Posts tagged ‘SBA’

SBA Has Killed Innovation in Small Business Lending

I got a note from some advocacy group asking me to lend my voice to stopping some cut in SBA lending.  This is what they linked to:

A federal program designed to help small businesses with commercial real estate mortgages is coming to an end this week.

The U.S. Small Business Administration’s 504 loan refinancing program, which expires Thursday, allowed companies to refinance real estate and equipment loans.

SBA 504 loans for new purchases are still available.

I had a couple of thoughts

  • Why do we need a government program for commercial real estate and equipment financing?  These are the only two sectors of small business lending that are robust right now.  I get 3 calls a week trying to give me equipment financing.
  • The SBA has already pretty much killed  small business cash flow lending.  Basically, if you want a loan secured only by cash flow, the SBA is your only choice.  Why would a bank make such a loan privately when they can make it and get an SBA gaurantee paid for by the client?   As a result, no bank even has a desk for non-SBA lending, and since SBA lending is hard, many don't have an SBA desk any more.

I can't prove it, but I am convinced the SBA has killed innovation in the private lending market to small businesses.

Update:  Another thought - the SBA is the barely-useful quid pro quo cited by statists from all the fantastically expensive and time-consuming regulation that gets dumped on small businesses.  Well, I don't want it.  I don't want to give statists any cover that this is somehow an equal bargain.  It's a quarter flipped up on one side of the scale to balance ten tons of bullshit on the other side.  It's like sending flowers to someone you raped.

Adverse Selection

From Radley Balko, this is just staggering:

Federal employees’ job security is so great that workers in many agencies are more likely to die of natural causes than get laid off or fired, a USA TODAY analysis finds.

Death — rather than poor performance, misconduct or layoffs — is the primary threat to job security at the Environmental Protection Agency, the Small Business Administration, the Department of Housing and Urban Development, the Office of Management and Budget and a dozen other federal operations.

The federal government fired 0.55% of its workers in the budget year that ended Sept. 30 — 11,668 employees in its 2.1 million workforce. Research shows that the private sector fires about 3% of workers annually for poor performance . . .

The 1,800-employee Federal Communications Commission and the 1,200-employee Federal Trade Commission didn’t lay off or fire a single employee last year. The SBA had no layoffs, six firings and 17 deaths in its 4,000-employee workforce.

When job security is at a premium, the federal government remains the place to work for those who want to avoid losing a job. The job security rate for all federal workers was 99.43% last year and nearly 100% for those on the job more than a few years . . .

White-collar federal workers have almost total job security after a few years on the job. Last year, the government fired none of its 3,000 meteorologists, 2,500 health insurance administrators, 1,000 optometrists, 800 historians or 500 industrial property managers.

The nearly half-million federal employees earning $100,000 or more enjoyed a 99.82% job security rate in 2010. Only 27 of 35,000 federal attorneys were fired last year. None was laid off.

Forgetting for a minute the adverse selection and incentive problems from preferentially attracting folks who want to work in an environment without any accountability for performance, how can an institution that is running $1 trillion over budget not have any layoff either?

Wither the SBA?

I don't have to explain to readers that I oppose the idea of government stimulus.   So I am loathe to argue about stimulus methodology, because I think one is just arguing over gradations of suck.

But if I were to discuss stimulus for employment, my first thought would be reducing the employer portion of FICA -- reduce the cost of employment, the quantity employed would likely go up  (of course, rather than doing this, the administration has done just the opposite, by requiring union shops on government contracts, effectively increasing the cost of employment).

My second thought was the SBA.  Most stats show that job creation is mainly in small businesses, and it appears to be small business credit that is impacted most for the 2008 banking crisis.  So, instead of sending more money to state governments; or welfare recipients; or large companies who have, by failing, proven themselves to have bad management or a bad business model or both  (none of whom are likely to be huge engines of private job creation).  Why not find a way to increase funding to small businesses?  Temporarily reduce the federal guarantee fee on SBA loans, provide tax credits for banks making such loans, something.

