One of the key benefits for lenders who offer SBA 7(a) loans to their small business customers is that the government guarantees a sizable portion of the loan. This guarantee can be up to 90% of the principal amount borrowed, providing the lender with a safety net in the case of a borrower default. However, if a bank fails to adhere to the SBA’s guidelines throughout any portion of the loan process, the lender can have that guarantee reduced (known as a “repair”) or denied in full. The SBA is clear that the responsibility is on the lender to ensure the guidelines are properly followed in order to protect the guarantee. The SBA also points out that one of the most common reasons for repair or denial is failure to properly document equity injections.
Lack of proper and complete documentation of an equity injection required in the Authorization is one of the most common reasons for a reduction or denial of SBA’s guaranty at the time of purchase.
SBA Lenders Guide, Chapter 2 – Loan Closing
In this guide, we cover what lenders need to know about properly documenting equity injections according to the SBA’s guidelines.
What is an Equity Injection?
An equity injection is an investment of funds borrowers contribute into their business before being granted a government guaranteed loan. It essentially functions as a down payment for the loan and demonstrates that the borrower has some “skin in the game”. The equity injection can be contributed towards the purchase of commercial real estate, purchase of a business, equipment purchases/leases, working capital uses, or other costs associated with the total project. Lenders are required to verify all equity (which includes sourcing deposits, as necessary) in the project prior to disbursing on the loan.
As an example, a borrower has a total project cost of $500,000 from an SBA 7(a) loan of $450,000 and an equity injection requirement of $50,000. They could satisfy the requirements by documenting that they purchased $35,000 of equipment for the business and spent an additional $15,000 on payroll before the loan closes, as long as the uses were part of the original $500,000 project.
Overview of SBA’s Documentation Requirements for Equity Injections
To document equity injections according to the SBA’s guidelines, lenders must collect the documents necessary to verify the source and use of the borrower’s total equity injection.
Equity Injections are required for SBA 7(a) loans if either the business is a startup, which is defined as having operations for less than one year, or if the project is for a change of ownership. While SBA only requires an equity injection for these two instances, a lender may still require certain levels of equity injection based on their internal policy. These instances must also be sourced and verified based on SBA guidelines.
Verification of equity injections must be done prior to loan closing and the disbursement of any loan proceeds. All documentation must be provided within a time frame for your institution to perform a proper review. Seven days before the scheduled close is an ideal time frame, however, this is at the lender’s discretion. The earlier the documentation is provided and reviewed, the better.
The wrong type of documentation, incomplete documentation, and/or failure to secure documentation before closing, are common mistakes that may impact a lender’s guaranty.
How to Properly Verify the Source of the Equity Injection
Lenders must collect documentation to verify the source of the equity injection. Applicable sources of equity injections may include checking accounts or savings accounts of the business owners, the borrower’s operating account, or affiliate business accounts (shown as a distribution).
Documents that are used to satisfy the requirements include:
· Bank Statements
Provide three most recent months of full bank account statements from the account in which equity was or will be used. The bank statements provided must maintain an adequate balance of funds for the time-period leading up to the injection.
If there are any large, unordinary deposits into a borrower’s account, additional verification is required to source the funds. Lenders need to request copies of cancelled checks/wires for the incoming deposits and three months of bank statements from the depositing account.
· Account Activity Summary
If payments or transfers are made during the current month, an Account Activity Summary should supplement bank statements, and show funds leaving the account up to close and/or making payment for any pre‐close expense.
· Gift Letters
A Gift Letter is needed if the source of the equity injection is from a person that is a not included on the loan (i.e., a relative). The Giftor must also provide three months of historical bank statements from their depositing account, and a cancelled check/wire to support the injection.
Documents that require additional due diligence to meet documentation requirements:
The documents below can meet the standards for equity injection documentation, as long as the proper due diligence is conducted.
· Promissory Notes
The borrower must be able to verify outside income to support the funds
· Borrowed Funds
The borrower must be able to verify outside income to support the funds
· Credit Card Statements
The borrower must be able to prove the funds have been paid off
In summary, collecting the documentation necessary to verify the source of the equity injection requires lenders to paint a comprehensive picture of where borrowers are getting their funds for the equity injection. Lenders may collect a combination of the documents listed above in order to do so.
