For many fledgling or small businesses, traditional commercial bank loans are either unavailable or cost-prohibitive. So other than finding a new equity investor, which may be difficult or undesirable, what choices does an entity have for infusing capital? If a potential borrower has overall project costs between $250,000 and $12,500,000, one answer may be the use of a Small Business Administration (SBA) 504 loan. Project costs may include land and building purchases, build-outs, remodeling, equipment, professional fees, and refinancing. However, inventory, goodwill, working capital and other fees are excluded. SBA 504 loans are 40% guaranteed by the Federal government in order to promote job creation and retention in “small” businesses. SBA 504 loans are not actually made by the SBA. Instead, certain SBA approved lenders make loans that conform to the SBA’s requirements so that the SBA will agree to guarantee such loans. New, emerging, established or expanding businesses may request SBA 504 loans in amounts up to around $5,000,000. The SBA 504 loans are further restricted to owner occupied (50 %+) real estate and equipment purchases.
A business in considered “small” for SBA 504 loan purposes if it meets the following conditions:
– Conducted for profit
– Profits are less than $5,000,000 after tax
– Tangible Net Worth is less than $15,000,000
– Appropriate use of proceeds
– Doing business in the United States
An SBA 504 loan involves the following entities: a commercial lender, a credit development company (CDC), the SBA, and the borrower. The lender loans 50% of the project cost and takes a first lien; the CDC loans 40% of the project cost and takes a second lien that is guaranteed by the SBA, and the borrower contributes 10% of the project cost (the equity). The borrower’s contribution may even be in the form of land previously purchased. Numerous lenders in the Houston area offer SBA 504 loans. Likewise, several CDCs are active in this market. Specific lenders and CDCs may be targeted by accessing the SBA’s website and searching by zip code.
Any person or entity that holds 20% or more of the equity of the borrower will be required to execute a personal guaranty for the SBA guaranteed portion of the loan. This provision insures that the borrower has a strong incentive to succeed in business and repay the financing.
Before applying for a SBA 504 loan, the borrower should collect the following documentation:
– Entity formation documentation
– Licenses/Permits to conduct desired business
– Personal credit reports for individuals that hold 20% or more of the equity in the borrower
– Business credit reports for the borrower and any entities that hold 20% or more of the equity in the borrower
– Biographical information about the owners and the borrower
– Business Plan
– Financial Statements ( including a Balance Sheet, Cash Flow, and Profit and Loss Statements) for the last 3 years
– Income tax returns for the last 3 years
SBA 504 loans have lower fees and costs because a portion of the risk is being assumed by the SBA. The commercial lender is also only loaning 50% of the funds, so its default risk is lowered. The borrower is only required to inject 10% of the financing, which is lower than the typical 25% requested in a traditional commercial loan.
The CDC’s loan has a much longer term—from 10 years for equipment up to 20-25 years for real estate. This situation allows the borrower to decrease its debt repayment amounts in the near term.
Borrowers that do not have other financing options are able to obtain funding
SBA 504 loans take longer to receive approval and fund. If the borrower supplies a complete application package at the outset, the timing should be comparable. The SBA approval of a CDC’s loan request normally takes about 3 weeks. Once the CDC loan approval has been issued, the borrower essentially has no further contact with the SBA.
SBA 504 loans require two sets of loan documents, so they are more costly. Although there are two sets of loan documents, the SBA’s set is essentially non-negotiable and contains no covenants. Also, any financing with two lienholders will require two sets of loan documents.
The prepayment penalty in the SBA guaranteed portion of the loan makes it unattractive. First, the SBA 504 loan is assumable and current rates are low, so fixing that low rate for the long term may actually be an advantage. Second, the penalty decreases over time, and disappears after year 10. Third, it is only logical that the CDC wants to be made whole for any losses on its debentures that financed its loan.
Once the loan proceeds have been advanced, the SBA has no involvement in the borrower’s daily business. Even in the event of a default, the first lienholder may negotiate the major terms of any workout or restructure of the financing without the need for SBA approval.
SBA 504 loans are an often underutilized financing mechanism that should appeal to manufacturers, heavy equipment users, real estate owners and developers, medical practices, and other entities that wish to preserve their working capital.