I called the SBA today.  They said they have no idea, just like the rest of us, what is in the bill.  Apparently there were a few incremental changes proposed, but nothing concrete.  The only specific proposal the SBA rep made was an early provision in the stimulus plan to raise the government gaurantee fee, which hardly seems like a way to promote small business credit.  It probably makes fiscal responsibility, but since when did the stimulus have anything to do with fiscal responsibility?

My Alternative to the Bailout

This is taken from and expanded from the end of this post.

Everyone involved in the bailout plan says, at least publicly, that they are not trying to bail out a bunch of Wall Street folks who lived high off the risk premium of these investments but now want to avoid the costs when the actual risks become clear.  They claim to be bailing out Wall Street and various large banks because they fear that a financial meltdown and liquidity crisis will starve main street businesses of cash, and create a deep economic slowdown.

OK, if this is the real policy goal -- to maintain the ability of main street businesses to borrow -- then here is my alternative proposal:

  1. Immediately increase the SBA loan gaurantee authority by $100 billion dollars.  That is enough for a million new small business loans of $100,000 each.
  2. Authorize treasury to spend up to X hundred billion to buy rated new issues of bonds and commercial paper of US non-financial companies.  Some limits should be applied - such as the feds cannot buy any more than 30% of a single issue and/or more than 10% of the entire outstanding debt of one company.

That's the plan.  Here are the advantages:

  • The government is addressing the actual policy goal of keeping liquidity in main street business directly
  • The government is investing in success, in main street companies trying to grow, and not in failed banks and financial institutions
  • Moral hazard issues are avoided with financial institutions. 
  • The SBA loan guarantees cost nothing today.  In fact, they are cash positive in the short term due to loan guarantee payments by borrowers.  Of course, they risk future losses,  but such losses in the future are in part covered by the guarantee payments, and a future loss is cheaper than a loss today.
  • Investments in corporate bond issues are much easier to value, and are far less risky, than investments in illiquid mortgage securities.  The taxpayer is far less likely to take a beating on these purchases.
  • Banks may still fail, but the FDIC has an infrastructure and experience for handling this.  If necessary to calm people, the FDIC could make a public commitment to assisted mergers to maintain all depositors.
  • If there is some big financial meltdown, which I still doubt, there might be a need to inject some mortgage liquidity, but since the Feds now own Fannie and Freddie, the vehicle for doing so is easily available.

Update:  I was not clear -- this is actually an alternative to by alternative.  My first, preferred alternative plan is "do nothing."

Final Thoughts on the Bailout (I Still Don't Like It)

I sat this weekend and pondered the pending financial bailout.  A number of fairly smart people who know more about Wall Street than I seem to think it a necessary evil, and this includes several folks who are nearly as libertarian as I.  Is a sort of knee-jerk libertarianism preventing me from accepting a necessary step to avert economic Armageddon?

I don't think so.  By the light of day on Monday morning, I still think it a bad idea.

Here is some of my thinking (to some extent my last point is the one that is most important to me -- if we want liquidity, let's put it in the right place).

