A Small Business Administration Loan Primer for Startup Restaurants

It is so-called "common knowledge" in the restaurant industry that banks don't lend money to independent restaurants. They're too risky. But that's not entirely true. You've likely heard of Small Business Administration (SBA) loans,

And in spite of the perceived risk of lending to restaurants, according to data published by the SBA, from 2006 to 2015, more SBA loans were issued to full-service and limited service restaurants than any other business sector. That amounted to nearly 39,000 loans totaling $10 billion. The average size of the loans was relatively modest at $250,000. About 54% of those loans were repaid.

Jeff White, a staff writer and financial analyst at Fit Small Business. writes, "The conventional wisdom is that lenders don't like to give loans to restaurants because they are riskier than other types of businesses. The data, however, casts doubt on this. Full service restaurants and limited service restaurants by far got the largest number of SBA loans between 2006 and 2015."

White notes, "They came in at numbers 3 and 5, respectively, in terms of their volume of SBA funding. The average loan size was $263,579 for full service restaurants and $238,177 for limited service restaurants. This is smaller than the average loan size for hotels, dental offices, and other businesses. This suggests that restaurants do get lots of SBA loans, but that their loan size may not be that high."

Case in point: Tracy Vaught and her husband, Chef Hugo Ortega, have benefitted from this program. They own Houston's nearly four-decade-old seasonal American bistro, the Backstreet Café. "I have funded three subsequent restaurants with SBA loans,- says Vaught. The paperwork is daunting. You need a good accountant to help, and a lawyer to help you with the bank loan contract."

Obtaining and using a U.S. Small Business Administration (SBA) loan for restaurant startup funding is a complex and arduous process, but potentially valuable to grow your business once you've gained experience and a track record.

Vaught, whose first restaurant is housed in a cozy '30s-era house in the city's River Oaks area, says there are a number of banks that specialize in these loans that are guaranteed by the government. Vaught got help with three of her loans from Capital CDC, a leading, private, non-profit provider of small business financing throughout Texas and New Mexico, and did a fourth on her own.

"I have used Comerica, BBVA and Texas National Banks. One of my bankers moved to a group called Harvest, and does these loans with them." Vaught says she prefers going this route to having partners "because when I pay it off, the restaurant is mine and not shared with others."

That said, before you make plans to meet with your banker, take a deep breath. An SBA loan provides capital; but it is not easy money. Moreover, as we discuss below, it is not likely a re- source for which a brand new startup restaurant is eligible.

Even if you are embarking on your first restaurant, down the road an SBA loan could be a welcome source of financing to grow your business if you use it prudently and you're willing to wade through the application process. In this article, we explain how the program works and its upsides and downside for the independent restaurateur.

First, a Gentle Reminder - Debt Equals Risk

Whether you are a Fortune 500 corporation or operating a hotdog stand, you are financing your business with either debt or equity, and in many cases, both. As you likely know, debt financing requires borrowing money. Equity financing requires investors who expect a share of future profits and/or an increase in the value of the shares. If you own a home, you likely were required to provide equity in the form of a down payment. The remainder of the purchase was likely financed by debt in the form of a mortgage.

If you understand that much, you understand that unless your business is borrowing money from you or family members who are not likely to take legal action if it defaults on the loan, creditors expect to be paid on time.

Your investors are banking on the future success of the business. They only receive a share of profits via a dividend (if the company is a corporation) or distribution (if the company is a partnership or LLC) if the company is profitable.

As Vaught points out, debt financing avoids having to sell shares of your business to partners or shareholders. The founders maintain full control of the enterprise. A lender is not a partner, which is a good thing. Just don't forget that the lender is only interested in one thing - being repaid with interest.

The big downside of debt financing is that it's risky for all businesses, but particularly startups that might not generate positive operating cash flow for a year or more. That is an axiom of classic finance that you need to accept. Investors, on the other hand, are gamblers who can sit by patiently waiting for the business to run "in the black". Monthly debt service, on top of payroll and rent factor, can put significant pressure on the business, particularly if it gets behind on the loan and the lender pursues collection.

