In a nutshell, the major benefit 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. If the borrower fails to repay the loan, the lender can recover the guaranteed portion of the loan from the SBA.
A limited guarantee. Effective December 22, 2000, a maximum loan amount of $2 million was established for 7(a) loans but the maximum amount guaranteed by the SBA is generally just $1 million. Small loans (those under $150,000) carry a maximum guarantee of 85 percent. Loans greater than $150,000 are guaranteed at 75 percent.
In considering whether to seek an SBA loan guarantee, here's what you can expect:
Required owner's equity. 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 are the borrower's character, credit, experience, and proof of a sufficient commitment to the business. Weaknesses in one area may be balanced by a strength in another area.
Adequate security for the loan. 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 a 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.
Personal guarantees. Unlike some of the other requirements, a personal guarantee by all owners having at least a 20 percent interest in the company is usually nonnegotiable.
Sometimes a higher loan cost. 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 prime rate. For loans with maturities of seven years or longer, the rate cannot be more than 2.75 percent above New York prime. 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 two 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 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 lender.
Longer loan terms. 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.