  • I am tired of businesses heading to the government bailout trough and arguing that the continued functioning not only of their industry, but of all the existing players in their industry, is critical to the health of the US economy and thus requires some sort of government subsidy/bailout/protection.  Coyote's first law of rent-seeking is that companies will always claim that failure of their business will have a disproportionately negative effect on the economy.  Coyote's first corollary to this law is that Congress usually accepts this argument at the exact point in time when it is no longer true.
  • This bailout is even more grotesque than a normal industrial bailout.  GM can be said to have honestly tried to make the right cars, and just failed.  I don't like bailing them out, because I don't particularly like diverting capital into the hands of organizations that are proven failures at using capital well.  But the financial investors that we are bailing out today knew they were taking a lot of risk by purchasing risky securities and then leveraging them up on their balance sheets.  They lived high for years off of the fat returns for taking this risk, arrogantly explaining that they made lots of money because they were smarter than everyone else and because they were being rewarded for taking on risk.  But then they come running to the government when the returns on their risky securities turned south, which just makes me sick.  They were paid for taking this risk, so take it.  I am sorry that you have no cushion because all those earlier returns are already spent on Maserati's for your mistresses, but that is what chapter 7 is for.
  • As many as 300,000 small businesses go bankrupt every year (this number is very, very hard to pin down, as it is hard to separate personal from business bankruptcy with small business).  Something like 299,998 of them do not get bailed out by the feds.  Why do the other 2 get special treatment vs. other US taxpayers?  Because they are better at lobbying Washington that they are essential?
  • Yes, the government created the Alt-A and sub-prime mortgage markets,and caused them to flourish via Fannie and Freddie aggressively asking for and buying these loans.  And the feds, via tax policy, and local governments, via zoning, helped pump up the housing bubble.  But nothing forced private companies, particularly highly leveraged institutions like banks, to load up their balance sheets with these things, or, crazily, to write insurance policies on their value.  Libertarians want to use these government interventions as an excuse for the bailout, but it doesn't wash. I do think many banks reasonably have lawsuit material against ratings agencies Moodys and S&P, which is fine.  I think new blood in that business would be a very good thing.
  • The total market capitalization of traded equities of public corporations on NYSE and NASDAQ is between $15 and $20 trillion.  That means that the first $150 billion of the bailout is equivalent to about a 1% price move on the exchanges, something that occurs almost every day.  Have we really close-coupled everything so tightly that a cumulative balance sheet hole on the order of magnitude of a 1% move on the stock market can bring down the whole financial system?  If so, we should just let the whole thing come down and rebuild itself in a more robust form.
  • Wall Streeters pat themselves on the back all the time for how creative they are financially.  So get creative here.  Create some sort of new entity and have banks contribute toxic mortgages into the entity in exchange for equity.  Find some pension funds to invest in the new entity at a deep discount.
  • These banks, who are experts in this stuff, claim they cannot value these failing, complex, illiquid mortgage packages.  OK, that may be true.  But how is the government possibly going to do any better?  Such a situation cannot possibly end well for the taxpayers. 
  • I saw folks writing in fear last week that the commercial paper market might dry up.  The commercial paper market dries up all the time.  It comes back eventually.  People treat lending markets like they are charities or something, and they fear that lenders will give up and never come back.  But they are not charities.  They serve just as much of a purpose for lenders and for borrowers.  Businesses and folks with capital need to make money on short term cash.  They are not going to stop lending forever.  Even capital markets dry up from time to time.  The IPO market has disappeared several times, including several years in the post-Internet-bubble period. The junk bond market comes and goes.
  • What is the government really worried about?  I presume that they are worried that liquidity will dry up and the ability of main street businesses to borrow will be impaired.  OK, then save the freaking $700 billion and if main street starts to have trouble borrowing, have the government participate somehow in that lending market.  Buy corporate bond issues, and/or increase the limit on SBA loan guarantees by a $100 billion  (this latter would allow a million new $100,000 SBA loans, and would actually generate money now in guarantee fees and only potentially cost money much later if the loans fail).  This way, we are investing liquidity in successful companies trying to grow rather than in failing banks that got us all into this.  Let's invest in success rather than in failure.

Crowding Out Private Alternatives

Due to the very nature of political pressures as well as poor accounting, a lot of government services are provided to the public below their true cost or market clearing price  (there are exceptions, like intra-city mail, but in these cases the government must pass laws to prevent private competition in order to maintain its market share).  When the government provides these below-cost or below-market-price services, it tends to crowd out private options.  So I am wondering why Kevin Drum is so surprised:

I guess rescuing them was the right thing to do. I'm still a little
taken aback by the apparent fact that American banks are now almost
flatly unwilling to make mortgage loans unless they're backed by Fannie
or Freddie, but that seems to be the case whether it takes me aback or
not. So rescue them we must. I suppose my next question is whether it's
worth thinking about how to restructure the American home mortgage
industry so that it can operate efficiently even in the absence of
massive levels of government backup. Or is Fannie/Freddie style backup
just the way the world works these days and there's no point fussing
over it?

