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1 welcome For Today s Session Quick review of recent legislative changes Update regarding coming changes to program requirements Discussion of some of the most difficult issues facing lenders now 2 Veterans Entrepreneurship Act of 2015 (7/28/2015) Changes: Increased (a) program level from $18.75 to $23.5 billion putting 7(a) back in business after the entire 2015 authority had been used up by 7/22/2015 Made the fee waiver for SBA Express loans to veterans permanent as long as no appropriations required for 7(a) loans (zero subsidy) Clarified credit elsewhere test requirements (change effective 10/1/2015 more on this later) Added new requirements for SBA to report various data to the Congress 3 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 1

2 Consolidated Appropriations Act of 2016 (12/18/2015) Provided a 7(a) program level for FY 2016 of $26.5 billion (zero subsidy) Provided a 504 program level for FY 2016 of $7.5 billion (returned to zero subsidy) Provided debt refinancing authority for the 504 program with defined parameters effective when the program is at zero subsidy 4 Pending Changes to Program Requirements 5 Pending New Regulations Final Rule on affiliation/franchises Will reflect public comments received in response to 3 requests for comments on affiliation and franchise requirements and processes Catch-all regulation Non-substantive housekeeping changes, e.g., removal of references to CLP, some modifications to oversight requirements and (hopefully!) minor change to clarify EPC/OC requirements 6 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 2

3 Two New Versions of SOP Pending SOP (I) Expected to be issued soon SOP Expected to be issued by the end of the year 7 SOP (I) Expected to include Changes from upcoming regulations regarding affiliation/franchises eligibility and process AND Additional guidance regarding meeting credit elsewhere requirements 8 SOP Rumor (subject to change!) has it that among possible changes in the SOP are Re-ordering of material possibly to discuss by program (e.g., CAPLines) as opposed by topic (e.g., collateral) EPC/OC to track to pending regulation changes 912 process possibly making fingerprinting mandatory which will speed up process Equity requirements/100% financing requirements for lenders discussion regarding leverage 9 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 3

4 Difficult Processing Issues 10 Issues Under Greatest Scrutiny Credit Elsewhere appropriately documenting that statutory test is met 100% Financing determining whether and how much equity injection to require 11 Credit Elsewhere Threshold issue loan is NOT eligible if credit elsewhere test is not met Congress, GAO, OIG and SBA, especially OCRM, are looking to assure that lenders are not using the SBA guaranty to make a loan that could be made conventionally 12 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 4

5 Credit Elsewhere Defined Small Business Act, Section 3(h): For purposes of this Act, the term credit elsewhere means the availability of credit from non-federal sources on reasonable terms and conditions taking into consideration the prevailing rates and terms in the community in or near where the concern transacts business, or the homeowner resides, for similar purposes and periods of time 13 Credit Elsewhere Requirements No financial assistance shall be extended pursuant to this subsection if the applicant can obtain credit elsewhere [Small Business Act, Sec. 7(a)(1)(A)] The Small Business Applicant Must Demonstrate a Need for a Guaranty on the Loan [5(H), page 87] 14 Documenting Need for Guaranty Lender must document in the loan file the factors that prevent the financing from being accomplished without SBA support This is not a box-checking exercise Rationale must be specific to the individual loan a generic statement is NOT enough Credit elsewhere issue is on Congress radar screen as evidenced by 7/2015 legislation expect greater scrutiny of how SBA and lenders satisfy the statutory mandate! 15 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 5

6 Factors That Demonstrate Need i.e., Credit Elsewhere Test Acceptable factors: Need for longer maturity than lender policy permits Loan exceeds lender s legal lending limit/policy* Lender liquidity depends on secondary market* Inadequate collateral under lender policy Violates lender policy regarding loans to new businesses or in applicant s industry and/or Any other factor related to credit that require guaranty * Per recent statute neither can be sole justification 16 Meeting Credit Elsewhere Test (cont) Unacceptable factors: To address CRA compliance To refinance debt already on reasonable terms 17 What you should be doing now... Watch for clarifying guidance from SBA expected out soon In the meantime Follow current guidance and Write your credit elsewhere justifications so that they are fact-specific to the individual loan This is NOT a box-checking exercise and A standard blurb is NOT enough 18 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 6

