The year ending this past September turned out to be the most successful 12 months ever for the U.S. Small Business Administration’s flagship 7(a) loan program. Authorizations for these loans, which can be used for everything from real estate acquisitions to equipment purchases, reached more than $36.5 billion, up a whopping 62% from the previous fiscal year.
Not only that, but this loan volume was up 44% compared to 2017, which was previously the SBA’s most active year ever. This enormous growth in 7(a) volume should not go ignored. The SBA was created in 1953 and has expanded over the years to provide resources to the U.S. small-business community, which is responsible for the majority of the nation’s new jobs. In fact, since 2000, small businesses have accounted for about 65% of net new job creation.
Today, the SBA offers numerous resources to support small-business owners — and access to affordable capital is at the top of the list. During the 2021 fiscal year, the country was facing tremendous headwinds that included the COVID-19 pandemic, government restrictions, supply chain problems, difficulties in hiring and rising costs for goods, to name a few.
This elevated level of risk helped to make the SBA a top lending source. In addition, the SBA offered certain incentives from February through September of last year, which also increased demand. Finally, with the agency becoming a household name due to the widescale reach and news coverage of the Paycheck Protection Program, awareness of its other programs, including the 7(a), has improved. With SBA lending more popular than ever, now is the time for commercial mortgage lenders and brokers to roll up their sleeves and immerse themselves in this small-business loan program.
Program basics
The 7(a) program works by providing banks (and 14 licensed nonbank lenders) with an 85% guarantee on eligible small-business loans of up to $150,000 and a 75% guarantee on loans of up to $5 million. The loans can be used for a variety of projects, such as owner-occupied commercial real estate purchases, business acquisitions, partner buyouts, debt refinancing, equipment purchases, leasehold improvements and expansions.
Preferred lenders are able to approve 7(a) loans in-house, on behalf of the SBA, while other companies must submit the loan request to the SBA for approval. If a loan goes into default, the agency will cover 75% of the loss, assuming the lender made an eligible loan in accordance with the SBA’s standard operating procedures. It’s important to note that lenders do take on risk — they are on the hook for 25% of the potential loss.
Every small business comes with its own unique story, and without understanding this story, it’s impossible to accurately process certain information.
Basic eligibility is just a starting point when analyzing an SBA loan proposal. The vast majority of privately owned businesses are eligible, but there are some landmines to look out for. For the most part, the business must be under majority ownership and control of a U.S. citizen or legal permanent resident. Real estate must be 51% owner occupied by an eligible small business.
Passive businesses are not eligible, nor are companies engaged with substances illegal on the federal level. Additionally, businesses that actively promote religion are generally ineligible. There is a long list of oddities that make a business ineligible, but these are the main ones to look out for.
The right lender
Once a project is deemed eligible, it becomes a matter of determining whether the business is qualified for the loan it is requesting — and this is where it gets complicated. Because the 7(a) program is a public and private partnership, the SBA relies on the lender to make a credit decision and fund the loan.
The SBA does not fund loans directly. Each bank and nonbank lender has its own unique process, credit appetite, requirements and loan structure that is layered on top of the basic eligibility guidelines. So, whether a business is qualified is determined by one of more than 1,700 SBA lenders. And each of these lenders may have a different answer.
Mortgage brokers with a deep understanding of SBA lending are critical to a small business in successfully obtaining the best loan. By pairing loan requests with the right lender and helping to navigate the borrower through the process, brokers provide an essential service to the small-business community.
The biggest mistake that mortgage brokers can make is to not perform their own analysis. This diminishes their chances of success and is a missed opportunity for a broker to add value to the transaction.
Quite often, a lender will pass on a deal that has been presented in a haphazard manner and will provide little to no explanation of the decision, leaving the broker no better off. Brokers should empower themselves by understanding how SBA underwriters think and by making their own assessment of a transaction prior to submission, which will greatly increase their chances of success.
Factors to consider
It is important for lenders and brokers to understand how an SBA loan is accepted. Depending on the size of the loan, approval is typically granted by a credit officer or a committee. Every deal is going to have its own unique set of strengths and weaknesses. A credit decision is made by weighing these factors and assessing the overall strength of the transaction.
Maybe the most important factor is a company’s cash flow, which is viewed in terms of a debt-service-coverage ratio (DSCR) and is analyzed using the past three tax returns plus the interim year. The SBA’s minimum DSCR is 1.15, which simply means that for every $1 of debt repayment, the business generates $1.15 in revenue.
Lenders are primarily looking at the last full year, plus the interim year, and in many cases will require more than the SBA’s minimum. Sufficient debt-service coverage also can be achieved on a pro forma basis, although the pool of lenders that are willing to consider projection-based loans is small. Pro forma-based expansion loans are a bit trickier, but even more challenging to underwrite are startup business loan requests, since there are no historic financial records to analyze.
Collateral also plays a key role. Lenders are technically not supposed to decline loan requests due to a lack of collateral, but they do. SBA lenders tend to have a threshold on their levels of unsecured debt exposure as a means to limit their losses on any one loan. That said, there are lenders that focused mainly on cash flow and others that are more interested in collateral.
For this reason, mortgage brokers often have a few good SBA lenders that they work with. Many small-business owners do not realize this. They could be wasting a lot of time going to collateral-based SBA lenders with more of a cash flow-based loan request, which further highlights the importance of engaging with an experienced broker.
Credit and liquidity
Lenders will have a minimum credit score for eligibility, which may be anywhere between 630 and 700. They can make an exception, however, based on an applicant’s unique situation. Ultimately, the SBA and the lender want to avoid giving money to individuals with poor character or an inability to repay the loan.
Experience becomes a key factor, particularly in the cases of business acquisitions and startups. Because the sponsor is not yet running the business, there is no track record to analyze. Instead, the lender will consider the borrower’s education and relevant work experience to determine whether they have the necessary skills to operate the proposed business.
Liquidity also plays a crucial role. Certain SBA loan requests will require an equity injection. Understanding and verifying the source of the equity is important when it comes to SBA lending. Not only that, but lenders will want to see that borrowers have sufficient post-closing liquidity. Lenders have their own rule of thumb when it comes to this, but the idea is to make sure that borrowers have a rainy day fund in case there is an unforeseen bump in the road.
External forces are yet another factor. This has become more prevalent of late due to the COVID-19 pandemic, which has been at the forefront of SBA underwriting since 2020. Secondary effects began to emerge, including supply chain issues, labor shortages, and rising costs for food and raw materials. These external forces have impacted nearly every small business in the U.S., and SBA lenders need to address their impact on the borrower when they underwrite the loan.
SBA underwriters also will analyze other factors — such as balance sheets, revenue trends, outside income, etc. — but the ones listed above are core to each lending decision. It’s important to know that presentation of this information is critical. Mortgage brokers that perform a basic analysis of these factors will achieve much higher levels of success.
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There is one additional item of importance to consider: Every small business comes with its own unique story, and without understanding this story, it’s impossible to accurately process certain information. For example, a drop in revenue in 2019 followed by even larger decline in 2020 will set off alarm bells in an underwriter’s mind. When simply looking at the numbers, they may see what appears to be a failing business.
But if the broker helps the underwriter to peel back the layers, so they learn that the business was impacted by wildfires in 2019 and pandemic-related shutdowns in 2020, it creates an opportunity to view things through a different lens. Presenting the story upfront instead of waiting for a lender to find an issue and ask about it — or worse, simply decline the loan request — is key to success for any SBA loan broker. ●
