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May 24, 2011

Firm News for May 2011: Best Practices: Stock Purchase Update

By: Ethan W. Smith, Esq.

In the March 2, 2011 edition of our newsletter, we discussed SBA’s new policy on changes of ownership that are structured as stock purchases. In that article, we articulated SBA’s position that person to person stock transfers are not eligible for SBA financing, and that any stock transaction must be structured as a stock redemption to be eligible for SBA financing.

At the recent NAGGL Mid-Year Technical Issues Conference in Atlanta, SBA officials provided additional clarification on this issue. Essentially, SBA maintains that to allow SBA financing of person to person stock transfers is to permit SBA loans to be used for the benefit of an Associate of the Applicant small business. 13 CFR 120.10 defines an Associate of a Small Business as:

(i) An officer, director, owner of more than 20 percent of the equity, or key employee of the small business;

(ii) Any entity in which one or more individuals referred to in paragraphs (2)(i) of this definition owns or controls at least 20 percent; and

(iii) Any individual or entity in control of or controlled by the small business (except a Small Business Investment Company (”SBIC”) licensed by SBA).

The SOP 50 10 and the CFR further state, in discussing prohibited uses of proceeds, that SBA will not allow a Borrower to use loan proceeds for “[p]ayments, distributions or loans to Associates of the applicant…” (SOP 50 10 5(C), p.141; 13 CFR §120.130). In the context of a change of ownership, SBA takes the position that it cannot finance an individual’s acquisition of stock because such use of proceeds would constitute a payment or distribution to or for the benefit of the acquiring shareholder who is an Associate of the small business applicant. Accordingly, the SOP was revised to remove provisions allowing for individuals to purchase the stock of a business if the individuals executed the note on a joint and several basis with the business.

Notwithstanding SBA’s policy clarification on this issue, difficult questions remain. 13 CFR 120.202 governs changes of ownership for 7(a) loans. It states: “One or more current owners may use loan proceeds to purchase the entire interest of another current owner, or a Borrower can purchase ownership of an entire business.” This provision clearly seems to contemplate the financing stock transfers between current owners, notwithstanding the fact that they are Associates of the Small business. Additionally, the SOP states that the following changes of ownership are not eligible:

“a) A non-owner who is purchasing a portion of the ownership of the business from a selling owner; or

b) An existing owner who is purchasing the ownership of another existing owner that will not result in 100% ownership by the purchaser.” (SOP 50 10 5(C), p.148)

Implicit in these provisions, which restrict partial transfers of ownership, is that transfers which are not prohibited by this language are eligible. Accordingly, this language implies that: (i) a non-owner may purchase the entire ownership interest of a business from a selling owner, presumably through a purchase of the ownership interest (the stock) of the business; and (ii) an existing owner (presumably both a shareholder and Associate of the business) may purchase 100% of the ownership (the stock) of another existing owner (also a shareholder, and interestingly, also an Associate of the business).

What options do lenders have in light of this policy ambiguity? For now, the safest course of action is to either: (a) to the extent possible, structure partner buy-out transactions as stock redemptions; or (b) submit all stock purchases for GP or CLP processing and approval to avoid potential eligibility issues in a guaranty purchase context.

For more information on changes of ownership and other SBA eligibility matters, contact Ethan at 267-470-1186 or esmith@starfieldsmith.com.