The Small Business Administration (“SBA”) announced changes, effective May 11, 2023, to the SBA 7(a) and 504 Business Loan Programs, broadening eligibility for SBA funding to prospective borrowers and increasing access to these funds for small business transactions. At a broad level, the new rules modify SBA 7(a) and 504 loan eligibility standards, lending criteria, and use of loan proceeds, among others. Prospective borrowers need to be aware of the following key changes. 

Revisions to the SBA’s “General Principles of Affiliation” Used to Determine Compliance with SBA’s Size Standards for SBA 7(a) and 504 Loans

As a general matter, the SBA considers a prospective borrower’s “affiliation” with other entities or persons in determining whether the prospective borrower satisfies the SBA’s so-called “size standards” for SBA loan borrowers generally. The SBA historically assessed a prospective borrower’s “affiliation” with other entities or persons using seven distinct factors, including a potential affiliate’s “control” over another entity. Per the historical rules, the SBA considered concerns and entities as affiliates of each other if (a) one affiliate controlled or had the power to control the other, or (b) a third party controlled or had the power to control concerns and entities seeking SBA 7(a) or 504 financing. The new rules remove the principle of control of one entity over the other(s) as a separate basis for determining whether entities are considered affiliates for purposes of SBA 7(a) and 504 loan eligibility. 

Consistent with this change, the new rules also remove consideration of affiliation based on management authority (allowing prospective borrowers to enter into services agreements with management companies) and identity of interest between non-owner relatives (no longer requiring non-owner close relatives in the same industry as the prospective borrower to provide their financial information to the SBA for purposes of determining a prospective borrower’s eligibility) and instead increase the SBA’s focus on affiliation based on ownership. To this end, the new rules will expand the definition of “ownership” under SBA 7(a) and 504 loan program rules to clarify ownership thresholds used to determine whether an applicant is affiliated with an individual or other business entity. However, the new rules make clear that affiliation based on ownership will only apply when the individual or entity subject to SBA review operates in the same three-digit NAICS subsector. Finally, the SBA will now consider the pro rata ownership of entities to determine affiliation for loan eligibility purposes. 

Permitting the Use of SBA 7(a) or 504 Loan Proceeds to Fund Partial Change-of-Ownership Transactions

Prior to the issuance of the new lending rules, the SBA 7(a) and 504 lending prohibited borrowers from using loan proceeds to purchase a partial ownership interest of a business. The new rules permit borrowers to use loan proceeds for the purposes of acquiring partial ownership interests of a business. Furthermore, with respect to transactions involving the acquisition of partial ownership, the SBA now allows a seller to remain as an owner, officer, director, key-employee, or employee of the target business. 

Financing Complete Partner Buyouts 

For changes of ownership between existing owners (such as a partner buy-out), the 7(a) loan will finance more than ninety percent (90%) of the purchase price if:

1. the remaining owner(s) certify that they have been actively participating in the business operation and held the same or an increasing ownership in the business for the past twenty-four (24) months
2. the business balance sheets for the most recent completed fiscal year and current quarter reflect a debt-to-worth ratio of 9:1 or lower prior to the ownership change, and, 
3. in the event that the lender is unable to document both (a) and (b), the remaining owner(s) contribute cash in the amount of at least ten percent (10%) of the purchase price of the business. For partial changes of ownership, only items (b) and (c) set out above are required.

Use of Seller-Financing for Borrower’s Equity Injection  

SBA rules require that an applicant contribute an equity injection of at least ten percent (10%) when seeking 7(a) loan financing for a startup or for the purposes of purchasing an existing business. Historically, an applicant could not use any type of seller-financing to satisfy this equity injection requirement. Under the SBA changes, for changes of ownership, seller-financing may now be considered as part of a prospective borrower’s equity injection if (a) the seller-financing is on full standby for the first twenty-four (24) months of the 7(a) loan repayment period; or (b) the prospective borrower’s acquisition target has historical cash flows to make payments of a debt that is on partial standby (allowing for interest-only payments under such debt) and at least a quarter of the SBA-required equity injection comes from a source other than the seller. 

Streamlining SBA Lending Criteria 

Under the prior SBA 7(a) and 504 loan rules, SBA lending eligibility focused primarily on a borrower’s credit, together with nine specific factors with respect to the prospective borrower ranging from character and reputation of the borrower-applicant to a businesses’ potential for long-term success. 

The new rules streamline the lending eligibility criteria by reducing the factors to three factors, being: 

1. the credit score or credit history of an applicant and its associates and guarantors; 
2. a target business’s earnings and cash flow, and; 
3. the equity and/or collateral of the applicant. 

The SBA may consider any of these three criteria singularly or in combination in assessing a borrower’s creditworthiness and eligibility for receiving an SBA 7(a) or 504 loan. 

Relaxation of Rules Regarding Hazard Insurance 

Currently, the 7(a) and 504 loan program rules require borrowers to maintain hazard insurance on all collateral, regardless of loan size. As this requirement may be burdensome and present difficulties for certain small businesses, the new rules set forth specific requirements contingent upon the amount borrowed. Under the new rules, the SBA requires a borrower to maintain hazard insurance on collateral for SBA 7(a) loans greater than $500,000. The SBA plans to issue further guidance on hazard insurance requirements for recipients holding collateral on SBA loans under $500,000. 

Many of these changes will increase access to SBA 7(a) and 504 loans which is good news for small businesses. If you think your business can benefit from this expanded access, or have questions about how these new rules may affect your business or transaction financing, please contact a member of Hinckley Allen’s corporate team to learn more.