Best Practices: Documenting Equity Injection from Affiliates in 7(a) Loans

Recently, we have been asked if equity injection from an applicant’s corporate affiliate can come in the form of a gift. The short answer is no. In addition to income and gift tax implications beyond the scope of this article, getting cash out of a corporation rarely takes the form of a gift, unless it is charitable in nature to non-profit entities. Generally, corporate law limits withdrawals of cash from a corporation to be in the form of a loan or a distribution of cash or property to its shareholders (in addition to salaries, dividends, fringe benefits and the like). Consequently, cash injection coming from a corporate affiliate must either be in the form of a loan or a distribution and not a gift.

In general, the analysis involving an applicant’s equity injection is three-fold: (i) determining whether an injection is required; (ii) sourcing the equity; and (iii) documenting and verifying the equity injection. Thus, for loans where an equity injection is required by the SOP, or the creditor’s internal underwriting decision, lenders are expected to use reasonable and prudent efforts to source, document and verify that equity is in fact injected and used as intended.

Sourcing Equity

Typically, when sourcing the applicant’s equity, the following may be considered as equity injection: (i) cash that is not borrowed, (ii) assets other than cash, and (iii) standby debt. If the equity is coming from a corporate affiliate, consider first whether it is coming in the form of a loan from the affiliate or a cash distribution to the applicant’s (and affiliate’s) owner.

Loans

Under the current version of the SOP 50 10 5, only debt owned by the applicant that is on full standby (no payments of principal or interest for the term of the SBA-guaranteed loan) may be considered as equity for SBA’s purposes. Therefore, equity injection originating from a corporate affiliate in the form of a loan, whether an intra-company or shareholder loan, will need to be placed on full standby for the term of the SBA loan. Documenting and verifying the loan from the affiliate will require the lender to obtain a copy of the promissory note and ascertain the standby and subordination terms that will be in place.

Distributions

Alternatively, if the equity from the corporate affiliate is in the form of a distribution of cash or assets to the principal of the affiliate, the lender should obtain documentation from the affiliate evidencing the payment of the distribution. Distributions to shareholders may either be in the form of a dividend or a return of capital. Each carries its own tax implications. In either case, the distribution must be documented in keeping with corporate formalities including, but not limited to, accurate financial records, minutes of meetings showing adopting resolutions to fund distributions to shareholders, and its tax treatment.

Verifying Injection

Once the equity injection from the corporate affiliate is duly sourced, the lender must further verify and document the cash injection into the applicant by obtaining the following:

a) A copy of a check or wire transfer along with evidence that the check or wire was processed showing the funds are ultimately moved into the borrower’s account or escrow;

b) A copy of the two most recent statements from the account where the funds are being withdrawn (showing that funds were available); and

c) A statement from the borrower’s account documenting the funds were deposited or a copy of a settlement statement or HUD-1 showing the use of the cash.

The rules regulating SBA lending require the loan applicant to be creditworthy and reasonably able to repay the loan. 13 CFR § 120.150(f). Principal among the factors considered as part of this analysis is whether the applicant has “[s]ufficient invested equity to operate on a sound financial basis.” Id. Sourcing, verifying and documenting injection is key to lenders in protecting and preserving their SBA guaranty. For more information regarding equity injection requirements, please contact Victor at vdiaz@starfieldsmith.com or at 407-618-0694.