Best Practices: Funding Equity Injection through a Corporate Affiliate

Although funding equity injection through a borrower’s affiliated entity is not an uncommon practice, lenders must exercise care in these circumstances.  On many occasions, such transfers of funds from the affiliate to a borrower are characterized as gifts.  This is problematic as corporations do not “gift” monies to other corporations; corporations have a duty to act in the interests of their shareholders or members and must keep sufficient invested equity in the business to protect the business’s survival.  Lenders may wish to ask how the borrower and its affiliate “account” for the “gift” on their tax records.  Remember, if the affiliate ever requires cash in the future, it may not go back to the borrower as that money, the equity injection, must remain in the borrower’s business for not just the life of the SBA loan but “forever”.  It is a gift.  Would a real business ever do such a thing?

Therefore, if equity injection originates from a corporate affiliate, then these funds may not be considered equity injection unless said funds are: (1) a loan from the corporate affiliate to the borrower that is placed on full standby for the term of the SBA-guaranteed loan; or (2) a distribution from the corporate affiliate to the principal of the borrower.

A loan on full standby means that the borrower may not repay the loan to the corporate affiliate until the SBA-guaranteed loan has been paid in full. The purpose of this rule is to ensure that a borrower’s cash flow is used to repay the SBA-guaranteed loan before any other debt that is owed by the borrower. At the same time, it would be prudent for the underwriter to review the affiliate’s finances and, in the best case, conclude that the affiliate possesses sufficient capital to make such a loan.

Alternatively, a distribution (e.g. like a bonus) of money from the corporate affiliate to a principal of the affiliate (who is also a principal of the borrower) may count towards equity injection for the SBA-guaranteed loan. However, said distribution should be properly documented in the financial records, minutes and corporate resolutions of the affiliate and borrower.  Moreover, the underwriter, after reviewing the affiliate’s finances, should consider evaluating whether the affiliate possesses sufficient capital to make such a distribution and, if so, document this analysis in the credit file. In addition, lenders should consider reviewing distribution history of the corporate affiliate to see if similar distributions were made to the principal in the past. If not, then questions need to be asked and the response included in the credit.

Although sourcing equity injection may at times be a tedious and time-consuming process, all participating lenders must take prudent actions to verify the sources of equity injection as indicated in the SOP because failure to do so may cause the applicant’s business to fail and jeopardize the SBA guaranty. For further assistance please contact the attorneys at Starfield & Smith, P.C. at 215-542-7070 or email us at info@starfieldsmith.com.