In SBA 7(a) lending, evaluating the risk and return of closely held businesses is critical to ensuring sound loan decisions. Unlike publicly traded investments, closely held businesses present unique risks—illiquidity, owner dependence, and lack of diversification—that demand a tailored approach to valuation and underwriting. This white paper explores how to measure return using net cash flow to equity and market-based return on equity (ROE), identifies key risk factors in private companies, and highlights the impact of borrowers’ lack of diversification. It provides practical guidance for SBA lenders to assess risk-adjusted returns and mitigate default risk.

Introduction

SBA 7(a) loans facilitate the acquisition of closely held businesses, which are inherently high-risk, illiquid investments for borrowers. Unlike diversified stock portfolios, these businesses concentrate a borrower’s wealth in a single asset, often backed by a personal guaranty. Lenders must evaluate whether the expected return justifies the risks, ensuring compliance with SBA’s fair market value standards and protecting both the borrower and the loan portfolio. This paper outlines a framework for assessing risk and return, drawing on valuation best practices and SBA guidelines.

Measuring Return in Closely Held Businesses

Beyond Net Income

Net income, often used to calculate return on equity (ROE) based on book value, is a poor measure of return for closely held businesses. Book value rarely reflects the business’s true worth, and net income excludes critical cash flow adjustments. Instead, lenders should focus on net cash flow to equity, which represents the cash available to the owner after:

• Taxes
• Capital expenditures
• Working capital needs
• Debt service

This cash flow is then divided by the fair market value of equity to calculate a market-based ROE:

Market-Based ROE = Net Cash Flow to Equity ÷ Fair Market Value of Equity

This metric provides a realistic estimate of the economic return, aligning with the fair market value standard.

Example: Redwood Custom Cabinets

Consider a buyer acquiring Redwood Custom Cabinets, a business with $4 million in annual revenue and strong margins. The deal structure is:

• Equity contribution: $300,000
• SBA 7(a) loan: $1,700,000
• Seller note: $500,000
• Total enterprise value: $2,500,000

The business generates $475,000 in net cash flow to equity annually. Using the income approach with a 20% capitalization rate (derived from a build-up method with risk premiums), the fair market value of equity is:

Fair Market Value = Net Cash Flow to Equity ÷ Capitalization Rate = $475,000 ÷ 0.20 = $2,375,000 – 20% Lack of Marketability Discount = $1,900,000

The market-based ROE is:

Market-Based ROE = $475,000 ÷ $1,900,000 = 25%

While a 25% return appears attractive, it must be weighed against the business’s risks and the borrower’s financial exposure.

Understanding Risk in Closely Held Businesses

Risk in private companies extends beyond economic volatility. Key risk factors include:

• Customer or Supplier Concentration: Reliance on a single client or vendor can destabilize cash flows.
• Owner Dependence: The business may rely heavily on the founder’s expertise or relationships.
• Lack of Succession Planning: No clear plan for leadership transitions increases long-term risk.
• Single-Location Operations: Local economic or regulatory changes can disproportionately impact the business.
• Emotional Decision-Making: Owners may prioritize personal goals over financial logic.

These risks are difficult to quantify like stock market volatility.

The Diversification Dilemma

SBA 7(a) borrowers often lack diversification, investing 70–90% of their net worth in a single business and signing personal guaranties. This concentration amplifies risk:

• Financial Exposure: The borrower’s entire wealth is tied to the business’s performance.
• Illiquidity: Private businesses lack ready markets for exit, limiting liquidity options.
• Emotional Bias: Personal attachment may lead to irrational business decisions.

Lenders must evaluate whether the borrower’s financial position can withstand business downturns, as overexposure increases default risk.

Practical Challenges in Assessing Risk and Return

SBA lenders face several challenges when evaluating risk and return in closely held businesses:

Identifying Hidden Risks: Non-financial risks like owner dependence or customer concentration may not appear in financial statements, requiring deeper due diligence.

Data Limitations: Small businesses often lack robust historical data to estimate cash flow volatility or fair market value accurately.

Borrower Optimism: Buyers may overestimate returns and downplay risks, complicating objective underwriting.

SBA Compliance: Valuations must reflect risk factors clearly to meet SOP 50 10 8 requirements or risk guaranty denial.

Recommendations for SBA Lenders

To address these challenges and ensure sound lending decisions, lenders should:

Prioritize Net Cash Flow to Equity: Use this metric over net income for return calculations, ensuring alignment with fair market value.

Assess Borrower Diversification: Review the borrower’s net worth and investment concentration to gauge their ability to absorb losses.

Encourage Annual Valuations: Post-acquisition, require yearly valuation updates to monitor value and risk, ensuring ongoing loan compliance.

Benchmark Returns: Compare the business’s ROE to alternative investments (e.g., stocks at 10%, private equity at 20%) to assess risk-adjusted attractiveness.

Case Study: Redwood Custom Cabinets Revisited

Returning to Redwood Custom Cabinets, the 25% market-based ROE is promising, but additional risks raise red flags:

• 40% of revenue from one client, creating concentration risk.
• The founder, retiring post-sale, is critical to customer relationships, with no succession plan.
• The business operates from a single location in a region facing new regulatory pressures.

The buyer’s lack of diversification and the identified risks warrant caution. The lender requires:

• A detailed succession plan within six months.
• A commitment to diversify revenue sources.
• Annual valuations to monitor fair market value.

These conditions mitigate risk, aligning the loan with SBA standards and protecting the borrower.

Conclusion

Evaluating risk and return in closely held businesses is essential for SBA 7(a) lending, where borrowers face significant financial exposure and private companies present unique risks. By prioritizing net cash flow to equity, market-based ROE, and risk assessment, lenders can ensure valuations reflect fair market value and comply with the SOP. Addressing diversification challenges and non-financial risks further strengthens underwriting decisions. By adopting this framework, SBA lenders can protect borrowers, minimize default risk, and uphold the integrity of the SBA loan program.