Many people think that the Small Business Administration (SBA) lends money. In fact, the SBA is not a direct lender to businesses. Banks loan money to businesses, while the SBA helps banks feel more comfortable loaning money to Small Businesses by offering the bank a loan guarantee.
When a person buys a home and doesn’t have more than 20% to put down, the bank requires that the buyer purchase private mortgage insurance (PMI). In the event that the buyer defaults on the loan and the bank can’t recoup their principle when the property is sold, the SBA will contribute the spread to make the bank whole. The SBA is essentially PMI for business loans.
Since banks are the direct lenders to Small businesses, the bank is the one that has to feel comfortable with the business’s ability to repay the loan. With all its influence, the government is not in a place to force banks to make loans they do not feel are prudent.
Banks are especially reluctant to extend loans when it comes to new ventures. One key criterion that banks use to determine if they will extend a loan to a business is sufficient cash flow to pay the principal and interest on the debt. New ventures don’t have cash flow yet so unless the loan if for an asset and there are sufficient other unencumbered assets that can be pledged as collateral banks are not in a position to issue a loan.
Generally speaking, the SBA hits its stride in the small business world only after the business has proven its business model and it is producing a cash flow that is contributing to profits. This is why I say that debt in the form of a bank loan is not for startups but to scale a successful business.
The following are the three primary loan programs that the SBA supports.
SBA 7(a) Loans
The 7(a) Loan Program is the SBA’s most common loan program and includes financial help for small businesses with special requirements. This is the best option when real estate is part of a business purchase, but it can also be used for:
- Short and long-term working capital
- Refinance current business debt
- Purchase furniture, fixtures, and supplies
The maximum loan amount for a 7(a) loan is $5 million. Key eligibility factors are based on what the business does to receive its income, its credit history, and where the business operates. Your lender will help you figure out which type of loan is best suited for your needs.
To be eligible for SBA 7(a) loan assistance, businesses must:
- Operate for profit
- Be considered a small business, as defined by SBA
- Be engaged in, or propose to do business in, the United States or its possessions
- Have reasonable invested equity
- Use alternative financial resources, including personal assets, before seeking financial assistance
- Be able to demonstrate a need for a loan
- Use the funds for a sound business purpose
- Not be delinquent on any existing debt obligations to the U.S. government
Basic uses for the 7(a) loan include:
- Long and short-term working capital
- Revolving funds based on the value of existing inventory and receivables
- The purchase of equipment, machinery, furniture, fixtures, supplies, or materials
- The purchase of real estate, including land and buildings
- The construction a new building or renovation an existing building
- Establishing a new business or assisting in the acquisition, operation or expansion of an existing business
Most 7(a) term loans are repaid with monthly payments of principal and interest. Payments stay the same for fixed-rate loans because the interest rate is constant. For variable rate loans, the lender can require a different payment amount when the interest rate changes
The SBA 7(a) program can guarantee up to:
- 85% of a loan up to $150,000
- 75% of a loan greater than $150,000
Loans to Buy Out Early-Stage Investors
One of the biggest values that I think the SBA brings to the small businesses community is the ability within the 7(a) loan program to buy out a minority partner that wants out of a successful business.
One of the early-stage funding options that I share with many clients who have an LLC and need funding is to reach out to a high-income earner, such as a Doctor or Lawyer, and encourage them to invest in their new venture simply to claim the losses on their income taxes.
With an LLC you can use the operating agreement to grant this investor 100% of the loss which they can use to offset their taxable income from other sources such as their high-income salary. A business can stipulate in its operating agreement any level of decision-making involvement the investor may have, if any, and the proposed exit strategy.
Once the business is successful and the business’s value has gone up the founder can use the SBA 7(a) loan program to get an SBA loan to buy the high-income investor out at the new and higher valuation.
The SBA 7(a) loan program offers 100% financing (no down payment) if both of the following conditions are met:
- Purchasing shareholder, generally the founder, has been in the business for at least 2 years and owns either an equal or greater percentage of the business then the exiting shareholder.
- Prior to purchase, the company is not leveraged more than 9 times on the last interim and fiscal year-end balance sheet.
SBA 504 Loans
The CDC/504 Loan Program provides long-term, fixed-rate financing of up to $5 million for major fixed assets that promote business growth and job creation.
The SBA 504 loan is available through Certified Development Companies (CDCs), SBA’s community-based partners who regulate non-profits and promote economic development within their communities. CDCs are certified and regulated by SBA.
