It’s easy to determine when you need to take an assignment of life insurance as collateral for a 504 loan. The SOP is clear: “Life insurance is required for the principals of sole proprietorships, single member LLCs, or for businesses otherwise dependent on one owner’s active participation…” SOP 50 10 5 (J) Subpart C, Chapter 5, D., 4. a),  pg. 329.

What’s not clear: Just how much life insurance is enough? This can be tricky. OK, let’s do the math. I once made a 504 loan to Maria’s Beauty Salon, LLC to buy its own building. Maria is an experienced, licensed cosmetologist and the sole member of the LLC. Her husband Ron is a football coach at the local high school. Since he knew nothing about styling hair, requiring Maria to have life insurance was an easy call. So you tell Maria you’ll need to get an assignment of life insurance on her. She asks, “How much life insurance do you need?”

Do you need it for the whole amount of the 504 loan? The amount of the 504 loan less the loan fees? The market value of the collateral less the Third Party Loan?

The SOP provides nuanced guidance as to how much life insurance is enough insurance. “The amount and type of collateral available to repay the loan may be factored into the determination of the appropriate amount of life insurance.” But to make sure we understand that this is a factor to consider, the SOP states it twice, amending it the second time only to read “…to repay the loan in the event of death…” SOP 50 10 5 Subpart C, Chapter 5, D., 4., b), pg. 329.

The apparent redundancy allows an opportunity to explore what this means. Most 504s have a large component of real estate and the value of that real estate must be factored into determining the amount of life insurance required. But what value: market value or liquidation value? At first glance it seems the insurance should equal the loan amount. After all, if Maria dies, what would Coach Ron do with a beauty salon? Yet if you require that much life insurance you’re not factoring in “the amount and type of collateral.”

A rule of thumb that works and has been accepted by SBA in some cases is to determine the liquidation value of the collateral. This may be 75% for real estate, or 50% for machinery and equipment. Deduct the third party loan and the net debenture from the liquidation value, and you will generally end up with a negative balance. If the CDC has to liquidate in a hurry due to the death of the principal, that negative balance is the amount of insurance you’ll need.

Of course you can require more life insurance. The SOP says that the amount and type of collateral “may” be factored into the determination, not “must”. And to protect her estate, Maria may want more. But if you factor in the collateral and do the math, you’ll come up with the minimum amount of life insurance required.

Richard Jeffrey
Associate, CDC/504 programs
richard@jrbrunoassoc.com