As evidenced by the current bailout (and their huge accretion in market share over the last several years), Fannie and Freddie were under-pricing the service they were providing.  So of course, all things equal, bankers will demand the Fannie/Freddie backing because that will be a more profitable product and will be less work for the banker.  This seems like a "duh" kind of thing.  Like the "mystery" of why in Massachussetts, while everyone is obligated to sign up for health insurance, only the ones who were eligeable for free coverage did so.

I have written before of a similar phenomenon in business loans, where loans with SBA backing have crowded out everything else out there, such that a small business really can't find a lender who will make small business loans except with SBA backing.  Bankers are people too, and they can get lazy.  They have come to rely on these government programs, but certainly the lending function would still exist in a robust form if these programs did not exist.  Bankers would have to find other risk-mitigation tools, or else the loans would be more expensive, reflecting that the banks could not get rid of all the risk and had to price that into the loan.

By the way, don't you love the technocratic hubris of "thinking about how to restructure the American home mortgage
industry so that it can operate efficiently even in the absence of
massive levels of government backup."  Why do I, or Drum, or anyone outside of banking have to think about this at all?  I don't personally know the best private alternative to government mortgage gaurantees.  So what?  The financial field has been rife with innovation over the last several decades.  Just remove the government backup and let the the banks figure it out.  And let them go bankrupt when they figure wrong.

Postscript: As an ironic aside, the bank that holds my SBA loans was closed by the FDIC last week, my guess is due to a bad mortgage book in the Las Vegas area.  This doesn't have a lot of impact on me except that as I have paid down my loans, they became wildly overcollateralized, and I was in the process of trying to renegotiate some of my collateral out of the deal.  That will have to be put on hold, I guess.

Update:  More on government crowding out private options, in an entirely different industry:

Basic
dental care in Britain is free to those under 16 or over 60, the
unemployed, students, military veterans and some low-income families.
For others, government dentists offer lower prices than private
practitioners.

However,
the government does not cover cosmetic dentistry, and a recent
reorganization of the way dentists work has prompted many to leave the
public sector. Katherine Murphy, a spokeswoman for The Patients
Association, an advocacy group, said it was proving increasingly
difficult for Britons to get anything beyond basic dental care from
Britain's National Health Service.

Update #2: More on Fannie and Freddie, again via Rick Perry:

The
Fannie Mae-Freddie Mac crisis may have been the most avoidable
financial crisis in history. Economists have long complained that the
risks posed by the government-sponsored enterprises were large relative
to any social benefits.

We
now realize that the overall policy of promoting home ownership was
carried to excess. Even taking as given the goal of expanding home
ownership, the public policy case for subsidizing mortgage finance was
weak. The case for using the GSEs as a vehicle to subsidize mortgage
finance was weaker still. The GSE structure serves to privatize profits and socialize losses.
And even if one thought that home ownership was worth encouraging,
mortgage debt was worth subsidizing, and the GSE structure was viable,
allowing the GSEs to assume a dominant role in mortgage finance was a
mistake. The larger they grew, the more precarious our financial
markets became.

How to Get an SBA Loan

Note that this article is one in a series of articles on small business how-to's.  Past series have covered how to buy a business, labor audits, sales taxes, and workers comp.

I recently went through the process of obtaining an SBA (Small Business Administration) loan.  These are loans that are what I call "cash flow" loans, secured more by the companies earnings rather than collateral (though collateral may be required, see below).  SBA loans are written by private banks to standards set by the government.  If these standards are met, then bank loans under this program get a partial guarantee from the US government.

Before I go on to describe the process, I feel compelled to note that as a libertarian who does not believe the SBA should even exist and who believes that such loan guarantees are a subsidy program that should be eliminated, I was obviously conflicted by whether to seek out such a loan.  What finally made the decision for me is that this government program has crowded out all other private options.  Banks get about the same rate for an SBA loan as they would for a commercial loan without the guarantee.  Since the guarantee is out there and doesn't cost the bank anything, the bank has no reason not to insist on it?  Therefore, as a small company in the SBA size range, there just are not any banks willing to lend without the SBA guarantee.  This does not mean that in a free market without the SBA there would be no loans - it just means that when such a free subsidy program exists, banks are going to take it.

