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SBA Loans 101: What Small Business Buyers and Sellers Need to Know

While there are misconceptions about Small Business Administration (SBA) loans, it’s important to understand the comprehensive advantages of the government-backed loan program. Some believe that they have a lengthy process and overly strict eligibility requirements. However, these misconceptions usually stem from businesses working with lenders that are not part of the Preferred Lender Program (PLP). Lenders with PLP status have the authority to make final credit decisions, which simplifies and speeds up the loan process.

In reality, SBA loans can benefit small businesses in many ways. In this article we will dive into what an SBA loan is, the top two SBA loan programs, their benefits, SBA rules and the lending process.

Small Business Administration (SBA) Loan Benefits

The purpose of an SBA loan is to make financing accessible for small businesses. The bank makes the loans, but the SBA partially guarantees the debt. This allows the bank to provide credit for borrowers who may otherwise have difficulty obtaining a loan with favorable terms.

SBA loans tend to be borrower-friendly with lower down payments and no collateral needed for some loans, with rates and fees comparable to non-guaranteed loans. Because the government guarantees a portion of SBA loans, small business owners can obtain capital with less equity than conventional loan requirements.

SBA loans also have longer terms with no balloons. For example, a conventional loan may have a 10-year amortization with a balloon in three to five years, while an SBA loan will have an amortization and term of 10 years. The SBA acts like an insurance company, allowing the bank to extend its conventional credit reach.

Because of the government guarantee or lower loan-to-value ratio, the lender can offer more money over a more extended period with better terms than they could otherwise with a non-SBA loan. Typically, lower down payments and smaller monthly payments (due to extended period) benefit the borrower.

Two Main SBA Lending Programs

SBA 7(a) and SBA 504 are the two most common SBA lending programs. They provide many advantages for businesses with less equity that are seeking capital compared to a conventional loan.

There are benefits of SBA loans for both the lender and the borrower. As mentioned, SBA 7(a) loans are attractive to banks because the government covers 75% of the net loss in the case of loan default. The bank is going to use that guarantee to insure against future losses. For 504 loans, the lender has a 50% first mortgage and a lower loan-to-value ratio, which protects the bank against future losses.

What is an SBA 7(a) Loan?

The SBA 7(a) loan is the most common SBA loan product, offering flexibility on terms and business uses. 7(a) funding is for tangible and intangible assets, such as business acquisitions, partner/manager buyouts, expansion through acquisition, real estate purchases, ground-up construction, tenant improvements, refinancing existing business debt and purchasing equipment.

The maximum 7(a) loan amount is $5 million. The interest rate varies based on the daily prime rate plus the lender spread. Common loan terms for SBA 7(a) loans are 10 years maximum for business acquisition without real estate, 15 years maximum for machinery and equipment and 25 years maximum when 51% or more of the loan is allocated to real estate.

There is typically a 10% down payment (except for expansion loans, which can be a 0% down payment), and personal guarantees are required from all owners of 20% or more of the business. In addition, personal assets may be required to meet SBA collateral guidelines.

7(a) loans have many advantages, including up to 90-100% bank financing, minimal collateral requirements, fully amortizing loans with no balloons, no pre-payment penalties for loan terms under fifteen years, and only a three-year pre-payment penalty for loans with a term greater than fifteen years.

This program is a good fit for profitable for-profit businesses in the U.S. with acceptable debt service coverage, good personal credit score, and a two-year average net profit after taxes of up to $5 million.

What is an SBA 504 Loan?

504 funding is for tangible assets, such as capital equipment and real estate. An SBA 504 loan may be a viable option if you're looking to expand, finance building improvements, refinance with an expansion, finance land acquisition, ground-up construction (including soft cost development fees), and purchase commercial real estate or heavy machinery and equipment.

Unlike other SBA loans, three parties are involved in financing each SBA 504 loan — the borrower, the bank, and the SBA-approved certified development company (CDC). The bank loan is 50%, the SBA (CDC) loan (20 to 25-year fixed rate) is 40%, and the borrower's down payment is 10%.

