Business owners often wonder if they can leverage invoice factoring if they already have a loan through the U.S. Small Business Administration (SBA). The short answer is yes. However, there are nuances to making it work, and not everyone will qualify. In this guide, we’ll walk you through the basics of SBA loan factoring subordinations and general approval criteria to help you gauge the likelihood of approval before submitting your request.
Subordination Agreements Are Common in Personal and Small Business Funding
If you’ve ever taken out a loan that uses an asset as collateral, or a secured loan, you’re probably familiar with liens. A lien is a legal claim that protects the other party’s interest in the property. Bank liens such as these are generally consensual, meaning you expressly give the other party rights to the property in specific situations. However, there are also non-consensual liens, such as tax liens and mechanic’s liens, which function similarly. The key difference is that your consent is not needed for the latter.
Lenders appreciate bank liens because they reduce risk and can help ensure they don’t take a loss if you’re unable to make your payments. Borrowers also benefit because liens can make funding more accessible, open the door to more capital, and reduce overall funding costs.
Liens can cover a wide variety of assets, such as real estate or even your accounts receivable. Some may also be blanket liens that cover all your business assets.
Liens Are a Routine Part of SBA Loan Requirements
With some exceptions, the SBA does not require collateral or liens for loans of $50,000 or less. However, lenders must follow their own standard commercial loan policies for specific types of 7(a) loans between $50,001 and $350,000, which usually involve taking business assets as collateral via a Uniform Commercial Code (UCC) lien. For Standard 7(a) loans above that threshold, collateralization is required.
This means if you have an SBA loan, there’s probably a lien involved. For secured direct SBA loans, the SBA is both the lender and the lienholder. For other types of SBA loans, where the SBA is serving as guarantor for some of the funds, and a bank or other participating lender is providing the funds, that entity is the lender and lienholder.
These are often blanket liens that include all business assets. One notable exception is 504 loans, which are generally secured by the real estate or equipment being financed.
Subordination Comes into Play When More than One Party Wants to Protect Their Interest in an Asset
Most lenders will run a lien check when you’re going through the loan approval process. The process often stops if they discover there’s already a lien on an asset you intended to pledge, simply because you cannot promise the full share of the same asset to two different entities. The parties must agree on how lenders will be paid if the asset must be liquidated.
Although sometimes lenders may agree to a proportional split or other terms, the most common solution is for each party to take a lien position. By default, the original lienholder, with the senior debt, takes first position, assuming the contract doesn’t prohibit the new funding arrangement. The newcomer, with the junior debt, then takes second position. The challenge comes in when the newcomer will not accept second position.
In these cases, the original lender may agree to subordination, meaning they accept second position and allow the newcomer to take the first position.
Example: How Debt Subordination in Funding Works
Let’s imagine that you have a mortgage. The bank likely has a lien on your home. That means if you don’t pay, the lender can go through a specific legal process to liquidate it and collect what it’s owed from the sale proceeds. But let’s say years into your payments, you want to take out another loan for repairs and use your home as collateral again. Should you default, there may not be enough equity to cover your debts to both parties, so lien positions are determined. If the second lender is willing to take on more risk, your initial loan becomes senior debt, and the initial lender takes first position. The new lender takes second position. The debt through the second loan becomes known as junior debt or subordinated debt. This means the first-position lender has the legal right to full repayment before the second-position lender receives any payment.
It would be highly unusual for the original mortgage provider to agree to take second position in a situation like this, but it’s somewhat common in commercial lending, especially when the value of the asset outweighs the original debt and when the first lender has a blanket lien and the second lender only wants first position on a specific asset, such as a new piece of equipment or receivables.
Combining an SBA Loan with Other Funding Can Be a Smart Business Decision in Specific Situations
It’s essential to weigh the pros and cons anytime you’re exploring business funding, as most forms come with debt and interest. Loan subordination adds another layer of complexity, as it impacts business cash flow management and requires some administrative effort to get approval. Still, there are a few situations that may make this worthwhile.
