Bottom Line Business Insights : Maryland Business Lawyer & Attorney : Wagonheim & Associates Law Firm : Mergers & Acquisitions & Contractual Negotiation

Last week, in response to popular demand, I discussed one of the two major types of SBA loan: the Section 7(a) Loan (if you missed it, click here. This week, I wanted to finish the discussion of SBA programs by talking about the other popular SBA loan program, the Section 504 Loan. 

The Section 504 Loan is limited to very specific corporate purposes. The loan funds can only be used to acquire major fixed assets for expansion and modernization, such as purchasing land and improvements, construction of new facilities or modernizing obsolete facilities, or purchasing long term machinery or equipment. For these reasons, the 504 Loan is less likely to be the right loan for a startup company.

 A 504 Loan is really two separate loans involving two lenders, but it’s treated as a single transaction and both loans are closed at the same time. One of the lenders is a bank, which takes the 1^st lien position and lends up to 50% of the loan amount. The other lender is a Certified Development Company (or CDC for short), which is usually a nonprofit or local governmental economic development entity. The CDC takes the 2^nd lien position and lends up to 40% of the loan amount. Each lender’s loan will be secured by the assets being acquired.  The SBA’s role, as in the 7(a) Loan, is to act as a guarantor. Here, the SBA guarantees 100% of the 2^nd lienholder’s loan, but doesn’t provide any guarantee to the bank (the 1^st lienholder). The theory behind this guarantee structure is that the bank has greater security for its portion of the loan via its 1^st lien position on the assets being acquired and therefore doesn’t need the SBA’s guarantee. 

Additionally, the principal owners of the business are required to provide personal guarantees to both lenders (are you willing to pledge your house, car, savings, etc. for your business loan?). And since the 504 loan only covers 90% of the financing (50% loaned by the bank and 40% loaned by the CDC), the company must contribute 10% of its own money in order to be eligible for the loan. Thus, the increased likelihood that the 504 Loan is not going to be the right loan for a startup.

So, again, we come full circle to the difficulty of obtaining bank financing and the “theoretical” nature of SBA loans. The 7(a) loan can be difficult enough to qualify for, but in the case of the 504 loan, the company actually has to come up with 10% of its own money, provide personal guarantees, and provide liens on its equipment and real estate to the lenders.  Plus satisfy the underwriting standards of the bank and the CDC.

Now that I’ve touched on the main SBA loan programs, I think it’s important to point out that no bank is required to make an SBA loan. Banks are still free to reject any SBA loan application based on their own lending and underwriting standards, even though the loan would be partially guaranteed by the SBA. In addition to all this, there are also eligibility factors that businesses must meet in order to qualify for any SBA financing. I’ve represented many regional and national banks in lending transactions, so I’ve usually got a pretty good idea which lenders are most likely to make SBA loans. It’s probably worth a discussion if you’re interested in exploring SBA financing.  

Let me add here that I am not trying to discourage any business from applying for an SBA loan. I’m merely trying to illustrate what’s involved in the process, provide some details as to how these loans are structured, and perhaps stimulate some thought by business owners and clients. I think the SBA program can be a wonderful tool where a business can meet the lender’s and the SBA’s credit and eligibility criteria.  I encourage my clients to apply for SBA financing if they meet those criteria, and I am more than happy to help present my clients’ applications in the best possible light.

Finally, let me briefly mention a couple of other SBA initiatives that are geared towards small business: the SBIC program, which is a venture capital program sponsored by the SBA, and the SBG program, which is a surety bond program geared towards construction and contracting firms (SBG stands for Surety Bond Guarantee).

A few words about the SBG program: under this program, the SBA will guarantee a certain percentage of a surety bond where the contractor cannot get the bond issued through ordinary channels (and frequently, new or startup contracting businesses will have trouble obtaining surety bonds). This gives sureties an incentive to issue surety bonds in situations where they might not otherwise have done so. Which in turn gives startup construction businesses greater access to contracting opportunities. Theoretically, of course.

Next week, I’m going to discuss one more possible (and sometimes overlooked) way to finance your startup or business, which will conclude what I have to say about the legal aspects related to financing your company.

Questions? Comments? Concerns? Raise it for discussion on Facebook, Twitter, or LinkedIn.

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Over the past few weeks, I’ve been using this blog to discuss various ways of financing a business, whether a startup or an ongoing enterprise. One question that seems to be on the minds of my clients and readers of this blog is the lowdown on SBA financing (i.e., financing under the auspices of the U.S. Small Business Administration, which is an agency of the Federal government). So here’s my take on it.

