What the Bank Actually Underwrites

Buyers talk multiples. Banks talk coverage. If you own a $5 million to $20 million company, the number that closes is the number that still looks like cash after a lender is done with your add-backs.

Add-backs that are not cash die in diligence. That is the whole post. I am writing what happens when the story meets the tax return.

What does a bank mean by cash?

Cash is money that showed up in the business and can show up again after you leave. It is not a spreadsheet adjustment. It is not a verbal. It is not “we could have charged more.”

Seller’s discretionary earnings is a useful owner metric. It is a starting point, not a closing number. A buyer using SDE is buying a job plus a business. A 7(a) lender is asking whether the business can service a note after a real person gets paid to run it.

The lender will start with tax returns, not your recast. They will match deposits to the bank. They will ask which expenses continue after closing. They will put a wage in the model for whoever actually runs the shop. Then they will ask whether what is left covers the note with room to spare.

Why do add-backs that are not cash die?

Because diligence is a subtraction exercise. Every add-back is a claim that an expense was not real, not repeating, or not required. Some claims hold. Most get smaller.

Personal expenses run through the company can be real add-backs if they stop at close and you can show them. A one-time legal bill can be real if it does not come back. Above-market owner compensation can be real if a replacement wage is documented.

Here is what dies.

• A “one-time” cost that shows up every year under a new name.
• Family payroll with no job, no hours, and no replacement plan.
• Customer entertainment that a new owner will still have to do.
• Capex you want treated as an expense add-back when the trucks still have to be replaced.
• A round number you added in April because a broker said SDE should look bigger.

If the add-back cannot be tied to a line on the return, a canceled check, or a contract that ends, it is a story. Stories do not cover a note.

What about officer pay that is not on the return?

This is the one that wrecks otherwise honest files.

The bank wants officer compensation on the tax return. W-2. Reasonable officer pay. A number a stranger can find without a speech. A story about unpaid salary is not cash. A story that you “should have been paid $300,000” while the return shows $0 and the distributions are already in the profit is not an add-back. It is double-counting dressed up as sophistication.

The other version is just as common. You ran lean. You took a small wage so the profit would look strong. You want to sell on that profit. The lender still loads a replacement officer wage into the coverage model. Coverage drops. The deal that looked easy on last year’s SDE gets tight.

Do the work now. Put a real officer wage on the return. If you take distributions, stop pretending they are a secret second salary you also get to add back. If a family member is on payroll, give them a job a buyer would keep or take them off.

If the shop cannot pay a market officer and still cover the note, it cannot be bought with a 7(a) loan at the price in your head.

How do most 7(a) lenders run coverage?

Most 7(a) lenders run the file at about 1.25 times debt service coverage. That is lender practice. It is how credit committees actually size the note. I am not quoting an SBA standard operating procedure. I am telling you how the underwriter I see on Main Street files usually builds the model.

Coverage means cash after a real officer wage, after the expenses that continue, divided by the annual payment on the acquisition debt. If that ratio is 1.25, the lender can breathe. If it is 1.05 on a good year, the file is a speech. Speeches do not get loan numbers.

This is why a price that looks fine at 3 times SDE can fail at the bank. SDE added back your wage. The lender put a wage back in. SDE used last year. The lender used a range.

Why does the three-year average show up?

Because last year is a scoreboard. Three years is a pattern.

If last year was a record, many lenders average. They will listen to a reason. They will not finance a spike as if it were a floor. Then they still look at year one and year two.

If last year was down, they may still underwrite last year and ignore the average you prefer. Owners always want the higher of the two. Lenders take the one that looks repeatable.

Bring all three years without being asked. Show the add-backs the same way on each year. If an add-back only appears in the best year, that is a tell. If revenue jumped because of one customer, say it before they find it. Concentration is not fatal. Surprise concentration is.

What is leftover after the note?

After the bank is paid, someone still has to live. The buyer needs a wage. The business needs a cash cushion. If you are carrying a seller note, that note needs a payment that does not break coverage.

The price is not the question. The question is whether cash after the senior note, a market officer wage, taxes, and a working-capital buffer still looks like a company. If a seller note is stacked on top, leftover has to cover that too, or the note is theater.

Lenders like a seller note when it is subordinated, and often when it stands by for a period. They do not like a seller note that eats the coverage they just built. If the only way your price works is a large seller note with payments from day one, you do not have a price.

Run the leftover before you name a number. Start with cash the lender will keep. Subtract the senior debt service. Subtract a real officer wage if it is not already in. Ask what is left for the buyer, for a rainy quarter, and for any paper you want to carry. If that leftover is thin, the price is the problem. Not the bank.

Do it with your CPA this month. Tax returns. Officer pay as filed. Add-backs you can show. A three-year view. A coverage sketch at 1.25. Then you will know whether the number in your head is a sale or a stalemate.

If a lender stripped every add-back that is not cash, would your price still cover 1.25 and leave someone a wage?