SBA loans can be a great way to finance a small business acquisition. Like most government programs, SBA loan programs have plenty of rules. In this post, I summarize the highlights of the rules for SBA 7(a) business acquisition loans.
There are three key sources of information about SBA loan rules: the U.S. Code of Federal Regulations, the relevant SBA SOP, and the SBA website. The SBA’s authorization boilerplate is another source of information about SBA loans, and it supersedes the SOP if there’s a conflict. Some of the text below is taken directly from the government sources but not set off in quotes to enhance readability.
In order for a business to qualify for the SBA 7(a) loan program, it must meet the following criteria:
- Be an operating business;
- Be organized for profit;
- Be small, as defined by the SBA;
- Be located in the United States or its territories or possessions; and
- Demonstrate a need for the desired credit.
In addition, the applicant must show that the funds are not available from alternative sources, including the principals’ personal resources.
The following types of businesses are not eligible for the program:
- Nonprofit businesses (for-profit subsidiaries are eligible);
- Financial businesses primarily engaged in the business of lending, such as banks, finance companies, and factors;
- Passive businesses owned by developers and landlords that do not actively use or occupy the assets acquired or improved with the loan proceeds (except eligible passive companies);
- Life insurance companies;
- Businesses located in a foreign country (businesses in the U.S. owned by aliens may qualify);
- Pyramid sales distribution plans;
- Businesses deriving more than one-third of gross annual revenue from legal gambling activities;
- Businesses engaged in any illegal activity;
- Private clubs and businesses that limit the number of memberships for reasons other than capacity;
- Government-owned entities (except for businesses owned or controlled by a Native American tribe);
- Businesses principally engaged in teaching, instructing, counseling, or indoctrinating religion or religious beliefs, whether in a religious or secular setting;
- Consumer and marketing cooperatives (producer cooperatives are eligible);
- Loan packagers earning more than one third of their gross annual revenue from packaging SBA loans;
- Businesses with an associate who is incarcerated, on probation, on parole, or has been indicted for a felony, or a crime of moral turpitude (an associate is basically an officer, director, or 20% owner);
- Businesses in which the lender or any of its associates owns an equity interest;
- Businesses that present live performances of a prurient sexual nature or derive directly or indirectly more than 5% of their gross revenue through the sale of products or services, or the presentation of any depictions or displays, of a prurient sexual nature;
- A business or applicant involved in a business which defaulted on a federal loan or federally assisted financing resulting in a loss to the government (a compromise agreement is considered a loss);
- Businesses primarily engaged in political or lobbying activities; and
- Speculative businesses (such as oil wildcatting).
The application process
The SBA’s website has a helpful application checklist detailing information that SBA loan applicants are required to supply with their loan applications. The following information is listed:
- SBA loan application on Form 4;
- Statement of personal history on Form 912 (required for each officer, director, and 20% owner);
- Personal financial statement on Form 413 (required for each officer, director, and 20% owner);
- Business financial statements for the applicant;
- Information about affiliates of the applicant;
- Business license;
- History of prior loan applications;
- Personal and business income tax returns for the previous three years;
- Personal resumes of each principal;
- Copy of real estate lease;
- Current balance sheet and profit and loss statement of the business to be acquired;
- Federal income tax returns for the business to be acquired for the previous two years;
- Copies of the acquisition contracts; and
- Asking price detail with schedule of inventory, machinery and equipment, furniture, and fixtures.
The SBA’s website has additional information about the application process and required documents on its Business Loan Checklist page.
Maximum loan amounts
The maximum loan amount for a standard SBA 7(a) loan is $5 million. The maximum for SBA Express loans is $350,000. If two loans are approved within 90 days of each other, the aggregate amount of the loans to one business, including affiliates, guaranteed by the SBA can’t exceed $5 million.
Maximum guarantee amounts
It’s a common misconception that the SBA loans money. The SBA doesn’t loan money through its 7(a) program: it guarantees loans made by lenders. Also, the SBA doesn’t guarantee the full amount of the loan. The SBA will guarantee 85% of the loan amount for loans of $150,000 or less and up to 75% of loans larger than $150,000 (if applications for a small loan and a larger loan are submitted within 90 days of each other, they are combined for purposes of determining the amount the SBA will guarantee). The maximum amount that the SBA will guarantee on a 7(a) loan is $3.75 million. The SBA will guarantee only 50% of the amount of SBA Express loans.