Even established, large, publicly traded companies balance debt and equity financing. A small startup company should be primarily equity financed, even if that equity is coming from a single owner's personal wealth.

Even if you qualify for an SBA loan, you should not incur more debt than you can comfortably service. That could require sitting down with your accountant to create a cash flow projection. Among many of the services provided by the SBA is access to Small Business Development Centers (SBDC), which are partly funded by the SBA, and provide free consulting services to the small business community.

The Upside…

On its face, an SBA loan is attractive indeed. Judith Collins, senior business advisor for the Dallas, Texas, Metropolitan Small Business Development Center, points out that an SBA loan differs from a conventional loan in that lenders, not the government, provide the funds that make up an SBA loan. The SBA doesn't lend money directly to small business owners. Rather, it works with approved lenders to insure up to 90% of the loan made by the commercial bank.

"But the government, in this case, the SBA, guarantees a portion of the amount, up to $3.75 million," she says. "That means if you default on the loan, the SBA pays out the guaranteed amount to the bank." This guarantee lets lenders offer longer terms for repayment than they otherwise could, which means the operator's monthly payments will be lower.

The benefits of SBA loans include lower down payments and longer repayment terms than conventional bank loans, Collins notes, "enabling small businesses to keep their cash flow for operational expenses and spend less on debt repayment."

SBA loans provide "competitive debt alternatives for early-stage or startup businesses that could not attract comparable financing in the conventional debt markets," explains Carty Davis, a partner in C Squared Advisors, LLC in Southern Pines, North Carolina.

By offering loans with an implied SBA or government guarantee, banks or other credit providers issue credit facilities, which shift most of the risk to the SBA in the event of a default. "The benefit is relatively low-cost debt versus raising all funding via personal funds, angel investors, or other more expensive capital."

Few borrowers relish the SBA process and infiexibility. The transactions also almost always take longer to approve, document and close than advertised, even when working with lenders with SBA-preferred status.

How competitive are SBA loan rates? "The answers to your questions can vary from deal to deal," says Dan Garcia, Vice President and SBA and Small Business Loan Originator for Community Bank of Texas, N.A. in Houston. Fees charged by brokers can vary from broker to broker, but probably average about 1% of loan amount. Adds Garcia, "Banks are not allowed to charge any fees on the SBA 7A loans, but are allowed to charge origination fees on the SBA 504 loans. These fees can average between 1.00% - 2.00% of the loan amount. Bank interest rates can vary from 1.00% - 2.75% over WSJ (Wall Street Journal) prime, depending on the strength of the deal."

Gary Henderson, executive vice president and chief SBA Officer for Allegiance Bank in Houston notes, "Some brokers charge a fee for referring an SBA loan to a Lender. Some banks pay these fees and some don't. Our bank does not. Each bank is different in how they price their loans. SBA has restrictions on the maximum interest rate lenders can use. For example, for floating rate loans the maximum is 2.75% over Prime."

The Downside…

That all sounds good. You should note, while the program was intended to boost small business growth, it is not intended for startups launched by newbie operators. The SBA data on loans to restaurants does not indicate whether the borrowers were startup or existing restaurants. In general, however, only 25% of SBA loans are issued to startups in any sector. And those startups are likely launched by experienced and successful entrepreneurs.

Indeed "very few banks in the U.S. will make a conventional loan to a startup company," says Herbert Austin, district director for the Dallas/Fort Worth District Office of the SBA in Fort Worth, Texas. "By definition, a startup business is deemed very risky because the rate of default is very high. Therefore, SBA-guaranteed loans and other sources of financing may be the only options to obtain financing."

Johnson & Wales University assistant professor Jeff Gilbert, who serves as the director of the university's Denver Campus Entrepreneurship Program, points out that when working through SBA, processing time is longer, there is more paperwork involved in the process, the interest rate will be higher (the higher the risk, the higher the rate), applicants are accountable to the bank as well as the SBA, and the loans tend to be less flexible. He calls the process itself "very hard." In spite of his experience, Gilbert says, "I have not seen a startup restaurant obtain SBA financing."

