SBA 7(a) and Community Advantage Loan Equity Requirements

When you apply for a small business loan through the Small Business Administration (SBA) 7(a) or Community Advantage programs, you may be required to provide a 10% owner-equity injection. If so, you’ll need to document the sources of the equity, as well as how it’s spent.

In this Q&A with Pursuit business advisor Andrea Dabney, we cover the questions we hear most often about the equity requirement and documentation, as well as tips that make this easier.

Is a 10% owner equity always required for SBA 7(a) and Community Advantage loans?

The SBA requires that owners provide a 10% equity injection when the business is a startup (less than two years of business operations) or when you’re acquiring an existing business. In addition, some lenders may require a 10% equity for any 7(a) or Community Advantage loan.

There are two parts to the process: sourcing funds and spending funds. Sourcing the funds means showing where the available money comes from and spending means documenting how you spent the funds, such as receipts for inventory or office equipment. In essence, the SBA needs proof that you have the funds available and that you used them as promised.

What sources of owner equity are allowed for SBA 7(a) and Community Advantage loans?

The SBA allows owner-equity funds to come from a range of sources. The sources have to be documented, as do the expenses, to ensure that they meet SBA requirements. Among the allowable sources for owner equity are:

  • Cash that’s not borrowed, such as:
    • Cash in the business account (for an existing business) or personal cash that’s provided for the business (such as from your personal savings).
    • Funds that are gifted (given) to you, as long as it’s documented through a gift letter that the funds aren’t borrowed and there’s no repayment.
    • Stocks or securities that you withdraw or cash out, with the funds deposited into your personal or business account for use toward the business.
    • In accordance with your accountant, the IRS and SBA requirements, funds from retirement accounts:
      • Cash that’s withdrawn from a retirement account, provided that you can also pay any penalties for early withdrawal, as applicable to your account.
      • Cash that’s rolled over into the business from a retirement account, as long as this is done with a reputable organization that specializes in the “rollover for business startups,” or ROBS, program.
  • Cash that’s personally borrowed, as long as the repayment comes from a source that’s not the business or the owner’s salary from the business. One example is owner equity from a home-equity loan, when the home-equity loan is repaid from a spouse’s salary.
  • Funds already spent on business expenses related to the project that the loan is funding, when these can be appropriately documented.

    Let’s look at an example. Your business has been in operation for several months and you’re applying for funds toward inventory and equipment. You’ve already spent funds toward those needs in the amount equal to your equity requirement and have the receipts to document it. This may be eligible toward the owner equity requirement.

    Be prepared to show where the funds came from to purchase those items, such as from personal savings or business revenue that’s already been earned.
  • If you’re acquiring an existing business, sometimes the seller will offer a note of “standby debt.” This means that they’ll provide a loan to cover up to half (typically five percent) of the equity requirement. And the SBA requires that this loan can’t be repaid (principal or interest) to the seller until the SBA loan is repaid in full (documentation of this agreement must be included with the loan).

    A seller can also provide financing for a portion of the equity above and beyond the 10% requirement and the borrower could repay this financing. Full standby is required when the seller note will account for a portion of the required 10% of the required equity. Let’s look at two scenarios as an example:

Scenario 1: Let’s say you had a $100,000 project to acquire a business. Ten percent equity on this project would be $10,000. The SBA would permit up to $5,000 (or 5%) to be covered by a fully subordinated note. This means the borrower would need to come to the table with the remaining $5,000. Overall, the seller could not provide the full 10% if the borrower is not injecting any funds. Because of this, the SBA says the borrower must find availability of at least 5% of the project for 7(a).

Scenario 2: In a $100,000 project to acquire a business, the borrower has the full $10,000 available to inject into the business. The seller is also willing to hold a note for $10,000. This is attractive to lenders because it would lower the loan amount and ultimate exposure.

Since the borrower is already injecting 10% into the project, it would be up to the lender what the subordination requirements would be on this seller note. The lender could permit principal and interest (P&I) payments, interest only payments or fully subordinate the debt with no payments allowed. This typically would depend on the strength of the business’s cash flow.

  • Assets other than cash: Sometimes, a business owner may have property or equipment to use toward the equity requirement. (In this case, an appraisal or other valuation by an independent third party is required if the valuation is greater than the net book value.)

What’s not allowed for the owner-equity requirement?

The SBA has a few particular types of funds that can’t be used as owner equity. These include:

  • Funds that are borrowed and repaid from the business’s cash flow.
  • Funds that are paid out of the owner’s salary.
  • The value or cost of education, even if that expense is directly related to the new or expanding business.

How do I document that owner equity was spent on the business?

Many lenders, including Pursuit, require that the equity is spent on appropriate business expenses before the loan closes. Be sure that you hold onto the documents you’ll need, such as invoices paid, receipts for purchases, checks used for payment and/or quotes for higher-cost items, such as equipment.

What types of spending wouldn’t count towards my equity injection? 

The SBA requires a paper trail for payments (and, of course, it’s a wise business practice anyway). For this reason, if you can’t produce original receipts, invoices or quotes for payments made, then these won’t count toward your equity injection.

Why do I have to provide bank statements?

Lenders and the SBA need to ensure that equity funds are in compliance with SBA requirements. In addition, the SBA requires that funds are in the business account for at least three months before the loan closes. This provides a level of assurance that the funds haven’t been obtained in a way that may not meet SBA requirements and that you’re able to sustain a certain level of financial stability for repayment of the loan.

Additional tips

  • When you start or acquire a business, setting up a dedicated business bank account should be one of the first things you do. Simpler is better, too – for most businesses, a single checking account can cover your needs.
  • After the account is opened, transfer funds into it regularly from a source that can be documented through your bank statements. If the business is just starting out (or if you haven’t acquired it yet), then often the source is money from your personal accounts, such as personal savings or a home-equity loan or line of credit.
  • Establish a three-month business-bank-account history before you apply for a loan. Your commercial banker may be willing to extend some form of credit, such as a line of credit or a credit card, to help you cover short-term expenses.

Wherever you are in the loan process, Pursuit is here for you

A loan approval is the best reward for your attention to detail and many Pursuit clients say that the SBA loan process helps them strengthen their financial-management processes, too. Pursuit business advisors are here to help, so contact us today if you need additional information.

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