In recent weeks Michael Burry, legendary short-seller and author of The Big Short came out swinging at the AI hyperscalers (Meta, Oracle, Microsoft, Amazon, and Google) and their suppliers (primarily Nvidia). In plain English, Burry is asserting that the hyperscalers are understating depreciation on their massive datacenters and thus pumping up their earnings; the equipment they are buying would be obsolete much faster than they are claiming and that in the very near term they will require far more capital expenditures, reducing their cash flow. They will also be forced to accelerate depreciation (or write-offs), driving down earnings. Enron redux.
What does that have to do with small business lending in general and SBA lending in particular?
Believe it or not, we worry about the same issue when we assess new loan requests; overestimation of cash flow and the ability (or inability) of borrowers to take on as much debt as they request.
When a loan request is presented to us, the initial spreads are typically derived by the borrower or broker based on someone’s calculation of EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) or Seller’s Discretionary Earnings (“SDE”) which also adds back one-time expenses and expenses that are associated with the seller’s management of the business and are considered “non-recurring.” The buyer is expected to pay a multiple of EBITDA or SDE and we are asked to provide debt to cover 80-90% of that amount.
However, we know that in addition to expenses, a business is also required to buy inventory, replace equipment, finance receivables and pay taxes, so we calculate what we term Free Cash Flow (“FCF”) which is always lower than what’s initially presented to us and may reduce the reasonable amount of debt the company should obtain.
Let me use an example of a loan we recently closed, financing the purchase of a FedEx route. By the way, we love financing FedEx routes, and the SBA 7(a) program is perfect for those businesses. Since the financials rarely talk about it, one of the first questions we ask is the age and condition of the trucks. Luckily there was ample cash flow and in this particular case we ascertained that the buyer would have to purchase two new trucks in the near future, and accommodated the request by adding a small line-of-credit to make sure that there is sufficient liquidity post-close to cover not only operating expenses but also the eventual purchase of the trucks. In other similar situations, we could not provide the debt requested and the loans were offered only after price reduction, seller-note and/or additional equity injections.
Here is my advice to entrepreneurs who come to us for capital to acquire a business (but really for any use of proceeds):
- The broker’s write-up and calculations of EBITDA/SDE is an excellent starting point to understand the business, estimate cash flow and even peg a price.
- Take it a step further and look at other near-term (2-3 years) cash needs, similar to what we will look at when we get the request:
- Equipment purchases and repairs,
- Inventory purchases,
- Growth of receivables as the business grows,
- Other anticipated cash needs such as taxes, rent escalation, and inflation that isn’t covered by price increases,
- A cushion for unanticipated uses of cash such as slower ramp-up, interest-rate increase, supply-chain disruptions, and loss of a major customer or an account,
- The needs escalate for fast growing/moderate margin businesses such as distributors and staffing companies.
- Using a very simple model, calculate the anticipated debt service on the loan requested and make sure that the actual cash flow covers it with some room for error. Share your findings with the seller and broker to get their point of view.
- Share your findings with the loan officer working on the deal; we put tremendous weight on your sober assessment of the opportunity.
I have no idea whether Burry is correct in his assessment of AI hyperscalers and their vendors. It seems reasonable. But unlike Burry, we aren’t in the short business; we take long positions on businesses we support. Paraphrasing a description of OpenAI founder Sam Altman, we are optimists yet survivalists, with a sense that things can go wrong. With the supporting loan guarantees provided to lenders like Gulf Coast Small Business Lending, the SBA 7(a) loan program is designed to assist entrepreneurs that cannot access traditional bank debt and we take that task seriously; help us by understanding the ability of the business to support our debt.
Gulf Coast Small Business Lending is among the nation’s leading SBA lenders. We are actively lending nationwide as SBA Preferred Lenders. Reach out to one of our business development officers (contact info here: https://gulfcoastsba.com/our-people/) or to me to help you with your next project. We work hard at finding a way to say YES!