Maturities of loans used for inventory and working capital are a maximum of 10 years. Maturities of loans used for furniture, fixtures, and equipment are a maximum of 10 years, unless the useful life of the asset exceeds 10 years (but still a maximum of 25 years). Maturities of loans used for real estate are 25 years, plus any additional period needed to complete the construction of improvements. When a loan is used for mixed purposes, the maximum maturity may be a blended maturity based on the maximum maturities of the asset classes being funded.
Interest rates on SBA 7(a) loans can be variable or fixed. The maximum rates a lender can charge are governed by the SBA’s regulations, but the lender sets the actual rate in negotiation with the borrower.
The SBA periodically publishes the maximum fixed rates in the Federal Register. The maximum fixed rates can be used by a lender only if the rate will be in effect for the entire term of the loan without adjustment or reset. Otherwise, the maximum variable rates will apply. The current allowable fixed rates can be found on the SBA lenders page.
For variable rate loans, SBA lenders can charge a rate up to an acceptable base rate plus an allowable spread. Although the base rate will fluctuate during the life of the loan, the spread may not be changed without the written agreement of the borrower. Generally, acceptable base rates are the prime rate, one-month LIBOR plus three percentage points, and the SBA optional peg rate.
A helpful chart listing the maximum rates for various SBA 7(a) loans can be found in the current SOP on pages 138-139.
SBA guarantee fees
Lenders must pay a guarantee fee to the SBA for each loan the SBA guarantees (lenders typically charge the fee to the borrower). The amount of the fee is calculated as a percentage of the amount guaranteed by the SBA (not the total amount of the loan). For loans of $150,000 or less, the guarantee fee is 0% of the guaranteed amount. For loans from $150,001 to $700,000, the fee is 3% of the guaranteed amount. For loans from $700,001 to $5 million, the fee is 3.5% of the guaranteed portion up to $1 million plus 3.75% of the guaranteed amount above $1 million. For short-term loans (i.e., loans having maturities of 12 months or less), the guarantee fee is 0.25% of the guaranteed amount.
Lenders also pay the SBA an on-going guarantee fee, and they may not pass this fee on to the borrower. Various other fees may be required to be paid by the lender or the borrower.
Permitted and prohibited fees
SBA lenders may charge borrowers service and packaging fees, fees for extraordinary servicing if approved by the SBA, out-of-pocket expenses, and late payment fees.
SBA lenders are prohibited from charging the following fees:
- Prepayment fees;
- Fees or charges for goods or services, including insurance, as a condition for obtaining an SBA loan;
- Commitment, bonus, origination, broker, commission, referral, or similar fees;
- Points or add-on interest; or
- Fees for legal services, unless they are hourly charges for requested services actually rendered.
In addition, SBA lenders may not share any premium received from the sale of an SBA loan in the secondary market with a service-provider, packager, or other loan-referral source.
Disclosure of fees
SBA Form 159(7a), Fee Disclosure Form and Compensation Agreement, must be completed by the loan applicant or SBA lender to disclose fees paid to agents who provided services in connection with the loan application. A compensation agreement must be completed for each agent that provided services, but accountants, appraisers, environmental professionals, and attorneys are not required to complete the form.
Use of SBA 7(a) loan proceeds
SBA loan proceeds can be used for the following:
- Permanent working capital;
- Revolving working capital;
- Furniture and fixtures;
- Machinery and equipment;
- Purchase of land and building including construction and renovations;
- Business acquisition; and
- Refinancing of existing debt under certain circumstances.
SBA loan proceeds can’t be used for the following:
- To refinance existing debt where the lender is in a position to sustain a loss and the SBA would take over that loss through refinancing;
- To effect a partial change of business ownership or a change that will not benefit the business;
- To permit the reimbursement of funds owed to any owner including any equity injection or injection of capital to continue the business until the SBA-backed loan is disbursed;
- For payments, distributions, or loans to an associate of the applicant except for compensation for services actually rendered at a fair and reasonable rate;
- To pay delinquent IRS withholding taxes, sales taxes, or other funds payable for the benefit of others (payment of delinquent income taxes may be permitted if the applicant has an approved payment arrangement with the IRS);
- For refinancing debt owed to an SBIC;
- For investments in real or personal property acquired and held primarily for sale, lease, or investment;
- To finance the relocation of the applicant business out of a community, if there will be a net reduction of one-third of its jobs or a substantial increase in unemployment in any area of the country (unless an exception applies); or
- For a purpose that is not considered to be a sound business purpose as determined by the SBA.
