Using an SBA 7a or 504 Loan for Equipment Finance
Have You Considered an SBA Loan for Your Next Equipment Acquisition?
By Jeff Bardos, CEO, Speritas Capital Partners (Jeff’s Bio)
Originally published in Newsline, the Magazine of the National Equipment Finance Association, March/April 2019 issue, page 46 – View Newsline online
Scenario… Amanda is the CFO of a $10 million manufacturing company that has decided to buy $1 million of equipment for a new product line. She’s used a private equipment finance company for previous purchases, but they only offer 5-year terms– even when her equipment has a useful life of well over 5 years.
She remembers someone had mentioned Small Business Administration (SBA) financing as an option, but she doesn’t know how those programs work and she’s heard they involve a lot of paperwork and take a lot of time.
But that’s not always the case. Although SBA guaranteed loans don’t fit every situation, they can be an option worth exploring. Many SBA lenders have a streamlined due diligence process and can offer longer maturities and lower rates than some leasing options. Lower rates and longer maturities yield more cash for operations.
What SBA Loan Programs are Relevant for Equipment Finance?
SBA loan programs have been around since 1953 when Congress established the SBA. These programs are designed to fill a gap for businesses which have sufficient cash flow (historically and/or projected) to repay a loan but don’t otherwise fit conventional lenders’ credit profiles (e.g., time in business, collateral, industry).
The SBA does not lend directly to borrowers. SBA-approved lenders originate the loan and the SBA guarantees a portion, up to 85% of the loan. If the borrower were to default, the SBA would repay the guaranteed portion of the remaining loan balance. As a result, lenders are more willing to provide a ‘less than perfect borrower’ with an SBA loan.
The main SBA loan programs relevant to equipment finance are 7(a) and 504. The 7(a) loan program is the SBA’s largest program, accounting for roughly 80% of all SBA lending 7(a) loans require a 10-20% equity contribution from the borrower.
The other 20% of SBA loan volume is lent out through the SBA’s 504 program. The 504 program provides long-term financing for the purchase of fixed assets, which includes real estate, heavy machinery and equipment. SBA 504 loans are made available through Certified Development Companies (CDCs), community-based partners that arrange the 504 financing. 504 loans are typically 10/40/50 – 10% equity, 40% SBA guarantee, 50% senior lender.
Small business owners may not realize two important aspects of the SBA’s 7a & 504 loan programs:
1) Many small to lower middle market businesses qualify as small businesses for SBA loan purposes, defined as having tangible net worth less than $15 million and after-tax net income of $5 million or less in the previous 2 years; and
2) The size of these loan programs – the SBA’s total program portfolio stood at $142 billion as of the end of fiscal year 2018.
Why Consider an SBA 7a or 504 Loan for Equipment Purchases?
Broad Range of Eligible Equipment
A wide range of both new and used equipment can be financed.
Examples of 7(a)-eligible equipment include rolling stock, construction equipment, production lines, IT-related, restaurant equipment, office equipment and office furniture.
Examples of 504-eligible assets, other than real estate, include equipment with a useful life over 10 years, such as manufacturing equipment, precision equipment, printing equipment, loaders and forklifts, construction equipment, large off-road trucks, commercial kitchen and commercial laundry equipment, and equipment involved in renewable energy or fuels.
Equipment appraisals may be required, mainly for used equipment purchases.
Competitive Interest Rates
SBA loan programs are priced between conventional bank interest rates and nonbank leasing rates. Recent 7(a) rates have ranged from 6% to 8%, while 504 loan rates have ranged from 4% to 5%.
Most 7(a) loans are variable rate, priced as a spread to Prime. The maximum spread is 2.75% for loans over $50,000. Lenders who keep the loans on balance sheet, mainly the largest banks, will offer fixed rate 7(a) loans to borrowers with strong credit.
504 loans are primarily fixed rate, although the senior, conventional loan can reset after a fixed period, typically 5 years. So a borrower can have relative cash flow certainty for up to 25 years for long-lived assets.
