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Editorial 9 MIN READ

SBA 7(a) and 504 loans for a new entity, as the week opens

What the standard SBA programs actually offer a business formed this quarter, before anyone figures out what comes next

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 7 sections
  1. What 7(a) actually is
  2. What 504 does that 7(a) doesn't
  3. The eligibility screen
  4. The personal guaranty and the collateral
  5. What a new entity should actually do this week
  6. What this week's declaration does not change
  7. Sources

our days after the national emergency declaration, the question in every founder's inbox is the same: what does the SBA actually lend, and can a company formed this quarter get any of it. The answer, as of this morning, is that the standard programs (7(a) and 504) still work the way they did in February, and a new entity that can document cash flow and pledge collateral can borrow under them.

Everything past that sentence is caveat. The 7(a) program is the general-purpose guaranty; the 504 is the long-term fixed-asset program run through Certified Development Companies. Neither is designed for the kind of sudden revenue gap small businesses are staring at this week, and Congress is plainly working on something else. This is what is in place right now.

What 7(a) actually is

A 7(a) loan is a bank loan that the SBA partially guarantees. The bank underwrites, closes, and services the loan; the SBA reimburses the bank for a defined percentage of the principal if the borrower defaults and the recovery on collateral falls short. The borrower is dealing with a commercial lender the entire time. The SBA is behind the curtain.

The maximum loan size is $5 million. The SBA guaranties up to 85% of loans of $150,000 or less, and up to 75% of loans above $150,000, with the agency's total exposure capped at $3.75 million per borrower. The SBA Express variant goes up to $500,000 with a 50% guaranty and a faster lender approval process. The Export Working Capital and International Trade variants run up to 90% guaranty for export-connected borrowers.

Proceeds can be used for working capital, equipment, inventory, owner occupied real estate, business acquisition, partner buyouts, and refinance of qualifying business debt. They cannot be used to repay owner loans, distribute cash to owners, or finance passive real estate.

Maturity runs up to ten years for working capital and equipment, up to 25 years for real estate, and is typically set to match the useful life of what is being financed. Interest rates are usually variable, pegged to the Wall Street Journal Prime Rate, the SBA optional peg rate, or LIBOR plus three points. The maximum spread the lender can charge above the base rate is capped by loan size, with the standard cap for most loans in the range of Prime plus 2.25% to 2.75% for larger loans and a wider spread allowed on the smallest loans. Fixed-rate 7(a) loans exist but are uncommon. Roughly four in five 7(a) loans carry variable rates.

The upfront guaranty fee, which the lender pays the SBA and typically passes to the borrower, is tiered by loan size and maturity; for loans with maturity over twelve months it has historically ranged from 2% on the smallest loans to 3.5% on the guaranteed portion of loans above $700,000, with an additional 0.25% on the guaranteed portion above $1 million. The fee schedule is republished at the start of each federal fiscal year (October 1), and some years the SBA waives or reduces parts of it. The fee is financeable, meaning the borrower can roll it into the loan principal rather than bring cash to closing.

What 504 does that 7(a) doesn't

The 504 program finances long-lived fixed assets: owner-occupied commercial real estate and heavy equipment with a useful life of at least ten years. It does not finance working capital, inventory, or goodwill in a business acquisition.

The mechanics are a three-party stack. A conventional bank funds 50% of the project. A Certified Development Company (a nonprofit chartered and regulated by the SBA under 13 CFR Part 120, Subpart H) funds 40%, which the SBA fully guaranties and which is sold into the market as a debenture. The borrower contributes 10% equity. For a start-up (an entity under two years old) or for special-purpose real estate (hotels, restaurants, gas stations, medical offices built for a specific use), the borrower equity requirement rises to 15%. For a project that is both a start-up and special-purpose property, it rises to 20%.

The CDC portion maxes out at $5 million for most projects and $5.5 million for manufacturers and for projects meeting a public-policy goal such as energy reduction. The bank portion is not capped by the SBA, which means total project size can run well above the CDC ceiling so long as the bank is willing to do its half.

The rate on the CDC half is fixed for the life of the loan, set monthly when the debentures are sold, and pegged to Treasury yields: ten-year and twenty-five-year debentures track the ten-year Treasury, and ten-year debentures track the five-year Treasury. The all-in effective rate adds roughly 3% in ongoing servicing fees to the SBA, the CDC, and the central servicing agent. Maturities run 10, 20, or 25 years.

The bank portion runs on whatever terms the bank offers. Typically it carries a shorter amortization and a balloon; the bank expects to be refinanced out somewhere between year 5 and year 10. The fixed CDC rate is the reason the program exists; very little else in small business lending offers 25-year fixed on commercial real estate.