7 Equity Injection Requirements Loans of $350,000 and less Lender must determine if equity and pro forma debt-toworth are acceptable based on its policies on similarly sized non-sba loans If equity injection required, must be verified if lender s policy would require verification on conventional loans... 5(H), page Equity Injection Requirements (cont) Loans over $350,000 Adequate equity important to long-term survival of business SBA generally EXPECTS equity injections! Lenders who do not require an equity injection, particularly for R/E purchase, business start-up, or change of ownership loans may be putting their guaranties at risk Lender must determine if equity and pro forma debt-toworth are adequate Credit analysis must include detailed analysis of required equity and its adequacy NAGGL cautions you provide strong rationale if no equity injection is being required 5(H), pages What you should be doing now... Watch for clarifying guidance from SBA In the meantime, remember 100% financing may be appropriate in an individual loan situation BUT Consideration/justification of equity injection especially important when loan is to start a new business, accomplish a change of ownership, or purchase real estate Lender must document rationale for not requiring an equity injection AND SBA has signaled that they are scrutinizing situations where lender is making all or most loans without requiring an injection 21 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 7

8 What are Acceptable Equity Injections? Issues: How far back in time can a lender go when considering an applicant s prior purchases as equity? What kind of expenditures counts e.g., franchise fee, travel in connection with mandatory franchise training, purchase of equipment, payment of fees, payment for services, etc.? 22 Acceptable Equity Injections (cont) Answers: Per SBA not in SOP Payment must appear to reasonably have been made as part of current project No specified limit on how far back in time, BUT a reasonableness test should apply Pro forma statements should recognize expenditures 23 Calculating Equity in Partner Buy-Out Scenario: change of ownership between existing owners, more than $500,000 in intangibles, lender wants to process via PLP Issue: How does lender show mandatory 25% equity injection requirement (buyer/seller combo) is met for PLP processing A: Per SBA not in SOP: Equity determination based on equity shown on posttransaction pro forma balance sheet (for this purpose only not in compliance with GAAP) That figure will reflect adjustment to equity based on creation of new debt obligation 24 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 8

9 EPC/OC Loan Structures 25 EPC/OC Per regulations and SOP (pages ), EPC must use loan proceeds to acquire or lease, and/or improve or renovate real or personal property (including eligible refinancing) that it leases to an active OC business Trickiest issue is when there is a holding company structure and 7(a) financing is being requested for a change of ownership generally... Complete changes of ownership involving holding companies are eligible BUT Partner buy-out situations involving purchase of holding companies are not eligible 26 Why do Small Businesses Choose Holding Company Structures? Why do small businesses use holding companies to own R/E, or major equipment? Avoid potential liability e.g., medical practice seeking to safeguard its building or major equipment from malpractice suits Tax implications Estate planning 27 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 9

10 Why does SBA have Special Requirements for Holding Companies? Holding company structure interjects an extra layer in the loan structure, BUT Benefits of loan still accrue to operating company Major concern is that loan proceeds not be used for passive investment purposes SBA requirements assure that holder of asset does not benefit from SBA loan no return on investment until after 7(a) loan is repaid 28 Who is the Borrower? EPC = primary borrower [may take any form of business structure, including tenants-in-common] Owns the asset Receives the financing for the asset Only one EPC per loan is allowed OC = either a co-borrower or a guarantor OC must be co-borrower if it receives any loan proceeds for its use (e.g., w/c, asset purchase, stock purchase, intangible assets, etc.) Multiple OCs are allowed 29 EPC Eligibility Requirements EPC and OC must each be small Proposed use of proceeds must be eligible as if OC were obtaining financing directly OC must be co-borrower OR give unlimited guaranty All 20% or more owners of EPC and OC also must personally guarantee 30 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 10