Types of Loans

The following is a gross simplification, but for a small company, there are basically two types of loans: secured loans and cash flow loans.  Secured loans are by far the most common for small businesses.  I, like nearly every entrepreneur I know, have had to pledge my house at various times as collateral for loans.  While it is fairly easy in today's market for a small company to get an equipment loan (typically lease-finance of a purchase) secured by hard assets, few lenders will provide loans for general business and working capital needs unless they are secured by something tangible -- homes, vehicles, receivables, etc. 

However, most businesses need capital for more things than just to buy hard goods.  Seasonal businesses may need loans to pay the rent in off-seasons, retail businesses need money to grow inventory and pre-pay for new leases, while opening new divisions may require paying salaries well in advance of first revenues.  Unfortunately, most businesses that claim to be business banks have no desire or talent to understand a business well enough to make a cash flow loan.  I am not talking about just Ethyl's Bank, but large banks like Bank of America and Wells Fargo who were stumped when I wanted to discuss some unique financing needs in my business.  I know people with a half million dollars a year in free cash flow out of their business who have trouble getting bankers to make unsecured cash flow loans.  And, as mentioned above, those who do make cash flow loans typically insist on having the SBA guarantee.

How an SBA Loan Works

I will not pretend to be an expert on all the intricacies and rules.  The SBA has a number of programs, offering loans of different lengths of time and for different purposes.  The SBA has programs for both revolving lines of credit as well as standard 10-15 year loans.  Each of these programs has different under-writing criteria, fees, and limitations, which your banker will have to explain to you.  Most SBA loans, including mine, fall under the section 7(a) program.  The SBA site tries to explain some of this.

As stated in the intro, an SBA 7(a) loan actually is issued by a bank, but to SBA underwriting criteria and with an SBA guarantee.  The SBA only guarantees a portion of the loan, something like 50-75% depending on the exact loan type, with the bank taking the rest of the risk.  These loans are issued at a floating rate of prime plus a percentage, and the SBA has rules that caps the rates as well as fees the bank can charge.  The SBA charges a substantial fee, in the 2-3% of total loan value, up front to the borrower for the guarantee.

Banks participate in the program in one of two ways.  Most any bank can originate an SBA loan, collecting all the (very substantial) paperwork needed by the SBA and forwarding it to the SBA for approval.  In addition to the underwriting time at the bank, the SBA can take many weeks to complete this analysis.   A smaller subset of banks have been pre-approved by the SBA to act as their underwriting agent - called a preferred lender or PLP.  This means that they can do the SBA's analysis for them.  This often greatly accelerates the process.  My total time form the bank's first data request to the final loan closing was less than a month, which is very fast.

Choosing the Bank is Critical

From the section above, it should be obvious that you should strongly consider working through a bank that has the preferred lender status with the SBA.  Note that having  or not having this status does not necessarily correlate with bank size.  The "expert" I was hooked up with at Bank of America (my main bank) was useless, and told me in so many words that it would be impossible for me to ever get an SBA loan.  I ended up working with Silver State Bank, a relatively new business bank out of Nevada.  They had the whole process automated, and when combined with a very knowledgeable banker on the front end named Jerry Woods here in Phoenix, the process was as smooth as silk and very, very fast.  In fact, I got the whole loan done in less time than it took BofA two years ago to do my line of credit.

Costs and Other Considerations

SBA loans are not cheap, and I would strongly urge you to pursue secured asset-backed loans as far as you can.  My total fees, including the cost of the guarantee, ran to about 3% of the total loan value.  In addition, I STILL had to put up collateral to back the non-guaranteed portion of the loan.  In retrospect, I think I did a bad job of negotiating with my banker on this.  No matter how good they are, bankers are still bankers and are going to attach every asset that can sit still for collateral whether they really need it or not.  I should have pushed back harder on this issue.  Overall, though, I am excited that I now have the capital to continue to grow my business.

