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December 16, 2015

Best Practices: When is Equity Injection not really “Equity Injection?”

by Ethan W. Smith

Over the years, changes to SBA’s guidelines have created some ambiguity for SBA Lenders regarding the Agency’s requirements for what validly constitutes equity injection. In general, a cash injection must come in one of the three following forms: 1) cash that is not borrowed; 2) cash that is borrowed through personal credit of a principal of the business, but only if there is a source of repayment for the debt outside of the business; and 3) cash that is borrowed under debt that is on full standby for the term of the SBA loan. SOP 50 10 5(H), Subpart B, Chapter 4, Subparagraph I.E.2. This general rule has remained relatively unchanged for many years. However, a separate section of the SOP dealing with change of ownership transactions has made this rule more difficult to interpret for some SBA Lenders.

Under SOP 50 10, when an SBA Lender is financing a change of ownership transaction that has more than $500,000 of intangible assets, SBA guidelines place limitations upon the Lender’s ability to process such loans under its delegated (PLP) authority. The SOP states that for Lenders to process and approve loans such as those under their PLP authority, the “borrower and/or seller must provide an equity injection of at least 25% of the purchase price of the business…” SOP 50 10 5(H), Subpart B, Chapter 2, Subparagraph IV.

For purposes of this section, “Seller equity is defined as seller take-back financing that is on full standby (principal and interest) for a minimum of 2 years.” Id. Therefore, in order to process these loans under PLP authority, 25% of the purchase price must be some combination of traditional equity from the borrower (as set forth in the first paragraph, above) plus seller debt that must be on standby for at least 2 years.

Many Lenders have interpreted this language as meaning that seller financing on standby for 2 years counts as equity injection in all cases. This interpretation is incorrect. Seller financing on standby for 2 years is only “equity” for the purposes of meeting the 25% contribution requirement for PLP processing of loans with intangibles in excess of $500,000; it is not considered equity for any other purpose other than meeting the PLP processing threshold. Lenders that structure deals where the only “equity” is seller debt on standby for 2 years should be aware that this may constitute 100% financing, a practice that is at odds with the rationale behind the SBA’s equity injection requirement – namely that the borrower should have some “skin in the game.” Lenders that conflate a seller note on standby for 2 years with true equity may also violate their own policies which may require a certain amount of equity injection from the borrower into the deal.

Equity injection continues to be an area of scrutiny by the SBA on early defaulting loans. Lenders should review their policies and procedures regarding equity injection to ensure that they are properly characterizing seller debt that is on standby for 2 years as debt, and not equity. Failure to properly characterize and document equity injection can result in a full denial of a Lender’s SBA guaranty.

For more information regarding seller debt and the SBA’s equity injection rules, contact Ethan esmith@starfieldsmith.com¬†or at 267-470-1186.