11 Other EPC/OC Requirements Lease restrictions assure that it is the OC, not the EPC, that controls the real or personal property EPC must lease project property directly to OC under a written lease with term (including options) at least equal to loan term Lease payments must be assigned to debt Rent cannot exceed: Debt service + property upkeep + taxes + insurance OC(s) must lease 100% of property but can sublease consistent with space occupancy requirements 31 EPC Scenario 1 Existing medical practice currently operating out of leased space wants to use a holding company to purchase the building from which it is operating Proposed EPC/OC loan structure with newly formed entity holding real estate Holding company (EPC) will be borrower; medical practice (OC) will give unlimited guaranty Eligible for 7(a) financing? Eligible for 7(a) financing if, instead of R/E, medical practice wanted to buy an MRI machine? 32 EPC Scenario 1 Analysis Loan is eligible as proposed for either R/E or MRI machine, subject to the following EPC will be borrower OC may be either co-borrower or guarantor All 20% or more owners of each must fully guaranty the loan AND All other EPC/OC loan conditions must be met e.g., assignment of lease proceeds, amount of lease payments, term of lease, space occupancy requirements, etc. 33 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 11

12 EPC Scenario 2 Loan for complete change of ownership business assets currently owned by an operating business, R/E currently owned by holding company Dad will be 100% owner of R/E and have 10% ownership interest in operating business LLC owned by son and daughter-in-law will own 90% of operating business and will operate the business Proposed EPC/OC loan structure One loan with EPC (dad) and OC (LLC) as co-borrowers, proceeds for purchase of R/E and other assets Eligible for 7(a) financing? Can transaction be financed with one loan? 34 EPC Scenario 2 Analysis Loan is eligible as proposed Financing may be made via one loan with dad (as EPC) and LLC as co-borrowers All other eligibility criteria must be met 35 EPC Scenario 3 Applicant, an operating small business, wants to buy the stock of a real estate holding company that holds, as its only asset, a parcel of R/E which applicant will use for its business Applicant wants to continue to hold R/E in a holding company Eligible for 7(a) financing? 36 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 12

13 EPC Scenario 3 Analysis Loan is NOT eligible as proposed SBA does not permit using a 7(a) loan to purchase a passive business, in this case the holding company BUT SBA would provide financing for the applicant to purchase the R/E from the existing holding company in an EPC/OC structure subject to all of the EPC/OC requirements 37 EPC Scenario 4 Loan requested for Partner buy-out involving both an operating company and a company that holds the real estate out of which the business operates (identical ownership structure for both 50/50) Proposed as one loan with an EPC/OC structure Eligible for 7(a) financing as proposed? Eligible for 7(a) financing if the remaining owner purchases the R/E from the holding company? 38 EPC Scenario 4 Analysis Loan is NOT eligible as proposed SBA prohibits an associate of the applicant business from receiving the proceeds of a 7(a) loan, and as noted in scenario 3, SBA also prohibits the purchase of a holding company So, while the purchase of the OC would be eligible, the purchase of the holding company, or of the R/E held by the holding company, would not be Note: it has been suggested that one solution would be to have the holding company quit claim the deed to the OC SBA does not condone this strategy because of tax implications and issues of lender liability 39 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 13

14 Other Tough Issues 40 Debt Refinancing [Covered in much more detail in separate session] Scenario: Applicant wants to refinance a seller take-back note created 25 months ago when applicant purchased business note was on full standby for the 1st 24 months Q: Is the loan eligible for refinancing? A: No. SBA recently clarified that in order to refinance a seller take-back note on a change of ownership, not only must the note have been in place for two years, but it must have been receiving payments for that time in order to meet the requirement that it have been current for the two year period. 41 Reimbursements to Applicant from 7(a) Proceeds Issue: regulations and SOP prohibit 7(a) proceeds being used for payments, distributions or loans to an associate of business (except for ordinary compensation for services rendered) [13 CFR (a)] So, historically SBA has said that funds advanced by the business (including a sole proprietor) can be reimbursed from loan proceeds, but funds advanced by a business owner cannot be reimbursed 42 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 14

