Best Practices: Change in Restriction on Uses of Proceeds under the SBA Proposed Rule

On October 26, 2022 Volume 87, No. 206 of the Federal Register contained a Notice of Proposed Rulemaking on Affiliation and Lending Criteria for the SBA Business Loan Programs.  The purpose of the proposed Rule is to streamline and modernize regulations on lending criteria and loan conditions for the 7(a) and 504 loan programs to better help meet the needs of America’s small businesses, create jobs, assist with recovery from the COVID-19 pandemic, and grow the economy.

Among the proposed changes is removing the barrier to using loan proceeds to purchase a portion of a business or another owner’s interest in a business.  Currently loan proceeds may only be used to fund the purchase of an entire business or an owner’s entire ownership interest.

The SBA believes such a change will help close the gap in financing for those businesses that wish to undergo a partial change of ownership, such as when a buyer for a complete change of ownership cannot be found or an owner of a small business is not yet ready to retire but wants to ensure the future of the small business by bringing in new ownership to learn the business under the owner’s tutelage.

The proposed change could also assist when employees being offered an ownership opportunity are unable to find private financing to purchase such a partial ownership, allowing for employee ownership of a business without the additional upfront and ongoing costs incurred by a small business in the formation and operation of an Employer Stock Ownership Plan (“ESOP”) trust.

This change would be accomplished by removing the reference to 13 CFR §120.202 in 13 CFR §120.130(g) and revising 13 CFR §120.202 to read as follows:

• 120.202 Loans for changes of ownership. Notwithstanding §120.130(a), a Borrower may use 7(a) loan proceeds to purchase a portion or the entirety of an owner’s interest in a business, or a partial or full purchase of a business itself.

The carve-out of the application of §120.130(a) to this provision is of great importance.  Without it the proposed partial change of ownership use of proceeds could be considered to be a payment to an Associate of the applicant, which is a restricted use of proceeds under such subsection (a).

If this part of the rule moves forward without revision, it will raise questions for lenders concerning how such a loan should be structured, especially if a selling owner owns more than 20% of the business prior to sale but drops to under 20% upon the closing of the sale.  Will such a seller be excused from being a guarantor due to the ownership being under 20% or will the seller be required to be a guarantor, such as when there is an ESOP involved and the seller who remains an owner must provide a full, unlimited guarantee regardless of percentage of ownership?

In the case of a partial ownership interest sale, will the SBA add any restrictions or requirements in relation to such seller (i.e., sale proceeds must pay down/off any debt owed by the seller to the small business)?

The restriction on a seller remaining as an officer, director, stockholder or Key Employee currently contained in SOP 50 10 6 would also have to be revised to allow an exception for partial changes of ownership transactions.

All SBA lenders should review the Notice of Proposed Rulemaking and provide the SBA with comments. You may submit comments, identified by RIN 3245–AH87, through the Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments. SBA will post all comments on http://www.regulations.gov. For more information, contact the attorneys at Starfield & Smith, P.C. at 215-542-7070.