In SBA 7(a) loan underwriting, business valuations play a pivotal role in determining loan eligibility and appropriate risk mitigation. While projections and annualized financials can offer a forward-looking view of performance, they come with significant pitfalls—particularly when used as a basis for valuation without adequate historical context. The SBA’s Standard Operating Procedure explicitly requires lenders to verify financial statements against filed tax return transcripts, reflecting a strong institutional preference for historical, verifiable data. This article explores the valuation risks of relying on annualized or projected data, potential sources of bias, the limited confidence projections inspire without supporting business plans, expanded research comparing forecasts to actual performance outcomes, and a practical example from the field.

Introduction

Business appraisals are essential in assessing the fair market value of a company being acquired with SBA 7(a) loan proceeds. The accuracy of the appraisal affects the lender’s ability to meet SBA compliance and the borrower’s risk profile. While projected performance or annualized partial-year data may be tempting sources for estimating future value, the SBA mandates a more conservative and evidence-based approach rooted in historical performance and tax-verified results.

The Problem with Annualized and Projected Financials

Annualized Data: False Precision from Incomplete History

Annualizing a few months of data assumes uniformity across the rest of the year—an assumption rarely justified in small business environments. Many industries face seasonal fluctuations, operational inconsistencies, or unforeseen changes in cost structure. Multiplying short-term earnings over 12 months may yield figures that are mathematically precise but economically misleading.

Projections: Hope Isn’t a Method

Pro forma financials, forecasts, and management projections often paint a more optimistic view of future performance than warranted. They may not incorporate adequate adjustments for risk, economic downturns, increased competition, or execution challenges. Research consistently demonstrates that small business projections are prone to significant inaccuracies:

A study published in Harvard Business Review (Foster, 2010) found that 65% of startups failed to meet projected revenue milestones, with significant overstatement of market penetration. The study highlighted that early-stage firms often underestimated customer acquisition costs and overestimated demand growth.

Research from the National Bureau of Economic Research (Gompers, Gornall, Kaplan, & Strebulaev, 2020) analyzed venture capital-backed firms and found that small business forecasts were biased upward by an average of 20–30% in revenue projections, particularly when used to secure financing. The study noted that optimism was most pronounced in firms with less experienced management.

A 2018 analysis by McKinsey & Company (Buehler, Freeman, & Hulme, 2018) examined small and medium-sized enterprises (SMEs) and reported that 70% of revenue forecasts missed actual performance by more than 15%, with overestimations driven by failure to account for competitive pressures and operational bottlenecks.

A longitudinal study in the Journal of Business Venturing (Cassar, 2010) tracked 1,200 small businesses and found that revenue projections exceeded actual outcomes by 25% on average within the first two years. The study identified overconfidence in market share growth and underestimation of cost escalations as key drivers.

Data from the U.S. Small Business Administration’s Office of Advocacy (2022) indicates that only 50% of small businesses survive beyond five years, yet projections often assume continuous growth without factoring in failure risks or economic cycles.

These studies underscore that small business projections are systematically overly optimistic, particularly in the absence of robust historical data or validated business plans. For SBA 7(a) valuations, relying on such forecasts without rigorous scrutiny can lead to overstated valuations and increased default risk.

Bias in Projections and Annualized Data

Cognitive and Incentive Biases

Optimism Bias: Business owners believe in their future success and may unintentionally inflate projections.

Incentive Bias: When valuations support financing, there’s pressure to present more favorable data—especially in owner-prepared projections.

Survivorship Bias: Projected data may not fully consider failure rates, especially in early-stage or turnaround companies.

These biases make projections inherently riskier for valuation purposes than verified financial histories.

The Role of a Business Plan in Projection Credibility

Business Plans as Supporting Evidence

A well-developed, written business plan can add credibility to projections—but it is not a substitute for proven performance. The SBA does not prohibit the use of forecasts but emphasizes the need to tie them to a credible operational plan. This includes:

• Market analysis
• Management experience
• Marketing and operational strategy
• Funding use and financial assumptions

Absence of a Plan = Red Flag

When projections are submitted without a supporting business plan, the appraiser has little basis to assess their reasonableness. In such cases, reliance on projections can materially overstate business value.