Change of ownership
SBA 7(a) loans can be used to buy an existing business, whether the purchase is structured as an asset sale or an equity sale. The purchaser is required to purchase 100% of the business — partial buyouts can’t be financed by SBA loans. This requirement also applies if an existing owner is buying out current owners of the business.
The seller may not remain as an officer, director, stockholder, or key employee of the business. However, if a short transitional period is needed, the small business may contract with the seller as a consultant for a period not to exceed 12 months including any extensions.
If the borrower is acquiring the small business’s real estate in a separate transaction with a non-SBA guaranteed loan, the SBA loan must receive a shared lien position (pari passu) on the real estate with the non-SBA guaranteed loan. (This doesn’t apply if the business real estate is being financed as part of a 504 project.)
An SBA-guaranteed loan may be used to finance a change of ownership that includes intangible assets. If the purchase price of the business includes intangible assets (including goodwill, client/customer lists, patents, copyrights, trademarks, and agreements not to compete) in excess of $500,000, the borrower and the seller must provide an equity injection of at least 25% of the purchase price of the business for the application to be processed under delegated authority. (Seller equity is defined as seller take-back financing that is on full standby (principal and interest) for a minimum of 2 years.)
The SBA lender’s loan documentation must include:
- A current business valuation (not to include any real estate) by the lender or an independent third party hired by the lender with proven experience in business valuations;
- A site visit of the business being acquired;
- A real estate appraisal for commercial real estate that meets SBA’s requirements; and
- An analysis as to how the change of ownership will promote the sound development and/or preserve the existence of the business.
The borrower must inject a sufficient amount of equity into the company that is applying for an SBA loan. The equity injection must be verified and documented prior to disbursement.
Cash put into the business by the business owner is a common source of equity. Borrowed cash can count toward the borrower’s equity injection if the applicant can demonstrate that repayment of the personal loan will be made from sources other than the cash flow of the business (the owner’s salary from the business can’t be counted). Assets other than cash put into the business can count for the borrower’s equity injection, but an appraisal or other valuation by an independent third party is required if the valuation of the fixed assets is greater than the depreciated value (net book value).
Seller take-back debt that is on full standby (no payments of principal or interest for the term of the SBA-guaranteed loan) may be considered acceptable equity. Debt that is on partial standby (interest payments only being made) may be considered equity when there is adequate historical business cash flow available to make the payments. The standby creditor must subordinate any lien rights in collateral securing the loan to the SBA lender’s rights in the collateral. The standby creditor must also take no action against the borrower or any collateral securing the standby debt without SBA lender’s consent. The SBA lender may use SBA Form 155 or its own standby agreement form that is used for similar non SBA guaranteed loans. A copy of the note must be attached to the standby agreement.
With respect to collateral taken, lenders are required to use commercially reasonable and prudent practices to identify collateral. The practices must conform to procedures at least as thorough as those used for the lenders’ similarly-sized non-SBA guaranteed commercial loans.
An SBA loan request is not to be declined solely on the basis of inadequate collateral; however, the SBA guarantee cannot be used by banks as a substitute for collateral. The SBA loan must be collateralized to the maximum extent possible up to the loan amount. A loan is fully collateralized when the liquidation value of secured assets equals the loan amount.
For loans from $25,001 to $350,000, the SBA lender must follow its established collateral policies and procedures for similarly-sized non-SBA-guaranteed loans. But at a minimum the lender must obtain a lien on the applicant’s fixed assets to secure the loan. The lender may secure the applicant’s trading assets (using a 10% current book value for the calculation) if it does so for similarly sized non-SBA-guaranteed commercial loans. For loans in excess of $350,000, the SBA requires the lender to collateralize the loan to the maximum extent possible up to the loan amount. If fixed assets do not fully secure the loan, the lender is required to take available equity (i.e., when the equity is 25% or more of fair market value) in the personal real estate of the principals as collateral. For loans of $25,000 or less, lenders are not required to take collateral.
Assets owned by the loan applicant’s spouse
When an individual alone or an individual and his or her spouse together own 20% or more of a business applying for an SBA loan, the lender must consider taking as collateral available equity in personal real estate that is owned individually by the business owner as well as available equity in personal real estate owned jointly. Real estate transferred by the applicant to the non-owning spouse within six months of the date of the application will not be exempt from consideration as available collateral.
