Best Practices: Documentation of Equity Injection from an Affiliate

Prudent lenders recognize that equity injection must be verified and sourced whenever injection is required on an SBA loan.  It is often helpful to think of equity injection as new cash added to the project that is not on the applicant’s balance sheet prior to the equity requirement.  Therefore, it is not uncommon for lenders to encounter situations in which the only source of funds is from an affiliate’s account.  The purpose of this article is to help SBA lenders comply with the requirements set forth in SOP 50 10 6 relating to documentation of equity injection provided by an affiliate (as defined in 13 CFR §§ 121.103).

Typically, equity injection is paid from outside the business so that the principal has “skin in the game,” and this often means that the source is an individual guarantor who has ownership in the borrowing entity.  Lenders tend to run into an issue when an affiliate, which may or may not be a guarantor on the loan and does not have any ownership of the borrowing entity, contributes the funds for equity injection.  For example, this scenario may occur when the borrowing entity is not formed and the existing affiliate signs a purchase/sale contract and pays the earnest money deposit pending formation of the new borrowing entity.

SOP 50 10 6 states that the following may be considered as equity injection: (i) cash that is not borrowed; (ii) cash that is borrowed through a personal loan to the business owner with repayment demonstrated to come from a source other than the cash flow of the business; (iii) assets other than cash; and (iv) debt placed on full standby (no payments of principal or interest for the term of the SBA-guaranteed loan).

SOP 50 10 6 further clarifies that a lender must obtain the following documentation in order to verify cash injection: (i) a copy of a check or wire transfer along with evidence that the check or wire was processed showing the funds were moved into the borrower’s account or escrow; (ii) a copy of the two most recent statements from the account where the funds are being withdrawn (showing that funds were available); and (iii) a statement from the borrower’s account documenting the funds were deposited or a copy of a settlement statement showing the use of the cash.  Equity injection may also be verified with a promissory note, “gift letter,” or financial statement plus sufficient evidence of cash injection as described above.

As a general rule, corporations and limited liability companies cannot make so-called “gifts” to affiliated entities and be considered “equity injection” for a variety of reasons, including IRS policy.  Such a transfer would be considered a loan.  Therefore, an affiliate can only make a loan to the borrower or a distribution to a shareholder or member who is an individual guarantor on the loan.  The borrower should explain how it is treating this type of transfer of funds on its financial statement.

If the equity injection is from an affiliate and constitutes a loan, then the funds must be placed on full standby for the term of the loan, and the affiliate must sign an SBA-compliant standby creditor’s agreement that includes a copy of the fully-executed standby note.  If a note has not been signed, then a note should be created by the borrower and its affiliate, and signed prior to closing.

If the affiliate instead makes a distribution to a guarantor on the SBA loan, then this distribution must be properly documented in order to be considered equity injection.  In this scenario, the lender should consider obtaining the following documentation: (i) corporate minutes or a resolution from the affiliate authorizing the distribution to the shareholder or member; (ii) a letter or affidavit from the borrower, affiliate and guarantor that the “distribution” will not be repaid to the affiliate by the borrower during the life of the SBA loan; and (iii) documentation (described above) to verify that the funds were transferred to the account of the owner/guarantor who then transferred the funds to the account of the borrowing entity to apply to the transaction.

With the exception of SBA Express and Export Express loans, Lenders must verify the injection prior to disbursing any loan proceeds and must maintain evidence of such verification in their loan files.  Lenders are expected to use reasonable and prudent efforts to verify that equity is injected and used as intended, and failure to do so may warrant a repair or partial/full denial.  Lenders must submit with each purchase request on a loan for which the loan authorization required an equity injection, documentation to show that they verified and sourced the equity injection, and that the actions taken constituted prudent lending.

As a final takeaway, an SBA lender may wish to consider adding a narrative in the credit approval which addresses the financial condition of the affiliate and why it is likely that the funds would not be needed by the affiliate during the term of the SBA loan.  Such an analysis requires the lender to carefully review the affiliate’s financials.  Explaining why the affiliate would likely not require repayment on the standby note during the term of the SBA loan, based upon the present and projected financial conditions of the borrower and affiliate, might help protect the lender’s SBA loan guaranty if the borrower transfers those funds back to the affiliate after loan closing and the SBA loan suffers an early default.

For more information regarding verification of equity injection provided by an affiliate, please contact the attorneys at Starfield & Smith, PC at (215) 542-7070 or visit us at www.starfieldsmith.com.