Helping small firms borrow money - Small Business Administration

Nation's Business, Jan, 1992 by J. Tol Broome, Jr.

Most start-up companies have two things in common: few assets and a high risk of failure. That's why banks will rarely consider extending a conventional commercial loan to a start-up business.

Even companies that have moved from start-up to growth can face difficulty in obtaining such loans. These firms often seek long-term loans against their assets' current value, which might drop over the payback period.

An alternative lending source for both start-up and growth companies unable to obtain conventional loans is the guaranteed-loan program of the Small Business Administration. About 25 percent of SBA-guaranteed loans last year went to new ventures, and most of the balance went to high-growth firms for working capital.

Since its inception in 1953, the Small Business Administration has guaranteed more than 400,000 loans totaling more than $45 billion.

In contrast to the agency's diminishing direct-loan operations, the guaranty system--known as the 7(A) program--is operated in partnership with private-sector lenders. Although the private lender provides the money, the agency guarantees repayment of up to 90 percent if the borrower defaults.

Because the SBA assumes most of the credit risk, lenders who utilize the guaranty program are typically more willing to look at riskier deals than they would be ordinarily.

Flexibility is another advantage of the guaranty program. SBA's guaranteed loans can be extended to finance real estate, machinery and equipment, furniture and fixtures, and working capital, and they even can be used to restructure existing debt.

Moreover, the repayment schedules are generally more liberal than those for conventional commercial loans.

For example, the typical repayment terms of conventional loans for real estate are 10 to 15 years, but the SBA allows up to 25 years under its 7(A) program. The SBA's repayment terms are also more favorable for machinery and equipment (10 years compared with five to seven years) and working capital (seven years compared with two to five years). The longer terms mean lower payments, which are generally more attractive for young or growing businesses.

But before entrepreneurs or would-be entrepreneurs begin to worry about repayment schedules, they must first address some more fundamental matters. The first is whether the business is in fact small.

Eligibility varies according to the type of business or industry, but most guaranteed loans go to firms with fewer than 500 employees and less than $3.5 million in annual sales. A wholesaler is limited to 100 employees, and a retail or service firm may not exceed $3.5 million in annual sales. According to the SBA, 98 percent of all U.S. companies meet its 7(A) program standards.

The second factor that a potential applicant must consider is the cost of an SBA-guaranteed loan. The agency charges a 2 percent guaranty fee for all 7(A) term loans--a fee that is nearly always paid by the borrower (either upfront or financed) in addition to the interest paid to the lender.

While many banks charge origination fees of 0.5 to 1 percent on commercial real-estate loans, there are generally no fees charged on those for equipment or working capital.

About 67 percent of SBA-guaranteed loans are for machinery and equipment or working capital. The median loan is $175,000, and the average guaranty amount is about $150,000. Consequently, the typical SBA borrower pays a fee of $3,000 that probably would not be paid to obtain a conventional commercial loan for the same purpose.

The interest rates charged for 7(A) loans also contribute to higher costs. The SBA imposes maximum rates (prime plus 2 3/4 percent for seven or more years; prime plus 2 1/4 percent for under seven years), but banks typically charge premium rates--within SBA limits--on 7(A) loans, primarily because of the higher risk associated with such loans.

Although the SBA assumes most of the risk, the portion retained by the lender is a factor in setting interest rates. The SBA/lender ratio is 90/10 up to $155,000; 85/15 from $155,001 to $350,000; and 80/20 above $350,000.

And although the rate is negotiable between the bank and the borrower, many lenders are unwilling to forgo the risk factor in setting the interest rate.

The average interest rate charged on an SBA-guaranteed loan is roughly equal to prime plus 2 percentage points, compared with prime plus 1 percentage pointd on conventional loans. For the borrower, willingness to pay the extra interest is often the key to obtaining the loan.

The third factor to consider is the time involved in seeking SBA approval for a guaranteed loan. Once it receives a completed loan application, the SBA generally responds in three to 10 business days, which is comparable to the turnaround time for a conventional commercial loan.

However, preliminary meetings, preparation of financial statements and projections, and filling out the loan application can add weeks or even months to this process. And although the paperwork is not as excessive as some believe (the documentation roughly equals that for a home mortgage), there is still more documentation required for a 7(A) loan than for a conventional commercial loan.