Andrew J. Hamilton
August 2019
State and National units of government have formed programs to assist existing and new businesses gain access to financial capital in order to help stimulate the economy and create employment opportunities for new workers. Many of these programs have rules that require the applicant to meet certain governmentally created criteria that include the creation or retention of jobs, matching funding from other sources or leverage, etc. These programs are typically structured as Gap loans or Participation loans.
The term Gap Loan is best described as a second mortgage. In a normal business lending structure, the applicant would borrow money form a local bank and then pay for the remaining funds needed from his own resources. His contribution or down payment is called equity. In some cases, the bank is unable or unwilling to advance the total amount needed or the company doesn’t have as much down payment, so this creates a “gap”. Either the bank has to loan more money, or the business has to come up with more equity.
A “Gap Loan” is a separate loan that is made to the borrower from a second source, usually a governmental entity. The borrower would then make two payments, one to the bank and the other to the Gap entity. Very rarely is a business able to borrow the entire amount of funds without any down payment. They are generally required to come up with some form of equity. The amount of the gap loan is generally between 20–40%. The general requirement for equity is between 10-30% of the total project, depending upon the risk of the venture.
The rate of interest on these gap loans are generally at or below market rates. The below market rate loans are intended to be used to entice the applicant to undertake the project and provide the low interest rate as an incentive for them to do so. But some projects are deemed so risky that the gap loan may be at or above market rates. Generally, rate is commensurate with the amount of risk. The higher the risk would cause a higher rate. An example of a typical project is in Table A.
There are numerous governmental programs that provide Gap Loans. Each program has a different set of rules and regulations. Most of these gap-type programs look at the following general criteria.
Jobs to Dollar Ratio – If you look at the amount of the Gap Loan and divide it by the total number of jobs the company plans to create, you come up with the job to dollar ratio. For example, if the borrower receives a $50,000 gap loan and plans to create eight new jobs, is job to dollar ratio is $6,250. Most of the gap programs require a ratio of $5-10,000 per job. If the applicant does not meet the minimum job ratio, the gap lender would either deny the request or reduce the amount of the gap loan so it can meet the ratio. These jobs must be created in a 12-18 month period. Some programs monitor the job creation and can default the gap loan if the jobs are not created as promised.
Leverage – The term leverage is best described as all funds that are not “gap” funds. This includes the amount of the bank loan and the proposed equity. Generally, Gap lenders require leverage at the 50% to 80% levels.
“But-For” Provision – The “But-For” Provision is best described as evidence that the project and related investment would not occur without the gap loan involvement. The provision’s origin comes from a sentence of poor grammar, (If it wasn’t “but-for” the gap loan, the project wouldn’t proceed).
Low to Moderate Income Provision – Some programs originate from federal funds that were appropriated under a purpose that is intended to provide assistance to certain groups. One common grouping is low to moderate income persons. This means that when you receive a loan, there must be a benefit to individuals that fit into this category. For example, if the borrower plans to create eight new jobs, this provision requires that at least 51% of them or five must be in this category. So when the applicant interviews new employees, they must award five of the jobs to individuals that were in the income range or they would be in violation of the requirements of the gap loan.
General provisions prohibit refinancing existing loans, have personal guarantee requirements for anyone who owns 15% or more of the company, require additional insurance, reserves, etc. Some Gap loan programs originate from private funds and establish their own requirements. These are sometimes called Local Revolving Loan Funds or Community Development Corporations.
Participation Loans – Participation loans are almost identical to Gap Loans. The features of leverage, job to dollar ratios, etc. generally still remain. The main difference is in the paperwork to execute the loan documents. Instead of making a separate second mortgage loan, the bank would make one loan and sell a portion of it to the gap provider. The look and feel of the total structure is virtually the same, it is just a matter of the paperwork.
Guaranteed Loans – Similar to Participation loans, a guaranteed loan is when the bank makes the full amount of the borrowing and seeks approval from a governmental agency to guarantee or back a certain amount of the bank’s loan. A modified structure of the earlier example would have the bank making a $150,000 loan with $50,000 of equity. But instead of participating the loan with a gap lender, the bank would ask the guaranteed lender to provide a guarantee of 85% of their loan or up to $127,500. If the borrower were to default, the bank would receive a check for the guarantee amount and only loose $22,500. The primary repayment of the loan is from the cash flow of the business. The applicant must have good character, management capability, collateral, and owner’s equity contribution.
Conclusion – The programs to assist existing and new businesses gain access to financial capital are intended to help stimulate the economy and create employment opportunities for new workers. The programs rules are complex and adjust and change each year. Larger projects can seek bonds to finance their capital improvements. The same project can structured as a gap deal or guarantee deal and in some cases a combination of both can be achieved. Generally, the more public programs involved, the more complicated the project becomes with regard to collateral, guarantees, etc.