How a Bank Underwrites Your SBA Loan

For most business owners, the underwriting process for any loan is a mystery. Your banker tells you the loan is ready for underwriting, and then you wait. Eventually, you get a massive list of questions, and usually only a few of them seem relevant.

If you apply for a loan guaranteed by the U.S. Small Business Administration (SBA), which specializes in lending to businesses with bad credit, you go through the same credit underwriting process, with government eligibility tests thrown in for good measure.

As an SBA underwriting veteran, I know exactly what goes into all those seemingly inane questions you have to answer. In this article, we’ll go over exactly what SBA underwriters are required to write about in their credit memos and help you prepare to go through the process as smoothly and quickly as possible.

What is a credit memo?

Credit memos are typically prepared by an underwriter and then presented to someone with loan decision authority. In many big banks, that is just the underwriter’s boss. In smaller community banks, it could be a committee of several executives and/or board members.

Every bank has its own version of a credit memo for SBA loans because most banks adapt a conventional credit memo to be used for SBA loans. As long as the memo includes all the information that we’ll discuss below, the SBA allows any format.

Note that we’re going to talk about what a run-of-the-mill SBA 7(a) credit memo would contain. SBA Express, 504, and USDA credit memos would all be slightly different. Each of the following subheads is likely what the subhead would be called in the actual credit memo.

Business analysis

It’s likely that your bank’s conventional credit memo requires more business discussion than the SBA does. The SBA only requires a “description of the history and nature of the business.” This is fairly straightforward.

To get this information, you’ll either be required to complete a business history document in the application packet or have a phone discussion with the banker or underwriter.

It’s also likely that the bank will include information on the industry you’re in. One bank I worked for would copy and paste industry information based on the business’s industry code into the memo for future reference.

Management experience

After I worked as an underwriter, I spent a few years as a banker, and the most common response to our needs list that I heard was, “Why do I need to do a resume? I don’t have one.”

There’s something freeing about owning your own business and not having to worry about applying for new jobs. But, alas, the SBA requires the bank to show that you have sufficient experience to manage the business.

This one is usually just a checkbox unless you have no experience. In that case, the bank may have to require one of your employees (who does have experience) to guarantee the loan as a “key employee.”

Financials: history and projection

There are three main parts to the SBA’s required financial analysis: debt service, current ratio, and debt/tangible net worth. Let’s look at each of these individually.

There are two ways to pass the SBA’s debt-service coverage threshold. The first is to have cash flow equal to more than 1.15 times annual debt payments in the most recent year or two. The second is to provide two years of projected financials in which the second year’s cash flow is at least equal to annual debt payments.

Usually you can only go the projected financials route if you’re expanding to a new location, buying a new business, have a super fast-growing business, or can directly point to a new revenue source or cost savings that will come about with the loan use. Also, you will need to provide in-depth assumptions for your projections. You can’t just say that revenue will grow 10% and margins will go up by 1%.

Cash flow is defined as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), plus or minus a bunch of other add-backs and deductions. Deductions include unfunded capital expenditures, non-recurring income, and distributions.

Add-backs include rent (if it will be replaced by a real estate purchase), distributions and owners’ compensation (if there is far more than necessary for personal expenses), and distributions again (if they were used to pay taxes that have already been accounted for).

The other two ratios both come from the balance sheet, and the SBA requires a pro-forma balance sheet. Pro-forma is a fancy finance word for adjusted. The pro-forma balance sheet is what your balance sheet will look like the day after the loan funds. The bank will make adjustments to your existing financials to add the loan to liabilities, take out any cash for the down payment, and add whatever assets are purchased with the loan.

The first balance sheet ratio, the current ratio, is current assets/current liabilities. The SBA doesn’t want the bank to do the loan if it takes all of your business’s liquidity to do it. The current ratio shows if you still have enough current assets to pay off all current liabilities even after you spend a bunch of cash on the down payment.

The second, debt/tangible worth, is calculated to make sure that your business is not overleveraging to purchase intangible assets that may not produce revenue.

This section is easily the biggest in this article, and it will be in the credit memo as well. The bank’s most important task is making sure you can repay the loan. Don’t be surprised if you get plenty of questions on your financials. I worked with a few overly eager underwriters who wanted an explanation for any line item change of more than 5% year to year.

Unfortunately, there is usually not an easy answer to these questions. The best thing to do is be patient and tell them something that makes sense.

Collateral coverage

The SBA requires an appraisal for any real estate or equipment purchase. If you use equipment that you already own, you can either get it appraised or use half of the book value (cost minus accumulated depreciation) of the asset.

The memo will have a narrative regarding the collateral and the appraised value, and the underwriter will apply the appropriate discount rate to the value to determine the maximum loan amount.

Credit scores

If your loan amount is less than $350,000, the bank is required to get an SBA credit score before it starts the underwriting process. The SBA score is provided using an algorithm based on business and consumer credit reporting.

For all other loans, expect the bank to pull a business and personal credit report, and if you have any outstanding derogatory accounts or judgments, you will likely be required to pay them (within reason) prior to the loan funding.

Otherwise, the SBA leaves it up to the bank to evaluate credit scores. This usually means you’re out of luck if your score is below 670 unless you have a really good story. Likewise, if your business credit report shows a lot of late pays, you’re going to need to write a letter explaining what’s going on.

SBA eligibility

The government has a specific agenda when it comes to dishing out loan guarantees. It wants to make sure your business is actually small. It wants to make sure you couldn’t get an equivalent loan from a conventional source. It wants to make sure you have an active business, and you don’t discriminate. And, it wants to make sure that you don’t sell drugs or prurient materials, and your business isn’t speculative.

The underwriter will complete a section testing these items. It’s unlikely that you would ever be asked a question about eligibility.

Be prepared

If I had to use one word to describe the SBA underwriting process, it would be “onerous.” There’s always the risk that you’ll encounter a zealous underwriter or loan committee that makes the loan process take forever. All you can do is prepare yourself to have all required documentation and be as patient as you can.