I’ve recently had a few of my SBA business plan clients ask me about the 7(a) loan program and its equity requirements.
Many resources on the internet answer this question very ambiguously, usually saying that business owners need to put in adequate equity to qualify for the program.
If you want to get a loan through the SBA loan programs, you’re going to need to know how much money you need to put in, what’s considered equity, and how to structure your contribution.
What is equity?
Before we get started, it’s essential to understand what I mean by equity.
Often when I ask a client how much equity they’ll be putting in, they tell me how much equity they have in their home.
Though home equity can be helpful if you need collateral, it isn’t what the SBA is looking for when they set minimum equity requirements.
In the case of an SBA loan, equity is how much cash you’ll be putting into the project or purchase.
So, to clarify, if you’re buying a business for $1,000,000, you’re going to need to put some money into the purchase.
Now, there are some different ways this can be structured, and I’ll touch on those a bit later, but you must know, you will need to infuse capital into the project.
How much equity do you need?
So, you know you need to put some of your own funds into your project, but how much?
The SBA provides a precise minimum amount to its participating banks. For the SBA 7(a) loan program, that minimum is 10%.
For start-up businesses, the SBA thinks that a 10% equity infusion into the project cost is the minimum needed for the company to begin its operations on solid financial footing.
For applicants wanting to buy an existing business, the requirement is 10% of the purchase price, or 10% of the total project cost if additional funds beyond the purchase are included in the final use of funds.
If you want to buy out your partner, your equity position after the change in ownership will have to be equal to at least 10% of the total assets of the company.
It’s important to remember that the 10% equity infusion is a minimum, not the amount the particular bank you’re talking to will require.
The SBA provides wiggle room in the amount a bank can ask for, leaving the decision up to the bank based on the business type, management experience, and market competition.
In other words, it depends on how risky the loan is for the bank.
What does the SBA consider as allowable equity?
Okay, now that we know that equity is and how much you need to put into the deal, let’s look at what types the SBA allows.
There are three allowable types of equity for the SBA 7(a) loan program. These are cash, assets other than cash, and standby debt.
Let’s go through each of these.
Cash seems pretty straight forward, and it is, but there are some stipulations.
The SBA standard operating procedure for its participating banks outlines restrictions on the source of the cash. For example, you can’t borrow the money through another business loan.
If you’re thinking about borrowing the funds personally, through a personal line of credit, for example, you can. You’ll just need to prove that that loan will be repaid by income outside of what you earn from the business.
If you have multiple sources of income, this is a great way to meet the equity requirement.
Assets other than cash can also be considered equity. Fixed business assets, such as equipment or property, can be appraised and the value put towards the equity requirement.
Be aware, though, that the appraisal will need to be completed by an independent third party if the value is higher than the net book value of the asset.
So, assets you’ve already bought for the project can be considered equity you’re putting in, as long as you have an outside evaluation.
Finally, standby debt can be considered equity. A great example of this would be a seller’s note.
If you’re buying a business and the seller is willing to hold a note and take a portion of the payment at a later date, you can consider this part of your equity infusion.
Standby Debt: Some Restrictions Apply
There are some stipulations to using standby debt. These pertain to paying the debt, the amount of the debt, and the lien position of the debtholder.
First, the standby debt must be on full standby, hence the name, for the entire length of the SBA guaranteed loan.
This means that the holder of the debt is not paid any interest or principal during the term of the SBA loan.
In addition to the standby requirement, the standby debt must take a subordinate position to the SBA guaranteed loan.
If you can’t pay back the loan and the lenders assume possession of your assets, the bank gets the first right to your assets. The person holding the standby debt, for example, the seller, will get what’s leftover.
Finally, you can’t have a seller’s note equal to the whole 10% equity requirement. The maximum amount of a seller’s note that is acceptable by the SBA is up to half the required equity injection.
Why is equity so significant?
The SBA will have guaranteed between 75% to 85% of the loan amount, and the bank will be on the hook for the remainder. It’s in the bank’s interest to minimize the loan amount and maximize your equity contribution.
Though the SBA has set minimum equity requirements, banks can and do, ask you to put in more than the minimum. In fact, the more equity you put in, the better your chance of getting the loan.
What if you don’t have enough money to put into the deal?
Well, as we’ve seen, if you’re buying a business, you can try to convince the seller to hold a note through the term of the SBA guaranteed loan. Many of my clients have successfully got the seller to keep some debt.
Additionally, you can bring in an investor or partner with the funds. A silent partner or minority owner can put the required equity in the deal, and you can maintain control of the company.
Now that you know the requirements, with a bit of out of the box thinking, you can structure a deal that can get funded without you putting in any of your own money.