How to Properly Verify the Use of the Equity Injection
After verifying the source of funds, lenders must verify that the injection went towards an eligible use. The SBA’s guidelines state that funds must be used for appropriate business expenses to count towards the equity injection requirement. It is critical to ensure the use of the equity injection is a part of the original project and not something unrelated or additional.
The uses may include, but are not limited to, the following:
- Closing Costs
- Construction/leasehold improvement‐related costs
- Furniture, fixture, and equipment‐related costs
- Commercial real estate and/or business acquisition deposits
- Employee Payroll
Bank statements and account summaries must be supplemented with a combination of checks, invoices, receipts, and wire confirms for the transactions that are included in the total equity injection amount. Documents used to verify the use of funds for an equity injection include:
· Checks and/or Wire Confirms
Corresponding copies of checks and/or wire confirms associated with the transactions factoring into the amount of the equity injection (with Fed reference number or IMAD/OMAD number confirmations).
· Invoices and Receipts
Matching invoices and receipts must also be collected. For loans where numerous pre‐close expenses are being considered (i.e., construction and renovations), only larger expenses may be considered depending on bank approval.
Examples of How to Document Equity Injections for SBA Loans
To further illustrate these requirements, this section details proper equity injection documentation using two hypothetical examples. These examples walk through sample businesses and the equity injection documentation that was required to satisfy SBA requirements.
1. Equity Injection Used for Commercial Real Estate Purchase Documented with Bank Statements, Check, and Wire.
Situation: The borrower’s equity injection requirement totaled $100,000, which the Borrower used to purchase commercial real estate. They spent $10,000 on earnest money deposit in March 2018 prior to closing, and the remaining equity injection of $90,000 was sent to closing in June 2018.
Needs: The lender required Bank Statements from January through March 2018 to verify the initial deposit and from April through June 2018 statements to verify the remaining $90,000 brought to close. If any large deposits were discovered in the statements that were unordinary or necessary to send the funds to escrow, the bank would have requested an additional three months of statements from the depositing account of those funds. A copy of the $10,000 earnest money deposit Check was provided before close and a Wire Confirm was supplied at close to verify the remaining $90,000, totaling the equity injection documentation to $100,000.
2. Equity Injection Used for Leasehold Improvements/Renovations Document by Bank Statements, Checks & Invoices/Receipts, and Wire.
Situation: The borrower’s equity injection requirement totaled $60,000 which the borrower spent on the bank-approved use of startup costs, soft costs, and a construction contract. They spent $30,000 on permits, architecture plans, engineering costs, and accounting fees from November 2017-March 2018. The remaining $30,000 of equity injection was brought to the closing in April 2018.
Needs: The lender required Bank Statements from September 2017-April 2018 for the account that sourced the funds. If any large deposits were discovered in the statements that were unordinary or necessary to make the deposits/expenses, the bank would have requested an additional three months of statements from the depositing account of those funds. Checks & Completed Invoices with Receipts were required to verify the use of the $30,000 worth of pre-close expenses. A Wire Confirm was sent to close to verify the remaining $30,000, totaling the equity injection documentation to $90,000.
By following the listed guidelines for verifying the source and use of equity injections, your institution reduces the probability of repair or denial. Our team at Windsor Advantage is available to help should you have any questions regarding SBA loan processing procedures for lenders.
About Windsor Advantage
Windsor Advantage provides banks, credit unions and CDFIs with a comprehensive outsourced SBA 7(a) and USDA lending platform.
Since 2010, Windsor has processed more than $2.8 billion in government guaranteed loans and currently services a portfolio in excess of $2 billion (as of December 31, 2021) for over 100 lender clients nationwide. With more than 150 years of cumulative SBA lending experience, cutting edge technology, rigid controls and consistent processes, Windsor is uniquely qualified to assist any size lender with implementing a thoughtful and profitable government guaranteed lending initiative.
The Company is headquartered in Chicago, IL with offices in Indianapolis, IN and Charleston, SC.