The SBA issued a new standard operating procedure earlier this year. The standard operating procedure, SOP 50 10 8.1, is set to take effect on October 1, 2026.
The big change here is that a significant portion of Main Street transactions closed on a pretty minimal set of supporting documents. These documents were typically tax returns and internally prepared financial statements. The updated standard operating procedure requires a higher degree of diligence and establishes additional underwriting requirements and standards. The most significant of these is the requirement for a quality of earnings report for transactions in which the business purchase price is $3 million or greater.
Which Transactions Require a Quality of Earnings Report?
The quality of earnings requirement does not apply to all SBA loans that exceed the $3 million threshold. It only applies to loans that are characterized as initial acquisition or business expansion transactions.
Initial Acquisitions
The initial acquisition is considered to be the default position. It describes the acquisition of a 100% ownership interest, irrespective of whether it is a stock deal or an asset purchase. These initial acquisitions typically require a 10% equity injection, or down payment, that cannot be waived. This means that the SBA will not finance the entirety of the acquisition and that the buyer needs to bring their own equity to the deal.
To the extent that the deal exceeds the $3 million mark, the lender will require a quality of earnings report.
The Real Estate Caveat
When the deal contains real estate as part of the transaction, the real estate portion of the deal does not contribute to the $3 million mark.
If you’re acquiring a business for $4.5 million that contains real estate, and the real estate portion attributes $2.5 million to the transaction, the remaining $2 million is the qualifying business purchase price. That is below the $3 million mark, and the quality of earnings report is not necessary.
The planning opportunity is to focus on the purchase price allocations between the business and the real estate. If the facts support, it that may waive the quality of earnings report requirement in the transaction.
Business Expansions
The other classification of transaction triggering the quality of earnings requirement is described as a business expansion. Said plainly, a business expansion is when an operating company buys another business. Some of the relevant qualifiers are:
- The buyer needs to have control of the current entity that is doing the acquisition for two full fiscal years.
- The target needs to be in the same four-digit NAICS industry group.
- The acquisition needs to be 100% of the target.
The interesting thing about this one is that the equity injection, or the 10% baseline, can be reduced or eliminated. Sufficient working capital (current assets in excess of current liabilities) in the target can be used to cover the equity baseline.
This is a unique fact pattern. Often, sellers like to take whatever cash is in the business with them when they close. This may become relevant if there is a degree of inventory or similar assets in the business to clear the working capital requirement. It is not a simple answer as it may raise questions about the valuation of the inventory and working capital.
The $3 million threshold, again, is in play for the quality of earnings report. Working capital testing and related procedures would be included in the quality of earnings report.
Transactions Outside the Requirement
It is worth noting that there are transaction types that would not trigger a quality of earnings report. Those would be owner buyouts and any transaction that involves an ESOP or a cooperative.
What Is the Intent of the Quality of Earnings Report?
As mentioned earlier, a lot of the transactions preceding this SOP were underwritten based on tax returns and internal books and records. Those underwriting standards have made it difficult for lenders to ascertain and test the validity of the financials. They also made it harder to make sure that the debt service coverage ratios mandated by the SBA are sufficiently covered, as the figures they were applied to were unreliable.
The intent of the quality of earnings report is to confirm that the financials and the activity of the entity are actual, factual, and sustainable.
Some procedures are directed at confirming validity, such as cash proofs. Some are intended to normalize and standardize the earnings. There are quite a few overlaps between what a valuation expert and what a quality of earnings financial expert would do in terms of producing their deliverables, particularly around add-backs and normalizing items.
In a typical valuation setting, the valuation expert looks to assess the earning power of the business on a normalized, arm’s-length basis, without regard to any related-party transactions. The quality of earnings report goes a step further for items such as:
- Assessing revenue quality
- Customer concentration
- Contract revenue continuity
- Normalizing the financials for accrual-based concepts
It is important to note that the standard operating procedure does not necessarily demand GAAP basis financials. But it does require some level of normalized accrual-like statements that fully describe a normalized and sustainable earning power of the business without a specific standard requirement.
Who Commissions and Pays for the Report?
The quality of earnings report needs to be commissioned by the lender. While a lender selects the expert who will be conducting the study, the costs of producing the report are on the borrower.
This creates a bit of a disconnect. The buyers are effectively footing the bill for the study, but the cost of the study is ultimately driven by the quality of the seller’s records. It’s not too uncommon for businesses that are trading just above the $3 million mark to have poor or incomplete business and financial records. It is very rare for the financials to be on an accrual basis.
Advice for Buyers: Check the Seller’s Records Early
The general advice for a buyer would be to get a sense of the quality of the seller’s records before engaging the lender and starting the process by probing about the in-depth diligence topics that a financial expert will. It is important to understand whether the seller can reasonably produce these materials or if these materials are going to be recreated from scratch by the financial expert. The process of recreation can be time-consuming, costly, and involved.
We would recommend that a buyer get an idea of the following:
- Concentrations regarding customers
- The contract terms and renewal conditions
- The presence of related parties in the business, and whether the seller is able to produce schedules surrounding the related parties
- The completeness, quality, and appearance of the financial statements that the seller is able to produce
If the seller cannot produce great records, the financial expert will likely have to recreate the records. This can add significant costs and, more importantly, create delays in terms of getting the transaction closed. Straightforward quality of earnings reports can take anywhere from three to six weeks. If the quality of records is low, the timelines may be significantly longer than that. It could be deal-ending and costly.
Advice for Sellers: Be Diligence-Ready
Sellers need to make sure that they are able to provide reliable records and are able to generate materials in a timely fashion. Speed and accuracy create trust and confidence for the buyer and lender. Proper planning prevents poor (transaction) performance.
If you’d like to talk about how the new SOP applies to your transaction, contact your WG advisor.
