SBA fails in recent change related to goodwill value

SBA fails in recent change related to goodwill value

By Edward L. Fixen

On Feb. 12, the Small Business Administration released revised standard operating procedures known as SBA SOP 50 10 5(A) that unnecessarily precludes the healthiest and most profitable businesses from being able to secure SBA business acquisition loans up to their appraised value. The revisions included a seemingly harmless change to its lending procedures and policies regarding a cap and restriction on small business acquisition lending related to the value of "goodwill." However, this seemingly minor change demonstrates a surprising lack of understanding of fundamental business valuation and economic principles that undermines the very purpose for which the SBA was established.

In a letter dated Feb. 27 and co-authored by Nydia M. Velazquez, New York representative and chairwoman of the House Committee on Small Business, and Sam Graves, Missouri representative and ranking member of the House Committee on Small Business, concerns regarding the "goodwill" restriction were submitted to SBA Acting Administrator Darryl Hairston requesting that the new policy regarding "goodwill" be rescinded based on its arbitrary nature and damage to our nation's small businesses.

At the heart of the issue is the arbitrary restriction that would limit SBA loans for goodwill in a small business acquisition to $250,000 or less. This restriction may seem insignificant, but if you are a small-business owner, aspiring entrepreneur, considering buying a small business, ready to retire and sell your business, an SBA lender, or just a member of the small-business community, then this minor regulatory revision affects you. More specifically, it limits the availability of SBA small business acquisition loans to the more deserving and better-performing businesses at a time when it is needed more than ever.

This is certainly not consistent with the SBA's stated mission to "aid, counsel, assist and protect the interests of small business concerns, to preserve free competitive enterprise and to maintain and strengthen the overall economy of our nation." Yet, as noted in the Velazquez/Graves letter cited above, more than 70 percent of the evaluations ordered for SBA small business acquisition loans involved companies that had more than $250,000 in goodwill and will be adversely affected by this new policy.

Why would limiting a loan on goodwill to $250,000 be bad business and economic policy? Quite simply, the higher the goodwill value of a business, the healthier and more profitable the business. In its simplest form, the value of a business consists of the market value of tangible assets plus its goodwill value (or intangible asset value). Tangible assets are items owned by a business such as equipment, inventory, furnishings, accounts receivables, etc., that you can see and touch. Goodwill is that portion of business value that cannot be allocated to tangible assets. Goodwill is generally considered to represent the intangible value in a business derived from strong sales and earnings, having a customer base, having ongoing operations and business systems in place, reputation, brand value, trade names, trademarks, patents, etc. Goodwill is a positive indicator of the strength and health of a business, not a negative factor as the SBA policy implies.

As an example, if a business is appraised by a certified business appraiser at a value of $2 million and has $1 million of appraised tangible assets such as equipment, inventory, accounts receivables, etc., then its goodwill value is $1 million (i.e., $2 million business value less $1 million tangible asset value). Any qualified business appraiser will acknowledge that the more profitable, less risky and healthy a business, the higher its goodwill value will be when compared with a similar but less profitable, more risky and weaker business.

In the example just given, the business worth $2 million with $1 million in goodwill value could only qualify for a loan of $1.25 million because the $250,000 goodwill limitation would arbitrarily prohibit lending on the balance of the company's $750,000 of appraised goodwill value. Yet a business in the same industry with the same tangible assets but less income and a total appraised value of $1.25 million (i.e., goodwill value of only $250,000) could qualify for the same loan amount even though it is a riskier, less profitable and weaker business.

Professional practices such as legal, dental, medical, accounting, engineering, etc., that have very little in the way of tangible assets in relationship to their overall business value would certainly be adversely affected by the arbitrary goodwill restriction. But even very profitable retail, manufacturing and wholesale/distribution businesses with substantial tangible assets are unnecessarily hurt by the arbitrary restriction. Fortunately, SBA lenders evaluate all aspects of a business before making a loan, but this analysis does show that their ability to make loans based on merit rather than arbitrary policy and criteria is severely restricted.

There is a simple solution to this situation. The SBA also added a revision to require all business acquisition loans worth more than $350,000 to have a business appraisal performed by a person accredited by a recognized business appraisal organization. There should be no argument that it makes sense to ensure that SBA loans are provided to qualified and deserving businesses. However, this otherwise positive improvement will often be rendered a moot exercise and expense since the arbitrary goodwill restriction will trump even the professional opinion of a certified business appraiser who deems a business to have goodwill value of more than $250,000. The SBA should rescind this arbitrary goodwill restriction immediately and instead let the new practice of requiring a professional business appraisal on larger loans do the job for which it was intended, validate good loans to good businesses.

More importantly, elimination of the SBA's goodwill restriction policy will help our country's small businesses, which many consider to be the economic engine of our economy.

Edward L. Fixen is president of BusinessQuest, a business appraisal, exit planning and business brokerage firm based in Rancho Cucamonga. He can be reached at ed@BusinessQuestBrokers.com.