Turn the lender's coverage ratio around and it gives the most a business can be financed for, and how much of that ceiling the business cannot actually pay.
Divide adjusted EBITDA by 1.25 to get the most debt service the lender will accept, then divide that by the annual debt service each dollar of price creates. On an illustrative business with 500,000 of adjusted EBITDA, a 10 per cent SBA 7(a) loan over ten years and a 7 per cent seller note, the lender's ceiling is 2,655,581, or 5.31 times EBITDA. After capex and tax, the price at which the business itself covers its debt 1.25 times is 2,071,354, 22.0 per cent lower.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Buyers usually ask the question the other way round: here is the price, does the loan work? Turning it around gives the most a lender will finance before anyone has negotiated, and it shows how much of that ceiling is the lender's ratio rather than the business's cash.
| Input | Value |
|---|---|
| Adjusted EBITDA, after a market manager's salary | 500,000 |
| Lender's minimum DSCR (credit policy) | 1.25x |
| SBA 7(a) rate: illustrative prime 7.00% + 3.00% spread | 10.00% |
| SBA term, level monthly payments | 10 years |
| Paying seller note, share of price | 10% |
| Seller note rate and term | 7.00%, 5 years |
| Equity injection: 5% buyer cash + 5% standby seller note | 10% |
| SBA loan, share of price | 80% |
| Maintenance capex, year 1 | 60,000 |
| Cash taxes, year 1 (illustrative estimate) | 50,000 |
The standby note pays nothing while the SBA loan is outstanding, so it counts towards the injection but not towards debt service. The paying seller note does count, and lenders include it. The 1.25 times is a common lender policy minimum rather than a figure fixed by the programme, so ask the lender which ratio, and which earnings figure, its credit policy uses.
Maximum debt service = adjusted EBITDA ÷ minimum DSCR
Annual constant = 12 × monthly payment per dollar borrowed
Maximum price = maximum debt service ÷ (SBA share × SBA constant + paying note share × note constant)
In Excel: =-PMT(10%/12, 120, 1)*12 gives the SBA constant, =-PMT(7%/12, 60, 1)*12 the note constant, and the price is =(EBITDA/1.25)/(0.8*K_SBA+0.1*K_Note).
Step 1. 500,000 ÷ 1.25 = 400,000 of debt service is the most the lender will accept.
Step 2. A ten-year loan at 10 per cent costs 0.1586 a year per dollar borrowed, 15.86 per cent. A five-year note at 7 per cent costs 0.2376, 23.76 per cent: the cheaper rate is more than offset by the shorter term.
Step 3. Each dollar of price is funded 80 cents by the SBA loan and 10 cents by the paying note, so it creates 0.8 × 0.1586 + 0.1 × 0.2376 = 0.1506 of annual debt service.
Step 4. 400,000 ÷ 0.1506 = 2,655,581, or 5.31 times EBITDA.
| Source | Amount | Debt service |
|---|---|---|
| SBA 7(a) loan | 2,124,465 | 336,900 |
| Paying seller note | 265,558 | 63,100 |
| Standby seller note | 132,779 | 0 |
| Buyer cash | 132,779 | 0 |
| Price | 2,655,581 | 400,000 |
The check closes: 500,000 ÷ 400,000 = 1.25x.
The lender's ratio is measured on EBITDA. The buyer pays the debt from what is left after capex and tax. Here that is 500,000 − 60,000 − 50,000 = 390,000, so at the lender's maximum price the business covers its own debt 0.97 times. The shortfall comes out of the owner's pocket in year one.
Run the same formula on 390,000 instead of 500,000 and the price at which cash coverage is 1.25 is 2,071,354, or 4.14 times EBITDA, with 312,000 of debt service. That is 584,228 below the lender's ceiling. Even the price at which cash coverage is exactly 1.00, 2,589,192, sits below what the bank would lend against.
The same gap is the centre of the book's Deal A. Cedar Ridge Mechanical is approved at a lender's coverage of 1.56 times and covers its own debt 0.96 times in its first year. A ratio that passes the credit committee says little about whether the owner can draw a salary.
| Variant | Max price | x EBITDA | Change |
|---|---|---|---|
| SBA rate 9% | 2,751,596 | 5.50x | +96,014 |
| Base: 10%, 1.25x | 2,655,581 | 5.31x | 0 |
| SBA rate 11% | 2,564,079 | 5.13x | −91,503 |
| SBA rate 12% | 2,476,879 | 4.95x | −178,702 |
| Minimum DSCR 1.35x | 2,458,872 | 4.92x | |
| Minimum DSCR 1.50x | 2,212,985 | 4.43x | |
| Whole 10% seller note on full standby | 3,152,965 | 6.31x | +497,384 |
A point on prime moves the ceiling by about 92,000 to 96,000. Putting the seller note on full standby moves it by 497,384, because a five-year note is the most expensive dollar in the stack per year. That is why a seller's willingness to defer is worth more to the buyer's borrowing capacity than a lower note rate. Every extra 10,000 of EBITDA the lender accepts is worth 53,112 of price, which is why the add-back schedule is fought line by line.
The common mistake is to treat the lender's maximum as a valuation. It is a debt ceiling built on EBITDA, with nothing taken out for the capex that keeps the trucks running or the tax the business will pay. It also ignores the guaranty fee, closing costs and the working capital cushion, all of which add to total uses and reduce the price the same debt can carry. Price the business on the cash test, then check the lender's ratio passes, not the other way round.
Maximum price = (EBITDA ÷ 1.25) ÷ the debt service per dollar of price. Then repeat it on EBITDA less capex and tax: the gap between the two answers is the part of the price the owner pays from his own salary. The free workbook for this case solves Cedar Ridge's lender maximum in closed form with the guaranty fee and every use included, and how to convert SDE to EBITDA covers the earnings figure the ratio starts from.
Many lenders set 1.25x as their credit policy minimum on an acquisition, measured as adjusted EBITDA over total annual debt service including any paying seller note. On 500,000 of EBITDA that caps debt service at 400,000. A lender asking 1.35x cuts the supportable price in the illustrative case from 2,655,581 to 2,458,872.
A paying seller note does. A note on full standby, paying nothing while the SBA loan is outstanding, does not. In the illustrative case, moving the 10 per cent seller note to full standby raises the maximum price from 2,655,581 to 3,152,965, because a five-year note costs 23.76 per cent of its balance a year.
The lender divides EBITDA by debt service; the buyer pays debt service out of EBITDA less capex and cash taxes. With 60,000 of capex and 50,000 of tax on 500,000 of EBITDA, a deal at exactly 1.25x on the lender's measure covers its debt only 0.97x in cash.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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