Best Practices: Updates to Equity Injection Guidelines

On May 9, 2023, the SBA issued Procedural Notice 5000-846607 (“SBA Notice”) that revised the guidelines in the SOP 50 10 6 pertaining to equity injection requirements. These changes are also reflected in the SOP 50 10 7, which will go into effect August 1, 2023. The SBA Notice removed the requirement that certain loans must have sufficient invested equity and instead made this a prudent lending requirement. As such, except for transactions involving changes in ownership, lender’s requirement for equity injection and source thereof must be consistent with its similarly-sized non-SBA commercial loans.

 For transactions involving a change of ownership, the amount equity injection remains similar to the current SOP 50 10 6, but what can count towards equity injection has changed. A complete change of ownership still requires minimum equity injection of 10% based on the total project costs; however, seller debt may now be counted towards borrower’s injection requirements when either: (1) the Seller debt is on full standby for the first 24 months of the SBA loan; or (2) the Seller debt is on (i) partial standby requiring the borrower to make interest only payments, (ii) there is historical business cash flow to make the interest only payments, and (iii) at least 25% of the SBA required equity injection is from a source other than the seller.

It’s important to point out that as of the date of this article, the SBA has not provided additional guidelines about when the borrower can start making the combined principal and interest payments for the partial standby seller debt loan, or whether cash gifts or funds from an affiliate can count towards the “other source” of the 25% equity injection.

For transactions involving a complete partner buyout, the SBA still requires a certification from the remaining partners (or owners) to attest to the fact that (1) they have been active in business and held the same or increasing ownership interest for the past 24 months, and (2) that the balance sheet of the business reflects a debt-to-worth ratio of no greater than 9:1 prior to the buyout. If these requirements cannot be met, the borrower will need to contribute at least 10% of the purchase price as dictated by terms of the purchase agreement.

Another big change that’s coming with the new SOP is the ability for the borrowers to obtain loans for financing partial changes of ownership. To implement this new rule, the proposed equity injection guidelines are similar (but not the same) to that of a complete partner buyout as mentioned above. Specifically, the business balance sheets for the most recent completed fiscal year and current quarter must reflect a debt-to-worth ratio of no greater than 9:1 prior to the change of ownership. In the event this condition cannot be documented, a minimum cash injection of at least 10% of the partial change of ownership purchase price will be required.

But what happens when there is no change of ownership – instead one business acquires another business? According to the new guidelines in the SOP, the SBA will treat this transaction as “business expansion” and will not require a minimum equity injection so long as: (1) the existing business and the business that’s being acquired have the same 6-digit North American Industry Classification System (“NAICS”) code, (2) both businesses will have identical ownership, and (3) both businesses are located in the same geographic area. It’s important to point out that as of the date of this article, the SBA has not provided additional guidelines about counts as the “same geographic area.” However, historically, many lenders have defined and treated the “same geographic area” to mean the “same area of commute.”

Given these changes to the SOP, if the lender or the SBA require equity injection, lenders must carefully consider the SBA’s expectations pertaining to properly sourcing the required equity injection. Although additional guidelines or clarity will likely be needed in the future, the SBA expects that all participating SBA lenders will follow their internal commercial loan policies to determine if the source of equity injection must be verified. It is important to note that this change took effect on May 11, 2023, as such, for loans that were approved after this date, SBA lenders must document the steps it takes to verify injection and explain in their credit memorandum any change to verification that may differ from those set forth in the SOP 50 10 6, but are consistent with lender’s non-SBA guaranteed commercial loans.

Under the new rules currently in effect, except for transactions involving changes in ownership, lender’s requirement for equity injection must be consistent with its similarly-sized non-SBA guaranteed commercial loans. This certainly does not mean that SBA lenders have carte blanche, however, lenders do have discretion to reduce (or increase) the requirement for equity or equity injection so long as doing so is consistent with its policy for similarly-sized non-SBA guaranteed loans. The rules also allow for flexibility in how source is documented, so long as such requirements are consistent with the lender’s conventional loan policies. Lenders must clearly document their justification for any such changes in their credit memorandum.

For further assistance please contact the attorneys at Starfield & Smith, P.C. at 215-542-7070 or email us at info@starfieldsmith.com.