First off, let me clarify a widespread misconception: the SBA does NOT make loans to small businesses. Rather, the SBA guarantees a portion of a loan made by a bank to a small business, as long as the bank participates in the SBA program and adheres to SBA guidelines when making and servicing the loan. By guaranteeing a portion (usually 50%) of the bank’s loan, the SBA eliminates some of the risk undertaken by the bank. This risk reduction is intended to make it easier for the bank to decide to lend to a startup or small business.

You may recall that a few weeks ago I wrote that getting a bank loan was virtually impossible for a startup business. So, can the SBA’s guarantee help a startup get a bank loan? The answer is “theoretically, yes.” I hate to wax metaphysical in my weekly blog, but in this instance it’s sort of unavoidable. Allow me to explain.

There are essentially two types of loan programs for which the SBA will provide a loan guarantee:  the Section 7(a) Loan and the Section 504 Loan. Let’s first look at the 7(a) loan.

The 7(a) loan can be used by a business for virtually any purpose (working capital, equipment & machinery, land & buildings, etc.). The 7(a) loan involves a sharing of risk between the bank and the SBA. The SBA will guarantee 50% of the loan, while the remaining 50% carries no SBA guarantee. If the borrower (the small business) defaults on the loan, the SBA will make good on the SBA guaranteed portion of the loan by indemnifying the bank for 50% of the bank’s loss. Which means that the bank is still on the hook for the remaining 50% of the loan, which is the portion not guaranteed by the SBA. 

Hence, the “theoretical” availability of the SBA loan to small businesses. Since the bank is still on the hook for at least 50% of the loan in the event the borrower defaults, the bank will still require the borrower to meet all the same credit and lending criteria it would have had to meet were the loan NOT guaranteed by the SBA. Which brings us full circle back to my admonition that getting bank financing for a startup business is difficult. While in theory the SBA guarantee can make it more palatable for a bank to make a loan to a startup, in reality it’s still tough going, especially in “Great Recession” America.

And by the way: if the business defaults on the loan, it is legally liable to both the SBA and the bank for the defaulted loan. The SBA and the bank can (and you can bet your life they will) sue the company after a default. They can also sue the owners personally, if the owners provided additional guarantees. If being on the business end of a lawsuit by the Federal government and a major bank isn’t palatable to you, don’t default on an SBA loan.

Now, a brief word about the logistics of starting the SBA Loan process. Virtually any major bank, and most of the local and regional banks, participate in the SBA loan program. There’s an excellent chance that if you walked into your local bank branch and inquired about SBA loans, they’d direct you to a loan officer who handles them. There’s not much mystery to it. 

Next week, in Part II of this discussion on SBA funding, I’m going to discuss the 504 loan, which is the more complex of the SBA loans. I’ll also have some additional comments on SBA loans and some thoughts on a couple of other SBA programs that don’t involve loans.

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I’m of the opinion that the best way to finance a new business is via the “3 F’s”: Friends, Family, and, for lack of a better term, Fools. Of course, the risk and headache you undertake when you accept money from relatives and close friends is often more aggravating and gut-wrenching than simply taking money from a faceless third party, like a bank or a venture capital firm. Unfortunately, however, because bank and venture capital financing is usually not viable for startups (and I’ll discuss why next week), new businesses are often left with no other alternative than to hit up the 3 F’s.

So, do you like your friends, family members and relatives? Want to continue to have a warm, fuzzy relationship with them? (I’m perhaps assuming too much here, but stay with me.) If the answer is yes (or even if it’s no), and if they’re considering providing funds for you to get your business off the ground, or to keep it running through a rough patch, then take heed of the advice I’m going to discuss here: come to an agreement with them in writing. BEFORE they give you the money.

Perhaps the best way to explain why you need to arrive at an agreement in writing with your family members or friends before they stroke you a check is by discussing what the agreement should, at minimum, include. Here are just a few of the issues you’ll want to focus on while you’re putting together some sort of document to memorialize the arrangements: 

• Did you discuss whether the money was going to be classified as debt (a loan) or as equity (an investment) in the company?

Debt and equity are treated very differently for tax and legal purposes, and they have very different characteristics with respect to repayment and expected returns. Lenders won’t (or shouldn’t) expect much more than 6% - 12% annual interest, plus return or amortization of principal on some agreed-upon schedule. Equity investors, however, often have visions of buying a Greek island with the triple digit returns they expect to make via an investment in your company. Which would certainly help out the Greek economy, these days.

