You should always carefully read the loan documents before borrowing money for your business. This is doubly true when you borrow money from the government.
Case in point: the Small Business Administration’s (SBA) Economic Injury Disaster Loan (EIDL) program.
The EIDL program provides loans of up to $150,000 to businesses in need of working capital due to the economic dislocation caused by the COVID-19 pandemic.
Unlike Payroll Protection Program (PPP) loans, EIDLs are not forgivable—you have to pay them back. But for a commercial loan, they do come with low interest—3.75 percent—and a long 30-year repayment period. More than 3.3 million businesses have already obtained EIDLs from the SBA.
To obtain an EIDL, your business must sign
∙ a loan authorization and agreement,
∙ a note, and
∙ a security agreement.
These documents contain some serious fine print that makes it clear the SBA really wants you to pay back the loan.
Some borrowers have expressed surprise at some of these loan provisions. But there’s nothing especially unusual about most of them—they are often required in some form or another in commercial loans.
But if you’ve never obtained a commercial loan, you may find some of these provisions quite strict—perhaps stricter than you’d expect from a loan program designed to help businesses struggling during the COVID-19 pandemic.
Here are seven things you should know about the EIDL requirements. You’ll be obliged to satisfy these terms for 30 years unless you repay the loan early (there is no prepayment penalty).
1. You Can’t Sell Your Business
Without SBA permission, you can’t sell your business. Nor can you merge, consolidate, or otherwise change ownership or business structure.
This could include removing or adding a business partner. Such a restriction is common in commercial loan agreements. Obviously, a lender doesn’t want you to sell or make other major changes to your business without letting the lender know about it.
2. You Can’t Make Certain Distributions without the SBA’s Consent
The EIDL agreement provides that the borrower—that is, your business—must obtain the SBA’s prior written consent before making (1) “any distribution of borrower’s assets,” or (2) any advance “by way of loan, gift, bonus, or otherwise,” to
∙ “any owner or partner.”
∙ “any of its employees,”
∙ “any company directly or indirectly controlling or affiliated with or controlled by the borrower,” or
∙ “any other company.”
Read literally, this provision is quite alarming. It appears to prohibit, without SBA permission, any distributions or payments to the owners of a business that has an EIDL—including payment of dividends to corporate shareholders or distributions to owners of LLCs or partnerships.
But SBA officials have stated in email guidance that this clause does not apply to any distribution of assets made in the normal course of business, including distributions of net income in accordance with the bylaws or operating agreement of a company, or distributions to owners of a pass-through business to cover tax obligations. Thus, it is unnecessary to obtain written consent from the SBA for these types of distributions.
This is especially good news for owners of S corporations. One of the main tax advantages of the S corporation is that its shareholder-employees may receive part of the profit their business earns in the form of corporate distributions that are not subject to employee payroll taxes—a 15.3 percent tax up to the Social Security tax ceiling.
If your S corporation takes out an EIDL, it may distribute part of its profits to the shareholders as distributions without obtaining SBA approval. But note that you are flatly prohibited from paying EIDL proceeds to shareholders as dividends or distributions. EIDLs may be used to pay employee payroll and other operating expenses, but not dividends.
You do need to obtain written SBA approval for distributions or advances outside the normal course of business. For example, SBA approval is needed to borrow money from your business.
3. You Have Record-keeping Obligations
EIDLs come with many record-keeping requirements.
First, you must obtain and itemize receipts and contracts for loan funds spent and retain them for three years. The SBA can request your itemization and copies of receipts at any time.
Planning point. It’s wise to place your EIDL funds in a separate bank account so you can easily keep track of how they are spent.
You must also “maintain current and proper books of account in a manner satisfactory to the SBA” for the most recent five years. You must keep these records until three years after the loan is paid off.
Your books must include financial and operating statements, insurance policies, tax returns, and records of earnings distributed and dividends paid. You must also keep records of all compensation paid to officers, directors, shareholders of more than 10 percent, members, partners, and proprietors.
You must furnish your financial statements to the SBA within three months after the close of your fiscal year. Moreover, the SBA may require you to provide an “accountant’s review report” prepared by an independent public accountant at your expense. Such a report will likely cost several thousand dollars. A bank typically wouldn’t require an accountant’s review report for a loan of this size.
You also authorize the SBA to inspect your records.
4. You May Have to Give Other COVID-19 Payments to the SBA
EIDLs are intended to cover disaster losses not compensated by other sources—for example,
∙ grants or loans from other government agencies or private organizations, and
∙ any legal claims you may have.