You Want to Preserve Beneficial SBA Financing Terms
If you’re happy with your overall rates and terms but need additional capital, securing funding with subordination can let you keep your good SBA terms instead of replacing the entire loan.
Your Funding Solutions Are Being Used for Different Things
Many businesses leverage a mix of long-term and short-term funding. Long-term funding is commonly used for large capital outlays, such as expansion or equipment. These investments typically allow the business to increase revenue, making it easier to cover payments and offset the cost of borrowing. Short-term funding is more commonly used to close cash flow gaps, manage seasonality, or cover emergencies. If you need both, and both require collateral, it’s quite likely there will be an overlap and subordination will be necessary.
You Can Generate Value Above the Cost of Funding
If the new funding will generate revenue that more than covers the cost of funding, securing a second round can be a smart move. This might be the case if you need immediate capital to cover the upfront costs of fulfilling a large order or accepting a new client. Some businesses may also use the new funding to secure bulk or early payment discounts.
You Can Strengthen Your Repayment Capacity
Sometimes securing additional capital allows the business to invest in something that helps it generate more revenue, improve margins, or strengthen cash flow, thereby making it easier to meet its existing debt obligations with greater ease.
Lenders in first position will almost always want to see proof of this before accepting subordination. It’s what gives them confidence that your debt is likely to be satisfied even if they move to second position.
Invoice Factoring is Often Used Alongside SBA Loans
Invoice factoring, also known as accounts receivable factoring, is a unique business funding solution that works differently than a loan. Instead of receiving a lump sum of cash that you have to pay back with fees and interest, you sell your open business-to-business (B2B) invoices to an invoice factoring company or factor. The factor provides you with most of an invoice’s value upfront, then collects the balance from your customer. You receive the residual when your client pays.
Factoring works well as a standalone funding solution. However, it offers many benefits that make it ideal as a second source of funding that’s being used alongside bank loans or SBA loans.
- No Debt: Factoring doesn’t add debt to your balance sheet, which can make it easier for businesses to keep up with existing debt payments.
- Preserves Credit: When you factor, you leave your existing credit and credit lines available for financing needs.
- Flexible: Depending on your agreement, you can factor as much or as little as you want. At Charter Capital, for instance, we don’t require long-term agreements or monthly minimums, so you can tap into the extra capital when it makes the most sense for your business.
- Improves Cash Flow Management: Factoring accelerates payments for work or goods you’ve already delivered, allowing you to align your cash outflows with your inflows better. It also makes cash flow more predictable, so managing it is easier.
- Fast: Whereas long-term financing options like SBA loans can take months to pay out and are typically part of a long-term growth plan, factoring can provide you with working capital on the day you submit your invoice. This makes it ideal for things like covering payroll or emergencies.
Candidate Qualification for Factoring is Straightforward
Getting approved for factoring is typically easier than getting approved for traditional financing because factors primarily evaluate your customers’ creditworthiness. Your credit history and score are not major factors in approval. In fact, at Charter Capital, we routinely provide small business factoring. Even businesses that have not established credit yet and startups can qualify as long as they have a history of invoicing B2B clients and those clients have good payment histories.
Expect to Undergo a Financial Risk Assessment in Factoring
In addition to evaluating your customers, your factoring company will run some simple checks to ensure they’re likely to receive the invoice payments without issues. Just like a traditional lender would, your factor will check for liens, too. However, the primary concern is whether there are liens against your accounts receivable or blanket liens, as those tend to cover your receivables, too.
An existing lien on your receivables will almost always stop the approval process, but what happens next depends on whether subordination is an option.
Factoring Subordinations Explained
Factors generally will not take second position on your receivables. However, many lenders will subordinate to a factor because the cash you receive from factoring often makes it easier for your business to cover its expenses and grow.
There Are Several Requirements to Qualify for SBA Loan Factoring Subordinations
If you’ve decided to start factoring, your SBA lender will need to agree to take a subordinate position on the lien tied to your receivables. Although each lender is a little different, you’ll likely need to meet the criteria outlined below.
