SBA504 Loans Explained

small business

Business owners have many options to consider when searching for the funds needed to finance a capital investment.  From traditional bank lenders to fintech startups, the options are plentiful and the purpose of this article is to highlight a lesser known, but widely used source of financing, the SBA504 loan.  To get you up to speed, this article covers the following aspects of the SBA504 program:

  • Brief history of the Small Business Administration and overview of lending programs
  • Purpose of the 504 program
  • Pros and Cons of using an SBA loan
  • Qualification Requirements
  • End to end example of the 504 origination process
  • Helpful links and additional resources

History of SBA504 Loans

The Small Business Administration was legislated into existence in July of 1953 with the passage of the Small Business Act of 1953.  The opening text of the bill reads:

“The essence of the American economic system of private enterprise is free competition. Only through full and free competition can free markets, free entry into business, and opportunities for the expression and growth of personal initiative and individual judgment be assured.

The preservation and expansion of such competition is basic not only to the economic well-being but to the security of this Nation. Such security and well-being cannot be realized unless the actual and potential capacity of small business is encouraged and developed.”

Among other things, the full text of the bill calls for the government to:  “…aid, counsel, assist, and protect, insofar as is possible, the interests of small-business concerns in order to preserve free competitive enterprise…” by doing the following things for small businesses:

  1. Enhance their ability to export;
  2. Facilitate Technology Transfers;
  3. Enhance their ability to compete effectively and efficiently against imports;
  4. Increase the access of small businesses to long-term capital for the purchase of new plant and equipment used in the production of goods and services involved in international trade;
  5. Disseminate information concerning State, Federal, and private programs and initiatives to enhance the ability of small businesses to compete in international markets; and
  6. Ensure that the interests of small businesses are adequately represented in bilateral and multilateral trade negotiations.

Drilling down into the details of item D above, Section 7 of the bill focuses specifically on lending stating that:

The Administration is empowered to the extent and in such amounts as provided in advance in appropriation Acts to make loans for plant acquisition, construction, conversion, or expansion, including the acquisition of land, material, supplies, equipment, and working capital, and to make loans to any qualified small business concern, including those owned by qualified Indian tribes, for purposes of this Act. Such financings may be made either directly or in cooperation with banks or other financial institutions through agreements to participate on an immediate or deferred (guaranteed) basis.

Given the above mandate, the SBA created 3 lending programs in the months following the passage of the bill:

  1. SBA 7(a):  Under this program, Banks, savings and loans, credit unions, and other specialized lenders participate with the SBA on a deferred basis to provide small business loans that are structured under 7(a) guidelines. If a borrower defaults on an SBA-guaranteed loan, the lender may ask the SBA to purchase the guaranteed portion.
  2. SBA CDC 504 Loan Program:  Success of the 504 program relies on Certified Development Companies (CDCs), which are non-profit lending institutions that work with the SBA and private-sector lenders to provide growing businesses with long-term, fixed-rate financing for major fixed assets, such as land, buildings, machinery, and equipment.
  3. Microloan Program:  The Microloan program provides small businesses with small, short-term loans — up to $50,000 — for working capital or to buy inventory, supplies, furniture, fixtures, machinery and equipment. The SBA makes funds available to specially designated intermediary lenders, which are non-profit organizations with experience in lending and technical assistance. These intermediaries then issue loans to eligible borrowers.

Purpose of SBA504 Loans

The stated purpose of the SBA504 loan program is to provide businesses with long term, fixed rate financing for the purchase of major fixed assets such as land, buildings, machinery, and equipment.

SBA 504 loans are originated by a participating lender (a retail bank) and issued in cooperation  with Certified Development Corporations (CDCs), which are non-profit entities set up to contribute to the economic development of the communities that they operate within.  CDCs are certified and regulated by the SBA.

How to Qualify for an SBA504 Loan

Under the terms of the SBA504 program, loan amounts can range in size from $25,000 to $5.5 million and terms are fixed at 10 years for equipment and 20 years for real estate.

There are 2 major eligibility requirements for an SBA 504 loan:

  1. The Borrowing entity’s net income cannot surpass $5 million after taxes for the preceding 2 years
  2. The borrowing entity cannot have a tangible net worth in excess of $15MM

In addition to the eligibility requirements, there are several other constraints to consider:

  1. Loan proceeds cannot be used for passive or speculative activities
  2. Loans cannot be made to corporations engaged in non-profit activities
  3. For real estate loans, the Borrower must plan to use a minimum of 51% of the property for its own operations within 1 year of ownership (NOTE:  If the building is newly constructed, the Borrower must plan to use 60% at once and to occupy 80% of total square footage
  4. The Borrower may create a real estate holding company and sub-lease the property to the operating company

SBA504 Pros

The SBA 504 program offers a compelling list of advantages for Borrowers, Lenders, CDCs, and the local community at large.  Among them:

  • Capital:  The SBA504 program provides business owners with access to capital to invest in assets that will provide benefits over the long term
  • Cash:  By covering up to 90% of project costs, the SBA504 program minimizes the cash outlay required by the business owner to invest in their project
  • Protection:  The rate on an SBA504 loan is fixed, protecting the Borrower from fluctuations in interest rates over the term of the loan
  • Rates:  SBA504 interest rates are competitive with other forms of financing and, on occasion, may even be lower
  • Safety: Because up to 40% of SBA504 loans are guaranteed, they offer a relative degree of safety for the lender when compared to traditional loans
  • Help:  CDCs were created to assist the Borrower throughout the course of the deal, including helping with the completion of required forms and other paperwork.
  • Community:  Strong and growing businesses benefit the greater community at large by hiring additional staff, purchasing raw materials, and patronizing other local businesses

SBA504 Cons

While SBA504 loans offer many advantages, there are a few downsides to consider:

  • Jobs:  In addition to the general qualification guidelines, the Borrower must create or retain a job for every $65,000 borrowed (an exception is made for “small manufacturers” in which one job must be created or retained for every $100,000 borrowed).  If this isn’t possible, the business must meet a community development goal. Examples include: Rural Development or increasing productivity or competition
  • Use of Funds:  SBA 504 loan proceeds can only be used for the following activities:  Purchase of existing buildings; Purchase and improvement of land; Building new facilities or improving existing buildings; Purchase of new equipment; and Pay off of previous debt incurred through the activities described above.