Again, an established independent concept is a different creature from a startup concept launched by inexperienced owners, as far as lenders are concerned. "If a restaurant is already up and running and has a need for access to financing, such as expansion, updating equipment or machinery," an SBA loan is a good idea, says Dianna Seaborn, director, office of financial assistance for the SBA.

"If they are already operational, they should have already developed a relationship with their bank or credit union, and they should contact their lender to make the financing request. The applicant should let the lender know they are willing to utilize SBA's loan programs if the lender feels it necessary."

By reducing the lender's exposure, SBA loans allow lenders to make a loan to a borrower they "may otherwise not provide financing when there may be factors that affect the ability of the lender to make the loan conventionally," adds Seaborn. "For startup restaurant small businesses, usually those factors include lack of historic financials, a collateral shortfall - restaurant equipment is valued at pennies on the dollar by most lenders - or industry risk."

With a few exceptions, there are five general requirements for getting an SBA loan:

• In business at least 2 years
• Personal credit score is 680+
• Seeking at least $30,000
• At least $100,000 in revenues for the past 12 months
• Business is profitable

These requirements put SBA loans out of the reach of inexperienced operators. Experienced restaurateurs, such as Vaught, who have operated a profitable concept for 40 years, are often eligible for conventional loans, let alone SBA loans. For businesspeople that meet SBA requirements, the advantages are significant, including:

• Less of a down payment required - as low as 10 to 15 percent with an SBA loan versus 20 to 25 percent with conventional loans.
• Amortizations of up to 25 years for real estate and 10 for good will, working capital and equipment where they can be much less on the conventional side.
• SBA loans are fully amortized, which means the borrower doesn't have to worry about renewals or balloon payments.
• Collateral shortfalls are not a barrier with an SBA loan - they are often the reason a bank will require an SBA guaranty.
• With an SBA guaranty, a bank will be more willing to finance businesses with higher risks like startups, acquisitions, expansions and special purposes.

Get Your Documentation in Order

If you are eligible for an SBA loan, keep in mind the application process can be daunting. "If you choose the SBA route, be sure to have all of your backup documentation in order, as solid upfront preparation assures a smoother process," Davis advises. "Be aware that if documentation is missing from your file, it can jeopardize a bank's ability to collect on their SBA guarantee. Also, do not look for an SBA-sponsoring bank to waive requirements under SBA applications."

Few borrowers relish the SBA process and inflexibility. The transactions also almost always take longer to approve, document and close than advertised, even when working with lenders with SBA-preferred status.

At the same time, some SBA loans may require additional documentation to be submitted by the applicant. If the lender is not what is called a "delegated" lender, i.e., already approved to issue SBA loans, the additional review by the SBA might add a few days to the processing time.

Generally, for a start-up business, borrowers will need an equity injection, a strong business plan and projections, and reasonable and attainable assumptions. According to Seaborn, SBA considers factors such as:

• The character, reputation and credit history of the applicant (and operating company, if applicable), its associates and guarantors.
• The experience and depth of management/owners.
• The strength of the business.
• Past earnings, projected cash flow, and future prospects.
• The ability to repay the loan with earnings from the business.
• Sufficient invested equity to operate on a sound financial basis.
• Potential for long-term success.
• Nature and value of collateral, although inadequate collateral will not be the sole reason for denial of a loan request.
• The effect any affiliates may have on the ultimate repayment ability of the applicant.

Applicants need to approach a commercial lender who will evaluate the application to determine if they need to obtain the SBA guaranty to make the loan to the applicant. If the applicant needs help with developing a business plan, they can utilize one of SBA's no-to-low-cost resource partners, such as SCORE (the Senior Corp of Retired Executives), the Small Business Development Center network, or the Women's Business Center network. Potential business owners should visit www.SBA.gov or contact their local SBA District Office for resources in their local area.