PS-  If you want to enjoy some of this capital at work, come to Lake Havasu and rent a jet ski for a day!  All those other entrepreneurs out there are investing money in dead-end stuff like microchips and improved manufacturing --  Ha!  There is nothing like being able to tear around a big lake on 110HP to really make America competitive!

Financing Small Business Growth

A while back I wrote a series of posts here, here, and here on buying a small business.  One of the things I said in that post was:

Then, there are the banks. From my experience, it is very, very
difficult to get a bank to make an collateralized loan - i.e. a loan
that is secured only by the cash flow of a company rather than by
assets. In fact, I have never been successful at that. About the only
way that I have found that banks will make a loan is if it is an SBA
loan, where the SBA basically guarantees the loan for the bank. The SBA
goes through cycles of being very open to lending to being very tight.
I have not dealt with them for over two years, so I don't know what
their stance is today. Remember, though, that the SBA is not going to
approve any loan where the buyer has no experience in the industry or
where the buyer is not putting down his own money as well. The SBA has
a lot of information here.

This statement is still mostly true but I have learned a lot over the last couple of months.  The following is an update.

One of the things they tell you all the time in business school, but frankly I always found impossible to really internalize, was how much cash growth takes.  I guess I always thought of businesses with cash flow problems as being unsuccessful, slowly sliding down the drain and trying to make ends meet.  Wrong.  Growth is tremendously expensive.  And stressful.

My business is based on concession contracts.  Each winter, we are usually presented with the opportunity to bid on many contracts.  We narrow the field down to 4-6 we bid on, hoping to win about 2.  One of the things I did last year was greatly improve our standard bid materials, hoping that would help us win good projects.  Did it ever.  We bid on 6 last year and we won 6 (including Burney Falls, Pyramid Lake, and Lake Havasu).  Yea!  But then I began adding up all the investments in new inventory, new equipment, salary (you always have to hire people before the first revenues come in), licenses, building improvements, etc.  Eeek!

After a lot of work with bankers, I stand by most of my statement above.  Most bankers will not lend to businesses on cash flow, and always want some type of collateral (like my home equity).  Over time, though, I have found a few bankers who are willing to lend on cash flow and really understand business growth and why maybe I don't want to have my business's growth rate limited by how much equity I have in my personal home.  There are bankers who will put together packages of long-term loans backed by the SBA plus short term working capital loans that will now let me grow faster.  The folks at Copper Star Bank, for example, have been great. 

One of the reasons I felt the need to post this update is that I have been told that my difficulty finding a good business banker was due in part to my location here in Phoenix.  The Phoenix banking market is very real estate driven, so bankers usually come from that background rather than a business background.  I am told that those of you on the east coast or in the Midwest may have an easier time finding good business bankers.

Postscript: By the way, you might ask how I feel as a small government libertarian about accepting the government subsidy implicit in an SBA loan.  The answer is "conflicted".  Some libertarians are fine accepting government services, on the theory that they certainly have paid for them with all their taxes.  Some try to avoid government services, but that is almost impossible in today's world (such as using government roads).  I generally try to be pragmatic, operating somewhere in the middle.

As far as SBA loans go - I don't know what the commercial banking world would look like without SBA loans.  I think that the banking world would have found an alternative way to mitigate the risk (e.g. via securitization) without the government gaurantee, but we can't know.  The fact is that SBA gaurantees exist and banks would be crazy not to use the gaurantees in making business loans.  So, the reality is, if I want a cash flow based loan for a company my size, it will likely carry the SBA gaurantee.  My appologies to all those whose taxes support my loan gaurantee.

Buying a Company, Part 3

This is the third (and hopefully last) installment of a series of posts on how I went about buying my current business. You should also refer to part 1 and part 2. This installment will focus on options for financing the purchase of a small company and what kinds of legal documents you will need to complete the transaction.

Continue reading ‘Buying a Company, Part 3’ »