SBA Loan Risks: What Business Owners Should Know

Last week I spoke with Jim from the New England area. Jim is planning to open a new craft brewery in Spring 2016 and he is looking for financing options for his equipment. I still laugh when I think back to what happened when our conversation shifted to the topic of bank loans....

Me: Jim, your brewery plan sounds solid. Tell me, what options have you explored for financing the equipment part of the plan?

Jim: Well, I went to my bank and they talked with me about an SBA Loan.

Me: Really? So... I gotta ask. How fast did you run out their door screaming?

Jim: (laughing) Pretty darn fast! I couldn’t believe what they wanted. I then asked my supplier for help and he gave me your number...

If you go to a bank for a business loan, chances are they will want to work with you to apply for a Small Business Administration (SBA) backed loan. Banks like SBA loans because they are federally-insured, so if you default on your loan the SBA will pay most of it back to the bank. This greatly reduces the bank’s risk.

Business owners can initially be attracted to SBA loans because of the advertised interest rates (currently 5.5% to 8%). Keep in mind this does not include several mandatory upfront fees (including an origination fee of up to 3.75%) that are not factored in to the interest calculation. Be sure to read the fine print and add up your total cost, not just the stated interest rate.

SBA Loans are often the only way a bank will approve a business’ request for financing (unless there is real estate involved), so they are a great option if you are set on having bank financing for your project but do not have any real estate equity.

So what makes business owners like Jim run from SBA Loans? As great as low rates and federal insurance sounds, there are 3 key reasons why an SBA Loan may not be right for many businesses:

#1 You must pledge all your business assets

The bank will file a “blanket lien” on your business, meaning the bank has first right of ownership of all your company’s assets including anything you buy in the future (while you have the bank loan in place). For this reason, anything you buy in the future will need to be paid for with cash-on-hand (most lenders will not give you a loan if they can’t secure their loan with collateral), and even then you don’t technically own the asset until the bank is paid off.

By contrast, companies like One Degree Capital file “specific liens” that only cover the specific asset being financed. This keeps your business open to the possibility of future purchases without the hassle of a blanket lien.

#2 You must stick to your plan

The SBA requires you to submit an extensive business plan and then treats your business plan like a bible - they expect you to stick to it. “Pivots” in your business plan are not only discouraged, they are often outright rejected.

Many new businesses pivot from their original plan once they get under way, as often it isn’t until you start working on something that you discover a better opportunity. Business owners can find the prospect of having to ask for permission to change course a frustrating - and lengthy - process.

#3 You must be ready to wait - and wait

SBA loans go through not only a bank’s underwriting but also the federal government’s underwriting. Red tape upon red tape means the typical SBA loan process from application to final approval (if approved at all) is several months. Once approved, there is still plenty of red tape. It can take on average 12-14 weeks to receive funds once your loan is approved.

SBA Loans are a great option if (a) you have a solid business plan that you know you will not deviate from, (b) know that you will not need any additional financing from any other lender for the length of time you have the SBA loan (5-10 years) and (c) you have lots - and lots - of time on your hands.