This post is written specifically for minority equity investors providing capital in self-funded search fund deals.
For reference, “minority investor” means an investor staying under the 20% ownership threshold that would trigger a personal guarantee (which we will never do at CapitalPad).
Without a proper guide, this process can be somewhat cumbersome. Hopefully this shines some light on what you need to do when providing “source of funds” documentation for M&A deals involving SBA loans.
Overview of SBA requirements from equity investors
First off… why do the lenders require so much documentation?
You probably know this, but just in case you don’t, the SBA is not directly providing funding to searchers. Individual banks are providing the debt financing (loans) for these acquisitions, and the SBA is providing a sort of guaranteed backing to the lending banks.
The lender makes the loan, and if the loan goes south, then the SBA will provide up to 90% of the principle amount to the bank. It’s an amazing program that caps the downside for banks and provides a safety net. This encourages banks to make these acquisition loans, which they might not be willing to do otherwise, or at least at the same rates (regardless of how low the default rate actually is).
But!
There is a huge but!
In order for the SBA to guarantee and backstop these loans, they require that each lender to follow strict procedures. If a lender fails to follow the correct procedure, then the SBA can reject the loan from being guaranteed (known as “repair”). Obviously, this terrifies bankers, and the individual loan officers would have their career on the chopping block.
The number one way that banks mess up these strict requirements is through poor documentation of the equity injection from investors.
So if the process of providing funding proof seems onerous, this is why. The lenders have every incentive to be overly precise, regardless of how cumbersome it may seem to investors.
The three requirements of of investors
There are edge cases outside of this, but for 99% of search fund investors, the below is what is needed.
1) The last three months of bank statements from the sending account
Note that the little details mentioned are very important!
- These statements must show both the “name” and the “account number.”
- The name on the statements must match what was used on the deal documents. If you invested through an entity, it will need to match, or you will need to show proof of direct ownership of entity.
- If the funds in the account are not “seasoned” (i.e. you transferred in capital from somewhere else into this account to fund the deal), then you will need to provide three months worth of statements from the transferring account.
2) Funding proof of the transaction
This is where it gets difficult
- You need to show direct proof that the funds left your account and went to the acquisition-funding account (to the actual company, to the attorney, to CapitalPad’s funding account, etc).
This documentation needs to include:- Your name and account number
- Showing the funds leaving your account
- Showing the location where the funds are going
- Why is this so difficult? Because about half of the actual banks that most investors use don’t usually have very good resources on being able to generate this very specific proof.
- Wire verifications sometimes show 2/3 of the requirements, but not the final one.
- How do you solve this? The dream scenario is if you fund a transaction on the 28th of the month and can then provide the lender with the full monthly statement on the 1st.
- If not, you need to do whatever you can (screenshots, talk to the bank, etc) in order to satisfy this requirement.
3) Lastly, you must verify that you are a “US Person”.
- This is a brand new requirement, but now all investors in deals that are using an SBA loan must confirm that they are either a legal US resident or a US citizen. Non-US people can no longer be on the cap table (sorry guys!).
Obviously all of these SBA equity injection requirements can be quite a hassle, but we believe the possible returns offered from searcher deals more than make up for the one-time nuisance.