The eligibility screen

Both programs require the borrower to be a "small business" under SBA's size standards, published at 13 CFR § 121.201 as a table indexed by NAICS code. A business classified under NAICS 541110 (offices of lawyers) is small if average annual receipts are under $12 million; a business under NAICS 238210 (electrical contractors) is small if receipts are under $16.5 million; a business under NAICS 332710 (machine shops) is small if it employs under 500 people. The table is several hundred rows. Founders should look up their own NAICS code rather than assume; the thresholds are not uniform.

For 504 specifically, the borrower must additionally have tangible net worth under $15 million and average net income (after federal tax) under $5 million for the two years preceding application. These are the original 504 thresholds and they act as a ceiling above the industry-by-industry size standards.

Both programs require that the business be for-profit, operate primarily in the United States, and demonstrate repayment ability from cash flow. They will not lend to businesses engaged in speculation, multi-level marketing, lending, passive real estate investment, or activities of a prurient sexual nature. They will not lend to a business in which an owner of 20% or more is on parole, probation, or has been formally charged with a felony in the preceding six months.

The most common disqualifier for an actual new entity is not the size standard or the activity list. It is cash flow. SBA lenders look at debt service coverage, which is cash available for debt service divided by total debt service. A healthy underwritten file comes in at or above 1.25x. For a business with no operating history the lender will lean on projections, but those projections must be supportable, and the lender will generally expect three to five years of tax returns from the principals, personal financial statements, and a business plan that is not obviously downloaded from a template.

The personal guaranty and the collateral

Every 20%-or-greater owner of the borrower entity is required to provide a full, unconditional personal guaranty of the SBA loan. That requirement is in SBA's Standard Operating Procedure 50 10 5(K), effective April 1, 2019, which governs 7(a) and 504 origination. The SOP does not treat the LLC veil or the corporate form as relevant to this question. If the lender asks why an SBA loan defeats the purpose of having formed an entity at all, the answer is that the entity still shields the owner from non-SBA creditors and from tort liability; the SBA has simply priced the guaranty to the agency's own loss exposure.

Collateral rules are similar. For 7(a) loans over $350,000, the lender must collateralize the loan "to the maximum extent possible" up to the loan amount, which in practice means a blanket lien on business assets and, if business collateral is short, a lien on personal real estate in which the principal has equity of at least 25%. A loan cannot be declined solely for inadequate collateral, but a new entity with little hard collateral and principals whose homes are fully leveraged is a harder file to get approved.

504 loans are collateralized by the financed real estate or equipment itself, which is usually sufficient given the 10% to 20% borrower contribution. Personal guaranties are still required from 20% owners.

What a new entity should actually do this week

Two practical points.

First, if the business was formed in the last year and the owner is trying to decide between 7(a) and 504, the answer is almost always 7(a). The 504 program is built for a specific transaction: buying or building the space the business will operate from, or buying long-lived equipment. It is not a general-purpose loan. If there is no fixed-asset purchase on the table, 504 does not apply.

Second, the lender matters more than the program. Not every bank is an SBA lender, and among those that are, a small number are designated Preferred Lenders (PLP), which allows the lender to approve the loan in-house rather than send the file to an SBA loan center for underwriting. PLP status cuts two to six weeks off the timeline. The SBA publishes a 7(a) lender ranking list by district; the lenders at the top of the list are the ones that close the most volume, which correlates with the ones that know the program best and make fewer avoidable mistakes on the credit memo.

The standard budget for a first-year LLC does not usually include SBA financing, because most first-year businesses cannot support the debt. The ones that can are the ones buying an existing operation with historical cash flow, or adding equipment to a proven line, or acquiring the real estate they already lease.

What this week's declaration does not change

The national emergency declaration on March 13 did not amend the 7(a) or 504 statutes. The programs run on their normal authorities, from their normal appropriations, with their normal fee schedules. The SBA's Economic Injury Disaster Loan program (EIDL, the standing disaster loan program authorized under 15 U.S.C. § 636(b)) is the agency's usual response to declared disasters, and as of this morning a number of states have requested EIDL declarations for COVID-19 related economic injury. But EIDL is a different program, with different maximums, different terms, and a different application process; it sits separately from 7(a) and 504 and runs through the SBA directly rather than through a bank.

Congress is reportedly drafting a larger small-business relief package. Whatever that package ultimately contains, it will not retroactively change the 7(a) or 504 loan your bank is pricing this week. A file that closes next month closes under today's rules.

For a business that was borrowing-ready in February and is still borrowing-ready now, the 7(a) and 504 programs are still open and still pricing well against the alternative, which for most new entities is a business credit card at 18%. For a business whose cash flow disappeared last week, a guaranteed loan that still requires a 1.25x debt service coverage ratio is the wrong instrument. That is the hole Washington appears to be working on filling.

Sources

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