The CDC/SBA component of the 504 loan, including fees, recently priced at 4.75-5.0%. Senior, conventional loan rates range from 4.75% to 7% depending on the credit of the borrower, the equipment type and the length of the initial fixed rate period.
Both the 7(a) and 504 programs allow for longer maturities than conventional loans and leases. 7(a) loans collateralized by equipment can go out to 10 years, while 504 equipment loans can go as far out as 25 years. Both programs limit the loan maturity to the shorter of the maximum maturity and the equipment’s useful life. Real estate in the collateral pool will extend the allowable maturity.
SBA loans are straight amortization loans with no balloon payments. At the end of the loan, the borrower owns the equipment free and clear without any residual or refinancing risk.
Low Equity Requirements
SBA lenders will require the borrower to provide “equity” in the equipment acquisition but the requirements are relatively low. The equity component will range from 10-20% depending on the strength of the borrower and the equipment being financed. This amount of leverage in an SBA structure is higher than most conventional equipment finance structures.
What Types of Businesses Can Borrow Through SBA Loan Programs?
SBA lenders focus on business cash flow as the primary source of repayment, with collateral a secondary consideration. SBA lending criteria is generally more flexible than conventional lending criteria. In fact, SBA lenders are required to document that they would not have provided a loan without the SBA guarantee.
SBA eligibility focuses on 5 main criteria: industry, size of the business, time in business, credit and cash flow.
- Industry – Most for-profit businesses looking to buy machinery or equipment will fall into allowable industries. Nonprofits are not eligible. A broad range of equipment is eligible for financing under the 7(a) program. Equipment financeable in a 504 loan is limited to fixed machinery and equipment.
- Size – The first issue is quantitative – does the business meet the net worth and income tests. To qualify, the business must have a tangible net worth less than $15 million and an average after-tax net income of less than $5 million for the previous two years.
- Time in business – The standard time in business is 2 years because many lenders want to see 2 years of tax returns. There are SBA lenders who will consider early stage companies which have a strong, supportable business plan and an experienced management team.
- Credit – SBA loans require good business and good personal credit. If the credit of the primary owner(s) is weak then SBA may not be a good fit. Personal credit strength is important because SBA loans will require personal guarantees from anyone with 20% or greater ownership.
- Cash Flow – SBA lenders are not primarily collateral lenders and will focus on the borrower’s ability to repay the loan. Ability to repay will be assessed through an analysis of historical and projected free cash flow. Some SBA lenders are more willing to rely on projected cash flow over historical. Debt service coverage ratios above 1.2x are common.
Who Offers SBA 7a & 504 Loans?
Many banks and even some nonbanks offer SBA loans. But borrowers should focus on “Preferred Lenders” because they have delegated authority to underwrite and approve SBA loans. Preferred Lenders have delegated authority for loan approval, closing, servicing and liquidation, enabling them to make loan decisions quickly.
SBA 7a & 504 Loans Might Fit
Small businesses should consider SBA loans as an option for their equipment financing needs. Most borrowers think in terms of the two better-known options for their equipment finance needs – equipment leasing and conventional equipment finance. SBA loans offer lower costs, longer maturities and higher leverage.
Sometimes the equipment finance division of a lender may not be aware of the SBA loan options or the lender may not be a Preferred Lender. Make sure you make direct contact with a SBA Preferred Lender if you think SBA could be a good fit.
Understanding all your options is the first step to finding the right equipment financing source.
About the Author
Jeff Bardos, CEO, Speritas Capital Partners
Jeff has over 25 years of experience in the financial services industry. After graduating from the Columbia Business School, he joined the New York Federal Reserve Bank as a senior staff member in Bank Supervision, leading the Bank Analysis department. From the nation’s central bank, Jeff moved into the private sector, working at senior levels in commercial banking, retail banking and risk management. He has also played senior founding roles in several start-ups. Learn more about Jeff.
CEO Speritas Capital Partners
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