What does the SBA expect in return for a 75% loan guaranty? a series designed to help lenders finance a change of ownership

RMA Journal, The, Sept, 2002 by Garry Barnes

Because SBA lending is highly specialized and volume driven, many banks are not as familiar with this source of funds for financing change of ownership. Here's an overview.

Almost 98% of the 28 million businesses in operation throughout the U.S. are classified as "small business." Interestingly, if not surprisingly, small businesses produce twice as many products and other innovations as large firms, employ 53% of the private-sector workforce, and can take credit for 50% of the private gross domestic product.

But now, to quote Paul Harvey, for "the rest of the story." Business failures and bankruptcies are at an all-time high; some studies indicate one out of every two new small businesses will fail at some point early on, and the majority of small businesses will fail within five years. Most fail because they lack management and financial skills, but to where does a small businessperson turn for advice and counsel? Obvious sources--certified public accountants, lawyers, or business consultants--don't come cheap, and if a businessperson has to meet payroll or hire an outside consultant, payroll will generally win out.

One source of expert advice that comes at little cost is the U.S. Small Business Administration. congress created the SBA in 1953 to stimulate economic development. Through 70 field offices, the SBA helps new businesses get started, assists more established businesses as they grow, and also assists in financing change of ownership. Although SBA offers a variety of financial services, this article addresses the 7(a) loan program.

The SBA has specific eligibility standards. "Normally, most for-profit businesses are eligible," says Robert Blaney, Arizona District Director. "However, there are some exceptions. For instance, financial (lending) and investment businesses, religious and charitable organizations, and businesses that are engaged in gambling or prurient interests would not be eligible in most cases."

The complete SBA loan guaranty lending standards can be found in the Standard Operating Procedures (SOP-1502), available directly from the SBA or on its Web site, www.sba.gov. The requirements must be fully understood and followed precisely. The following is only a summary of the program and should not be relied upon as a lending guide.

Who Qualifies?

Most independently owned and operated for-profit businesses will qualify, as will individuals and companies with good credit histories. Borrowers must, however, meet specific size standards based on number of employees or gross revenue. The following is a summary of the size qualifications by industry:

* 500 employees for most manufacturing and mining industries.

* 100 employees for all wholesale trade industries.

* $5 million for most retail and service industries.

* $27.5 million for most general and heavy construction industries.

* $11.5 million for all special trade contractors.

* $0.75 million for most agricultural industries. (1)

The above condensed size guidelines are an extract from the SBA Web site. The SBA replaced the Standard Industrial Classifications (SIC) with the new system called the North American Industrial Classification System (NAICS). For a more detailed explanation of size standards, refer to the SBA Web site or contact the nearest SBA field office.

Credit Criteria

Character, reputation, and credit history of borrower as well as experience and depth of management are all important considerations. Other credit considerations should be based on past earnings, projected cash flow, and future earnings potential of the borrower, who must have sufficient equity invested to operate on a sound financial basis. The lender must understand the nature and value of the collateral.

Loans may be used to:

* Purchase fixed assets.

* Purchase existing/new owner-occupied commercial buildings.

* Refinance certain outstanding business debts.

* Purchase an existing business (change of ownership).

Repayment terms:

* Working capital--generally, three to seven years.

* Equipment/fixtures--usually, seven to 10 years.

* Owner-occupied commercial real estate--up to 25 years.

Loan Structure

Interest rates for loans are generally based on the borrowers financial condition. The maximum loan amount is $2 million. The SBA guaranty covers:

* 85% on loans of $150,000 or less.

* 75% on loans in excess of $150,000, up to a maximum of $1 million.

Monthly installments of principal and interest are fully amortized. Prepayment penalties are 5% for the first year, 3% for the second year, and 1% for the third year, applying to loan terms of 15 years or longer. Personal guaranties are required if the principal owns 20% or more of the business.

Financing a Business

Lenders see many risks associated with change-of-ownership financing and are particularly concerned with the goodwill portion of the transaction. Since goodwill is not considered tangible collateral, the SBA has attempted to structure funding procedures that will afford a degree of added safety to the buyer and lender.

The SBA requirements for change-of-ownership transactions are rather detailed and complex, but can be summarized as follows: