Tapping capital for small companies.

Companies can raise as much as $1 million for expansion through the SBA's 504 program.

Today's economy is a Catch-22 for small businesses: While prevailing interest rates for business loans are the lowest they've been in decades, the money generally is unavailable because most banks maintain a tight-money policy, which usually hurts small businesses the most. This article explains one way to overcome the banks' reluctance to lend by tapping the resources of the Small Business Administration (SBA).

The most popular federal loan-assistance program is the SBA's 7A program, which the SBA estimates will provide guarantees of as much as $7 billion to small businesses this year. Funds raised under 7A can be used for a wide assortment of business needs - from funding startups and meeting cash flow needs to financing expansions. However, as helpful as the 7A program is, it has at least one drawback: While the loans are guaranteed by the SBA and therefore are easier for small businesses to get than regular bank loans, their interest rates float with the prevailing rate of interest, as is the case with most conventional bank loans. When the current interest rate slump passes - and it undoubtedly will - 7a loan repayment costs will rise apace.

One way of getting around this drawback is to consider another SBA loan program - the 504. Under 504, 40% of each loan carries a rate that is fixed for its duration and is lower than prevailing rates; the June rate is 6.77% for a 10-year loan and 7.3% for a 20-year loan. By comparison, the prevailing small business loan rate is 2 to 3 points over prime, and the current prime rate is 6%.

However, 504 has drawbacks, too. While 7A loans can be used to pay for startup working capital costs or to meet cash flow squeezes, 504 loans can be used only to finance the acquisition of fixed assets: that is, to buy real estate; to build, expand or improve buildings; or to purchase machinery or equipment.

HOW THE LOAN PROGRAM

WORKS

The 504 program enables small businesses to borrow 90% of a project's cost; the borrower must provide the remaining 10%, which must be equity. Half of the loan comes from a participating financial institution, usually the company's bank, and 40% comes from a nationwide network of certified development companies (CDCs), which are certified by the SBA to process 504 loans and provide other financial services to small businesses. Most CDCs are not-for-profit organizations; some are privately owned, while others are publicly owned.

A CDC raises its 40% share by floating SBA-guaranteed debentures. The CDC loan is subordinated to the bank's collateral.

While the SBA portion of a loan can be as much as $750,000, under special circumstances that maximum increases to $1 million (see "When the Loan Can Be a Million," above).

The loan term, which can be either 10 or 20 years, is determined on the basis of the useful life of the assets to be acquired. For example, machinery and equipment must have a useful life of at least 10 years and loans for real estate or real estate improvements have a 20-year term. If the SBA loan is for 10 years, the bank's loan must be for 7 years; if it is for 20 years, then the bank's loan must be for 10 years.

ELIGIBILITY

Not all businesses are eligible for 504 loans. Only for-profit companies with a net worth of less than $6 million may apply. Further, a company's average net profit after taxes for the previous two years must be less than $2 million. The loans are not available to companies in the opinion-forming businesses such as newspapers, magazines, radio and television stations and film producers.

To qualify for an SBA 504 loan, the borrower must be able to show that, for every $35,000 lent under the 40% portion, it will create one job or retain one job that otherwise will be lost or that the project will have an "alternative impact" on the local economy - for instance, it will enable the loan recipient to update its equipment and enhance its ability to compete in its industry. Ironically, the alternative impact requirement is met even if the expansion of modernization means that some employees are let go. The reason is that the company is given credit for the employees that are retained because their jobs will be lost if the company goes out of business without the loan.

LOANS FOR BUILDINGS

Owners that occupy their buildings may lease a portion of them for a short time after the acquisition. But if a company uses the funds to build a new building, it must occupy at least 75% of it. If a company uses the funds to purchase an existing building, it initially must occupy at least 51% of it. However, an investment company can't raise 504 money for a building unless it's fully owner-occupied.

The SBA 504 loan is an end loan - that is, it's funded only after the construction or renovation has been completed or the asset has been purchased. In the case of construction or renovation, the borrower must find an interim lender until the work is completed. Usually the bank that provides the 50% portion of the end loan also provides the construction loan.

The SBA portion of the loan is paid after the building's certificate of occupancy has been issued. Payment goes directly to the interim or construction lender. The company then has two separate amortizing loans, one with the end lender and one with the CDC. The borrower's 10% down payment, or equity, must be paid before the SBA loan is funded.

FEES

There are fees associated with a 504 loan. In addition to all out-of-pocket expenses, the bank often charges a commitment fee of 1% of its loan amount. The CDC also charges a fee of 1.5% of the guaranteed portion. It usually collects a deposit up front and applies it against the fee when the loan funds. If the borrower withdraws from the commitment, the CDC may keep all or part of the deposit based on the work it has completed.

There are other fees: 0.625% of the loan is paid to the underwriter of the debentures, 0.5% to the SBA for a reserve account deposit and 0.25% to the Development Company Funding Corp., which negotiates borrowers' rates with the underwriters of the debentures. Also, the monthly payments include ongoing servicing fees for the CDC (0.5%) and the agent (0.1%) who processes all the loan payments and disbursements.

Finally, the borrower must pay the CDC's out-of-pocket expenses, including its legal fees and other closing costs. All the fees associated with the SBA loan can be added to the loan amount.

HOW TO GET STARTED

For more information about the SBA 504 loan program and for the name and phone number of a local CDC, accountants should write the National Association of Development Companies, 4301 North Fairfax Drive, Suite 860, Arlington, Virginia 22203, or call [phone].

EXECUTIVE SUMMARY

* SMALL BUSINESSES FACE a Catch-22 in this economy: While prevailing interest rates for business loans are the lowest they've been in decades, the money generally is unavailable because of tight-money policies. One way to get funds for growth is through the Small Business Administration (SBA).

* ONE NOT VERY WELL-KNOWN program is the SBA 504, which enables small businesses to borrow 90% of a project's cost; the business must provide the remaining 10%, which must be equity.

* UNDER THE 504 PROGRAM 40% of the SBA loan carries a rate that is fixed for its duration and that is lower than prevailing rates.

* TO QUALIFY, SMALL BUSINESSES cannot use the money as startup working capital or as a stopgap to meet a cash flow squeeze. It must be used instead to finance the acquisition of fixed assets: that is, to buy real estate; to build, expand or improve buildings; or to purchase machinery or equipment.

* HALF OF EACH LOAN comes from a participating financial institution; 40% comes from a nationwide network of organizations called certified development companies (CDCs), which are certified by the SBA to process 504 loans.

WHEN THE LOAN CAN BE A MILLION

If a company meets one of the following criteria, it can exceed the $750,000 limit for the Small Business Administration (SBA) portion of a loan and borrow as much as $1 million:

* The business is situated in a community with a plan that encourages business redevelopment.

* The project will enhance export sales and at least 10% of the borrower's revenue comes from export sales.

* The borrower is owned at least 51% by a minority individual or group designated by the SBA.

* The company is situated in a rural area.

* The project will enhance economic competition - such as an advancement in technology, conversion to robotics, etc.

* The borrower is situated in an area affected by federal budget or defense cutbacks or adversely affected by federally mandated environmental standards or policies.

SBA DIRECTORY

LISTS STATE ASSISTANCE PROGRAMS

The 1993 edition of The States and Small Business: A Directory of Programs and Activities lists more than 1,000 small business assistance programs in every state, the District of Columbia, Puerto Rico and the U.S. Virgin Islands. It is published by the Small Business Administration's Office of Advocacy.

The programs include business financing, procurement assistance and business service centers that furnish information on licenses, fees and regulations. The directory gives a brief description of each state program and provides addresses, telephone numbers and contact names. It also summarizes recently enacted state legislation affecting small businesses.

The States and Small Business: A Directory of Programs and Activities (product no. 045-000-00266-7) can be obtained for $21 per copy from all U.S. Government Printing Office bookstores. Written requests should be mailed to the Superintendent of Documents, P.O. box 371954, Pittsburgh, Pennsylvania 15250-7954. Telephone orders can be placed by calling [phone] between 7:30 A.M. and 4:00 P.M. Eastern time. (Visa and Mastercard are accepted.)

COMPARING CONVENTIONAL,

SBA 7A AND SBA 504 LOANS

A small business that needs $1 million to acquire a building has at least three borrowing options: a conventional bank loan or one of two Small Business Administration (SBA) loans - a 7A or a 504 loan. Here is a snapshot of the cost and payback schedule for each:

Assumptions: The prime rate currently is at 6% - an unusually low level. These examples assume the rate will rise to 7% in two years and to 8% in five years. They also assume the business is able to get its bank loan at two percentage points above prime, with a one-point commitment fee.

Conventional bank loan

This loan is made in two parts: a 30% down payment ($300,000), which is borrowed separately for 5 years, and the rest ($700,000) for 10 years. (Typically, a business does not borrow the down payment, but in order to make this example comparable with the 504 example, such a loan has been included.) The conventional 70% ($700,000) portion is for 10 years at 2 points over prime. In years 1 and 2 the interest rate is 8% (6% prime + 2 points). In years 3 to 5 the rate is 9% (7% prime + 2 points) and in years 6 to 10 the rate is 10% (8% prime + 2 points).

                                           Yearly     Aggregate
Payments for years 1-2                   $ 174,912    $ 349,824
Payments for years 3-5                     179,692      539,076
Payments for years 6-10                    108,103      540,515
Total payments for the life of the loan              $1,429,415

SBA 7A loan

Such a loan has two parts. The first part is a $250,000, separate 5-year loan for the down payment, which is shown here to make this example comparable with the 504 example. In years 1 and 2 the rate is 8%; in years 3 to 5 the rate is 9%. The second part of the loan is a $750,000, 15-year, 7A-guaranteed loan with a rate of 7 3/4% (prime + 1 3/4 points). In years 1 and 2 the rate is 7 3/4%, in years 3 to 5 the rate is 8 3/4% and in years 6 to 15 it's 9 3/4%.

                                          Yearly      Aggregate
Payments for years 1-2                   $150,216     $300,432
Payments for years 3-5                    154,997      464,991
Payments for years 6-15                    93,269      932,690
Total payment for the life of the loan              $1,698,113

SBA 504 loan

Such a loan has three parts. The first part is a $500,000, 10-year floating-rate conventional bank loan (prime + 1 3/4 points). In years 1 and 2 the rate is 7 3/4%; in years 3 to 5 the rate is 8 3/4% and in years 6 to 10 the rate is 9 3/4%. The second part is the SBA's $400,000, 20-year loan. It is fixed at 7 1/4%. The third part is the $100,000 down payment, which must be equity; to be consistent with the previous examples, this example assumes the money is borrowed separately and the interest rate is 2 points over prime for 5 years. In years 1 and 2 the rate is 8% and in years 3 to 5 it's 9%.

                                           Yearly     Aggregate
Payments for years 1-2                    $135,698     $271,396
Payments for years 3-5                     138,683      416,049
Payments for years 6-10                    115,753      578,765
Payments for years 11-20                    39,360      393,600
Total payment for the life of the loan               $1,659,810

JOSEPH J. VASSALLO is a director of industrial development for Detroit Economic Growth Corp., a certified development company in Detroit. He is a member and a former vice-president-communications of the National Association of Development Companies.