You've decided to apply for an SBA loan. After all, it's cheap money. Before you start down that path, I'd like you to do something out of the ordinary:
Think like a banker.
The effort may save you anxiety and time.
First of All, They're Bank Loans
We call them "SBA loans," but they're not. The Small Business Administration (SBA) doesn't make loans. Instead, it issues partial guarantees of eligible loans originated by banks. That's a distinction with a difference.
Regulators don't want banks to make imprudent loans. That said, banks' credit requirements constrict and relax over time. Those cycles can exacerbate ups and downs in the economy. An SBA guarantee helps prospective borrowers meet banks' credit requirements when credit is tight. That, according to theory, will help calm economic gyrations.
Here's what that means for you:
- Even if your loan is eligible for an SBA guaranty, you first have to sell the creditworthiness of your loan to a bank. A bank must believe your proposal makes sense on its own before considering the impact of a guarantee.
- Eligibility for an SBA loan guarantee isn't a layup. It's also bureaucratic and rigid. Know the rules before you enter the game.
The most common guarantee program is the SBA 7(a) program for small business loans. You can learn more about the guts of the 7(a) program here:
I'm going to focus on the softer (meaning harder) aspects of getting a loan.
Sell Before You Buy
In a previous life, I was in the private equity business. During my apprenticeship, I learned from my mentor to, "Sell before you buy."
The consequences of a poor financial decision tend to last a long time. Part of making a good decision is ensuring all parties to the deal get what they need.
It's easy to figure out what you need. It takes effort to figure out what the other person needs. That's why you should make learning your banker's needs a priority.
Seek to understand what your banker needs. Then determine if she can give you what you need. Sell before you buy.
What Bankers Need
Like any business, banks need profit (at least those not "too big to fail"). Their revenues must exceed their costs. A bank can generate revenue on a business loan in a couple of ways:
- Interest income
On the flip side, banks incur several costs over the life of a loan:
- Interest expense
- Origination, administration, and compliance costs
- Collection costs
- Loan losses
Banks are like grocery stores: they live on narrow margins and high volumes. A bank's net interest margin may vary between 3% and 5%. That's paper thin. There's not a lot of room for non-interest expense.
Furthermore, banks carry a lot of debt themselves. Leverage magnifies a bank's returns when all goes well, but it also magnifies the effects of losses. Bankers are conservative because their business model demands it.
Profit on a Typical SBA Loan
Under the 7(a) program, the SBA will guarantee up to 75% of a loan of up to $5 million. But note the following:
- The average 7(a) loan is about $380,000.
- The SBA charges a fee of 3% to 3.5% for its guarantee.
- The SBA imposes a limit on the interest a bank can charge on SBA-backed loans.
- SBA loans impose extra administration costs on banks.
So, a typical 7(a) loan might yield net interest to the bank of around $30,000 over five years. That leaves less than $6,000 a year to pay for administering the loan and still leave profit.
Guaranteed Loans Are Costly to Collect
This is important: a loan in default guaranteed by the SBA is still costly for the bank to collect. Banks will not make a loan that they think may default - with or without a loan guarantee.
If you default on an SBA loan, the bank has to jump through the normal hoops to collect. That includes its right to call on personal guarantees and other collateral. Only after exhausting those avenues can the bank make a claim against the SBA guarantee. (You're not off the hook. The SBA will take over loan collection from the bank.)
The bank will get its loan back. In the meantime, it will have burned time and money that eats into its profit. When the net interest on an average SBA loan is only $30,000, it's not hard to understand why a bank has little appetite for risk.
How Banks Assess Risk
So, bankers can afford to take little risk - even with an SBA guaranty. How do bankers go about assessing risk?
A common framework is the "5C's of Credit":
- Collateral: acts as repayment insurance. It can take the form of personal guarantees, equipment, real estate, accounts receivable, inventory, or financial securities.
- Capital: is the amount of money you have in your business relative to the loan amount. It's your "skin in the game."
- Capacity: is the anticipated ability of your business to generate enough cash to pay its obligations, including interest and principal.
- Conditions: represents the lender's expectations about relevant industry, sector, local, national, and global economic conditions.
- Character: is a subjective judgment of the sense of obligation you feel to repay the loan.
These factors are - to a degree - substitutes for one another. Strong collateral might offset some uncertainty about capacity. SBA guarantees are a particularly strong form of collateral. Even so, collateral isn't enough to overcome every perceived shortcomings elsewhere.
