Best Practices: The Price of A Discount: Documenting Collateral Analysis Under the SOP 50 10 5(K)

An underlying premise of the Small Business Administration (“SBA”) 7(a) loan program is to provide financing opportunities for small businesses that demonstrate repayment ability but lack adequate collateral. Overall, lenders are expected to use commercially reasonable and prudent practices to identify collateral, which conform to procedures for their similarly-sized non-SBA guaranteed commercial loans.

Decisions regarding what  collateral must be taken to secure a loan are based on the circumstances of the individual loan. A lender’s credit should provide a detailed analysis of what assets are available and which are to be taken as collateral to comply with SBA regulations.

Under SOP 50 10 5 (K), Chapter 4, Paragraph II, B for 7(a) loans over $350,000.00, a lender MUST (i) collateralize the loan to the maximum extent possible up to the loan amount; (ii) obtain a lien on assets financed with loan proceeds (assets that are purchased or improved) and (iii) obtain a lien on all of the applicant’s fixed assets to the extent required to secure the loan, excepting real estate with equity less than 25% of its fair market value.

If the business fixed assets do not “fully secure” the loan, the lender (i) MUST take available equity in the personally owned investment and residential real estate of the principals as collateral, excepting real estate with equity less than 25% of its fair market value; and (ii) MAY include trading assets (using 10% of current book value for the calculation) if it does so for similarly sized non-SBA guaranteed commercial loans.

When an individual alone or an individual and his/her spouse together own 20% or more of the Small Business Applicant, the lender MUST consider as collateral available equity in the personally owned investment and residential real estate that is either owned individually by the applicant owner or owned jointly by the individual and his/her spouse.  Real estate transferred to non-owning spouse within six (6) months of loan application is not exempt.

In order to determine whether a loan is fully secured, a lender’s analysis must include the proper adjustment to the net book value of the borrower’s collateral using the following guidelines:

1. New machinery and equipment (excluding furniture and fixtures) may be valued at 75% of price minus any prior liens for the calculation of “fully-secured”;
2. Used or existing machinery and equipment (excluding furniture & fixtures) may be valued at 50% of Net Book Value or 80% with an Orderly Liquidation Appraisal minus any prior liens for the calculation of “fully-secured”;
3. Improved real estate can be valued at 85% and unimproved real estate can be valued at 50% of the market value for the calculation of “fully-secured” and the value must be determined in accordance with the requirements set forth in the SBA SOP concerning real estate appraisals; and
4. Furniture and Fixtures may be valued at 10% of Net Book Value or appraised value.

Lenders should carefully review the borrower’s business assets to determine which of the above categories apply, paying particular attention to properly distinguishing between machinery and equipment versus furniture and fixtures. The lender’s credit memo should ensure the proper discount is being used prior foregoing a lien on an owner’s personal residence.

While inadequate collateral of the small business applicant in and of itself is not deemed a sufficient reason to deny a loan application, the SBA does not permit its guaranty to be a substitute for available collateral. Failure to properly document the collateral analysis could be grounds for a repair or denial of the SBA guaranty.

For more information regarding SBA’s collateral requirements, please visit our website at www.starfieldsmith.com or call us at 215.542.7070.