Last week, in response to popular demand, I discussed one of the two major types of SBA loan: the Section 7(a) Loan (if you missed it, click here. This week, I wanted to finish the discussion of SBA programs by talking about the other popular SBA loan program, the Section 504 Loan.
The Section 504 Loan is limited to very specific corporate purposes. The loan funds can only be used to acquire major fixed assets for expansion and modernization, such as purchasing land and improvements, construction of new facilities or modernizing obsolete facilities, or purchasing long term machinery or equipment. For these reasons, the 504 Loan is less likely to be the right loan for a startup company.
A 504 Loan is really two separate loans involving two lenders, but it’s treated as a single transaction and both loans are closed at the same time. One of the lenders is a bank, which takes the 1st lien position and lends up to 50% of the loan amount. The other lender is a Certified Development Company (or CDC for short), which is usually a nonprofit or local governmental economic development entity. The CDC takes the 2nd lien position and lends up to 40% of the loan amount. Each lender’s loan will be secured by the assets being acquired. The SBA’s role, as in the 7(a) Loan, is to act as a guarantor. Here, the SBA guarantees 100% of the 2nd lienholder’s loan, but doesn’t provide any guarantee to the bank (the 1st lienholder). The theory behind this guarantee structure is that the bank has greater security for its portion of the loan via its 1st lien position on the assets being acquired and therefore doesn’t need the SBA’s guarantee.
Additionally, the principal owners of the business are required to provide personal guarantees to both lenders (are you willing to pledge your house, car, savings, etc. for your business loan?). And since the 504 loan only covers 90% of the financing (50% loaned by the bank and 40% loaned by the CDC), the company must contribute 10% of its own money in order to be eligible for the loan. Thus, the increased likelihood that the 504 Loan is not going to be the right loan for a startup.
So, again, we come full circle to the difficulty of obtaining bank financing and the “theoretical” nature of SBA loans. The 7(a) loan can be difficult enough to qualify for, but in the case of the 504 loan, the company actually has to come up with 10% of its own money, provide personal guarantees, and provide liens on its equipment and real estate to the lenders. Plus satisfy the underwriting standards of the bank and the CDC.
Now that I’ve touched on the main SBA loan programs, I think it’s important to point out that no bank is required to make an SBA loan. Banks are still free to reject any SBA loan application based on their own lending and underwriting standards, even though the loan would be partially guaranteed by the SBA. In addition to all this, there are also eligibility factors that businesses must meet in order to qualify for any SBA financing. I’ve represented many regional and national banks in lending transactions, so I’ve usually got a pretty good idea which lenders are most likely to make SBA loans. It’s probably worth a discussion if you’re interested in exploring SBA financing.
Let me add here that I am not trying to discourage any business from applying for an SBA loan. I’m merely trying to illustrate what’s involved in the process, provide some details as to how these loans are structured, and perhaps stimulate some thought by business owners and clients. I think the SBA program can be a wonderful tool where a business can meet the lender’s and the SBA’s credit and eligibility criteria. I encourage my clients to apply for SBA financing if they meet those criteria, and I am more than happy to help present my clients’ applications in the best possible light.
Finally, let me briefly mention a couple of other SBA initiatives that are geared towards small business: the SBIC program, which is a venture capital program sponsored by the SBA, and the SBG program, which is a surety bond program geared towards construction and contracting firms (SBG stands for Surety Bond Guarantee).
A few words about the SBG program: under this program, the SBA will guarantee a certain percentage of a surety bond where the contractor cannot get the bond issued through ordinary channels (and frequently, new or startup contracting businesses will have trouble obtaining surety bonds). This gives sureties an incentive to issue surety bonds in situations where they might not otherwise have done so. Which in turn gives startup construction businesses greater access to contracting opportunities. Theoretically, of course.
Next week, I’m going to discuss one more possible (and sometimes overlooked) way to finance your startup or business, which will conclude what I have to say about the legal aspects related to financing your company.