Announced on October 16, 2017, and effective January 1, 2018, the Small Business Administration (“SBA”) has issued a newly amended Standard Operating Procedure (“SOP”), known as 50 10 5 (J), which includes substantive changes to the SBA’s equity injection requirements for applicants financing start-up businesses and/or changes of ownership.  Specifically, SOP 50-10 5(J) provides (see Page 174):

 Equity requirements (for 7(a) loans greater than $350,000 and loans of $350,000 or less that do not meet SBA’s minimum credit score requirements for 7(a) Small Loans):

1. The Lender must determine if the equity position, any required equity injection and the pro forma debt-to-worth are acceptable based on the factors related to the type of business, experience of management and the level of competition in the market area. The Lender must include a detailed discussion of the equity position (net worth) and any required equity injection. (See Chapter 7 of this SOP Subpart for requirements concerning documenting and verifying equity injection.)
2. Minimum equity injection requirements for certain Applicants or loans:
   1. Start-Up businesses – At a minimum, SBA considers an equity injection (Applicant contribution) of at least ten (10) percent of the total project costs to be necessary for a start-up business to operate on a sound financial basis;
   2. Changes of ownership:
      1. Resulting in a new owner (complete change of ownership): SBA considers an equity injection of at least 10 percent of the total project costs to be necessary for such change of ownership transactions. Seller debt may not be considered as part of the equity injection unless it is on full standby for the life of the SBA loan and it does not exceed half of the required equity injection;
      2. Change of ownership between existing owners (“partner buyout”): The pro-forma equity position after the change of ownership must be at least 10 percent of the total assets. Otherwise, the remaining owner(s) must provide an additional equity injection that will result in at least a 10 percent net worth (maximum pro forma debt-to-worth ratio of 9:1).
3. Source of Equity Injection:
   1. The following may be considered as equity injection:
      1. Cash that is not borrowed.
      2. 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 (the salary paid to the owner by the business does not qualify). If the personal loan is made by the participating Lender, the Lender must submit the application through non-delegated 7(a) processing.
      3. Assets other than Cash – Lenders must carefully evaluate the value of assets other than cash that are injected by owners. An appraisal or other valuation by an independent third party is required if the valuation of the fixed assets is greater than the depreciated value (net book value). A valuation of the fixed assets provided as part of a business valuation will not meet these requirements
      4. Standby debt – Only debt that is on full standby (no payments of principal or interest for the term of the SBA-guaranteed loan) may be considered as equity for SBA’s purposes. A copy of the note must be attached to the standby agreement.
   2. The following may not be considered as Equity Injection:
      1. Value or cost of education; and
      2. Funds that are borrowed and do not meet the exception noted in subparagraph (a)(ii) immediately above.
   3. Standby Agreements:
      1. Lender may use SBA Form 155 or its own Standby Agreement form. A copy of the note must be attached to the standby agreement.
      2. Standby Creditor must subordinate any lien rights in collateral securing the loan to Lender’s rights in the collateral, and take no action against Borrower or any collateral securing the Standby Debt without Lender’s consent.

WHAT THIS MEANS:

The requirement that start-up applicants inject at least ten (10) percent of the total project costs  is a change from recent versions of the SOP; presently, there is no minimum equity injection requirement for start-up businesses and lenders have the discretion to determine the appropriate amount of equity injection.  Likewise, borrowers financing a complete change of ownership must also need to inject a minimum of ten (10) percent of the total project costs.   However, per the revised SOP, when a change of ownership occurs between existing owners:  (1) the pro forma equity position of the remaining owner(s) after the change of ownership must be at least ten (10) percent of the total assets; if not, then the remaining owner(s) must provide an additional equity injection that will result in not less than a ten (10) percent net worth of total assets (i.e., a maximum pro forma debt-to-worth ratio of 9:1).

Accordingly, the Lender’s best practice it to properly document the value of the borrower’s assets when calculating its net worth and the corresponding equity requirement.   Note that SOP 50 10 5(J) does not require a minimum equity requirements for real estate acquisitions; however, a prudent lender should ensure that a reasonable equity injection is considered.

SOP 50 10 5 (J) also has new rules as to what is eligible equity injection:  seller financing may only qualify as equity injection if the seller debt is on fully standby for the life of the SBA loan and the seller debt does not exceed half of the required equity injection.  Prior to SOP 50 10 5 (J), seller debt could be counted as equity injection provided that it was subordinate to the SBA financing and on standby for the first two (2) years of the SBA loan.  As before, the Lender is required to obtain SBA Form 155 (or lender’s equivalent Standby Agreement) with a copy of the Promissory Note representing the seller debt.

Further, SOP 50 10 5 (J) removes the SBA’s requirement for PLP processed loans in which an applicant financing a change of ownership and acquiring $500,000 or more of intangible assets inject twenty-five (25) percent of the total project costs.  In lieu of the twenty-five (25) percent equity injection requirement, the lender must comply with the ten (10) percent equity injection rules discussed above.