The Small Business Administration (SBA) recently released an update to its Standard Operating Procedures, (SOP) 50 10 5(J), effective January 1, 2018. The SOP establishes the SBA’s procedures for supervision of and enforcement actions for SBA’s 7(a) Lenders, Certified Development Companies (CDCs), and Microloan Intermediaries as it relates to their SBA lending operations.
This article is the first in a series of articles outlining the major changes Innovative Financing Solutions believes Lenders and Borrowers should be keenly aware of when utilizing an SBA loan for their financing needs.
The following article highlights selected revisions in the new 410-page SOP 50 10 5(J) document, covering:
- Minimum Equity Injections
- Eligible Passive Company Rule
- Personal and Corporate Guarantees
- Express Loan Maturities and Default Provisions
Minimum Equity Injections
Previously, the SBA did not require a minimum equity injection from the Borrower and allowed the Lender to use prudent business judgement as to whether the pro forma debt to worth ratio was acceptable based on competition, management experience, and cash flow. However, this will change under the new SOP. Under the new guidelines, a minimum equity injection is required for loans to start-up businesses and in cases where there is a change in ownership between existing owners.
- Start-Up Businesses – At minimum, the SBA now requires an equity injection (from the applicant) of at least 10 percent of the total project for a start-up business to operate on a sound financial basis.
- In cases where there is a change in ownership resulting in a new owner, the SBA requires an equity injection of at least 10 percent of the total project. Seller debt may not be considered as part of the equity injection unless it is on full standby for the life of the SBA loan and it does not exceed half of the required equity injection.
- Change of ownership between existing owners (“partner buyout”): Under the new guidelines, the pro-forma equity position after the change of ownership must be at least 10 percent of the total assets. Otherwise, the remaining owner(s) must provide an additional equity injection that will result in at least a 10 percent net worth.
Eligible Passive Company (EPC) Rule
The Eligible Passive Company (EPC) Rule is an exception to SBA regulations that prohibit financing assets held for passive income. An EPC must use the loan proceeds only to acquire or lease, and/or improve or renovate, real or personal property that it leases to one or more Operating Companies (OCs) for conducting the OC’s business.
The most significant change to the EPC rule under the newly revised SOP is that an EPC may use loan proceeds to finance a change of ownership between existing owners when the real estate has been held by the selling owner(s) for a minimum of 36 months. With the exception of a change of ownership between existing owners of the EPC, an EPC may not otherwise use loan proceeds to acquire a business, acquire stock in a business or any intangible assets of a business, or to refinance debt that was incurred for those purposes.
Conditions that continue to apply to all EPCs include: The OC must be an eligible small business; the proposed use of proceeds must be an eligible use as if the OC was obtaining the financing directly; the EPC and the OC each must be small under the established appropriate size standard; the EPC must lease the project property directly to the OC; the OC must be a guarantor or a co-borrower on the loan; the OC must be a co-borrower if it receives any loan proceeds as working capital and/or for the purchase of other assets, including intangible assets, for the OC’s use.
Personal and Corporate Guarantees
Previous versions of the SOP generally required Personal and Corporate Guarantees by individuals or entities with 20% or more ownership in the applicant business in addition to any spouse owning less than 20% when the combined ownership of both spouses is 20% or more.
The SBA has since expanded the requirement to provide the option to a SBA or a Preferred SBA Lender to require other appropriate individuals or entities to guarantee without regard to ownership interest, if any. For example, an individual subject to this requirement may be a minority-owner or non-owner officer critical to the day-to-day operations of the business. An entity may be a closely held entity that manages the day-to-day operations through a management agreement.
While it is a prudent lending practice to require key individuals or entities critical to the business operations to guarantee, this new requirement offers the opportunity for a ‘surprise’ guarantee requirement deep into the loan application process; particularly for GP Lenders submitting applications to SBA for approval.
To avoid catching a Borrower off-guard late in the process, Lenders should closely analyze the management team, affiliate relationships, and management agreements of all new applicants to detect possible individuals or entities subject to this loosely defined new guarantee provision. The Borrower should then be informed early on that SBA may request a limited or unlimited guarantee of these individuals or entities upon application submission.
SBA Express Loan Maturities and Default Provisions
The SBA Express program provides a reduced 50% SBA guaranty (opposed to the typical 75% guaranty) to allow participating Lenders to substantially follow their internal policies and procedures for similar sized non-SBA loans. Lender’s still must follow certain SBA structural and eligibility provisions specific to the Express Loan program and all SBA Loan Programs. In the new SOP, the SBA has adjusted SBA Express Line of Credit (LOC) term/maturity requirements to minimize the opportunity for guaranty purchase situations created by a fully advanced line at the time of maturity. In addition, SBA has provided Express Lenders the opportunity to use non-financial default provisions to enforce loan conditions under certain circumstances.
- LOCs may revolve for no longer than 60 months, with a term out period of up to an additional 60 months, for a total term of 120 months. And, under no circumstances may there be any advances after the initial 60 month period. Additionally, the term out period must not be shorter than the revolving period.
- Under certain conditions, Express Lenders may now utilize non-financial default provisions to enforce violations of loan conditions. Key conditions to use non-financial default provisions include: 1) the provisions must be substantive and agreed to by the Borrower in writing at closing; 2) they must be consistent with those used by the Lender on similarly sized non-SBA loans; 3) a guaranty purchase request may not be submitted solely based on a non-financial default; and 4) a line of credit with a maturity date may be payable upon demand under certain conditions, but in no case later than a certain date.
These are just a few of the many changes going into effect on January 1, 2018. In future articles, we will cover additional SOP revisions including Franchise Affiliation, SBA Form 912 Clearance Procedures, Change of Ownership, Credit Underwriting Standards and much more. In the interim, we encourage you to contact the experts at Innovative Financing Solutions for guidance on your SBA lending needs.