Learn about the SBA's offer in compromise process, including who is eligible and important do's and don'ts for handling SBA default.
When you first decided you wanted to become an entrepreneur, where did you see yourself five years down the road? If you are anything like me, it was almost exclusively positive. I've spent lots of time thinking about how great things are going to work out and almost none contemplating the potential downside.
Well, that's what I want to discuss with you today – the downside. I want to talk about a very specific downside: what happens if you default on a Small Business Administration (SBA) loan.
The internet is chock-full of info about SBA loans, so I'll spare you the book report. Instead, I'm going to bullet point the key features of SBA loans. If you want more details, the SBA's website is a great place to start.
Here are the key points:
- The SBA is not a direct lender (in most situations). It simply guarantees repayment to the bank in the event you fail to repay the loan.
- The SBA charges a guarantee fee for you to obtain an SBA loan. This is how the SBA program is primarily funded.
- The SBA guarantee does not get you off the hook if you default on the loan. The SBA reimburses the lender, but this does not impact how much the borrower owes. Borrowers often get confused by this, so I'm going to say it again: The SBA guarantee is for the lender, not the borrower.
- SBA loans are great for borrowers who meet all the normal criteria for a traditional business loan except collateral. If you have good personal credit, two to three years of profitable operating history, strong experience in the field and cash to inject, but not enough collateral to cover the loan, an SBA loan might be a good option for you.
- A startup with no operating history is unlikely to be approved unless it's part of a franchise with a good track record. A business plan and a good idea are not enough to get you funding.
What happens if you default on your SBA loan?
I'm not going to sugarcoat it: If you can't make your loan payments, some pretty bad things can happen. Bank levies, wage garnishment and foreclosures are common collection techniques. What exactly will happen to you depends on the details of your situation and your lender.
If you default on your loan and have pledged your home that contains equity, you risk foreclosure (in most states). That's why you should think long and hard about pledging your home. Once it's pledged, it can be awfully hard to get it released, even if your loan officer makes verbal assurances that the bank will release it after a few years of prompt repayment.
Even if you didn't pledge your home, you still have that pesky personal guarantee. Since virtually every SBA loan I've ever seen requires a personal guarantee from the business owner, this particular point applies to almost everyone.
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If you default on your SBA loan, the lender could sue you and attempt to levy your personal assets. Bank account levies and wage garnishment are most common, but I've had clients call me after the local sheriff's office knocked on their door to levy personal possessions (not that common, but jarring if it happens).
Does the SBA forgive loans?
The SBA generally doesn't offer 100% forgiveness on 7(a) and 504 loans, no matter how dire your finances are. However, for companies that have had to cease operations, the SBA will consider settlements that have been agreed to between a borrower and their loan issuer.
Offer in Compromise
While the SBA does not forgive loans, it does have a settlement program called SBA Offer in Compromise (OIC) for businesses that have ceased operating. The SBA's Offer in Compromise program is a process for borrowers who can't fully repay their loan after liquidation and agree to settle with their lender for less than the full outstanding balance.
To get accepted into the program, there are some basic parameters you'll need to meet:
- Your business needs to have ceased operations, and all of the business's assets need to be liquidated. It's extremely rare for a business to remain open and operating to settle its SBA debt, and it typically happens through some sort of bankruptcy.
- All obligors (i.e., borrowers and guarantors) who are seeking forgiveness must submit full a financial disclosure. Here is a specific list of the required items. Some borrowers want to negotiate without that information, and it's typically a nonstarter. The SBA isn't willing to negotiate for the sake of negotiating.
- An OIC will only be considered if you can demonstrate your ability to repay the debt over a reasonable period. This is why full disclosure is required. The SBA wants to understand what resources are at your disposal, and it will compare what it sees as available to what you are offering through "enforced collection" (i.e., what it could get if it sues you). When those amounts are similar, your OIC is likely to get some consideration.
Borrowers that are accepted into the OIC program will have their loans closed and no further efforts will be undertaken by the SBA to collect their loan amount.
There is one notable exception to all of this. Loans that were provided as part of the Paycheck Protection Program. Those loans awarded via that program during the CVOVID19 pandemic are forgivable.