Have a Satisfactory Payment History
SBA guidance calls for a satisfactory credit history, which extends beyond your SBA loan payment record. Your lender or SBA servicing center may also consider how you manage other credit obligations. Delinquencies, defaults, collateral deficiencies, or loan document issues may need to be resolved before your request is approved.
Remain Financially Viable After the Subordination
Your financial records must show that your business is viable and likely to remain that way after factoring begins. Expect the reviewer to evaluate your current financial condition and how the factoring arrangement will impact your cash flow, operations, and overall financial health.
Be Able to Repay the SBA Loan and Meet Other Obligations After
You must show that you can continue making your SBA loan payments and meet your other financial obligations after factoring costs are considered. Your lender may review financial statements, debt schedules, and projections to confirm that your business will have enough cash flow to meet these obligations.
Prove the SBA Loan Will Be Adequately Secured
Your lender or SBA servicing center will evaluate how moving behind the factor impacts its ability to recover funds if your business defaults. For 7(a) loans, sufficient collateral value must remain to adequately secure the SBA loan. The subordination must also be limited to a specific amount and cannot automatically cover additional funding in the future. Direct SBA loans are reviewed under their own servicing requirements and may have different conditions.
The SBA Loan and Factoring Process is Generally Five Steps
The exact process varies by SBA loan type, lender, and factor, but it generally follows five steps. There is no standard approval timeline, and missing information can delay the process.
Step 1: Apply for Factoring
Tell the factor about your SBA loan at the outset and provide the records needed to evaluate your business, customers, and invoices. The factor will determine if you are a potential fit and whether it is willing to move forward if it can obtain first position on your receivables.
Step 2: Establish the Proposed Factoring Terms
If the factor wants to proceed, it will establish the proposed funding amount and lien position. You may receive a term sheet, conditional approval, or factoring agreement that is contingent on obtaining subordination. This provides the existing lienholder with the details needed to evaluate your request but does not necessarily mean the factoring setup is complete.
Step 3: Follow the Process for Your SBA Loan Type
Your next step is to submit the subordination request to the party responsible for servicing your SBA loan.
Direct SBA Loans
For a direct SBA loan, such as an Economic Injury Disaster Loan (EIDL), follow the servicing instructions for your loan and submit the request directly to the appropriate SBA servicing center. Required documents vary but may include a written explanation of how you will use the funds, the factor’s term sheet or agreement, a UCC lien search, proof of insurance, financial records, and authorization for the SBA to communicate with the factor. The SBA reviews the request and makes the decision.
SBA Loans Through a Bank and Other Participating Lenders
If your SBA loan was issued through a bank or other participating lender, submit your request to that lender. You will generally need to provide the proposed factoring terms, explain how the funding will benefit your business, and supply any requested financial and collateral information. The lender reviews the request under SBA servicing standards. In many cases, it can make the decision without prior SBA approval. If SBA approval is required, the lender submits the request on your behalf.
Step 4: Finalize the Subordination Agreement
If the request is approved, the subordination agreement is finalized. It identifies the assets covered, establishes the factor’s first position on the receivables, and outlines any limits or conditions. All required parties must sign the agreement.
Step 5: Complete the Factoring Setup
The factor confirms that the signed agreement and any required UCC filings are in place. You then complete any remaining paperwork, account setup, and customer notification or verification steps. Once all conditions are satisfied, the factor can begin purchasing and funding eligible invoices.
Get Help Navigating Your SBA Loan Factoring Subordination
Your existing SBA loan doesn’t have to be a barrier to additional funding. At Charter Capital, we help businesses navigate the SBA loan subordination process and unlock working capital with factoring. If you’d like to explore your options and get more details on the process, talk to one of our funding specialists.
DISCLAIMER: This article is not intended to provide finance, insurance, or legal advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, finance, insurance, or legal advice. You should consult your own finance, insurance, or legal advisors before engaging in any transaction.
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