Each SBA loan must be guaranteed by at least one individual or entity.
All individuals who own 20% or more of the equity of the applicant for an SBA loan must provide an unlimited full personal guarantee of the indebtedness on SBA Form 148 or an equivalent document. Lenders may also require others to guarantee the loan. Owners of less than 20% of the equity might be required to sign limited personal guarantees on SBA Form 148L or an equivalent document. The lender is required to obtain a personal financial statement from all individuals guaranteeing the loan.
Personal guarantees may be secured or unsecured, but they must meet the SBA’s collateral requirements. If the loan is not fully collateralized by fixed assets, available equity in personal real estate (i.e., equity in excess of 25% of the value of the real estate) must be pledged to secure the guarantee, up to the collateral shortfall.
Each spouse owning five percent or more of the applicant for an SBA loan must personally guarantee the loan in full when the combined ownership interest of both spouses is 20% or more. For a non-owner spouse, the lender must require the signature of the spouse on the appropriate collateral documents. The spouse’s guarantee secured by jointly held collateral will be limited to the spouse’s interest in the collateral.
Corporate and trust guarantees
All entities that own 20% or more of an applicant for an SBA loan must provide an unlimited full guarantee. If the entity that owns 20% or more of the small business applicant is a trust (revocable or irrevocable), the trust must guarantee the loan with the trustee executing the guarantee on behalf of the trust and providing the required certifications. In addition, if the trust is revocable, the trustor also must guarantee the loan. Financial statements are required to determine the assets available to support the guarantee.
ESOP and 401(k) guarantees
When an employee stock ownership plan (ESOP) or 401(k) account owns 20% or more of an applicant for an SBA loan, the plan or account cannot guarantee the loan, but the plan or account must meet all applicable IRS eligibility requirements. In addition, the following loan conditions must be met:
- Each owner of a 401(k) must provide his or her full unconditional personal guarantee regardless of the individual ownership interest in the applicant concern. This guarantee must be a secured guarantee if required by the SBA’s collateral policies.
- The members of the ESOP are not required to personally guarantee the debt, but all owners of the loan applicant who hold an ownership interest of 20% or more outside the ESOP are subject to the SBA’s personal guarantee requirements.
- The application cannot be structured as an eligible passive company/operating company. (SBA regulations require each 20% or more owner of the eligible passive company and each 20% or more owner of the operating company to guarantee the loan, and the regulation does not provide for an exception.)
Assignment of lease and landlord’s waiver
The SBA lender should obtain a landlord’s waiver and an assignment of lease when a substantial portion of the loan proceeds are to be used for leasehold improvements and also when a substantial portion of the collateral consists of leasehold improvements, fixtures, machinery, or equipment that is attached to leased real estate. The assignment of lease should have a term (including renewal options) that equals or exceeds the term of the loan, and it should contain a requirement that the lessor provide a 60-day written notice of default to the lender with option for the landlord to cure the default.
The landlord’s waiver gives the lender access to the leased premises and facilitates the liquidation of the collateral on the borrower’s premises and should be obtained for all SBA loans with tangible personal property as collateral.
Special provisions for franchisees
When lending to a franchise, the SBA lender should consider obtaining an agreement from the franchisor that:
- Allows the lender and the SBA access to the franchisor’s books and records relating to borrower’s billing, collections, and receivables;
- Upon loan payment default or deferment, defers payment of franchise fees, royalties, advertising, and other fees until borrower brings loan payments current;
- Gives the lender 30 days’ notice of intent to terminate the franchise agreement; and/or
- Gives the lender an opportunity to cure any default under the franchise or lease agreement that is given the franchisee under the same agreements.
In addition to the rules summarized above, these additional requirements apply:
- Appraisals of the borrower’s assets might be required.
- Hazard insurance is required on all collateral.
- Flood insurance is required if within a special flood hazard area.
- Life insurance is required if the viability of the business is tied to an individual or individuals; the SBA lender must obtain a collateral assignment, identifying the lender as assignee, that is acknowledged by the home office of the insurer.
- A fifty percent owner of an SBA loan applicant must certify that he or she isn’t delinquent on child support.
- The SBA lender must verify the borrower’s financial information and payment of taxes, including submitting IRS Form 4506-T.
- New construction and additions must comply with the National Earthquake Hazards Reduction Program.