Small Business Administration Business and Disaster Loans

By Henry Wichmann, Jr., and D.J. Kilpatrick

In Brief

Finding the Right Financial Solution

The Small Business Administration (SBA) has developed a wide variety of programs to help small businesses get started, expand, and deal with unexpected events, such as natural disasters. The authors describe four of the SBA’s 17 current business loan programs and give an overview of the SBA’s disaster loan programs. SBA disaster loans are not limited to the owners of small businesses, and large businesses as well as individuals who do not own a business may be eligible. The authors also discuss eligibility and feasibility criteria for SBA small business loans, information to include in SBA loan applications, and how to develop a business plan.

The Small Business Act of 1953 created the Small Business Administration (SBA) to “aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns.” SBA-guaranteed loans are an excellent source of financial assistance for small companies. If the owner-manager of a small business represents an unacceptable credit risk for a private-sector lender such as a local commercial bank, the lender may apply for a SBA-guaranteed loan.

Rather than provide direct funding to small businesses, the SBA provides guarantees for major portions of loans made by SBA-qualified private-sector lenders (typically commercial banks, called lending partners) to small businesses. This arrangement is beneficial in a number of respects. First, the small business benefits by being able to obtain financing it could not receive otherwise. Second, the SBA does not have to lay out large amounts of cash. Finally, the bank can sell the guaranteed portion of the loan on the secondary market, providing liquidity while generating profits from the new customer base.

The SBA’s four main business loan programs are—

The Exhibit summarizes the major SBA business and disaster loan programs.

7(a) Loan Guaranty Program

The SBA’s primary financial assistance program is the 7(a) Loan Guaranty Program. Others include the SBA LowDoc Program, SBA Express, SBA Export Express, CAPLines Program, International Trade Loan Program, and Export Working Capital Loan Program. Information on these other programs is available at www.sba.gov.

Businesses can use 7(a) guaranty loans for most legitimate business purposes, such as the purchase of real estate to house business operations; construction, renovation, or leasehold improvements; acquisition of furniture, fixtures, machinery, and equipment; purchase of inventory; and working capital.

Loan and guaranty caps. The SBA guaranty can be obtained for small or large loans. The SBA can guaranty up to 85% percent of small loans (up to $150,000). The SBA can guaranty up to 75% percent of large loans (more than $150,000 and generally no more than $2 million), with the maximum guaranty generally not exceeding $1 million.

Interest rates and fees. Interest rates on SBA-guaranteed loans may be lower than conventional bank loans for comparable risks. Both variable and fixed interest rates are available, and most loans have variable interest rates that are pegged to either the lowest prime rate or the SBA optional peg rate. Variable rates are adjusted on a consistent basis (e.g., monthly, quarterly, or annually). Specific terms are negotiated between the lending partner and the small business. Maximum fixed interest rates are pegged to the prime lending rate. Fixed interest rates for loans of $50,000 or less may not exceed prime plus 2.25% for loans that mature in less than seven years or prime plus 2.75% for loans that mature in seven or more years. Higher maximum fixed interest rates apply to loans under $50,000.

The SBA charges the lender a one-time guaranty fee of 2% to 3.5%, depending on the size of the loan. In addition to the interest and guaranty fee, the SBA charges an ongoing annualized servicing fee of 50 basis points (0.5%) that is applied to the outstanding balance of the SBA’s guaranteed portion of the loan. Both of these fees may be passed on to the borrower. In some cases, borrowers of loans processed after December 22, 2000, are subject to prepayment charges if they elect to prepay the loan. Certain other fees, such as origination fees, processing fees, and application fees, are not permitted on 7(a) loans.

On January 10, 2002, President Bush signed the Supplementary Terrorist Activity Relief: The Defense Appropriation Act, which reduces the ongoing fee charged to the lender on new 7(a) loans made to small businesses that were adversely affected by the September 11 terrorist attacks and their aftermath.

Terms. The 7(a) program has a maximum term of 25 years for fixed-asset loans; working capital loans are generally limited to seven years. The actual terms for a loan are determined on a case-by-case basis.

Eligibility. An eligible small business must be independently owned and operated and not dominant in its field. It must also have a profit motive and conform to the SBA’s size standards. This definition varies by industry, but most businesses meet the SBA’s size standards. In general, a small business is defined as follows:

Effective February 22, 2002, all revenue-based size standards were adjusted upward by 15.8%. The SBA has further eligibility criteria based on the nature of the business and the use to be made of the borrowed funds. For example, the funds cannot be used to encourage monopoly, speculation, gambling, multilevel sales, or businesses primarily involved in rentals.

