The meaning of the phrase “equity injection” depends heavily on context. By itself, the phrase could relate to a specific provision in the way SBA loans work, or act as a more general term. Read on to learn more about the differences and see what to do if your company needs an equity injection to continue normal operations.
Equity Injection Definition
In its simplest form, an equity injection occurs when an investor makes a cash payment to a company in exchange for shares in that company. Other sources might refer to this act as a capital injection. Typically, the word “injection” in this context communicates that the company receiving the funds has experienced a degree of financial distress and needs additional funding to continue operating.
On the other hand, an equity injection can also refer to a rule within the SBA loan framework which requires some applicants to “put some skin in the game” and make a down payment to receive a 7(a) or 504 loan.
Depending on the context, you might hear this phrase used for SBA loans or more generally to describe the act of an outside investor making an emergency cash investment in exchange for an equity stake in the target company.
Finally, the phrase may appear during a business acquisition or other types of transactions, although its meaning in those contexts acts outside the scope of this article.
SBA Loan Equity Injection
Two SBA loan programs will usually require some form of additional equity invested by the borrower: the 7(a) loan program and the 504 program.
The 7(a) program helps businesses pay for working capital, refinance debt obligations, and purchase assets like office furniture, new fixtures, and other supplies and overheads.
The 504 program focuses on helping businesses pay for new property, plant, and equipment as well as other expensive fixed assets. Such assets might include new land, buildings, facilities, and long-term PP&E. All 504 loans require an equity injection by the borrower.
Requirements
As of 2018, the SBA put into practice new standard operating procedures which require that all borrowers of 7(a) loans with principles of $350,000 or more must make a 10% equity injection 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.
For 504 loans, the 10% equity injection requirement also exists. The key fact to note here revolves around the necessity of providing some degree of upfront cash before taking on an SBA loan. Businesses should treat SBA loans like certain other forms of consumer debt like mortgages; ultimately, the government wants business owners to have a stake in the outcome of the funded project.
Eligible Programs
The following SBA loan programs and associated SBA lenders require some or all applicants to put forward a minimum equity injection prior to receipt of loan proceeds:
- 7(a) loans with principals larger than $350,000.
- All 504 loans regardless of loan size.
The following SBA loan programs do not require applicants to make a preliminary equity injection:
- Some types of 7(a) loans.
- SBA Express loans.
- SBA Export Express loans.
- CAPLines.
- SBA Veterans Advantage loans.
- SBA microloans.
Other requirements associated with these programs may exist for your specific circumstances. A lending institution can provide more information about the exact requirements for a given business as well as the exact amount of upfront cash required, a number usually based on the total project cost. Also note that SBA requirements change with some regularity.
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 plan such as a 401(k), IRA, or Roth IRA.
- 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.
The lending institution will have more information about applicable funding sources for the equity injection requirement for an SBA loan.
Unique Equity Injection Funding Sources
Outside of SBA loan requirements, businesses may develop a pressing need for additional cash to continue business as usual. Businesses which have reached a point of financial distress due to a downturn in the economy, operational disruptions, or inability to react to changing market conditions may find themselves in a difficult financial position.
The following unique equity injection funding sources may help a business to navigate difficult financial times:
- Friends and Family: Business owners and startups may turn to friends and family to provide much-needed cash during difficult times. In some cases, family and friends may ask for an equity stake in the business in exchange for the cash they provide.
- Angel Investors: Some types of investors known as angels can provide early-stage financing for small businesses in exchange for a large equity stake.
- Venture Capital Firms: VC firms can provide financing for businesses which have established a degree of product-market fit and have received a prior angel investing round.
- Private Equity Funds: PE firms can step in to acquire businesses or purchase large stakes in existing businesses meeting certain EBITDA requirements.
- Government Programs: In some jurisdictions, government financing may help businesses to continue operating during difficult times. For example, during the COVID-19 pandemic, the US government provided businesses with emergency cash injections to pay for employee expenses in a program known as the Paycheck Protection Program or PPP.
What to Do If Your Business Requires an Equity Injection
When determining the next best step in financing a distressed business, small business owners should consider the following funding sources prior to distributing equity to outside parties:
- If your business needs cash to pay for working capital like inventory, consider an SBA loan first.
- Consider turning to private-sector lenders for additional debt financing if needed.
- Avoid the pitfalls of giving outside investors equity by making use of innovative financial products like royalty financing.
- Consider making use of the services of an invoice factoring firm to turn future customer payments into immediate cash in exchange for a fee.
- As a last resort, consider a merchant cash advance (MCA) to keep the lights on until your business can achieve a higher level of financial stability. Ensure that your business’s cash flow can handle this type of financing.
Determining Next Steps
Owners and managers should first closely examine the financial statements to determine the exact degree of financing needed. Then, business owners should carefully consider the exact amount and mix of financing needed to bring the business back to a level of financial stability.
Ultimately, equity acts a precious commodity of any business, and owners should only consider granting this equity to investors if the situation warrants it. Alternative financing options may offer a more appropriate solution for short-run capital challenges.