The Small Business Administration (SBA) recently made changes to its standard operating procedures (SOP), which banks must follow when approving and administering SBA guaranteed loans. The changes are effective January 1, 2018 and were recently announced at the national annual Government Guaranteed Lenders conference, held at our very own Broadmoor Resort in Colorado Springs. While some changes are more administrative in nature, others, such as increased equity requirements for business acquisition loans, will have a more profound effect on the buyer’s required cash equity and how banks underwrite SBA loans.
Why is cash equity important?
Why does the SBA require the buyer to contribute their own cash equity? First, equity lowers the amount of the loan, thus freeing up capital to sustain and grow the business. Second, bringing cash equity to the closing signals the new owner’s commitment to the business. Business owners who have their own cash at risk are much less likely to walk away from the business when it experiences a challenge, as all businesses do. In fact, the SBA provides specific guidance that borrowers must have “sufficient invested equity to operate on a sound financial basis to insure its long-term survival” (Code of Federal Regulations 13 102.150). Lastly, equity in the business reduces the risk to the bank, allowing it to approve more loans.
SBA equity requirement changes are in the works.
While banks have always been required to assess the adequacy of equity in a purchase, the new SOP 50 10 5(J) effective January 1, 2018 mandates a minimum 10% equity injection for new starts and changes of ownership AND requires at least 10% equity on post-sale pro-forma balance sheets. Previous to the change, the SBA allowed seller carry notes, which were on “full standby for at least 2 years” (no payments), to be considered equity. In general, the SBA currently requires 25% equity in the form of a combination of seller carry on 2-year full standby and buyer cash equity. After the proposed changes, seller carry notes will only be considered equity if the note is on full standby for the ENTIRE term of the SBA loan. Furthermore, at least 50% of the required equity must come from the buyer’s own resources. For example if the purchase price of the business is $1,000,000, then the seller can only provide half of the mandatory equity injection of $100,000. In this example, the seller provides a full standby note of $50,000 and the buyer provides cash equity of $50,000. So, while the overall amount of the equity required will be reduced from 25% to 10%, the requirements for seller carry notes and buyer’s cash equity are more restrictive as the company’s balance sheet must also show at least 10% equity as a percent of assets being retained in the company. The new SBA requirements are still subject to change, so stay tuned.
How about other sources of buyer equity?
Can the buyer’s cash equity injection be borrowed? In most cases, the answer is no. One exception is if the debt will be repaid from other sources of income (e.g. spouse’s income). Can the buyer’s cash equity injection come from retirement accounts? The answer is yes, so long as there is no requirement for the business to repay the withdrawal (e.g. during 60 day window to avoid IRS penalty). Can the source of the cash equity be in the form of a “gift?” The answer is yes, as long as there is no expectation that the gift be repaid. Furthermore, the gift cannot be provided by the seller. In all these cases, should the borrower mask the source of the equity in violation of SBA requirements, both the bank and borrower could face a possible action of fraud and the bank would lose its SBA guaranty. I suspect that the SBA will also give greater scrutiny to business evaluations to ensure that the business acquisition price is not inflated to compensate for full standby seller carry notes for the life of the SBA loan.
What else do I need to know?
Again, prudent SBA lending requires that banks evaluate each SBA loan on a case-by-case basis. While some business acquisition transactions may warrant using the minimum mandatory 10% equity requirement with 50% of the equity coming from the buyer, other situations may require higher equity. I would recommend consulting with your bank during the due diligence process to ensure a smooth sale transaction. Banks that are designated by the SBA as Preferred Lending Program (PLP) lenders have demonstrated their ability to originate and administer SBA loans and are generally more knowledgeable about SBA programs and use a more streamlined process when underwriting SBA loans.
Jim Harris is a Senior Vice President and Manager of Commercial Banking at Peoples Bank, Colorado Springs’ largest local and family owned bank. He leads a team of 11 bankers. Together his team ranked #1 among Colorado Springs Community Banks in SBA loans for Colorado Businesses. Peoples Bank is proud to be an SBA PLP approved lender. Peoples Bank will soon be joining with Community Banks of Colorado, which will expand its foot print across Colorado to over 44 locations. Jim can be reached at 719-264-2086, firstname.lastname@example.org