If you’re wondering how to fund the expansion of your small business, you might want to consider a Small Business Administration (SBA) loan. Although they’re not for every business owner, these loans are a viable option for those who can’t obtain other financing to grow their business.
Essentially, when a qualifying business applies for an SBA loan, it is actually applying for a commercial loan, structured according to SBA requirements with an SBA guaranty. Small business owners and borrowers who have access to other financing with reasonable terms are not eligible for SBA-guaranteed loans. “SBA loans are a good idea if a small business owner did not qualify for a traditional bank business loan and they have a specific use for the funds that will help the business grow, says Anthony Pili, vice president and director of strategic planning, Greater Hudson Bank in Bardonia, NY. Read more in The Basics Of Financing A Business.
An example of a good, specific use is if, for instance, orders are outpacing supply and some new machinery, an additional employee, another location or another truck would help meet that demand profitably after covering the new debt payment, says Pili.
Other good uses for an SBA loan include: buying out a competitor’s business to gain economies of scale, refinancing higher-rate debt or purchasing the building in which the business operates if the new mortgage payments are equal to or lower than the lease payments.
A poor example is acting on a hunch. Many marketing activities fall into this category, Pili says. “Many think if they take out a loan for a billboard advertisement or newspaper advertisement, customers will come.” That’s rarely the case.
The Small Business Administration offers a variety of financial programs aimed at helping small businesses succeed. The programs range from offering assistance facilitating a loan with a third party lender to guaranteeing a bond or helping a small business owner find venture capital.
Guaranteed loan programs – also called SBA loans – are one of these offerings. Several different types of loans are available, including:
- 7(a) Loan Program. This is the SBA’s most common loan program and includes financial help for businesses with special requirements, such as franchises, farms and agricultural businesses, and fishing vessels.
- Microloan Program. This provides small, short-term loans to small businesses and certain types of not-for-profit childcare centers.
- Real Estate & Equipment Loans: CDC/504. This loan provides financing for major fixed assets, such as equipment or real estate.
The SBA does not make direct loans to small businesses. It merely sets the guidelines for the loan and then backs the loan or guarantees the loan will be repaid, says Joseph Lizio, CEO, Capital LookUp LLC, and a former commercial lender. That eliminates some risk to lenders.
A small business owner can apply for an SBA loan through any bank offering SBA loans. “A business owner may also apply through a local Certified Development Company (CDC), which is a nonprofit corporation certified and regulated by the SBA that works with participating lenders to provide financing to small businesses,” says Pili. There are 270 CDCs nationwide, each covering a specific geographic area.
“Many banks partner with their local CDC to help borrowers who would not otherwise qualify for a traditional business loan that the bank offers,” says Pili.
In order to be approved, an SBA loan application has to first be approved and underwritten by a financial institution or small business lender. “Then it’s sent to the SBA who, under its own guidelines, will also underwrite and approve it or not,” says Lizio.
If both organizations approve the loan, the financial institution will fund and service the loan from that point on. “The SBA will only guarantee the loan or some portion of it – usually around 85% – in the event of a default by the borrower,” says Lizio.
If you’re not sure whether your local lender is an SBA-approved lender, visit the SBA site. While every lender has its own criteria to approve a loan, Lizio says there are some common qualifying criteria that all lenders use, including:
- Cash Flow to Service the Loan Payment. If a monthly payment is estimated at $1,000 per month, applicants need to demonstrate the business can earn that amount, above and beyond its total operating profits.
- Personal Credit History. Loan officers do not want to waste their time on an application they could never get approved through their underwriting or credit committees. So, they pull a personal credit history on the applicants. If those scores do not meet a minimum threshold, Lizio says, the lender will walk away immediately.
- Collateral. Although there can be a few exceptions, the SBA generally requires that all SBA loans be collateralized with all available assets (inventory, buildings, cash, etc.) – both business and personal. Banks and other commercial lenders will want full collateral as well. Without collateral valued at a minimum of 100% of the loan amount, Lizio says the application will likely be denied.
For owners of small businesses, going the SBA route has some key advantages.
Term of Loan. Lizio says one of the biggest benefits of an SBA loan is the term of the loan. “Most lenders want borrowers to have the shortest term available. But SBA loans extend those terms,” says Lizio.
For instance, a bank might only agree to a 10-year term on real estate, but the SBA might approve a 20- or 25-year term. Or, let’s say a private lender will only underwrite an equipment loan for 5 years – the SBA might approve 7 years.
Why does this matter? Lizio says a longer term makes the loan payment more affordable and also makes it easier to qualify for a loan. In addition, it adds flexibility for a borrower. “No business has constantly smooth revenue. It could have a good month or a good period, or a bad month or period. A smaller minimum loan payment is easier to cover during a bad month or period.
“I always tell borrowers to take the longest term they can, then work to manage the loan to reduce its overall cost by paying more when they can afford to do so,” he adds.
Flexibility on Collateral. The collateral requirements are also more flexible. Lizio says most business loans require collateral worth 100% or more of the loan amount for approval. But the SBA may approve a loan where the borrower meets all the other criteria – and pledges all available business and personal collateral – even if that collateral doesn't add up to 100% of the loan amount. Those without much collateral may still be approved for an SBA loan where they might have been declined by a traditional lender.
You're a Borderline Case. Sometimes, the SBA might be the only reason you get the loan. "If the bank or lender is on the fence for some reason, the SBA's guarantee could be what pushes you over to the right side, getting you approved," says Lizio.
Higher Costs. Fees associated with SBA loans can become costly. “You have to pay two sets of fees: an origination fee and closing costs to the lender, as well as fees up to 3.5% for some SBA approvals,” says Lizio. You also have to go through two underwriting processes, which may require two different valuations of property or collateral. That can be expensive.
Slower Processing. You also have to be patient. For one thing, you're dealing with two institutions – the lender and the SBA – not just the lender. “The application process for these loans takes forever, as many bank officers don’t like doing them and the SBA is always backed up,” says Lizio.
For 7(a) loans, you may want to investigate the SBAExpress loan program, which has expedited deadlines and promises a 36-hour response time to loan applications.The specifications of these express loans may or may not meet your needs.
The Bottom Line
Before applying for any type of business loan, it’s wise to assess your business’ financial health and needs. The SBA suggests you consider the strength of your industry, how you’ll use and repay the loan, and the strength of your management team.
Develop a business plan that answers these questions. All lenders will want to review a substantial, comprehensive and well-thought-through business plan before approving a loan to expand – or launch – a business.
A traditional business loan will generally be faster to get and have lower fees. But SBA loans can offer important advantages, including being able to get a loan at all at certain stages of your company's development.