Different lenders will have different underwriting models. That is, they will place differing emphasis on the various contributors to credit quality.
Community banks can tap knowledge about local conditions and character. Industry specialists may have an advantage in evaluating capacity and sector conditions. In other words, your loan proposal may be perceived differently by different lenders.
The financial industry is rife with inflated titles. Everybody you bump into is an "officer" or "vice president" of some kind. It's tough to know who can make a decision.
When in doubt - ask. In the meantime, here are some guidelines:
- Banking officers, relationship managers, and varying degree of vice president often have a dual role. They are the friendly face of the bank, the sales people. In some cases, they may also be responsible for collecting loan application data and conducting credit assessment. These days, your primary contact at the bank will almost never have the final word on your loan, though they will have the first.
- Underwriting specialists work in the background. They may be part of central group that serves a large bank's national network. They rarely see - or even speak - with the loan applicant. By design, they are the counterbalance to over-enthusiastic loan originators. Their job is to determine whether a loan application meets the bank's current criteria.
- Senior bankers and credit committees are responsible for the bank's profitability, the quality of the underwriting process, and portfolio policy. An otherwise creditworthy application might be denied if the bank already has too many similar loans. Again, you are likely never to meet these people.
- Some banks even have SBA specializations that cut across the preceding roles. The issuance of an SBA guarantee requires that a loan meet both the bank's and the SBA's requirements. So, a solid understanding of both is a plus. SBA Preferred Lenders can process, approve, and close SBA-backed loans on their own. Other must submit loans to the SBA for final approval of the guarantee.
Prepare for a Slow Process
It usually takes weeks - even months - for a bank to prepare, process, and evaluate a business loan application. There are several reasons:
- Unprepared applicants. It takes time to identify and rectify gaps in the application.
- Supportive banking officers. What's that? A supportive banking officer can slow the process? Sometimes, if you need a quick answer, the answer is, "No." Your local banking officer may need time to make and present the best case for your application. The risk is that the answer might still be, "No."
- Lack of familiarity with your business or SBA loans. Smart banks are prudent. They'll take the time necessary to understand your application. If they are not already familiar with your business or the SBA loan process, it will take extra time.
- Institutional inertia. A month is an eternity to a small business. It's the blink of an eye to a big business. Banks are big businesses.
- Profit priorities. Not even the largest banks have unlimited resources. So, they will try to focus their people on generating the highest profit at the lowest risk with the least effort. Just like you. Small business loans offer modest profit and some combination of relatively high risk and effort.
Increase Your Odds for Success
SBA loans offer attractive terms and are the cheapest money you'll find this side of friends, family, and fools. There are several things you can do to shorten the process and increase your odds of success:
- I know. You've maintained a deposit relationship with your local bank for years. They give you dog treats at the teller window. They love you. They should - you are lending to them. That doesn't mean they will lend to you. Know what they need, and make an honest assessment of your ability to deliver.
- A lack of planning on your part doesn't constitute an emergency on the bank's. Do the work necessary to anticipate your financing needs well in advance. The more time you create for yourself, the more and better options you'll have.
- Everything you need to know about SBA loan programs is available online for free. You can - and should - know about your chances before your first meeting with a banker. Competent preparation boosts your perceived capacity and character.
- Communicate that you understand the bank's and the SBA's needs. Ask good questions that reflect your thorough preparation. Be responsive to requests for information.
How cheap is the loan that takes you months to negotiate and close - if you get it at all? SBA loans are a great resource for small businesses that fit "nearly bankable" criteria. But, the criteria is stringent. Businesses that can't offer a history of profitability and collateral need not apply.
If your business is "almost, almost bankable," you may want to consider speaking with your local non-profit lenders. Many are affiliated with Small Business Development Centers (SBDC). Some of these organizations offer "stretch" or "gap" financing that complements and extends SBA loans.
Finally, consider the alternative lenders who are signatories to the Small Business Borrowers' Bill of Rights. They are more likely than some other bank alternatives to offer clear, fair terms.
Dave is a “business advisor” who gets energy from helping people innovate in and through their human scale businesses. As a former private equity investor and lender, he helped make more than $500 million in capital commitments to finance growth, acquisitions, and recapitalizations. As part of entrepreneurial teams, Dave has helped raise more than $30 million of equity capital. He's also worked in product development, innovation management, manufacturing, and administrative roles.