The Small Business Administration (SBA) is making an important addition to its 7(a) loan program that will change the way that small and medium-sized businesses can access and use funds from the government-backed loan program.
For the first time, business owners and search funds will be able to use the SBA 7(a) loan to fund partial acquisitions with rollover equity. This development is expected to further level the playing field for SMBs, allowing them to pursue their own private equity (PE)-like roll-up strategies and accelerate value creation.
The Importance of Rollover Equity
In lower-middle market private equity acquisition structures, rollover equity plays a critical role. It is a mechanism through which the seller (e.g., CEO, founder, or business owner) retains some equity ownership interest after the acquisition.
This ensures that the seller’s long-term interests are aligned with the acquirer and that the acquired business retains valuable institutional knowledge.
The previous SBA 7(a) loan program restrictions meant that only 100% full ownership acquisitions were allowed, creating a significant barrier to deal structuring. The inability to retain the seller as a “partner” limited the potential for collaboration and knowledge sharing between the buyer and the founder of the acquired business.
How a Roll-Up Private Equity Structure Works to Compound Growth
A roll-up private equity structure is a type of acquisition strategy in which a private equity firm acquires multiple smaller companies in the same industry and combines them into a single, larger entity.
The goal of the roll-up strategy is to:
- Create Economies of Scale
- Increase Operational Efficiency
- Enhance Value
In a roll-up acquisition, the combined entity achieves value accretion through increased market share, improved profitability, and reduced costs.
The roll-up strategy typically involves a series of acquisitions, with the private equity firm purchasing each target company and integrating it into the existing portfolio of companies. The private equity firm may use a variety of financing strategies to fund the acquisitions, including equity, debt, or a combination of both.
Once the target companies are acquired, the private equity firm may consolidate operations, streamline costs, and implement best practices across the combined entity to maximize efficiencies and profitability.
Traditionally, these types of acquisitions have enabled unprecedented growth for larger companies, while small and medium-sized businesses lacked the resources to match growth opportunities. As a result, the gap between big corporations and small businesses continued to grow. The changes to the SBA 7(a) loan program will provide a much-needed solution that enables M&A-driven growth for founder-owned businesses.
Roll-up structures can be particularly attractive to private equity firms because they provide an opportunity to acquire multiple companies with complementary strengths and weaknesses and create a larger, more competitive entity in the market. In other words, a roll-up strategy compounds growth. The strategy can also provide a path to exit for the smaller companies, who may not have had access to other liquidity options.
SBA 7(a) Loan Program: A Primer
The SBA 7(a) loan is a government-backed loan provided by banks that enables entrepreneurs and SMBs to make acquisitions of up to $5 million. With a low cost of capital, it is one of the primary sources of funding for SMBs. The changes rolling out on May 20, 2023, will add much-needed flexibility to promote growth in the middle market.
A 7(a) loan can be used for:
- Working Capital
- Equipment & Machinery
- Real Estate
- Business Acquisitions (Now with More Flexibility)
- Expansion
Implications for Entrepreneurs and Business Owners
The new changes to the SBA 7(a) loan program provide much-needed flexibility that will allow buyers to structure deals in a more thoughtful manner.
By allowing the seller to retain an equity interest in the pro forma merged company (or “roll-over” equity), the buyer is able to retain institutional knowledge through the acquisition. For small businesses, a lot of the core know-how and relationships reside in the selling owner. By retaining ownership in the combined company, the buyer ensures that the seller still has some “skin in the game” and that long-term interests are aligned.
All in all, this will enable buyers to structure deals that add value by bringing on partners that can help stabilize the business during the transition. This is a big game-changer that will further level the playing field between middle-market businesses and large corporations–ultimately fostering SMB growth.
At Embarc Advisors, we serve as the corporate development advisory team for many middle-market businesses. We provide end-to-end M&A support so that founder-owned businesses can take advantage of the PE playbook while retaining majority ownership.
The ability to leverage low-cost SBA 7(a) loans to structure acquisitions with rollover equity brings much-needed change to further empower business owners in their M&A strategies.
If you’re looking for an advisory team to help you navigate a PE-like roll-up acquisition strategy using the new SBA 7(a) loan flexibility, contact Embarc Advisors today.
To learn more about how we’re helping small and medium-sized businesses access top-tier corporate development talent, read our blog: A New Approach to Corporate Development for SMBs
