Franchise and Business Opportunities

Financing Your Franchise: SBA Lending Basics

K. Andrew Hall

Securing adequate financing on reasonable terms can be crucial to your franchise’s long-term viability and profitability. The money to purchase your own franchise or expand your existing business must come from somewhere and often a large portion must be borrowed. Because of the low interest rates and long payment terms, an SBA loan can often be the most cost efficient means for financing your business – at least it is a financing avenue worth exploring.

SBA loans are guaranteed by the Small Business Administration, hence the name SBA loan. The Small Business Administration, however, is not the lender. SBA loans are provided by many commercial banks, which will advertise SBA lending as one of their services. Because the loans are guaranteed by the Small Business Administration, the interest rates and terms for repayment are typically more favorable than the borrower could otherwise secure. In order for a loan to qualify as an SBA loan, the borrower will typically have to meet certain criteria and the money must be used for specific expenditures.

It is a common myth that an SBA loans are only available to start-up businesses and those business going through severe financial hardship. This is simply not the case. The purpose of providing SBA loans is to provide small businesses, who might not otherwise qualify for financing, with loans on reasonable terms. The fact that a business could secure financing elsewhere does not make it ineligible for an SBA loan. However, the business must meet the requirements set by the Small Business Administration.

First, the business must be deemed a “Small Business.” The size limits vary by industry. A manufacturing company usually will qualify as a small business if it has no more than 500 employees. Retail and service businesses typically must have annual sales below $13.5 million. A start-up business will always meet this criterion and most franchisees will easily qualify as a small business.

In addition, the funds received through an SBA loan must be used to purchase or expand a business. Typical examples of acceptable uses of the funds include purchasing an existing business, purchasing land, buildings, equipment or materials and providing the business with working capital for the purchase of inventory and other such items. A business may also use an SBA loan to restructure old debt that is financed on unreasonable terms. The funds may not be allocated to restructure debt, except as described above, effect a change in ownership in the company, pay delinquent federal or state taxes, which should have been placed in escrow, or used for any unsound business purpose.

Although your business is a “small business” or start-up and you intend to use the funds for the creation or expansion of the business, you still must qualify for the loan. It is important to note that being turned away by one SBA lender does not mean that you will be turned away by all SBA lenders. Qualifying for the loan is essentially a two-step process.

First, the lending bank must approve your loan application, and each bank has its own credit standards. Second, the Small Business Administration must examine the application prior to guaranteeing the loan. Just like any other loan, the lending bank is going to want to be assured that the borrower has the ability to pay back the loan.

For an existing business, the bank will look at the financials of the company to predict future cash flow and potential profitability. Existing businesses should have up-to-date financial statements including an income statement and balance sheet when first approaching an SBA lender. Start-up businesses will need to provide the bank with a business plan, which provides realistic financial projections for the company.

The bank will also look at the borrower’s personal credit history and the amount of collateral offered in determining the borrower’s credit worthiness. If possible, any blemishes on the borrower’s credit history should be cleaned up prior to applying for the loan. Your ability to secure an SBA loan will also be improved and less time consuming if the franchise you are purchasing with the funds is on the Franchise Registry with the Small Business Administration. Choosing a “Preferred Lender Program” can also expedite the application process. Preferred lenders have a proven track record in SBA lending and can are allowed to make certain loans without receiving prior approval from the Small Business Administration, which greatly reduces the application turnaround time.

The Small Business Administration requires that all SBA loans be personally guaranteed by any person with a 20% or larger ownership interest in the business. In addition the loans will typically be collateralized with some or all of the business’s assets and possibly with personal assets such as a second home mortgage. A personal guarantee is required and the amount of collateral needed is rarely a negotiating point with the bank. However, it is important to remember that a borrower who qualifies for an SBA loan could rarely find more favorable lending terms through other sources such as a conventional commercial loan.

For SBA 7(a) loans, the Small Business Administration only guarantees 85% of the loan amount on loans up to $150,000 and 75% of the loan amount on loans over $150,000. Because the loans are not 100% guaranteed, the lenders are still taking a risk and want assurances of a borrower’s ability to repay. In addition, if a bank issues too many SBA loans that eventually default, the lender could lose its status an SBA lender.

There are several SBA loan programs, but the two most popular are the SBA 7(a) loan and the CDC 504 loan. The SBA 7(a) term loan can be utilized to finance land, buildings, machinery, equipment, inventory and working capital. As mentioned above, the Small Business Administration guarantees these loans for between 75% or 85% of the loan amount. The maximum amount of an SBA 7(a) loan was just recently increased to $2 million. The interest rates are negotiated between the lender and the borrower and can be fixed or variable. However, the Small Business Administration requires that the rates not be set above a certain level. The ceiling on the interest rates is set at between 2.25% and 4.75% above the prime rate, depending on the size and term of the loan.

The CDC 504 loan program is designed to finance long-term capital projects such as acquiring land or buildings and machinery. These funds cannot be allocated to restructure debt, provide working capital or purchase inventory. Typically, the SBA loan portion of a CDC 504 loan project is 40% with other lenders providing another 50% and the business itself supplying at least 10% of the required capital. Generally, the SBA portion of the financing cannot exceed $1 million. The loan will be collateralized with the assets being financed. To qualify for a CDC 504 loan the business must have a net worth of less than $7 million and less than $2.5 million average net income for the prior two years. While this program may be beneficial for the right business, most borrowers looking to start or fund a franchise will find that the SBA 7(a) loan program will best fit their needs.

The two largest benefits associated with using an SBA loan to finance your business are the below market interest rates and longer repayment terms, which produce lower interest expenses and better cash flow for the business. In addition, there are no balloon payments that are standard with other commercial loans, which will require refinancing at a later date. Form more information on SBA lending, there are numerous online resources available, including the Small Business Administration’s website at www.sba.gov/financing/sbaloan.

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