To be eligible for an SBA 504 Loan, your business must:
- Operate as a for-profit company in the United States or its possessions
- Have a tangible net worth of less than $15 million
- Have an average net income of less than $5 million after federal income taxes for the two years preceding your application
Other general eligibility standards include falling within SBA size guidelines, having qualified management expertise, a feasible business plan, good character, and the ability to repay the loan.
Loans cannot be made to businesses engaged in nonprofit, passive, or speculative activities. For additional information on eligibility criteria and loan application requirements, small businesses and lenders are encouraged to contact a Certified Development Company in their area.
An SBA 504 loan can be used for a range of assets that promote business growth and job creation. These include the purchase or construction of:
- Existing buildings or land
- New facilities
- Long-term machinery and equipment
Or the improvement or modernization of:
- Land, streets, utilities, parking lots and landscaping
- Existing facilities
An SBA 504 loan cannot be used for:
- Working capital or inventory
- Consolidating, repaying or refinancing debt
- Speculation or investment in rental real estate
Maturity terms available for an SBA 504 loan can be:
The SBA microloan program provides loans up to $50,000 to help small businesses and certain not-for-profit childcare centers start up and expand. The average microloan is about $13,000.
The SBA provides funds to specially designated intermediary lenders, which are nonprofit community-based organizations with experience in lending as well as management and technical assistance. These intermediaries administer the Microloan program for eligible borrowers.
Each intermediary lender has its own lending and credit requirements. Generally, intermediaries require some type of collateral as well as the personal guarantee of the business owner.
The SBA Microloan can be used for a variety of purposes that help small businesses expand. Use them when you need less than $50,000 to rebuild, re-open, repair, enhance, or improve your small business.
- Working capital
Proceeds from an SBA microloan cannot be used to pay existing debts or to purchase real estate.
The maximum repayment term allowed for an SBA microloan is six years.
Disaster Loan Assistance
SBA also provides low-interest, long-term loans for physical and economic damage caused by a declared disaster. There are four types of disaster loan assistance that the SBA provides.
Home and Personal Property Loans
If you are in a declared disaster area and have experienced damage to your home or personal property, you may be eligible for financial assistance from the SBA, even if you do not own a business. As a homeowner, renter, and/or personal property owner, you may apply to the SBA for a loan to help you recover from a disaster such as a fire or flood.
Business Physical Disaster Loans
If you are in a declared disaster area and have experienced damage to your business, you may be eligible for financial assistance from the SBA. Businesses of any size and most private nonprofit organizations may apply to the SBA for a loan to recover after a disaster.
SBA makes physical disaster loans of up to $2 million to qualified businesses or most private nonprofit organizations. These loan proceeds may be used for the repair or replacement of the following:
- Real property
- Leasehold improvements
The SBA Business Physical Disaster Loan covers disaster losses not fully covered by insurance. If you are required to apply insurance proceeds to an outstanding mortgage on the damaged property, you can include that amount in your disaster loan application.
If you make improvements that help reduce the risk of future property damage caused by a similar disaster, you may be eligible for up to a 20 percent loan amount increase above the real estate damage, as verified by the SBA.
You may not use the disaster loan to upgrade or expand a business, except as required by building codes.
Economic Injury Disaster Loans
If you have suffered substantial economic injury and are either a small business, small agricultural cooperative, or private nonprofit organization and you are located in a declared disaster area, you may be eligible for an SBA Economic Injury Disaster Loan (EIDL):
Loan Amounts and Use
Substantial economic injury means the business is unable to meet its obligations and to pay its ordinary and necessary operating expenses. EIDLs provide the necessary working capital to help small businesses survive until normal operations resume after a disaster.
The SBA can provide up to $2 million to help meet financial obligations and operating expenses that could have been met had the disaster not occurred. Your loan amount will be based on your actual economic injury and your company’s financial needs, regardless of whether the business suffered any property damage.
Military Reservists Economic Injury Loans
The Military Reservist Economic Injury Disaster Loan (MREIDL) provides funds to help an eligible small business meet its ordinary and necessary operating expenses that it could have met, but is unable to, because an essential employee was called-up to active duty in his or her role as a military reservist.
The maximum MREIDL loan amount is $2 million. The amount of each loan is limited to the actual economic injury as calculated by SBA. The amount is also limited by business interruption insurance and whether the business and/or its owners have sufficient funds to operate. If a business is a major source of employment, SBA has the authority to waive the $2 million statutory limit.
The purpose of MREIDL loans is not to cover lost income or lost profits. MREIDL funds cannot be used in lieu of regular commercial debt, to refinance long-term debt, or to expand the business.
How can you use one of the SBA programs to scale, buy out one of your early-stage investors or recover from a declared disaster?
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