How does SBA measure the $3 million quality of earnings threshold?

On Business Purchase Price, not the headline price in the purchase agreement. SOP 50 10 8.1 defines Business Purchase Price as the price set by the purchase and sales agreement less the portion of owner-occupied commercial real estate being acquired, established by the appraised value. Where real estate is part of the acquisition the lender must remove its appraised value before testing the threshold, and must input the resulting figure into the SBA Loan System.

Does buying the building change whether a quality of earnings report is required?

It can. Because owner-occupied commercial real estate is excluded at appraised value, a transaction priced above $3 million that includes owner-occupied real estate may have a Business Purchase Price below $3 million and therefore fall outside the quality of earnings requirement. This is how the rule is written rather than a loophole: the lender must input the Business Purchase Price into the SBA Loan System and the business valuation must still support the price.

Which transactions are exempt from the SBA quality of earnings requirement?

Three categories. Owner buyouts, subject to an anti-avoidance test under which anyone not employed by the business for at least 24 months may take less than 50 percent and may not become the largest direct or indirect shareholder. ESOP and cooperative transactions. And the acquisition of an owner-occupied Special Purpose Property, which the SOP exempts regardless of Business Purchase Price.

Is financial due diligence required on small SBA acquisitions?

Yes. SOP 50 10 8.1 states that financial due diligence is required on all change of ownership transactions and that the requirements are determined by the Business Purchase Price. What changes with size is the depth: at or below $350,000 the lender may perform its own business valuation unless buyer and seller are closely related, above that an independent valuation is required, and at $3 million or more a quality of earnings report is required as well.

SBA Acquisition Financing

The $3 million line is not where you think it is

SBA tests its new quality of earnings mandate on a number that is not the price in your purchase agreement. On a deal with real estate in it, the two can be a long way apart.

Most of the writing about SBA's new acquisition rules, including mine, has described the quality of earnings mandate as applying at a purchase price of $3 million or more. That is close enough to be useful and wrong enough to matter, because SOP 50 10 8.1 does not test the price in your purchase agreement. It tests a defined term, and on some deals the two are very different numbers.

What SBA actually measures

The SOP's glossary is specific:

"Business Purchase Price: In a change of ownership transaction, the price set by the purchase and sales agreement, less the portion of owner-occupied commercial real estate assets being acquired in the transaction. The portion of the owner-occupied commercial real estate is established by the appraised value."

Appendix 15 then says what that number is for, and it is not a footnote:

"Financial due diligence is required on all change of ownership transactions. The financial due diligence requirements are determined by the Business Purchase Price."

And the mechanics are mandatory rather than advisory:

"The Lender is required to input the Business Purchase Price into the SBA Loan System. When real estate is part of the acquisition, the Lender must remove the appraised value of the real estate from the price set by the purchase and sale agreement to determine the Business Purchase Price."

So every threshold in the appendix runs off the price net of owner-occupied commercial real estate, valued at appraisal. There is only one defined term here. "Business Purchase Price" appears ten times in the SOP and there is no separate definition of "purchase price", so where the text says "the Purchase Price as defined in Paragraph A.1" it means the same net figure.

What that does to a real deal

Take a business and its building selling together for $3.4 million, where the building appraises at $500,000. The headline price is above the threshold. The Business Purchase Price is $2.9 million, and the quality of earnings requirement does not apply.

Run it the other way and the same logic bites. A $3.1 million all-business purchase with no real estate in it sits squarely above the line, and the buyer is paying for a third-party report the $3.4 million buyer is not.

This is not a loophole, and I would be careful about treating it as one. The lender has to input the Business Purchase Price into SBA's own system, the business valuation still has to support the price, and if the amount paid exceeds the valuation the difference has to be made up in equity. What it is, is a planning fact: on any deal near the line that includes owner-occupied property, the appraisal determines whether a quality of earnings engagement is mandatory. That is worth knowing before you sign, not during diligence.

The three tiers, stated properly

Business Purchase Price at or below $350,000. The lender may perform its own valuation of the business, unless there is a close relationship between buyer and seller. This allowance did not exist in the version of the SOP published in August.
Between $350,000 and $3 million. An independent business valuation from a named qualified source: ASA, CBA, ABV, CVA or BCA.
$3 million and above. The independent valuation, plus an independent quality of earnings report with a cash proof over the trailing twelve months and the last two fiscal years, and the lender must calculate debt service coverage from its findings.

Note what is the same at every tier. Financial due diligence is required on all change of ownership transactions. The smallest deal in the country still needs its earnings verified. What size changes is who is allowed to do the verifying and how deep it goes.

Three ways out of the quality of earnings requirement

The mandate reaches business expansions and initial acquisitions. Three categories sit outside it, and the third is easy to miss.

Owner buyouts, but with a test. Anyone not employed by the business for at least 24 months may take less than 50 percent and may not become the largest direct or indirect shareholder. A transaction that fails that test is processed under the initial acquisition credit standards, quality of earnings included. An outside buyer cannot be employed briefly and called an insider.
ESOP and cooperative transactions, on the reasoning that the management structure does not change.
Owner-occupied special purpose property. The SOP is blunt about this one: a quality of earnings report "is not required for a transaction involving the acquisition of an owner-occupied Special Purpose Property, regardless of the Business Purchase Price." A special purpose property is one whose design or construction restricts its utility to the use it was built for. All other financial due diligence still applies.

How much of the market this actually touches

It is worth putting the threshold against the shape of the market it governs. In the index I maintain of 7,601 small-business transactions with a usable earnings multiple, 98 percent of the sample sits below $5 million. The mandate is drawn at $3 million, on a figure measured net of real estate, against a market whose mass sits well underneath it.

I want to be precise about what that does and does not establish, because it is the kind of number that gets repeated carelessly. It does not tell you what share of deals fall under $3 million, because the sub-$5 million band contains deals on both sides of the line and I have not published that split. What it does establish is direction: the quality of earnings requirement is a rule about the upper end of Main Street, not about Main Street. Most buyers reading about it will never trigger it.

What every one of them will trigger is the valuation requirement, and that is the part the coverage has largely skipped.

If you are near the line

Get the real estate appraised early. On a deal with property in it, the appraisal is not just a collateral exercise. It sets the Business Purchase Price, and the Business Purchase Price decides what diligence is compulsory. Discovering that in week six is expensive.

Do not structure toward the threshold. Allocating more of the price to real estate to duck a report is the kind of thing that survives exactly until an appraiser disagrees, and the valuation still has to support what you are paying. The threshold is a consequence of how the deal is actually shaped, not a dial.

If you are above the line, the report is now a pricing document. The lender has to underwrite debt service to its findings and reduce the loan if coverage does not support the price. The adjusted earnings figure is not advisory, it decides how much you can borrow.

All of which is downstream of the same thing. From 1 October a buyer's price has to survive somebody else's arithmetic, and the first question is which arithmetic applies to you.

Go deeper

If you are buying or selling a business into this rule change and want the earnings reconciled before a lender does it for you, that is the work I do.

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Tomasz Felpel is an investor, founder, and advisor in private markets, based in New York. He publishes the Felpel Private Company Index and has priced more than a thousand private companies.