what is AN SBA LOAN?
An SBA loan is one that is partially guaranteed by the Small Business Administration (SBA). SBA loans are a form of debt financing offered by private lenders (not the SBA).
The businesses that need these kinds of loans often have limited assets, a limited operating history, or other characteristics that would make a normal loan too risky for private lenders to consider. With a partial guarantee from the Small Business Administration, private lenders can consider a wider range of small business applicants.
The commitment from the SBA means that, should the business default on the loan, the lender will still be repaid—at least in part—by the government.
How Does an SBA Loan Work?
The Small Business Administration is a US government agency that provides support to small businesses and entrepreneurs. As unlikely as it may seem, over 99 percent of America’s nearly 30 million firms are considered small businesses.
Therefore, it is very much in the interest of the federal government to encourage and support the growth of these businesses for the health and well-being of the national economy.
This is the role of the SBA, and while there are many local, regional, and state-level small business support organizations, the SBA is the only cabinet-level federal agency that is fully dedicated to American entrepreneurs.
To spur the growth and development of small businesses, the SBA offers the 7(a) guaranteed loan program, commonly known as SBA funding or an SBA loan.
These loans vary in size from $500 to $5.5 million, so there is a financing option for small businesses of any size. In some cases, businesses only need (or can only repay) a thousand dollars or less; in this case the loan is called an SBA microloan, a term you may come across when researching your own SBA loan.
Traditional loans normally consist of two parties: the lender and the borrower. In the case of an SBA loan, the Small Business Administration acts as a third party that guarantees up to 85 percent of the loan total (the principal) in the event that the borrower fails to repay (defaults).
It is important to remember that SBA loans are still bank loans. Banks that have elected to work with the SBA are referred to as SBA participating lenders. These designated lenders accept applications for loans, accept payment for SBA guaranteed loans, close the loans, and distribute any proceeds.
The SBA’s role as a third party is to review loan applications to ascertain whether or not applicants meet credit and eligibility standards, and of course to pay the balance of the loan in the event that the borrower defaults.
Who Qualifies for a 7(a) Guaranteed Loan?
As with other forms of debt financing, SBA loans come with a set of requirements. Borrowers must not only meet a few basic criteria to be considered by the SBA but must also meet minimum standards of financial responsibility and demonstrate an ability to repay debts.
This is generally referred to as creditworthiness.
To qualify for consideration, a business must meet the following criteria:
- Be a for-profit business
- Do business in the US
- Have invested equity
- Have exhausted financing options
Simply put, small business owners must not be head of a nonprofit or be an individual seeking funds.
They must have a physical location in the United States or its territories, they must have invested their own time or money into the business, and they must be unable to secure funding from other lending services.
SBA loans are not handouts.
Lenders cannot afford to lend to borrowers who will misuse funds and fail to repay their obligations. Similarly, the SBA, as a government agency, is funded with taxpayer dollars, and they have a duty not to waste this money by handing it over to businesses that will not contribute back to the economy.
Applicants for SBA loans can expect to produce evidence that they are creditworthy in the following areas:
- Repayment ability
- Credit history
To demonstrate repayment ability, applicants must show that they can meet business expenses and repay their obligations. This is often done through cash flow statements, historical financial records, and reliable cash flow projections.
To demonstrate adequate management, applicants must be able to show that they can operate the business successfully. This is often done through documented work experience in the industry or field, documented experience of the managerial team, and/or historical business data.
The Small Business Administration offers some basic guidelines for applicants to demonstrate that they meet equity requirements.
For new businesses, owners should have approximately one dollar of cash or business assets for every three dollars requested. In this case, the smaller your financing requirement, the better.
For established businesses, the SBA guidelines point to a 4:1 debt/equity ratio. This means that the balance sheet should show no more than four dollars of total debt for each dollar of net worth. What the SBA finds an acceptable ratio varies by industry.
To demonstrate a healthy credit history, applicants should expect that their personal and business credit histories will be reviewed.
Of course, the more consistently they have met their obligations, the better. If applying for a 7(a) guaranteed loan with a spotty credit history, one must be prepared to fully explain any blemishes.
SBA Funding versus Traditional Debt Financing
Because SBA loans are issued and administered through traditional lending institutions, they have quite a bit in common with most traditional debt financing solutions.
Besides the support of the SBA, other key differences can be found in the amount of collateral provided and the terms of the loan.
SBA loans often have lower interest rates, longer repayment terms, and minimal collateral, and they frequently see higher approval amounts than traditional bank loans.
Additionally, though there are restrictions on the use of 7(a) funds, these loans are much more flexible than traditional loans that are only approved for a stated purpose (such as purchasing equipment).
Keep in mind, however, that not only does the lending institution have to review your application, but so does the SBA. This means that loan approval can take significantly longer than for traditional debt financing.
In the eyes of many entrepreneurs, this is a minor inconvenience in light of the access to much more favorable terms and rates.