SBA SOP Guidance: Prefer Historical, Verifiable Data

SOP 50 10 7, Subpart B, Chapter 3, Section D(9) states:

“The lender must obtain and review the IRS tax transcript(s) for the Applicant and compare it to the business financial statements provided with the application to confirm that the information is consistent with the Applicant’s tax filings.”

This policy exists to mitigate the risk of misstatement or manipulation. When a business appraiser uses financial data in a valuation, the underlying figures must be reconcilable with IRS filings. This guidance directly discourages the use of standalone projections or annualized financials as the primary basis for valuation.

Practical Challenges in Using Projections for SBA Valuations

Valuation professionals and SBA lenders face several challenges when incorporating projections or annualized data:

Reconciling with Historical Data: Projections often diverge significantly from historical performance, requiring appraisers to justify discrepancies, which can be difficult without a robust business plan.

Seasonal and Cyclical Variability: Annualized data may misrepresent performance in industries with seasonal peaks or economic sensitivity, leading to unreliable valuation inputs.

Regulatory Scrutiny: SBA underwriters closely examine valuations relying on projections, increasing the risk of loan rejection or guaranty denial if historical data is not prioritized.

Bias Detection: Identifying and mitigating owner or management biases in projections demands time and expertise, which may not always be feasible in fast-paced lending environments.

Recommendations for Appraisers and Lenders

To address these challenges and ensure robust valuations, consider the following:

Prioritize Historical Data: Use at least three years of tax-verified financials as the primary basis for valuation, relegating projections to supplementary analysis.

Require a Detailed Business Plan: Only consider projections if accompanied by a comprehensive business plan with market analysis, management credentials, and realistic financial assumptions.

Apply Risk Adjustments: Discount projections for optimism bias and external risks (e.g., competition, economic downturns) using sensitivity analysis or conservative growth rates.

Document Discrepancies: Clearly explain any reliance on annualized or projected data in the valuation report, reconciling it with IRS transcripts and historical trends.

Real-World Example: A Café in Transition

A local café operating for five years was recently acquired through an SBA 7(a) loan. The seller had undergone health issues, and the business had posted a net loss for two consecutive years. However, the buyer—a former corporate operations manager—had already taken over partial operations and implemented several changes.

The appraiser used 3 months of improved financial performance from the current year and annualized it, stating the business was now profitable and assigning a significant valuation based on this short-term uptick. The valuation also incorporated projections for the next two years that assumed rapid revenue growth and margin improvement.

Problems quickly arose:

• IRS transcripts showed consistent historical losses not reconciled in the valuation.
• The improvements were not yet consistent or proven.
• The buyer had no formal business plan submitted to support the forecast.

Within 18 months, the business defaulted. The actual revenues lagged projections by 40%, and margins were squeezed by rising labor costs not anticipated in the forecast.

The SBA later reviewed the loan file and noted that the valuation relied heavily on annualized and speculative data, without reconciliation to tax returns. The loan was denied a full guaranty.

Implications for Lenders and Appraisers

For SBA Lenders

• Ensure that business valuations supporting a 7(a) loan are primarily based on historical, verifiable performance.
• Review IRS Form 4506-C transcripts to confirm reported revenue and income match appraiser inputs.
• Scrutinize valuations that rely heavily on annualized or pro forma data.

For Business Appraisers

• Clearly disclose any reliance on projections or partial-year data.
• Adjust projections for risk and reconcile with historical performance whenever used.
• Prefer full-year tax return-based financials when applying the income or market approach.

Conclusion

Valuing a business based on projected or annualized data can create a dangerous mismatch between perceived and actual risk—particularly in the SBA lending context. While projections may have a place in strategic planning or scenario analysis, they should not solely form the foundation of SBA business valuations. The SBA’s SOP clearly emphasizes the importance of historical, tax-verified data. Both lenders and appraisers have a duty to adhere to this standard to maintain the integrity of the SBA loan program and minimize risk of default or guaranty denial.