How do SBA loan guarantees work and who qualifies for one?

The SBA guarantees a large share of a loan that a business gets through a private lender, thereby encouraging the bank to lend. Here we look at the options, as well as the businesses that qualify, and which do not. If you are hearing “no” from a lot of banks, then knowing how the guarantee works can make the difference.

The idea behind the guarantee program is to assist small firms in obtaining the startup and operating capital they need to open shop.

In the event of a default, lenders can recover up to 85% of the principal balance unpaid. So the bank takes on only a fraction of the risk, not the entire balance.

The reason Uncle Sam guarantees is so that bankers are encouraged to make loans they wouldn’t otherwise make on fair terms.

Commercial bankers often prefer SBA loans, actually.

• Lower risk: Banks get a U.S. government guarantee on a huge chunk of the outstanding principal balance. A lot of their risk evaporates.
• Secondary market: The SBA guaranteed piece of the loan can be sold on a secondary market.
• Reserve requirement: The SBA guaranteed piece of the loan does not count against the bank’s required loan-loss reserves.

The SBA guarantee is usually used when the lender doesn’t think the collateral is worth the whole loan. So the guarantee substitutes for collateral, but when the loan fails the lender will get back the guaranteed piece of it. It’s important because if you don’t have assets to collateralize the debt, the guarantee gives the bank the security it needs to give you a thumbs up.

As of June 2012, the maximum SBA 7(a) loan amount was $5 million, with a maximum SBA guarantee of $3.75 million. For loans under $150,000 the SBA can guarantee the lender up to 85% of the unpaid balance - above that limit the maximum guarantee falls to 75%. But caveat emptor: these are 2012 numbers and they can change over time. So check for yourself with your lender.

Getting the Guarantee

How do you go about getting an SBA guarantee? Getting the guarantee is actually a fair amount of work.

The SBA likes to see borrowers put a 25% stake in the project. That’s not a legal requirement but it does demonstrate a commitment. This way the SBA - and the lender - know that you’re not just risking their money, but that yours is on the line, too.

Your ”skin in the game” can often be negotiated downward. The SBA looks to the owner’s character, credit, management ability, and repayment ability. A strong characteristic in one of these areas can overcome a weakness in another.

The SBA says that it will not deny a guarantee solely because the collateral is thin. The bank will still most likely require collateral anyway, but if the collateral is insufficient, the deal will hinge on other strengths like very strong cash flow.

But the SBA’s major test is, “Is the loan as collateralized as well as the owner can manage?” A borrower with significant personal assets might be asked to pledge those assets. If the business fails, the owner could lose personal assets or property pledged as collateral.

If you as the business owner own 20 percent or more of your business, you will almost certainly need to personally guarantee the loan. Sometimes this is negotiable but usually not.

SBA loans may cost the borrower a little more interest than a conventional loan, but not much. You and the bank negotiate the rate. It’s capped, pegged to prime rate or an optional rate.

A 7(a) SBA loan can be made with a fixed interest rate, which is capped based on the size of the loan: $25,000 or less; $25,000 to $50,000; and over $50,000.

The SBA guarantee fee may be passed along to the borrower. The fee varies depending on the size of the loan and length of time. One year or less: 0.25%. Longer terms carry a different fee.

So there are some extra costs, but these are offset by advantages. For example, without a guarantee a bank might charge the borrower up front points for a high risk loan. However, the SBA bars any points beyond the guarantee fee. And if you can get an SBA guarantee you could possibly stretch the maturity of your loan out further. And so the opinion here is that the extra costs are generally well worth what you get back for your money.

Most small businesses have trouble getting long-term financing. Such loans are risky for the lender.

Lenders usually limit the maturity to three to five years. Your typical SBA program will go out 10, and you can get 25 with some real estate. Cash flow is steadier with a long term. Clearly, every cent counts to you. And longer terms mean smaller payments.

Qualify for an SBA 7(a)

You might qualify for an SBA 7(a) if you pass all these tests: SBA size; acceptable type; for-profit; independent; not dominant in industry; already turned down for a conventional loan.

Have two lenders already declined your loan application? If so, it might be time to rethink. Can the obstacles be overcome? Talk with the lenders. What are they afraid of? Is it warranted?

To qualify as a small business, the enterprise usually has fewer than 500 employees. However, the number varies by industry. The SBA publishes guidelines for size.

Most businesses - about 99 percent - qualify under the SBA definition of small. Don’t assume, however. Look it up.

Some Businesses Can’t Get Direct or Guaranteed Loans

This is controversial because government is seen as picking the winners and the losers.

Is yours prohibited? Restrictions are divided into classes.

Nonprofits themselves are not eligible for SBA loans, except for sheltered workshops which employ disabled workers. However, for-profit businesses owned by nonprofits are fine.

Businesses that produce, distribute or sell ideas, values or opinions are not eligible for SBA loans. Specialty stores that mainly sell such products and distributors that handle just such material, are also not eligible for SBA loans.

Academic schools are ineligible for SBA loans. However, schools that are primarily technical, secretarial, vocational or trade oriented, qualify. Preschools and nursery schools are permitted unless half or more of their time is spent teaching an ideology or academics.

Cooperative organizations are eligible for SBA loans as long as the size standard is met, the organization is organized for business, and its members qualify as small businesses. Excluded from eligibility are marketing and consumer co-ops.

Generally, for-profit lending companies, speculators and real estate investors may not apply for SBA loans. However, hedging commodity futures in a normal business is allowed. For instance, a grain elevator operator can hedge their commodity inventories.

You may not be in the business of lending or investing funds, either. However, pawn shops that derive at least 50 percent of their incomes from the retail sale of merchandise are eligible.

SBA loans cannot be used to encourage or foster monopoly or unfair competition. Pyramid sales schemes cannot receive SBA loan financing.

Gambling enterprises cannot be financed with an SBA loan, unless less than a third of their revenues come from a state-sponsored lottery or legal gambling. A business that sells state lottery tickets on the side might be able to use an SBA loan.

Illegal businesses need not apply for an SBA loan. Nor may you, if you have been convicted and are serving jail time, probation or on parole. Nor can you apply if you are under indictment or charged with a crime. It does not matter that the judge has lifted probation just to apply for a loan.

Cable television systems that broadcast live television stations or select the programs transmitted are excluded from applying for SBA loans. So are automobile floor planning companies.

If you do qualify, the SBA Express program allows the agency to speed up its review of a loan. Under this program a response is generally forthcoming within 36 hours. A lower SBA Express rate is often available to borrowers and they might be better off with the faster SBA loan, so research this program very thoroughly before committing to one or the other.