If the money is a loan, you’ll want to deliver a Note to your lender (yes, even if that lender is a relative or friend) which includes, at minimum, the principal amount, interest rate, maturity date, default provisions, repayment/amortization schedule and terms, possible collateral (in which case you’ll also need a security agreement and a UCC filing or a deed of trust), and dispute resolution terms. If the money is an investment (equity rather than debt), you’ll want to include the family member or relative as a shareholder or member of your corporation or LLC, and the rights and obligations of both the company and the equity investor must be spelled out in detail in the company’s constituent documents.  If you want to avoid problems both legal and personal, that is

• Did you provide anything in writing describing your business and the expected return on an investment in your business (e.g., a business plan or a more sophisticated document, such as a Private Placement Memorandum)?

Bear in mind that even the smallest startup is bound by the antifraud provisions of federal and State securities laws with respect to the raising of equity capital, as opposed to debt financing. There are filings to make (such as a federal Form D and state Blue Sky filings), documents to deliver (such as subscription agreements, accredited investor questionnaires, and shareholder or operating agreements), and regulations to follow. Each investor must receive exactly the same information as each other investor, so if you delivered a business plan or PPM to any investor, you’ll need to deliver the exact same document to ALL potential investors. Running afoul of any of these requirements could result in serious problems for your business if you ever find yourself in the middle of a dispute with your investors.

It would also be very useful to prepare a set of pro forma financial projections demonstrating the expected return on an equity investment. This is not only useful for managing expectations, but it’s also important, from a legal perspective, that you disclose any and all material facts about your company and its prospects to your potential investors.

• If the company goes belly-up (and lots of startups do), what are the rights of your lenders or investors? Remember, we’re talking about your friends and relatives here. Will they expect you to personally make good on their losses? Will they silently seethe and exclude you from all future family functions while badmouthing you within the business community? Are you sure you’ve discussed these issues with them and that your documents accurately reflect both your intentions and your investors’ or lenders’ expectations?
  
• Suppose the company needs additional cash. Do you have a right to subordinate the loans of your family members to subsequent lenders (such as other family members)? Can you subordinate their Notes to a bank? (It would be a very good idea to retain this flexibility in case it’s ever necessary to utilize it.) Or, in the case of equity, do you have the ability to dilute the shares or equity interests you issued to your family members or friends by issuing additional equity to third parties?
  

These are just a few of the many issues you’ll need to consider as you raise money at the startup phase or for ongoing operating expenses. Which is why it bears repeating: if you’re going to be raising money from third parties (even if, or especially if, they’re relatives or friends), be sure you put the terms in writing. A very detailed writing. When all parties understand up front what their rights and obligations are, it’s much less likely that you’ll end up estranged from your family members down the road. Remember that you’re going to be married to your relatives and friends for an extended period of time via your mutual business interests in the company. There are rarely any divorces, and courts are not sympathetic to family issues in corporate disputes.

So, before you take money from the 3 F’s, ask yourself: Are you ready to get married? And is the necessity of financing the business worth the potential family issues that could arise down the road? If the answers are yes and yes, be sure you put the arrangements in writing at the outset, and be sure all parties sign that agreement before any money changes hands.

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The first response I usually get from most businesspeople when I mention “corporate formalities” is a puzzled look. Which is not surprising, since the term is rarely used except by lawyers.  The second response is invariably a request by my clients for another cup of my famous high-octane coffee, since the mere mention of “corporate formalities” usually results in the realization that the meeting isn’t over yet (the end of a meeting with me being the highlight of most of my clients’ days). Fortunately, high-octane coffee is plentiful around my office. In extreme cases, I can even produce a finger or two of single-malt scotch if I notice my client snoring and slumped over in their chair mid-discussion.

But I digress. “Corporate formalities” is a term with which you ought to become familiar if you intend to run, or are already responsible for running, a business.

The reason I even bring this arcane term of art up is because of an admonition I included in my last blog (which you can access by clicking here. In that blog, I suggested that even if you make proper filings with the appropriate State agencies to set up your company, you would still not be adequately protected from company liabilities if you failed to also adhere to “corporate formalities” and maintain proper corporate records. So, what did I mean by that?

Let’s discuss a major misconception about “incorporating” (which is a term I use to mean forming any corporate entity, whether an LLC, corporation, partnership, or something else).  The misconception is that all one need do to obtain the “magic bullet” of limited liability is to file a document with the proper State agency, and voila! -- instant “teflon” for the company’s owners.  But the reality is quite different.

