they are paid a hefty premium in the secondary market when they sell off the guaranteed portion of the loan (sometimes as much as 10 percent in fees). For this reason alone, commercial bank debt and SBA-guaranteed loans are synonymous when it comes to acquisition financing.
The Equity Injection Obstacle
An SBA-guaranteed loan has great terms but it requires a 10 percent down payment —$400,000 in the case of this $4 million deal. The owner of the company had promised to help meet the requirement by expanding his carry-back financing note. However, when he found out that recent SBA regulatory changes preclude sellers who carry a note for the down payment from receiving any interest or principal payments during the life of their loan, he couldn’t afford the terms.
The SBA personal guarantee requirement isn’t relevant when the workers cannot raise the equity needed for the down payment.
This new wrinkle meant that the group would be left on its own to raise the $400,000 for an equity injection. Most of the options involved drawing on some source of personal wealth, which they did not have, and thus the deal failed. No one individual in the room had even 10 percent of the funds needed.
Instead, the firm was sold to one key employee who found a way to borrow 50 percent of the required down payment from a “patient” investor willing to finance the deal for a share in the profits after all debt was repaid. The seller supplied the other half. For this deal, and so many others, the down payment represented too large a hurdle for the workers to overcome.
Cooperatives and other employee-owner advocates rail against the SBA personal guarantee requirement (see: The Government Is Here to Help Small Businesses — Unless They’re Cooperatives), but it isn’t relevant when the workers cannot raise the equity needed for the down payment (money that is unsecured by any asset being purchased, has no set repayment term, and is patient enough to wait until all the senior debt is repaid). This is the real impediment to employee-ownership business transfers.
The Solution: A Down Payment Fund
Any number of CDFIs, investment funds, cooperative loan consortiums, and banks have debt capital available but few, if any, attempt to deal with the equity injection required for employee purchases of companies with 50 or more employees (deals of over $1.5 million that require substantial equity). The whole idea of extending totally unsecured credit with no set repayment feature is an anathema to traditional lenders—it’s like trying to describe a planet in another galaxy; it simply does not exist in their universe.
A Down Payment Investment Fund dedicated to employee ownership could address the down payment dilemma. It would have the following features:
- Offer an investment in conversion deals in the form of preferred stock redeemable at the end of term of senior debt or upon refinance or company sale (additionally, the preferred stock would have convertible features in the event of a forced company sale).
- Require that employee purchasers issue preferred stock with dividend requirements tied to profitability and to set aside revenues in a “sinking fund” designed to retire the investment. No other distributions of profits could be made until the “equity injection” is fully repaid.
- Overall return on investment that would conform to market rate for comparable types of equity investments unless foundation money or other “soft capital” could be found to support it.
Use of SSBCI Program for Down Payment Funds
The reauthorization of the State Small Business Credit Initiative (SSBCI) could offer a timely answer to the down payment dilemma. The SSBCI program is intended to expand existing or to create new state small business investment programs, including state capital access programs, collateral support programs, loan participation programs, loan guarantee programs, and venture capital programs.
We believe, therefore, that these Treasury dollars are eligible to be used for the above outlined purposes. We recommend that these funds be channeled through an existing nationwide network of Small Business Investment Companies (SBICs) that provide equity investments.
SBICs understand equity investment, and therefore offer an ideal vehicle to launch a fund to help employees find the equity needed for a purchase. Special provisions in SBA regulations provide for SBIC equity injections in deals, and an SBIC manager is well-positioned to provide critical oversight to ensure that employees buy value for their investment.
The pandemic represents an important opportunity to further employee ownership, and begin to address both wealth inequality and racial injustice. The down payment dilemma needs to be quickly solved if this opportunity is to be widely afforded to workers.
Bruce Dobb serves as senior partner and Tomás Durán as president of Concerned Capital, a social-benefit investment banking firm in downtown Los Angeles that specializes in saving local jobs by helping employees buy the company they work for.
