If you’re starting a business, one of the first things you’ll need to do is figure out how to finance it. One of the more common ways to finance a business is to get a small business loan, but in order to get one, an equity injection is typically needed. So what exactly is an equity injection and why is it needed to get a loan?
Equity Injection Definition
In its simplest form, an equity injection is a business owner or an investor putting money into a company. In most cases, this is the small business owner providing a loan to the business in the form of owner investment, though it can also be an outside investor putting money into a company in exchange for an ownership stake of the business.
Many new small business owners think they can get a bank to finance the entire amount of their project.
Unfortunately, that’s not usually the case.
Lenders want to see what they call “skin in the game”. This probably comes from banking school as every lender says this. Don’t believe me? Just ask them if you can finance the entire project.
Skin in the game refers to the business owner investing in their project. From the bank’s perspective, why would they invest in your project if you aren’t going to? Small businesses have a certain amount of risk whether they will survive or not, and by the owners investing personally, they are strongly motivated to see the business succeed.
An equity injection can be thought of as a down payment, much like you would normally need to do when buying a house or car. For a small business loan, lenders will want to see an equity injection of somewhere between 15% and 25% of the total project cost,
So, if you’re looking for a loan to start or grow your business, be prepared to put up some of your own money.
Do SBA loans require an equity injection?
The Small Business Administration (SBA) is a government agency that provides support for small businesses, including guaranteeing loans. This can make it easier to get approved for a loan from a bank or other lender.
To clear up any misconceptions, the SBA doesn’t (in most cases) loan directly to a business. Instead, the federal government provides a guaranteed repayment of the loan, even if the business fails. Due to the higher risk of making a small business loan, SBA lenders have a greater incentive to make loans to small businesses, which is important because small businesses create a lot of jobs.
And even though an SBA guarantee takes a lot of the risk off of the bank, the borrower will still need to invest money personally into the business.
The 7(a) program, is the most used of all the SBA programs, helps businesses pay for all sorts of things. Loan proceeds can be used for working capital, building renovations, and purchasing assets like equipment, office furniture, new fixtures, and office supplies.
As of 2018, the SBA requirements say that all borrowers of 7(a) loans with principles of $350,000 or more must make a minimum equity injection of 10% in the form of cash or in assets that constitute 10% of the loaned value.
The SBA does not allow borrowers to fulfill equity injection requirements with borrowed cash, proceeds from a personal loan, most assets other than cash, or standby debt unless said debt is on full standby with no payments of principal or interest.
For borrowers who make an equity injection with gifted cash, the SBA requires a letter proving the validity of the gift and a deposit statement. The lender may also have additional requirements with respect to the gift letter.
Types of Equity Injection Financing
Businesses may use the following sources of cash as a valid equity injection payment when applying for an SBA loan:
- Cash directly from your business’s bank account.
- For non-cash property, the SBA requires a professional appraisal. Your business must have owned the property for a minimum of two years.
- Cash withdrawn from a personal retirement account such as a 401(k), IRA, or Roth IRA.
- Refinancing a personal residence or using a home equity line of credit
- Personal loan cash proceeds if the borrower intends to repay the personal loan with non-business-related income or from a salary from an external operation unrelated to the business itself.
- Angel Investors: Some types of investors known as angels can provide early-stage financing for small businesses in exchange for a large equity stake.
The lending institution will have more information about applicable funding sources for the borrower’s equity injection requirement for a business loan.
Do SBA loans require a collateral requirement?
The Small Business Administration (SBA) does not have any specific collateral requirements for its loans. However, most lenders will require some form of collateral, such as your home or business assets. This helps protect the lender in case you’re unable to repay the loan.
Collateral is something of value that a lender can take if you can’t repay your loan. For example, if you’re taking out a loan to buy a car, the car serves as collateral for the loan. The lender puts a lien against the items being borrowed, which is a legal right or claim against a property by a creditor. If you default on the loan, the lender can repossess the car.
Related: What is collateral?