Depending on the amount requested and down payment available, however, they can be a bit restrictive. An owner may need to sign a personal guarantee and potentially provide outside collateral. Even though it's easier today than in years past, there are quite a few forms to be filled out that can be a bit cumbersome.

"All applications for a loan will first be considered by your bank on a conventional basis," says Austin. "If the underwriter feels that the prospective borrower does not meet all the requirements for a loan, the bank may decide to either to turn you down or use the government guarantee. Most banks can commit the government to the guarantee without our approval."

These loans, Davis emphasizes, are highly regulated with limited flexibility on pricing, fees, guarantees and term. Personal guarantees generally require security interest in personal assets, outside investments, real estate holdings, etc. Fees are significantly higher than conventional funding. The application, approval, and documentation process are very thorough.

Easy Money, It's Not

Gilbert views an SBA loan as an insurance policy. "It's not cheaper or easier to obtain. Loan-terms are extremely limiting and restrictive. It requires a two-level approval process: first the bank, then SBA."

What restaurant operators don't know about SBA loans but should, says Henderson, is that "they offer the most generous terms available in terms of equity injection and amortization."

Echoing Vaught, he notes, "They allow the owner to keep the ownership for himself versus using investor funds. Also, the process can seem overwhelming, but sometimes these owners have never had bank financing, and are not aware of the requirements banks have in underwriting and closing loans. We are subject to heavy oversight, so documentation is crucial."

The biggest mistake, in general, is not with the loan, "but with underestimating the working capital needs for a start-up, and making sure if they have investors to have their funds in hand prior to getting started," Henderson finds. "The other issue I see is the restaurant taking on too heavy of a lease for what the business can handle." The banks will want to see a projection of monthly expenses to the penny.

Once a borrower has an SBA loan, it can prove "challenging" to refinance this debt to a new payment schedule, adds Collins. "The SBA does not refinance a loan that already has an SBA guarantee, in most circumstances. The SBA generally believes the borrower is already benefiting from the organization's programs, and it would rather appropriate funds to a new borrower. It is important to consider the fact that SBA loan refinances of existing SBA loans are rare before applying."

Collins believes operators should always seek assistance from the intended lender. "If they are not available, or you are intimated by lenders, Small Business Development Centers (SBDC), which are SBA-funded non-profit, is available to assist you with the SBA loan process at no charge." According to the SBA, SBDCs provide a vast array of technical assistance to small businesses and aspiring entrepreneurs.

Most of the time, the lender is available to provide SBA loan assistance, but may refer the borrower to SBDC to ensure he has a solid and complete business plan, along with other requirements. This referral tends to cut down on the odds of being rejected by the bank.

"The SBA finds it hard to justify a loan for a cash business unless it will be used to purchase the real estate,- says Kevin Moll, president of Restaurant Consulting Services, Inc. (RCS) in Denver, Colorado. "To pay down high-interest debt, the business typically needs to have positive cash flow for 24 months and been in business for at least three years for a bank to consider. Debt refinancing can be a lengthy process."

Moll has found that it "really pays off to have a great feasibility study/ business plan document. Our funding sources have seen our plans, know that there are hospitality industry professionals that are creating these documents, and that the numbers are not coming out of thin air."

Moll is adamant that other than paying for a feasibility study/business plan document, in most cases a startup should spend "not one red cent until the startup has been funded. Don't pay for architectural, design, liquor license, lease; nothing until funding is approved. Otherwise, the startup principal will be spending personal money on a venture that may not ultimately be funded, putting unnecessary financial burden on the aspiring, but unfunded restaurateur."

Ryan Mathews, the principal of Black Monk Consulting in Royal Oak, Michigan, advises that operators seeking an SBA loan seek the counsel of "a good accountant and a great lawyer". In addition to assistance with the application, they can "help you think through whether or not you should apply in the first place, and help you understand exactly what you are signing up for."