SBA Microloans

The SBA Microloan Program provides small loans to start-up, newly established, or growing small businesses through nonprofit community-based lenders, called intermediaries. The intermediaries process loan applications, make all credit decisions, and are required by the program to provide business-based training and technical assistance to borrowers. Sometimes a potential borrower must fulfill mandatory training or planning requirements before the SBA will consider its loan application.

Microloans can be used to buy machinery and equipment, furniture and fixtures, inventory, supplies, and for working capital. Microloans may not be used to pay existing debt.

Loan amounts, interest rates, and terms. Microloans are subject to a $35,000 maximum, and the average loan size is approximately $10,500. Microloan terms vary based on the intended use of the funds, size of the loan, and needs of the borrower. The allowable maximum term is six years. Interest rates vary depending on the intermediaries and their costs. Intermediaries generally require some collateral and the personal guarantee of the borrower.

Certified Development Company (504) Loan Program

Certified development companies (CDC) are nonprofit corporations that contribute to the economic development of their communities. The United States currently has approximately 270 CDCs, each covering a specific geographic area. Under the SBA’s CDC (504) Program, a CDC works with the SBA and private-sector lenders to provide long-term, fixed-rate financing to growing companies so that they can acquire major fixed assets. CDC program loans are granted for job creation and retention purposes, to help meet community development goals, or to meet a public policy goal.

Under this program, a private-sector lender, the CDC, and the owner-manager of the small business share the financing of fixed assets. The private-sector lender makes a loan at its rates for up to 50% of the small business project, taking a first-lien position on all collateral. The CDC makes a loan covering up to 40% of the cost (backed by a 100% SBA-guaranteed debenture). Funding for at least 10% of the project’s cost must come from the small business itself.

A business that receives a CDC loan must use it for fixed asset projects such as purchasing land and improvements, including existing buildings, grading, street improvements, utilities, parking lots, and landscaping; construction of new facilities or modernizing, renovating, or converting existing facilities; or purchasing long-term machinery and equipment. A business cannot use a CDC loan for working capital, inventory, consolidating or repaying debt, or refinancing.

Loan and guaranty caps. If the CDC loan is for job creation and retention purposes or to meet a community development goal, the maximum SBA debenture is $1 million. To meet job creation and retention criteria, the borrowing business generally must create or retain one job for each $35,000 provided by the SBA. If the CDC loan is for the purposes of meeting a public policy goal, the maximum SBA debenture is $1.3 million. Public policy goals include business district revitalization, expansion of exports, expansion of minority business development, rural development, restructuring because of federally mandated standards or policies, changes necessitated by federal budget cutbacks, and expansion of small businesses owned and controlled by veterans or women. Although SBA participation in CDC projects is limited, the projects may be unlimited in size because of local participation.

Terms, interest rates, and fees. Loans under the CDC program are long-term in nature. Maturities of 10 and 20 years are available. Interest rates are pegged to an increment above the current market rate of U.S. Treasury issues. Fees are about 3% of the debenture and may be financed with the loan. Collateral is normally made up of the project assets being financed. The principal owners are required to provide personal guaranties.

Eligibility. Eligible businesses must be operated for profit and follow the same size standards as 7(a) Guaranty Loans. In addition, under CDC program guidelines, a business qualifies as small if it does not have a tangible net worth in excess of $6 million, including affiliates, and does not have an average net income in excess of $2 million after taxes for the preceding two years. Speculative ventures or investments in rental real estate are ineligible. The majority of CDC loans are to existing businesses; however, new businesses may receive loans to buy real estate and equipment.

Small Business Investment Company Program

The SBIC program was created in 1958 to fill the need for venture capital by small firms in start-up and growth situations. The purpose of the SBIC program is to assist SBA-licensed business investment companies, which, in turn, provide equity capital by making long-term loans and supplying advisory services to small firms.

SBICs are privately owned and managed investment firms that use their own capital, plus funds borrowed with an SBA guarantee, to make venture capital investments. All SBICs are for-profit businesses. A corporation, limited partnership, or limited liability company may apply to the SBA for an SBIC license.

Financing available. SBICs must provide equity capital to small companies, and may do so by purchasing equity securities. The SBIC may not control the small business, either directly or indirectly, on a permanent basis and may not violate conflict-of-interest criteria established by the SBA.

SBICs may also make long-term loans to small firms to provide sound financing and growth potential. Loan terms are limited to 20 years. Loans and debts purchased as securities from small firms, however, should have a minimum term of five years. Reasonable penalties may be applied for prepayments of a loan. Interest rates are determined by the SBIC.

Eligibility. The SBIC program makes funding available to all types of manufacturing and service industries. Individual SBICs may choose to specialize in fields in which their management has expertise.