You see, incorporating involves a trade-off between you and the State (you didn’t really think that the State was going to give you a freebie, did you?). In exchange for limited liability for the owners of a company, the State insists that the company adhere to certain laws, keep certain records, and adhere to certain procedures.  Those laws, records, and procedures include the following:

• The company must keep a separate bank account, and cannot commingle its funds with its owners’ funds and bank accounts. (Note that this is more straightforward in theory than in practice. I’ve seen numerous businesses get tangled up in banking and segregation of funds issues that could potentially lead to loss of the owners’ limited liability).
• The company must make certain information public, such as the identity of the owners, the address of its corporate headquarters, and the identity of its agent for service of process.
• The company must carefully authorize and document all actions taken by the company, usually in the form of signed resolutions (this is one of the most frequently overlooked corporate formalities, and potentially one of the most serious if the company is ever sued by a shareholder, employee, or customer).
• The company must not engage in activities that are extraneous to its corporate purpose, or that properly belong to the owner or owners (e.g., don’t have your company pay for your tickets to Tahiti, or take on any tasks related to your spouse’s widget factory).

The bottom line is that the failure of your company to adhere to corporate formalities can result in a “disregard” of the corporate form by a court if your company is ever sued. Legally, this is known as “piercing the corporate veil,” and it’s a disaster by any measure. How? Well, if the court awards damages to the person suing your company, it means that YOU, as an owner of the company, are personally liable for those damages. It could also result in fraud and shareholder actions being upheld against you, and the literal unraveling of your company. 

Finally, let’s take the example of a corporate acquisition: your company has been approached by a competitor with a buyout offer, or you decide that, after 15 years in business, you want out and you want to sell your company. As a mergers and acquisitions attorney, I can tell you that the first thing the lawyers on the other side are going to ask for are your corporate books and records. Because the acquirer wants to know what they’re acquiring, and they want to ensure that they’re not inheriting any potential liabilities that they don’t want to inherit. Inadequate books and records can quickly scuttle a potential deal.

Again, I would urge you to ask yourself the following question: Is the modest cost of keeping adequate corporate books and records worth the potential personal liability, or the risk of scuttling a potentially lucrative sale of the company? Only you, as the business owner, can answer this question.

Has your company properly adhered to corporate formalities? Need help getting your corporate house in order? Give me a call. 

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One of my favorite lawyer jokes goes like this:

Q:  What’s the definition of a corporate lawyer?

A:  Someone who prevents exciting things from happening.

Unfortunately, and all too often, the joke is true.  Many corporate lawyers fail to see the forest for the trees.  They get so wrapped up in focusing on every possible thing that could go wrong in your business or transaction that they “overdraft” your corporate documents and contracts and scare off the other party to your transaction.  Moreover, they often adopt an adversarial stance vis a vis your business partners, customers, and contracting counterparties, which ends up souring what is supposed to be a positive business experience for the companies involved.  All this extra time and extra analysis ends up costing you time, unnecessary anxiety, and more money in legal fees.

 In short, corporate lawyers too often act like overly wordy litigators.  And that’s not what we’re supposed to be.  We’re supposed to help you build, not to tear down.  We’re supposed to help you perform cost-benefit analyses with respect to your contract language, not throw in everything but the kitchen sink.  And building and benefiting should always be a cooperative and forward-looking endeavor, not an adversarial and retrospective one.  It’s not about your lawyer’s ego.  It’s about your business.

However, there’s at least one time during the life of your company when letting your lawyer get analytical and obsessive is actually more beneficial than detrimental, and when there’s a quantifiable benefit to the money you’re paying him for his services.  And that time is when you decide to start a new business.

You’ve got to get your ducks in a row, make sure the language in your formation documents is tight, and keep your gaze steely.  You don’t want your lawyer to stop this exciting thing from happening, but you DO want him to slow it down enough for you to make some serious decisions that will affect the financial and operational future of your new enterprise.  Decisions such as choice of corporate form, tax considerations, investor rights and obligations, corporate governance, banking relationships, and a host of other issues.  Some can be put off until a few months after you’re up and running.  Most cannot.  This is one time when preventing an exciting thing from happening too quickly is actually desirable.

 Are you going to part with some money in legal fees, as the title of this blog states rather forcefully?  Probably.  You might be able to spend a bit less, but you might end up spending more.  It depends on the type of business you’re starting, your financing, your facilities, your investors, your choice of corporate entity, certain tax considerations, and your appetite for risk, among other things.  It won’t cost you an arm and a leg, but it’s going to cost you something.  And it’s going to be some of the best money your business ever spends. 

 I’m going to explain why over the course of the next several weeks of blogging.  Stay tuned . . . .

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