When it comes to the SBA’s credit standards for SBA 7(a) loans, lenders (for PLP loans) or SBA (for non-delegated loans) must determine that there is sufficient invested equity. SOP 50 10 8.1 sets forth minimum equity injection requirements for Start-Up Businesses, as well as the various Change of Ownership transactions (Initial Acquisition, Business Expansion, Existing Owner Buyout, Partial Change of Owner, ESOP & Cooperatives).
In addition to the amount of invested equity, lenders must document the source(s) of the equity injection to ensure that the equity injection is allowable. For purposes of SOP 5010 8.1, the following may be considered equity injection.
- Standby Agreements – only debt that is on full standby (no payments of principal or interest for the term of the 7(a) loan) may be considered as equity for SBA’s purposes. Lender must use SBA Form 155 or its own equivalent Standby Agreement form, and a copy of the note must be attached to the standby agreement. The standby debt may accrue interest and may be added to the standby debt and amortized after the 7(a) loan is paid in full. Standby Creditor must subordinate any lien rights in collateral securing the loan to Lender’s rights in the collateral and take no action against Borrower or any collateral securing the Standby Debt without Lender’s consent.
- Cash that is not borrowed, whether on the business’s balance sheet or from other sources.
- Cash that comes from a personal loan where repayment can be demonstrated to come from a source other than the cash flow of the business (the salary paid to the owner by the business does not qualify).
- Grants that do not have repayment or claw back provisions during the life of the 7(a) loan.
- Assets other than cash – An appraisal or other valuation by an independent third party is required if the valuation of the fixed assets is greater than the Net Book Value. A valuation of the fixed assets provided as part of a business valuation will not meet these requirements.
- Eligible prepaid expenses that the Lender has verified by obtaining paid invoices, canceled checks, or bank statements. Lender must retain copies of the documentation in the loan file.
- Expenses related to education, advisory services, or fees paid by the Applicant to an Agent are not eligible prepaid expenses and are not considered equity.
- An equity investment not subject to an agreement to repay equity or make distributions to recover an investor’s investment prior to release of the guaranty. Note: SBA considers any investment subject to an agreement to repay equity or make distributions to recover an investor’s investment prior to release of the guaranty (e.g., certain types of redeemable preferred stock) to be debt and not equity.
Specifically, for purposes of Changes of Ownership under SOP 50 10 8.1, Appendix 15, lenders must also confirm whether the source(s) of equity injection is/are “unlimited” or “limited”.
Unlimited Equity Injection Sources:
- Cash that is not borrowed, whether on the business’s balance sheet or from other sources.
- Cash that comes from a personal loan to a guarantor where repayment can be demonstrated to come from a source other than the cash flow of the business (the salary paid to the owner by the business does not qualify).
- Grants that do not have any conditional repayment requirements, claw backs, or any other provision that could require the repayment of the grant during the term of the 7(a) loan.
Limited Equity Injection Sources:
The following sources, whether individually or in the aggregate, may provide no more than half of the required Equity Injection.
Additional Limited Equity Sources may be used when additional funds are required to supplement the purchase when the sales price exceeds the value supported by the Business Valuation and Quality of Earnings report. In this situation, any additional funds provided must be on full standby.
- Standby Debt Agreements:
- Debt that is on full standby (no payments of principal or interest for the term of the 7(a) loan) may be considered as equity for SBA’s purposes. Lender must use SBA Form 155 or its own equivalent Standby Agreement form, and a copy of the Note must be attached to the standby agreement and included in the credit file.
- The standby debt may accrue interest and may be added to the standby debt and amortized after the 7(a) loan is paid in full. Standby Creditor must subordinate any lien rights in collateral securing the loan to Lender’s rights in the collateral and take no action against Borrower or any collateral securing the Standby Debt without Lender’s consent.
- The provider of standby debt may not take an equity investment in the business.
- Seller Debt:
- Seller debt that is subordinated to the Lender and on full standby (no payments of principal or interest for the term of the 7(a) loan) may be considered as equity for SBA’s purposes.
- Seller debt structured in conjunction with a 7(a) change of ownership transaction is eligible to be refinanced after it has been in place and current for 36 months.
- Non-controlling Minority Equity Investments
- To be considered as eligible equity, the investment may not be subject to any agreement to repay or make distributions to recover the investment prior to release of the SBA guaranty. To qualify as a Non-controlling Minority Equity Investor, the investor must have less than 20% equity in and exert no control over the operating business.
- The Lender must review and document the terms of all equity investments, including provisions that are realized upon the sale of the business, in their credit memorandum as part of their underwriting requirements.
- When Equity Investments are used to meet the equity injection requirements, distributions to the investor that are not made solely for the purpose of satisfying the investor’s tax obligations attributable to the business’s income are prohibited until the 7(a) loan has been paid off.
- Additional Equity Investments that are not used to meet the equity injection requirements, such as those providing additional liquidity, may receive standard distributions subject to any agreements of the Lender. The Lender may require inclusion of covenants such as DSC into investor agreements, or include DSC covenants into the loan agreement, to ensure that the business has sufficient cash flow to make distributions beyond tax purposes.
Lenders must include in the credit memorandum a detailed discussion of the equity position (net worth) and any required equity injection. Additionally, lenders must verify the SBA-required equity injection prior to disbursing any loan proceeds and must maintain evidence of such verification in their loan files