Indeed, Mathews adds, common problems include "looking before you leap, underestimating what they really need, overestimating their prospects for success, and taking an unnecessary economic shortcut rather than tightening their belts and funding their operation on existing revenue."

An Interim Step

SBA financing is "an interim step and generally not a long-term solution for growth concepts or operations,- C Squared Advisors' Davis warns. "Most borrowers do not relish the SBA process. As companies grow, conventional financing should be the long-term goal of most SBA borrowers. The process of obtaining SBA financing is never seamless."

Obtaining SBA financing on projected results can prove dangerous, Davis continues. Ensure that seasoned operations can service the loan, or ensure that projections are obtainable and supportable. "An SBA default is a serious black eye. Don't borrow before you can service the debt. The SBA and member banks do pursue collateral and secondary sources of repayment."

Rudy Miick, CMC, FCSI, founder and President of the Miick Companies, LLC, in Boulder, Colorado, cautions that the process is "typically slow, slow, slow; not a quick fix." The biggest error commonly made, he concludes, is default or lack of payback.

His advice: "Pay the loan off."

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WORDS OF WISDOM
SBA Loan Mistakes to Avoid

Johnson & Wales University assistant professor Jeff Gilbert serves as the director of the university's Denver Campus Entrepreneurship Program. His experience includes more than 30 years as managing partner of several businesses, including independent and franchised restaurant concepts such as Sbarro's the Italian Eatery and Cinnabon, identifies several miscues that restaurant operators commonly make:

• Overly optimistic business plans that under-estimate start-up costs while over-estimating revenues. "It will generally cost 50% more than planned and take twice as long to open as planned."
• Starting under-capitalized, and needing to fund initially through personal investment. "I recommend a minimum of 50%, not the 10% or 20% that most financial planners will recommend. Once open, you cannot go back to ask for more funding when you run short. It's a clear admission that your business plan was bad, and that you as a manager are weak."
• Not completing the due diligence. Many restaurateurs get impatient with the process and jump ahead to the launch before completing basic feasibility of the concept. This leads to applying for a loan before the package is prepared.
• Not being able to answer questions about how revenue projections were made, and not clearly identifying all associated costs once again tells bankers you are not ready to move forward.



Gilbert recommends that operators reach out to one of SBDC's 2,600 offices nationwide for free one-on-one counseling services, as well as education programs to assist with business plan development and funding options.

He routinely directs people to SCORE, the Senior Corp of Retired Executives. It also provides free counseling services for clients, and focuses on package development for completing and submitting the SBA loan application.

Director, Office of Financial Assistance for the SBA, Dianna Seaborn offers an additional caveat. "Don't spend all of your money before securing financing. Use your equity to leverage what you need into the financing you need to start the business successfully."

Once your money is spent, she adds, many lenders will discount equipment or other start-up expenses. "Some lenders will allow for expenditures related to the business start-up to be used as equity, but you need to document those costs."

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TYPES OF SBA LOANS

There are several types of SBA loans. You should be aware of them and what they are intended to provide. These include:

• SBA 7a Loan. This is the most common type of SBA loan used to finance working capital needs. This is the kind of loan you would seek if you needed capital to survive after a period of bad weather that hurt business and put you behind expected sales for the year.
• SBA Express Loans. With loan amounts up to $350,000, the proceeds from this program may be used for financing business acquisition, equipment, debt refinance, working capital, inventory, and tenant improvements. You might pursue this option if you were upgrading your kitchen or expanding your bar or dining room.
• SBA 504 Loan. The US Small Business Administration 504 Loan or Certified Development Company program is designed to provide financing for the purchase of fixed assets, which usually means real estate, buildings and machinery, at below market rates. A business qualifies for a 504 loan if its tangible net worth is $15 million or less and its average net income for the last two years prior to application is $5 million or less after federal income taxes. Generally, a business must create or retain one job for every $65,000 guaranteed by the SBA debenture; for small manufacturers, the amount is $100,000.
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