Disaster Loan Programs

Even though the SBA’s mission emphasizes making small business loans and entrepreneurial development, the SBA also provides financial assistance to businesses and families recovering from disasters. The SBA offers long-term, low-interest loans to disaster victims. Rather than provide loan guarantees, as under the business loan programs, disaster loans are direct loans made with monies from federal government appropriations.

Disaster Assistance for Homes and Personal Property Loans are provided to victims of a disaster in a declared disaster area. These loans are available to homeowners or renters to repair or replace damaged real estate or personal property. Individuals may be eligible for SBA home and personal property loans even if they do not own a business.

Physical Disaster Business Loans are provided to both small and large businesses to repair or replace disaster damages to property owned by the business. Any business or nonprofit organization located in a declared disaster area that has incurred damage during the disaster may apply for assistance.

Economic Injury Disaster Loans (EIDL) provide loans to small businesses and small agricultural cooperatives in declared disaster areas, regardless of whether they sustained physical damage. EIDLs assist businesses that, due to a disaster, cannot meet their financial obligations as they mature, paying their ordinary and necessary operating expenses. EIDLs are available only to businesses that cannot obtain credit elsewhere.

Loan maximums differ for the three disaster loan programs. Home and Personal Property Loans are limited to $200,000 for real estate and $40,000 for personal property. Physical Disaster Business Loans are limited to $1.5 million for physical damage to property owned by the business. EIDLs are limited to $1.5 million for economic damage, as calculated by the SBA. If the business is also obtaining a loan through the Physical Disaster Business Loan program, the total of the two loans cannot exceed $1.5 million.

Interest rates on disaster loans are determined by formulas set by law and vary with market conditions. The physical damage disaster loans currently have a maximum rate of 8% if the borrower can obtain credit elsewhere and 4% otherwise. EIDLs have a maximum rate of 4%. Disaster loan terms for all three programs are for a maximum of 30 years.

A new, expanded EIDL program is available to small businesses that suffered significant economic injury as a direct result of the terrorist attacks of September 11, 2001, or federal actions taken thereafter. Applicants outside the declared disaster areas of the World Trade Center and Pentagon are also eligible if they were affected by the attacks. The application deadline was April 22, 2002. The EIDL program makes working capital loans (direct loans) to help businesses pay expenses and obligations that they would have been able to pay if the disaster had not occurred. As with regular EIDLs, interest rates are limited to 4%, terms are limited to 30 years, and loans are limited to $1.5 million

SBA Loan Packaging

Only qualified lending partners that have guaranty agreements with the SBA are eligible to participate in the guaranteed-loan programs. The borrowers work with a local qualified bank, which deals directly with the SBA. Prospective borrowers should do their homework beforehand. The prospective borrower must sign a document allowing the SBA to ask the IRS for tax returns.

For new businesses, the prospective borrower should prepare a narrative that includes information on the type of business, legal organization, location, customer base, competition, availability of suppliers, and other pertinent details. A loan applicant starting a new business should take the following steps:

For established businesses, the prospective borrower must submit the following information:

Feasibility Criteria for Loans

Both eligibility and feasibility criteria must be satisfied for loans made through SBA guaranties. Once eligibility is established, the SBA evaluates the loan application. Missing information is the most common reason for delay, so processing time can be considerably reduced if the prospective borrower submits a complete application.

In analyzing the loan application, the loan officer will apply feasibility criteria similar to the credit criteria used by a private lender. The SBA looks at four business areas to assess creditworthiness:

If the loan application shows that the loan is feasible, the prospective borrower will generally obtain the necessary funds. Management ability and cash flow are the key criteria. If management ability and cash flow are good, then the loan is usually made.

Business Plans

In addition to the minimum SBA loan package, the borrower, in consultation with its accountant, may want to expand the information provided by developing a comprehensive business plan. The minimum SBA loan package may be enough to satisfy some lending partners, but others may also want a more comprehensive business plan. The business plan should generally contain the following information:

The benefits of developing a comprehensive business plan are that most lenders and investors will ask for it, it can serve as a guide for the business, and business plans help borrowers and bankers determine financial needs. The business plan should be tailored to meet the information needs of potential investors and creditors. The business plan should be concise and communicate the facts clearly.

The SBA website (www.sba.gov) provides detailed instructions for writing a successful business plan. The SBA also has resource partners, such as Small Business Development Centers (SBDC), Service Core of Retired Executives (SCORE), Women’s Business Centers, and Business Information Centers, to provide resources and counseling when preparing business plans.

In addition, the SBA Answer Desk can give assistance on financing and entrepreneurial development. Answer Desk operators are available Monday to Friday from 9 to 5 EST at (800) U-ASK-SBA, and an automated system is accessible 24 hours a day.

©2002 CPA Journal. Legal Notices