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Are SBA Loans the Elixir of Life for Startups or Going Concerns? (Part I)

Over the past few weeks, I’ve been using this blog to discuss various ways of financing a business, whether a startup or an ongoing enterprise. One question that seems to be on the minds of my clients and readers of this blog is the lowdown on SBA financing (i.e., financing under the auspices of the U.S. Small Business Administration, which is an agency of the Federal government). So here’s my take on it.

First off, let me clarify a widespread misconception: the SBA does NOT make loans to small businesses. Rather, the SBA guarantees a portion of a loan made by a bank to a small business, as long as the bank participates in the SBA program and adheres to SBA guidelines when making and servicing the loan. By guaranteeing a portion (usually 50%) of the bank’s loan, the SBA eliminates some of the risk undertaken by the bank. This risk reduction is intended to make it easier for the bank to decide to lend to a startup or small business.

You may recall that a few weeks ago I wrote that getting a bank loan was virtually impossible for a startup business. So, can the SBA’s guarantee help a startup get a bank loan? The answer is “theoretically, yes.” I hate to wax metaphysical in my weekly blog, but in this instance it’s sort of unavoidable. Allow me to explain.

There are essentially two types of loan programs for which the SBA will provide a loan guarantee:  the Section 7(a) Loan and the Section 504 Loan. Let’s first look at the 7(a) loan.

The 7(a) loan can be used by a business for virtually any purpose (working capital, equipment & machinery, land & buildings, etc.). The 7(a) loan involves a sharing of risk between the bank and the SBA. The SBA will guarantee 50% of the loan, while the remaining 50% carries no SBA guarantee. If the borrower (the small business) defaults on the loan, the SBA will make good on the SBA guaranteed portion of the loan by indemnifying the bank for 50% of the bank’s loss. Which means that the bank is still on the hook for the remaining 50% of the loan, which is the portion not guaranteed by the SBA.

Hence, the “theoretical” availability of the SBA loan to small businesses. Since the bank is still on the hook for at least 50% of the loan in the event the borrower defaults, the bank will still require the borrower to meet all the same credit and lending criteria it would have had to meet were the loan NOT guaranteed by the SBA. Which brings us full circle back to my admonition that getting bank financing for a startup business is difficult. While in theory the SBA guarantee can make it more palatable for a bank to make a loan to a startup, in reality it’s still tough going, especially in “Great Recession” America.

And by the way: if the business defaults on the loan, it is legally liable to both the SBA and the bank for the defaulted loan. The SBA and the bank can (and you can bet your life they will) sue the company after a default. They can also sue the owners personally, if the owners provided additional guarantees. If being on the business end of a lawsuit by the Federal government and a major bank isn’t palatable to you, don’t default on an SBA loan.

Now, a brief word about the logistics of starting the SBA Loan process. Virtually any major bank, and most of the local and regional banks, participate in the SBA loan program. There’s an excellent chance that if you walked into your local bank branch and inquired about SBA loans, they’d direct you to a loan officer who handles them. There’s not much mystery to it.

Next week, in Part II of this discussion on SBA funding, I’m going to discuss the 504 loan, which is the more complex of the SBA loans. I’ll also have some additional comments on SBA loans and some thoughts on a couple of other SBA programs that don’t involve loans.

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