Be cooperative – the SBA doesn't have to forgive your loan.
Being in default on your SBA loan is likely one of the more stressful things you'll have to deal with in life, so I get the temptation to avoid dealing with it. It's much easier to simply ignore those emails and phone calls. Just keep in mind that if you want to eventually settle, one requirement (per the SBA) is that the participating bank recommends the OIC for approval. So, if you act like a jerk or annoy them, you run the risk of the lender not supporting your OIC. It's not hard to imagine a loan workout officer being on the fence about your settlement offer, then deciding to decline it because you were rude, aggressive or nonresponsive.
Loan forgiveness is not a right. The SBA doesn't owe you anything. A settlement is based on financial hardship, which means you need to prove that you lack the assets and income to repay the debt in full. From time to time, I get calls from people who say, "Sure, I can afford to repay it, but with the business being gone, I really don't want to." It's an understandable way to feel about a business that you no longer own but still owe a ton of money on.
Sometimes people call me even when their loan isn't yet in default, wanting to know if there is a way to settle their SBA 7(a) loan without actually going into default. Lenders vary on this point. Some won't give you the time of day unless you have already missed payments. Others are more practical and will entertain an SBA OIC once the business closes, regardless of the payment status (current versus defaulted).
The bottom line is that if you expect to settle your SBA loan through the OIC process, expect to give the bank or SBA full disclosure. It wants to fully evaluate your situation to determine if you can repay the loan in full and, if not, what amount would be reasonable to accept as a settlement.
Organizational standards vary between SBA offices and bank branches.
While you may qualify by these criteria, that doesn't necessarily mean you'll get the same deal at every single branch or office. The standards and accepted practices vary by region (which is frustrating, considering they all are bound by the same standard operating procedures). While this may seem subjective and unfair, it's a reality, one that an inexperienced advisor won't know much about.
So yeah, I'm tooting my own horn here. I do enough of these with enough frequency that I know the little quirks of each SBA office. Does that mean I know with 100% accuracy how much they will accept? No. But I have a good understanding of which office won't take anything less than half, which office is a stickler for paperwork and which office typically only approves or declines offers with nothing in the middle (i.e., no counteroffers).
Bypassing the lender rarely works.
When working directly with your SBA lender, sometimes you're not going to get the answer you're looking for. But when things don't break your way, going over your lender's head isn't going to work unless they've done something egregious. Why? If your lender is servicing the loan, the SBA will defer to the lender in the vast majority of situations.
The SBA depends on (and compensates) its lending partners to service SBA loans, which includes making decisions on OICs. There are millions of SBA loans out there, so the SBA simply doesn't have the manpower to get involved in every single loan.
It's not an easy way out; it has costs.
I've said this a bunch of times over the years, but it bears repeating: The OIC is not a free pass. If you want to settle, you need to be prepared to give the SBA the pound of flesh it requires. Obviously, the biggest question every borrower has is how much the SBA will want. The exact amount depends on a lot of factors (I cover many of them here), so there is no blanket answer.
These are some factors the SBA considers:
- Is your home pledged and is there equity?
- Do you have cash savings? (This is an easy one. If you have cash, the SBA will want at least a portion of it unless you have a valid reason why you can't give it.)
- Do you own assets that could be sold to raise cash? Boats, RVs, extra cars (the SBA usually won't ask you to sell your only car), collectibles, etc., are all possible sources of cash.
- Do you have steady income (or a spouse with income, even if they didn't guarantee the SBA loans)?
- What does your future earning potential look like? Age, profession, education and health are all factors here.
SBA loan forgiveness is a hard nut to crack, but it's possible. Because it's the government, the rules, protocols and general thought processes often defy logic. "But that makes no sense!" is the refrain I've heard a million times, to which I say, "True, but that doesn't mean it's not the reality of your situation."
Understanding what's negotiable and what's not is imperative to succeeding with the OIC process. It's their game, their rules. If you want to settle, you don't have the option to take your ball and go home, so make sure you understand all the nuances of the process, or find someone who does.
Additional reporting by Dock Treece.