The SBA citizenship rule can shut out borrowers who still qualify

• Key insight: The Small Business Administration’s move to bar businesses with any non-U.S. owners from loan guarantees has created a headache for lenders and borrowers alike. There is a better solution.
• What’s at stake: The new rules will inevitably lengthen processing time, and the delay itself introduces a new risk that lenders will need to contend with: What happens when a small business runs out of the ability to wait.
• Forward look: As SBA rules become more restrictive, private capital can help fill the small-business credit gap.

Earlier this year, the Small Business Administration changed ownership requirements for its main small-business loan programs: 7 (a) and 504 loans. These programs help small businesses access lower-cost, government-guaranteed financing through participating lenders. As of March 1, every person who owns any share of an applicant business, whether directly or indirectly, must be a U.S. citizen or a U.S. national. If a lawful permanent resident owns even a small share of a business, that business no longer qualifies for an SBA loan.

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The attention on immigrant-owned businesses losing access is warranted. But there’s another question here: What happens to businesses that still qualify when a bank has to verify every owner before it can make the loan? That process can get complicated quickly. A business may have multiple layers of ownership (e.g., as part of a partnership, a trust, or as an entity owned by another company). The lender must go through each layer to determine who the actual owners of the business are. The more complex the ownership structure of the business, the more time and effort the lender will need to ensure compliance with SBA rules.

The SBA mandates that lenders provide a complete list of all direct and indirect owners of the business and attest to the fact that, based on the lenders’ investigation, these individuals meet the SBA’s citizenship requirements. If a borrower defaults on a loan, and if the SBA determines that the lender failed to adhere to the requirements of the program, the SBA may deny all or part of its loan guarantee. This represents a key risk a lender has to consider when providing SBA-backed financing to businesses.

The rule changes can create significant friction for small businesses. With sole proprietorships, proving citizenship is straightforward. But in reality, many growing businesses have more complicated structures. In our experience onboarding small businesses at OneAM, we see a variety of company structures: an architectural firm with over 20 limited partners; a high-growth, angel-backed software company; an oilfield servicer owned by family trusts; and many others.

Because the SBA requires lenders to review ownership changes over a six-month lookback window, chasing down proof of citizenship (passports, birth certificates, certificates of naturalization) for every fractional owner will lead to much greater overhead and back-and-forth with borrowers. If a business has a complex ownership structure, the lender may instead point it toward traditional bank credit where there are higher interest rates, stricter financial covenants, and more onerous collateral requirements.

Under the new rules, lenders would need to allocate operational, legal, compliance and audit resources. The extra cooks in the kitchen will inevitably lengthen processing time. The delay itself introduces a new risk that lenders will need to contend with: What happens when a small business runs out of the ability to wait.

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Creditworthy businesses left waiting by the lender don’t stop needing capital. Without affordable and timely solutions, business owners may be compelled to turn to the shadowy corners of small-business lending while they wait: online lenders charging 40% to 50% APR, or worse; merchant cash advances, or MCAs, with effective APRs exceeding 100%. High cost of capital and compounding late fees can drive a good business down a spiral and ruin their financials right before closing. For the lender trying to process a loan, it can result in months of wasted time and effort. 

Meanwhile, elsewhere in the financial markets, there’s plenty of capital. Institutional investors are actively looking for yield in private credit, asset-based lending and corporate credit. The fundamental problem lies in the lack of infrastructure — the ability to bridge institutional capital to Main Street borrowers efficiently.

Small businesses are heterogeneous and will not all fit into standard bank lending. As SBA rules become more restrictive, private capital can help fill the small-business credit gap. Through partnerships with private capital providers, banks can continue to serve their clients and preserve deposit relationships. At the same time, banks can provide responsible alternative financing for small businesses.

The SBA has an opportunity to support businesses by developing voluntary standards that make private financing of small businesses easier for everyone. This could include defining common benchmarks around transparent and fair terms, giving business owners a clearer way to evaluate financing options; providing guidelines to enable lenders to refer borrowers who fall outside SBA criteria to reputable private capital; and creating greater standardization to give institutional investors more confidence to fund small-business credit at scale. 

The goal of the SBA should not be to guarantee every small-business loan. It should be to ensure that tightening the boundaries of a government program doesn’t restrict the path to capital for otherwise viable businesses. Creating a better infrastructure for access to private capital will ensure that small businesses — the backbone of the American economy — will thrive without relying on government guarantee.