The Ins and Outs of SBA Loans

The Small Business Administration (SBA) loan program is perhaps one of the best heard of but most misunderstood ways to borrow money out there. The SBA loan program was started as a way for the federal government to encourage traditional lenders to lend money to small businesses that traditionally may not get a loan or a loan at much higher interest rates.

Here’s an overview of what SBA loans are all about:

• The Same Guidelines. All banks follow the same lender guidelines provided by the SBA to provide SBA loans. There is no such thing as a SBA loan “specialist”. The program is all under equal footing and follows the same guidelines.
• No Extra Risk. Banks are not supposed to accept any special or extra “risk” in providing a SBA loan as they would any other loan. In other words, the bank isn’t supposed to act like a VC firm in providing money. As a matter of fact, “gambling” with SBA loan monies could land the bank executives in jail. Also, the Fed doesn’t backstop all the financial loss for the bank.
• Small Businesses Welcome, Startups No So Much. In almost all circumstances (with rare exceptions) you’ll need an existing business that is post revenue (you actually have paying customers) and most likely cash flow positive (you’re making profits). This is going to rule out most startups.
• Growth Focus. SBA loan programs are mostly focused on providing growth capital. This is generally and broadly defined. This can include facility expansion, increases in inventory, machinery purchases and small acquisitions. This is not intended to help you “cash out” money from an existing business although I do know two partners in a business that used a SBA loan to buy out their third partner.
• Personal Guarantees. Personal guarantees on the loan will be required. The bank will look at your personal credit scores. The bank will also require owners of the business to sign personal guarantees of repayment. An owner will generally be defined as someone with 20 percent or more equity in the business. So minor equity holders generally won’t sign personally for the loan.
• Limits on Personal Guarantees. Personal guarantees are in place so you take the loan repayments seriously and don’t consider closing the business to get out of paying the loan. The personal guarantee could put all your personal assets at risk of possession by the bank. In reality the chances are low the bank will pursue anything but real estate you own. They aren’t an auction business. Even in that case, your personal home has percentage limits they can pursue. This is called homesteading laws. Homesteading laws put a limit based on the laws of your state in how much of your home equity the bank can pursue. For example, in California banks have a sliding scale of equity possession based on your age. The older you are, the less of the home value they can claim.
• Short and Long Terms. Loans can have all sorts of different terms (lengths) to pay back. You can get 5, 10 or 20 year loans. There can be all sorts of variations on the loan such as balloon payments or early buy out periods. If you amortize a loan over a long period (20 years) the monthly payments can get quite small BUT remember the total amount paid back at the end of 20 years is higher.
• Magic Ratio = 1.2 In general, banks want to see a minimum ratio of 1.2 in free available cash flow in your business to the amount of the loan payment. A higher ratio is better from the bank’s standpoint. That means if your loan requires $1,000 monthly payments they want to see a financial history that shows at least $1,200 in free cash monthly in your business to make these payments.
• Skin in the Game. The bank wants to see you have “skin in the game”. That means they want to see the business is putting in at least 20% of the money required for the project you want a loan on. For example, let’s say you want to buy a new manufacturing machine. The machine costs $500,000. The bank would like to see you taking out a loan for 80% - $400,000 and putting in the remaining 20%. The bank doesn’t really care is the money goes in upfront or later. The bank is also not going to pursue the other cash invested by your company once the loan is completed. A way to play this, for example, is to lay out your machine project as follows. You need $500,000 for the purchase of a new machine. You lay out an additional $50,000 cost for installation and $50,000 for the integration into your existing manufacturing and logistics processes. So instead of $500,000 you have a project that requires $600,000. You tell the bank you’re looking for a loan of $500,000 and you’ll be investing the $100,000 for the installation and integration of the machine. Now whether you spend that as hard dollars or not is up to you.
• Startups Need Strong Financial Commitment and Strong Story. Startups can get SBA loans but they need certain circumstances. I know of a startup creating a plant to create food proteins from vegetation. The overall project will be $8.5 million. He was able to secure a $5 million SBA loan BUT he had $3.5 million already invested into the project. He also had a full business plan, partnership agreements and financials. His own financial commitment showed the bank he had “skin in the game” and strong business opportunity enough to secure the loan.
• Preparing for the Loan App. In pursuing a SBA loan you’ll need an executive summary that explains your business, your opportunity and the use of funds. Keep the business information simple. You aren’t pitching a VC. You shouldn’t be complicated or too “rah, rah”. You are plainly explaining your business and how the loan money will help you grow revenue. You’ll also need to provide cash flow summaries to show you can pay back the loan. The bank will have you fill out an application and then will ask for a lot of extra information including tax filings, cash flow statements, balance sheets, incorporation documents, etc.
• Timing. You can expect that fast in securing a SBA loan is 1 month and long is 3 months. So count on 2 months being the average time to get money.
• Rates. Currently SBA loan interest rates are running 5-10% annual interest rates on average. A bank will use loan underwriters like any other larger loan. This is not unlike securing a home mortgage.
• The Bank Will Restrict Certain Business Activities. The SBA loan will have lots of loan covenants, rules you must follow. Most SBA loans will have a financial penalty for paying off the loan in full sooner than 5 years. This is usually on a sliding scale. The bank will hold a lien position on your business. The bank will have rights of permission to allow you to take on more debt. You need a second loan? They can say no you can’t get it. The bank can also put a limit on how much of the business equity you can sell. So you want to sell half your business? You’ll need bank permission. There can be lots of other limiters. You should ask the bank upfront what covenants are typically on their loans so you understand this early. You may not like them and not pursue the loan.