I had a conversation with an entrepreneur friend this week who was bemoaning the torture of going through a Small Business Administration loan process. As a businessman, this is the kind of guy who has done everything right. He keeps up with his taxes, pays his employees well, stays in compliance with various state inspections, and is active in his community in only the best ways.
He survived the Covid lockdown and other setbacks that were no fault of his own, and actually turned those into an opportunity to help his neighbors. He is the kind of guy you naturally root for, and a credit to any community he would be part of. During our call, he was justifiably upset that after months of filing forms and discussions, the Small Business Administration was putting covenants into his loan that would make it impossible for him to execute. My commiserations were real because, sadly, I have had the same conversation with other clients too many times to count, and I feel like it’s time to address government-backstopped lending as it pertains to entrepreneurs.
The Small Business Administration is a government entity that works with community banks to finance businesses. Provided certain criteria are met, it acts as a guarantor of a significant portion (typically 75 to 80 percent) of a loan. The program was designed to get working capital into the hands of entrepreneurs when they need it most, and at a time when, for whatever reason, conventional financing is off the table.
While it can provide a lifeline for businesses, the covenants are so invasive that many businesses have to forgo the loan because of them. For example, a “standard” 7(a) loan, the most common one, means the lender must fully securitize the loan. That means they need collateral worth the entire value of the loan. This only tells part of the story. I am personally aware of loans failing to fund with collateral three times the requirement because of other needlessly restrictive covenants.
For example: the lender needs to take security interests in all assets acquired, refinanced, or improved by the loan, all available fixed assets of the business, and all personal real estate of any 20 percent or greater owner, or any co-signer. Additionally, there are “haircuts” on the collateral value of each asset of up to 90 percent of the current book value. The borrower also needs to provide an unlimited personal guarantee, which is separate from the hard assets. There are also strict limits on what the business owner can use the capital for once he gets it.
If the borrower has their documentation in order (tax returns, financial statements, loan documents, projections, and other things), it can still take 120 days to get approval. If you ask anyone who has gone through the process, it’s incredibly painful, time-consuming, and frustrating. An approval rate in the mid-40 percent range makes this even worse.
The federal government seems to enjoy loaning money to people. Everywhere you look, there are examples of it.
We loaned Ukraine $20 billion, $20 billion to Mexico (which paid us back), and $4.7 billion to Mozambique. Chile and Mexico have revolving lines of credit at the International Monetary Fund that we backstop of north of $10 billion. None of these are collateralized to a significant extent.
Domestically, General Motors got $50 billion in return for some stock during the financial crisis of 2008, and, my favorite, “too big to fail” banks got a whopping $445.5 billion from the Troubled Asset Relief Program. Those loans required no underwriting whatsoever, which is ironic given what banks themselves demand from borrowers.
By comparison, the SBA averages about $40 billion per year in loans to all borrowers (who are required by statute to be American citizens). We can and need to do better than this.
Small businesses are the lifeblood of the domestic economy. Some 45.9 percent of all jobs are at companies with fewer than 500 employees, and most of them die because of lack of capital. Given the displacement of workers due to AI and other factors, I would imagine this trend will only increase over time. Entrepreneurs need access to capital, and they need it with more expediency, less red tape, and more flexibility in structure.
Some ideas on improving things dramatically would include allowing a co-signer to escrow securities, cash, or cash-value life insurance in lieu of their real estate. Any of those instruments are more liquid than a personal residence anyway. Banks would like this, as it has the potential to attract deposits. This could also bring more borrowers into the program.
If enough collateral to cover a loan is pledged, there should be a waiver on personal guarantees. The amount of the pledge should be in line with the borrow, not dramatically in excess of it. The partner lending bank should be able to modify the process based on the case, the market they are in, and other unique circumstances. Local bankers know their markets better than the federal government does, and we need to allow them to operate as lenders. The best part is that most of these reforms could be done as a modification of standard operating policy, not requiring new legislation.
Another simple fix would be to relax the FICO requirements. For example, the generally accepted minimum FICO score for a 7(a) loan is 650. Many entrepreneurs will max out credit cards trying to keep their companies alive before they turn to the SBA, but this hurts their credit, which in turn makes a relief loan either significantly harder or impossible to get. I have actually seen loans with three times debt coverage require co-signers for this very reason, and that serves no one.
Instead, we should empower the local lender to make a judgment call on that, especially if the intention of the loan is to replace higher interest rate debt like credit cards, or my favorite business killers, factor loans. If you take the interest carry on, say, $500,000 from 30 percent to 9 percent, it adds $105,000 in free cash flow back to the balance sheet, per year. That can be life changing to a small business. Furthermore, instead of adding risk to a debt table, by lowering the average interest rate, you are making it possible for a company to deleverage, so I would argue it actually lowers the default risk of a loan.
By letting banks have more flexibility under the program and allowing more collateral options, approval rates would climb without dramatically increasing loan failure rates, saving countless businesses and jobs. Doing a few simple, reasonable things can make the American dream more attainable for so many, and that is a very good thing.