The minimum equity requirement is 10% to 20% (subject to CDC and SBA

approval and based on property use and length of time in business). This low down payment helps you conserve your cash for a rainy day or to invest back in your business. Equipment must have a minimum 10-year economic life. Generally, the project assets being financed are used as collateral, and personal guarantees of the principal owners of 20% or more ownership are required. Also, 51% owner occupancy is required for existing buildings and 60% owner occupancy is required for new construction.

504 loans are a good fit for for-profit businesses operating in the U.S. with strong personal credit looking to finance tangible assets. The project must create or retain jobs or promote other public policy goals.

What SBA Rules Should Borrowers Know?

There are always two sets of policies for SBA loans: the SBA policy (SOP) and the bank policy. SBA SOP provides detailed standard operating procedures by which all banks participating in the program must abide. Bank policy will vary by the institution to reflect their internal credit policy separate from the SBA's SOP. At no point can a bank have an internal policy that conflicts with an SBA policy. The moment that happens, the loan becomes ineligible.

The three most important SBA rules are:

Debt service coverage: a business borrowing the money must be able to demonstrate through historical financials or projections the ability to repay the loan. The loan is not eligible if there's insufficient cash flow to cover the loan payments.
Down payment requirement: this is dependent on project type. Typically, up to 10% equity injection is required to secure a 7(a) loan. 504 loans may require more for special use or start-up businesses.
Collateral: the SBA divides collateral types into two different categories, primary and secondary. Primary collateral is all the fixed assets of the business and any subject real estate being financed.

In secondary collateral, the SBA is looking for real estate in which you own 25% or more equity. Secondary collateral is only required on projects where the loan is not fully secured by primary collateral. The SBA is not saying you must have secondary collateral to do an SBA loan. The SBA is saying if you have it, you must pledge it.

For example, the borrower owns a home worth $400,000. The borrower owes less than $300,000. This property has 25% or more equity. Therefore, SBA would consider that property secondary collateral. However, take that same home worth $400,000, and the borrower owes more than $300,000. The SBA does not require that property to be secondary collateral.

What is the Lending Process for an SBA Loan?

Every loan is unique, and every bank has its own rules and requirements. While this process is a general road map for what our borrowers can expect, it's not guaranteed for every SBA loan. Some deviations from this process may occur.

Step 1: Pre-qual. During pre-qualification, the lender and borrower connect to discuss long-term business goals and current challenges to create a tailored loan package. The borrower must provide all pre-qualification due diligence documents for the lender to review. After review, the lender will issue a letter of interest that states how much the customer is eligible to borrow and outlines the next steps.

(Business sellers can also pre-qualify their business - and many do to appeal to more buyers.)

Step 2: Underwriting. The borrower provides a letter of intent or purchase contract to the lender. Then, the lender reviews the borrower's documents to validate that they have the necessary information to get an approval decision.

Step 3: Credit review. After receiving documents from the borrower, the bank's credit team reviews the loan package to ensure that it aligns with our credit philosophy. Note that it may be somewhat repetitive to the connect/prequalify stage, but the credit team must understand the full scope of the loan. After approval, a formal commitment letter is issued to the borrower.

Step 4: Closing. After the borrower executes the commitment letter, the closing process, affectionately known as the "great paper chase," starts. This is when the lender and borrower are working to gather all the required documents needed to close and fund the loan.

Once the lender has received all closing documents from the borrower, the loan is closed, and the project gets funded. This step will be slightly different if construction is involved in the project. Not surprisingly, SBA lending requires numerous documents and can be tedious for borrowers when the lender is not a specialist.

When considering an SBA loan, seeking out a lender who is part of SBA's Preferred Lender Program is helpful. A PLP lender will know how to determine eligibility and properly structure the loan. PLP status allows the bank to approve the loan without waiting for prior SBA approval, the bank acts on behalf of the SBA.

What You Need to Prepare for an SBA Loan

Every bank has its own rules and requirements. However, the following is what you can likely expect from a PLP lender:

Purpose of the loan
Business background and plan
Business debt schedule
Personal tax returns (three years)
Year-to-date financials
Personal financial statement
Other eligibility information (personal background, character, credit)
Resume
Business tax returns and financials (three years from existing business and/or selling business)
Projections

This information will help the lender understand the owner and the business and determine creditworthiness.

The preferable terms, lack of covenants and lower down payments make SBA loans an excellent choice for small businesses looking to build, buy or expand.