Best Practices: Active Businesses

It is a fundamental tenet of SBA lending that businesses must be “active” small businesses to be eligible to receive SBA guaranteed loans.  SBA lenders should ensure that the small business concept that they are financing meets SBA’s definition of an active small business.  But what does this mean?

SBA regulations discuss active small businesses in various ways:

• 13 CFR 120.100 states that: “To be eligible for an SBA business loan, a small business applicant must: . . [b]e an operating business”;
• 13 CFR 120.130 states that SBA loan proceeds may not be used for: “[i]nvestments in real or personal property acquired and held primarily for sale, lease, or investment …”;
• 13 CFR 120.110 states that ineligible businesses include: “[p]assive businesses owned by developers and landlords that do not actively use or occupy the assets acquired or improved with the loan proceeds…”.

SBA’s various treatments of the concept of an active small business include the concepts of conducting operations, actively using and/or occupying the real or personal property financed with the loan, and not merely holding the assets for sale, lease, or investment.  SBA has further characterized passive businesses as those that include mere ownership interests (investments), royalty interests, income interests, or interests that do not include active day-to-day operations.  See: In The Matter Of: Buckskin Construction Company, Inc., SBA No. 480 (S.B.A.), SBA No. 480, 1994 WL 1071694.

This is germane to SBA lenders for two reasons:

First, there are small business franchise concepts popping up that involve the mere ownership of equipment by the “small business” but is actively operated by the franchisor.  Some of these franchises have even had forms of their franchise agreements listed on the SBA franchise directory in prior years, leading lenders to mistakenly believe that the business is eligible for SBA financing, notwithstanding the fact that the borrower only owns the equipment and collects a monthly royalty check from another party’s operating activities; and

Second, businesses that contract out all or substantially all of their operations to management companies, while no longer a basis for a finding of affiliation, may render their business passive and therefore ineligible.  What level of involvement is enough to render a business “active”?  SBA has not expressly addressed this question.  However, it is safe to say that an owner that contracts out 100% of the operations of the business to a third-party management company is not actively operating its business.  SBA lenders should be mindful of the fact that if a borrower is not actively managing the day to day operations of its business and is merely receiving income from the operations, the business is likely an ineligible passive business.

SBA lenders’ failure to recognize an ineligible passive business can lead to a denial of the SBA guarantee in a default situation.  For more information on SBA eligibility issues, contact Ethan at: esmith@starfieldsmith.com or 267-470-1186.