15 Reimbursing Applicant from 7(a) Loan Proceeds Scenario: After 7(a) loan approved, applicant found a great deal on equipment that was to have been purchased with loan proceeds now wants to be reimbursed for purchase from loan proceeds Q: Is such reimbursement allowed? A: It depends. Under current interpretation, loan proceeds could be used to reimburse applicant business, but not business owner funds expended by owner could be considered to be part of equity injection. Best practice: Encourage applicant to establish a business checking account immediately and to use that account to pay all business expenses 43 Proving Repayment Ability When Relying on Projections Issue: how soon does a new start business have to meet SBA s mandatory debt service coverage ratio (1.15:1)? Scenario: new start membership business (gym) General discussion contemplates 12 months, but a longer period (18-24 months) can be used if circumstances warrant Lender must provide Rationale for allowing longer ramp-up period AND Month-by-month projections for entire period showing adequate W/C to assure business survival until break-even 44 Collateral Trading Assets Issue: whether/when SBA requires lien on trading assets (inventory/accounts receivable) SOP says lender may take such assets (page 166) When depends on the purpose of the loan and whether the trading assets need to remain available to secure needed LOC financing If loan purpose is W/C, inventory, etc., lien should be taken; otherwise not mandatory Lenders have advised LGPC sometimes requiring lien even when not mandatory lender may need to appeal decision on a case-by-case basis 45 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 15

16 Loans to Purchase Raw Land Issue: whether 7(a) loan can be used to purchase raw land Facts: applicant seeking to buy land with anticipation that it will construct a building to house its business sometime in next 6 months to 2 years eligible? Not specifically addressed in SOP, but SBA s informal advice is probably NOT eligible Rationale Purchasing raw land is inherently speculative Uncertainty regarding financing for construction Uncertainty that building will ever be built or, if built will meet SBA s space occupancy requirements 46 Maximum Loan Term Regulations and SOP (page 132) mandate that loan term be shortest appropriate term considering Use of loan proceeds SOP specifies MAXIMUM terms available, NOT automatic maturity Borrower s ability to repay Issue: LGPC has been setting maturities for shorter periods than lenders believe appropriate Cited rationale is that lenders can later extend (up to 10 years longer if necessary) Longer terms help to assure repayment ability if times get tough BUT balancing act required Cash flow projections must support term requested/given 47 Flood Insurance Issue: Can lenders allow a borrower to purchase private flood insurance when a property is located in an NFIP community and NFIP flood insurance is available, but more expensive? A: Per SBA, yes! 48 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 16

17 LSPs, Fees, SBA Form 159 Issue: How do you report fees > $2,500? A: SBA has confirmed that even when fees are calculated as a percentage of loan, they must be itemized i.e., a list of the work performed must be provided Issue: Can lender pass on to borrower, the fees that it pays to LSPs for handling routine disbursement and servicing actions, e.g., disbursing funds or processing (for lender review and approval) a request for a deferment, release or exchange of collateral, etc.? A: NO listed functions are considered to be administrative responsibility of lender 49 LSPs, Fees, SBA Form 159 (cont) Issue: Does submission of loan (including Form 159) via SBA ONE constitute providing copy of form to SBA? A: Yes Issue: Does the $30,000 fee limitation (when fees charged as a percentage of the loan) apply only to fees paid by borrower, or to fees paid by lender as well? A: SBA has confirmed that the $30,000 fee limitation applies only to fees paid by borrowers 50 Questions? 51 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 17

18 Not Yet a NAGGL Member? NAGGL is THE VOICE of the 7(a) industry with the SBA, the Administration and the Congress NAGGL offers its members a full range of services including up-to-the-minute information and training Visit to see what we have to offer us at info@naggl.org to learn more about the services that NAGGL provides to its members and the availability of a trial membership 52 Copyright 2016, NAGGL, Inc. - Do Not Copy/Distribute 18