If you receive payment from any such other sources to help defray your COVID-19-related losses, you are required to notify the SBA. The SBA will then determine, at its sole discretion, whether the payments are a duplication of benefits. If so, you must give SBA the money, up to the outstanding balance of your loan. This is not a provision you’ll find in a standard commercial loan agreement.
Example. The owners of the Lucky Diner obtain a $150,000 EIDL. They later recover $100,000 from their business interruption insurance policy. They must notify the SBA of the insurance recovery, and the SBA may require them to use all or part of it to repay their EIDL.
But you may obtain both a PPP loan and an EIDL as long as you don’t use them for the same expenses.
5. You Must Preserve Your Collateral for Loans of More Than $25,000
The SBA requires collateral for EIDLs of more than $25,000. But your collateral need not be equal in value to the EIDL. You won’t be turned down if you have little or no collateral.
The SBA does not require that you pledge real property. Rather, it obtains a security interest in all tangible and intangible personal property your business has or acquires or creates in the future. Your collateral includes present and future inventory, equipment, deposit accounts, promissory notes, negotiable instruments, and receivables.
This is called a “blanket lien” because it covers all your business personal property. To perfect its lien in your collateral, the SBA files a UCC-1 financing statement with the secretary of state for the state where your business is located. Blanket liens are very commonly required for commercial loans, especially when no personal guarantee is required, but they are the most intrusive type of lien.
With the exception of selling your inventory in the ordinary course of business, you may not sell or otherwise dispose of your collateral without the SBA’s prior written consent.
If you have a desire to do so, you need to apply to the SBA loan servicing center and ask it to release the SBA’s lien on the collateral you wish to sell. The SBA is under no obligation to release its lien, but it will ordinarily do so if your remaining collateral is near in value to the outstanding balance of your loan—or if it is clear your business can repay the loan based on its profits and cash flow.
Example. Evergreen Tree Removal, Inc., obtains a $150,000 EIDL from the SBA that is secured by the company’s assets, including a crane. Evergreen decides to sell the old crane and purchase a new one.
To get this done, Evergreen must ask the SBA for permission to sell the crane and to release the SBA’s lien on the asset. If Evergreen sells the crane without SBA permission and a lien release, the SBA will be legally entitled to repossess it.
Also, your business may not further encumber your collateral without SBA consent. Since the SBA’s blanket lien applies to all your business personal property, you’ll have no unencumbered personal property to offer a lender as collateral.
This is not unusual. Many businesses have liens on all their assets. But depending on the total value of your collateral and the amount of your SBA loan, you may find it more expensive to obtain additional loans.
Finally, within 12 months after you sign the EIDL agreement, your business must obtain hazard insurance, including fire, lightning, and extended coverage.
The insurance must be for at least 80 percent of the insurable value of your colleterial. You must send the SBA proof of your insurance coverage and keep it in place throughout the term of your loan.
The collateral requirements are stricter than you would typically face when getting a line of credit or bank loan of $150,000 or less.
6. You Should Buy American
You promise to purchase only American-made equipment and products with the loan proceeds “to the extent feasible.”
7. There Are Penalties for Violations
If you breach any of the terms of your loan agreement, you’ll be in default, and the SBA can demand immediate payment of all that you owe. The SBA also can sue you in court for what you owe and/or can collect against your collateral. The SBA will also report your default to credit reporting agencies, likely resulting in a drop in your business’s credit rating.
Your legal woes can be even worse if you misapply your EIDL—for example, if you use it for personal expenses.
In this event, you’ll be liable to the SBA for an amount equal to one-and-a-half times the original loan. You also face criminal and civil liability if you made false statements or misrepresentations to the SBA. The penalties can include treble damages, fines, and even imprisonment (though this is highly unlikely except in cases of blatant fraud).
SBA EIDLs can provide your business with a badly needed cash infusion of up to $150,000. But these low-interest commercial loans have to be paid back, and the SBA imposes numerous legal requirements on borrowers for the life of the loan. Here are some highlights from the article:
∙ During the life of an EIDL, you can’t sell your business or make unusual distributions of its assets without SBA approval.
∙ You must keep itemized receipts of how you spend your loan money and maintain detailed books and financial records showing how you run your business.
∙ If you borrow more than $25,000, you’ll have to pledge all your business property (other than real estate) as collateral and insure it. You can’t sell or otherwise dispose of your collateral without SBA approval.
∙ If you obtain other loans, grants, or insurance proceeds to cover your COVID-19 losses, the SBA may require that you use the money to pay off your EIDL.
∙ The SBA makes you promise to buy American products for your business whenever feasible.
∙ If you violate your EIDL agreement, you have to pay hefty damages and the SBA will report you to credit agencies.