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Inside Advice on SBA Loan Guarantees

Filed under Finance.

Even though your mother always told you that there are no guarantees in life, the Small Business Administration (SBA) nonetheless frequently offers private lenders a guarantee on loans made to qualified small businesses. That means that, if the borrower fails to repay the loan, the lender can usually recover up to 75 or even 80 percent of the outstanding loan principal from the SBA. So if Mom won't co-sign a loan for you, maybe you can get your Uncle Sam to do it.

The government guarantee encourages lenders to grant credit that otherwise would not be available on reasonable terms and conditions by giving them a couple of significant incentives. A federal guarantee not only reduces the lender's risks, but the bank has a readily available secondary market in which to sell the guaranteed portion of the loan. In addition, the guaranteed portion of the loan does not count against the federally mandated reserve funds that banks must maintain as protection against loan losses.

In a nutshell, the major objective of an SBA loan guarantee is to make conventional financing available to a small business that might not otherwise qualify for the loan. Most often, an SBA guarantee is sought when a conventional lender feels that the prospective borrower has insufficient collateral to support the small business loan request. The SBA loan guarantee works as a substitute for the needed collateral and provides the lender with satisfactory security to support the loan.

There are a couple of strings attached. For one, the agency limits the guaranteed portion of the loan to the lesser of $750,000 or 75 percent of the loan amount; for loans of $100,000 or less, the SBA will guarantee 80 percent of the loan. For another, the SBA prefers an owner's equity investment of at least 25 percent of the total cost of the project. While no fixed legal requirement actually exists, the SBA (and the lender) want proof that you won't walk away from your business at the first sign of trouble.

Nonetheless, you should also be aware that the specific amount of an owner's investment can often be negotiated so that a lesser percentage of financing may come from the owner. The stated basis for granting an SBA loan guarantee is the borrower's character, credit, experience and proof of a sufficient commitment to the business. Weaknesses in one area may be balanced by strengths in another area.

Another string is the concern about adequate collateral. The SBA states that a guarantee will not be denied merely because of inadequate collateral; however, in most instances, the private lender will still demand collateral, and the SBA's guarantee of an under-collateralized loan will be extended only if the business shows other favorable factors (e.g., solid cash flow) to support the creditworthiness of the borrower.

The most important consideration for the SBA is whether the loan is collateralized to the maximum capability of the individual business owner. An owner who has valuable personal assets may be requested to pledge those assets as security on the business loan before the SBA agrees to guarantee the loan.

Unlike some of the other requirements, a personal guarantee by all owners having at least a 20 percent interest in the company is usually non-negotiable. This is one string you're just going to have to live with.

Sometimes the loan will cost a little more. A private lender can charge a slightly higher interest rate for an SBA-guaranteed loan than for a similar conventional loan. The SBA continues to put a maximum cap on the interest rate and prohibits extraneous fees. On loans for less than seven years, the rate cannot exceed 2.25 percent above the New York bank (Wall Street Journal) prime rate. For loans with maturities of seven years or longer, the rate cannot be more than 2.75 percent above the prime rate as reported in the Wall Street Journal.

To encourage banks to make relatively small loans to small businesses, an extra interest point (up to 3.75 percent over WSJ prime) can be charged for loans between $25,000 and $50,000, and an extra 2 points (up to 4.75 percent over WSJ prime) can be assessed for loans under $25,000. If a floating rate is used by the lender, the rate can be adjusted periodically, pursuant to the guarantee agreement with the SBA; however, the spread between an adjusted rate and the WSJ prime cannot be increased. In addition, the SBA's guarantee fee (2 percent to 3.875 percent of the loan amount) can also be passed on to (ouch!) the borrower.

However, while these additional costs may sometimes make an SBA-guaranteed loan more expensive than a conventional loan, you must also consider several counterbalancing factors. First, if the bank were to make the loan without the SBA guarantee, the lender might assess additional upfront points because of the higher risk; these points could equal the SBA guarantee fee. In contrast, SBA loans prohibit any points from being assessed in addition to the guarantee fee. Moreover, because of the SBA guarantee, many small businesses obtain a longer loan maturity term than they could otherwise obtain from a conventional loan.

Most small businesses have considerable difficulty obtaining long-term financing, because small business lending is so risky. One of the significant benefits of an SBA loan guarantee is that the government's backing will often support a longer-term loan. Instead of three- to five-year maximums on conventional bank loans for a small business, the SBA guarantee commonly covers loans up to 10 years, and some real estate loans have maturities up to 25 years. These longer terms provide much needed cash flow consistency so vital to a small business.

To be eligible for an SBA loan guarantee, a business must meet all of the following criteria:

  • be small enough to fit SBA's criteria
  • be a type of business acceptable to the SBA
  • be for-profit
  • be independently owned and operated
  • not be dominant in its industry
  • have applied for, and been denied, a conventional loan by a private lender

But consider this: If at least two conventional lenders have denied your loan application, you may want to rethink, or rework, your business plans. Try to assess whether the denials are based upon factors that you can realistically overcome if your business gets going or whether adjustments in your plans are necessary.

Posted September 2, 1998.

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