Best Practices: Leasehold Improvements with Tenant Improvement Allowance

SBA 7a loan proceeds may be used by a borrower to make improvements to a leased premises where it operates its business. Many times, a borrower will negotiate a tenant improvement allowance into the lease terms. A tenant improvement allowance is an amount of money the landlord is willing to contribute towards the improvements to entice the tenant to sign a lease and improve its space. A tenant will typically spend its own money on the build-out first and then the landlord will either: (i) reduce rent payments for a portion of time; (ii) provide the tenant with progress payments as work is completed; or (iii) reimburse the tenant with the a lump sum payment once construction is complete. The focus of this article is how a lump sum reimbursement of tenant improvement allowance should be treated within the context of an SBA 7a loan.

So, who may receive a reimbursement of funds spent on leasehold improvements? Does it matter if the funds spent on leasehold improvements were equity injection or loan proceeds? And, what must that individual or entity do with those funds once received?

Although SOP 50 10 5 (J) (the “SOP”) does not include written guidance on “rebates” such as a post-construction lump sum payment of a tenant improvement allowance, the SOP is clear that SBA loan proceeds may not be used for payments, distributions or loans to an Associate of the Applicant (as defined in 13 CFR §120.10) except for compensation for services actually rendered at a fair and reasonable rate. This restriction also includes the replacement of funds used or borrowed for any such purpose. Also see 13 CFR §120.130(a). When the small business applicant is a start-up, the borrower’s equity injection typically comes from an owner of the business. Thus, the owner cannot pocket a reimbursement of funds injected into the loan as equity towards leasehold improvements via a tenant improvement allowance. Instead, the reimbursed funds must be used by the owner to pay down the loan.

But, what if the borrower is not a start-up and the funds for tenant improvement come from the borrower’s own sources or loan proceeds? Can the tenant allowance reimbursement be paid directly to the borrower?

While the SOP does not specifically state these funds must be used to pay down the loan, we reach the same conclusion as above that upon receipt of a reimbursement of tenant improvement allowance, the borrower should pay down the loan. The lender should at all times pre-emptively protect its guaranty and prevent any potential SBA repair or denial related to the ultimate use of proceeds and/or borrower equity injection. In light of this, the best practice is for the lender to require the borrower to immediately pay down the principal balance of the loan with a portion or all of the tenant reimbursement, which amount would be determined by the use of proceeds and the equity injection requirement.

Usually the borrower must provide specific documentation to the landlord to show the completion of construction in order for the landlord to disburse a post-construction lump sum reimbursement, but the lender does not typically have control over this process. Therefore, it is important for the lender to include provisions in the construction loan agreement or another appropriate loan document which requires the following provisions at a minimum:

• Absolute and unconditional assignment, transfer, and conveyance to lender of all or a portion of the borrower’s right, title, and interest in and to the tenant improvement allowance;
• Confirmation that the borrower has not assigned, transferred, pledged, or otherwise encumbered the tenant improvement allowance, or any part thereof, or any portion of borrower’s right, title, and interest thereto, or contracted to do any of the foregoing; and
• Lender’s receipt of a portion or all of the tenant improvement allowance no later than thirty (30) days from the date of receipt by borrower of the funds, or it shall be a default under the loan.

For more information regarding the treatment of a tenant improvement allowance as part of an SBA loan for leasehold improvements, please contact Kristen at (407) 618-0698 or at kdickey@starfieldsmith.com.