From the January 1997 issue of Entrepreneur

Three SBA programs face closer scrutiny.

Recent changes made by Congress to the Small Business Administration's (SBA) leading lending programs can, depending on the prism you view them through, either make the loans more expensive or ensure their continued existence. At issue are the 7(a) and 504 guaranteed loan programs, plus the Small Business Investment Company (SBIC) program.

Congress felt the three programs were costing the federal government too much in the form of annual appropriations. The appropriations were necessary because the SBA was having trouble liquidating delinquent loans. That difficulty was a result of the rapidly rising number of loans and the rapidly plummeting numbers of SBA staff. For example, the 504 loan program set a record in fiscal 1996, with 6,884 loans approved.

The congressional Rx came in the form of the Small Business Programs Improvement Act. Introduced by Rep. Jan Meyers (R-KS), retiring chair of the House Committee on Small Business, it includes an SBIC amendment written by her Senate counterpart, Sen. Christopher Bond (R-MO).

The SBA's solution for the 7(a) program is to turn over liquidation duties to banks. That won't affect small businesses much, except those that had previously defaulted and got away with it.

However, Congress did impose a series of new fees on borrowers, lenders and others connected with the 504 and SBIC programs. "These changes are crucial," says Rep. Meyers, "not only to ensure the livelihood of a fundamental capital source for small business but also to establish a better balance between public and private program funding and to streamline liquidation duties that the SBA clearly can no longer handle efficiently."

N 7(a) LOANS

The 7(a) is the SBA's most popular program--not surprising, since the loans are given to small businesses that have already been turned down by other lenders. In fiscal 1996, the agency made some 46,000 guaranteed loans totaling $7.7 billion. For loans over $100,000, the SBA guarantees 75 percent of the total up to $750,000; for loans up to $100,000, the guarantee is 80 percent.

The advantage of 7(a) loans is that they can be paid back over as long as 25 years for real estate and 10 years for equipment and working capital. Interest rates are a maximum of 2.25 percent over prime if the loan term is less than seven years and 2.75 percent if over seven years.

Banks package the guaranteed portion of about half these loans and sell them in the "secondary market." The SBA receives a fee from the bank based on those sales. That money helps defray 7(a) costs, reducing the federal appropriation needed.

The White House Office of Management and Budget (OMB) each year establishes a "subsidy rate," which reflects the amount of reserve the SBA must have to cover losses from its loans. A subsidy rate of 2.74, for example, means Congress must appropriate $2.74 for each $100 of SBA lending authority.

In the SBA's fiscal 1996 budget, Congress had set a subsidy rate of 1.06 for the 7(a) and zero for the 504. But when President Clinton proposed his fiscal 1997 budget in February 1996, he calculated a 2.68 percent and 6.85 subsidy rate, respectively, for the programs. That would mean much higher appropriations than Congress was willing to provide.

Rep. Meyers jumped into action. Her bill, which passed Congress at the end of September, gives banks much more authority to collect on defaulted 7(a) loans. The bill also sets a new requirement for 7(a) "Low-Doc" loans--loans under $100,000 that require only a one-page application to the SBA. Just three years after being introduced, the number of Low-Doc loans has ballooned to about 45 percent of total 7(a) loans awarded and to 20 percent of 7(a) dollars lent.

The SBA's John Cox says the Clinton administration has used the program to direct loans to smaller businesses, where it believes the 7(a) program's emphasis should be. But Republicans in Congress believed Low-Doc was growing too quickly. Enter the Meyers bill, which sets a new requirement that only banks with significant small-business lending experience can make Low-Doc loans. Cox, however, does not believe there will be fewer loans approved as a result.

504 Loans

There is no question small businesses will be paying more for 504 loans, which typically run 20 years and are used for purchasing land and building structures. Loans from the 504 program are generally limited to $750,000. The small business must put up 10 percent to 15 percent of the total project amount, either in cash, collateral or a combination; under the Meyers bill, companies less than 2 years old must put up an additional 5 percent.

"The advantage of this program is that [without it], small businesses cannot get 20-year construction loans from banks, much less for 10 percent down," says Chris Crawford, executive director of the National Association of Development Companies. "Even when you add in the new fees, these loans are an attractive alternative for small businesses."

The new 504 fees keep the program's subsidy rate at zero. The legislation increases the guarantee fee paid by 504 borrowers from one-eighth of 1 percent of the principal to seven-eighths of 1 percent. For a $1 million loan, that means instead of paying $1,125 on the $900,000 principal, the business pays $7,875.

In addition, there is a new one-half of 1 percent onetime fee that will come from one of three sources: the first mortgage lender (the bank), the borrower, or the certified development companies (CDCs) that put up some of the loan. Who pays that new fee will be determined via negotiation between the three parties. "It will depend on how bad the borrower wants the deal," says Crawford. This new fee is in addition to the service fee the borrower already pays the CDC. It was raised by one-eighth of 1 percent and has been capped between 1 percent and 1.5 percent, depending on where the borrower is located.

SBIC Program

The Bond amendment means entrepreneurs will have to ante up more of the company stock they give to SBICs in exchange for funds. Typically, of course, entrepreneurs have little luck when trying to get financing from venture capital companies. But when the venture capital firm invests, it is exclusively in the form of stock. That means the business owner is giving up more control than he or she would with a convertible debenture--a combination long-term loan and stock deal--from an SBIC.

The SBIC gets money from the SBA when the SBA sells a security debenture to the private market; the most recent example was a $160 million debenture the SBA sold with an interest rate of 7.35 percent. Purchasers were pension funds and other institutional buyers.

Assume the SBA parceled out that $160 million to 16 SBICs, each of which got $10 million. In the past, each SBIC would have paid the SBA a onetime 2 percent transaction fee. The Bond bill raised that to 3 percent. In addition, the SBICs would have had to pay that $10 million back at a 7.35 percent interest rate. The Bond bill added a 1 percent point "add-on," so the SBIC now has to pay 8.35 percent.

The new fees enabled Congress to reduce the SBIC appropriation from $40.5 million in fiscal 1996 to $21.7 million in fiscal 1997. As a result, the amount of SBA money available to SBICs will jump from $374 million to $650 million.

But while there may be more money available, it will cost entrepreneurs more dearly. Don Christensen, associate administrator at the SBA for investment, presumes SBICs will partially pass along those fees. "Where the SBIC gave an entrepreneur $100,000 and took maybe 10,000 shares of stock before, maybe they will take 11,000 shares now," he explains.

Still, the congressional rescue of the 7(a), 504 and SBIC programs seems like a pretty good deal. Money needed for the SBA budget is reduced while the amount of money available to small businesses expands.

Contact Sources

National Association of Development Companies, 4301 N. Fairfax Dr., #860, Arlington, VA 22203, (703) 812-9000;

Small Business Administration, 409 Third St. S.W., #7200, Washington, DC 20416, (800) 8-ASK-SBA, (202)205-6642.