How to Get an SBA Loan – An Example

Now that we know about the history of the SBA and the qualifications needed to apply for an SBA loan, let’s go through an example.

Let’s assume that a small business owner has experienced tremendous growth over the past two years and they would like to purchase a building with enough space to allow for future expansion.

The price is $3 million and the business owner would like to utilize the SBA504 program to finance the purchase.  Here’s how it would work.

Step 1 – Prepare

Before doing anything else, our business owner should prepare several key documents that lenders will ask for as part of their due diligence on the transaction.  Having them ready ahead of time demonstrates organization and preparedness:

Business Plan:  A document outlining the strategic objectives of the company, anticipated growth, and key risks to the business.

Budget and Financial Projections:  A detailed accounting of how loan proceeds will be used and how existing operating income will be used to repay the debt.

Company Financial Statements:  At a minimum, our business owner needs to be ready to hand over 3 years worth of financial statements on the borrowing entity..  They can either be: (1) Tax Returns (for smaller companies); or (2) CPA prepared financial statements (for larger companies). If the borrowing entity is single purpose (an LLC formed just for the purchase of the building), then 3 years of financial statements on the operating company are required.

Personal Financial Statement:  Most transactions will require the personal guarantee of anyone that holds an ownership stake greater than 20%.  As such, a personal financial statement needs to be available for all owners that meet the 20% threshold. You can find a good template here.

Credit History:  The participating lender will pull credit reports on all individuals involved in the transaction so it will be important to make sure any freezes are lifted and that any potential red flags are resolved so that credit reports are pristine

Collateral Information:  The lender will ask for as much information as is available on the collateral including:  appraisals, environmental reports, inspections, and title information.

Step 2 – Find a participating lender

Not all banks participate in the SBA504 lending program so a critical first step is to find one that does.  Fortunately, the SBA has created a Lender Match service, designed to bring together entrepreneurs and SBA lenders.  Using it is easy:

Go to the website for the SBA’s Lender Match Program

Fill out the online form, which requests basic information about the borrowing entity and the proposed use of funds

Based upon the information provided, the SBA will direct the business owner’s answers to participating lenders and connect them within 48 hours

Once connected, the business owner will discuss their plans with the local lender and they can have preliminary discussions about things like Rates, Term, and Fees.

Step 3 – Apply for the loan

With documents prepared and a lender identified, the next step is to apply for the loan.  As part of the application process, the business owner will fill out a lot of paperwork and turn over all of their prepared documents to the lender.  In addition, the lender may request documents unique to the proposed transaction.

Step 4 – Review the terms of the deal

Assuming that the application process went smoothly and that the transaction is feasible, the lender will issue a Term Sheet, outlining the structure of the proposed transaction.  For an SBA504 deal, the structure is consistent from deal to deal.  The lender will typically cover up to 50% of the project (or purchase) costs in the form of a first lien on the collateral; while the CDC will cover 40% in the form of a second lien.  The Borrower is expected to contribute the remaining 10% in cash. Combining these figures and our example, the deal terms would look something like this:

Building Purchase Price:   $3,000,000

Lender Contribution:   $1,500,000 (1st lien on the property)

CDC Contribution:   $1,200,000 (2nd lien on the property)

Borrower Contribution:   $300,000 (Cash)

Step 5 – Close the loan

Provided that the terms of the deal are palatable to the Borrower, the term sheet is signed and loan documents are prepared.  At closing, the lender will advance the loan proceeds for the purchase of the property and the purchase transaction is closed simultaneously.  Once closed, the Borrower will move into their new facility and utilize the extra space to expand their business, hire additional staff, and invest in their community.

Beneath the terms and structure of the deal in our example lies the beauty of the SBA504 program; all parties come out as winners:

Lender:  The participating lender gets to make a new deal at a safe 50% loan to value ratio.  Because they are the first lien holder, their position is well protected. In addition, they will likely get the operating accounts of the business and the chance to expand their banking relationship into other products like Treasury Management and operating Lines of Credit.

CDC:  The CDC obtains an interest bearing asset, which will produce cash flow for years to come and their position is protected by an SBA guarantee.

Borrower:  The borrower gets access to long term financing with a small equity contribution (10% in the example above), which will provide them with the space and resources to continue to grow their company.

Community:  Local communities benefit from healthy small businesses in the form of additional jobs and tax revenue.  Surrounding businesses benefit from ancillary good and services purchased such as: office supplies, shipping, dry cleaning, and lunch.  It is a virtuous cycle that benefits many.

Helpful Resources

If, after reading this article, you decide that an SBA504 loan might be for you, here are a few helpful resources to get you started:

Text of the Small Business Act:  The complete text of the congressional bill that created the SBA

SBA Lender Match Program:  Find a participating SBA 504 lender near you

Find a Local CDC:  Find a local Certified Development Company (NOTE:  The lender should have an established relationship with local CDCs, but it may still be helpful to be aware of local players

SBA Regional Offices:  A complete list of regional SBA Offices

Small Business Development Centers:  Find local assistance for things like: Business Plan Development; Financial Packaging; and Lending Assistance

Women’s Business Center:  The SBA offers specific programs to assist women in the creation of a small business

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