Popular media today would have us all believe that more capital is the answer to all of our small business problems. Although access to capital is important to businesses large and small, there are costs associated with borrowing that should be considered; and borrowing more than is needed can become expensive. Additionally, depending upon the business need, some types of financing might make more sense than others.
Taking a thoughtful and strategic approach to deciding when borrowing makes sense, what type of small business financing is a good fit, and how much to look for will help businesses leverage the power of additional capital to grow and thrive.
Is your business looking for capital to fuel a growth initiative, boost ROI or for some other reason? Although many businesses use a small business loan to finance these types of initiatives, some aren’t prepared for the sometimes-rigorous process associated with finding the right small business loan to meet their objectives. With that in mind, here are four questions that will help you prepare for your search and evaluate if you will qualify. They might even help you find the small business loan that will be the right fit for your situation.
1. Why am I borrowing? In other words, what is your loan purpose? In the same way the financing requirements for purchasing a new car are vastly different than buying a home, looking for financing to fill a short-term need like launching a new marketing campaign, buying quick-turnaround inventory, or borrowing to ramp up for a new contract can be very different when compared to adding a new location or purchasing an expensive piece of equipment. The appropriate loan term (or the length of the loan) is often best determined by considering the average lifetime value of your loan purpose.
For example, a long-term loan of four, five or maybe even 10 years could make a lot of sense if you’re planning to build a new warehouse or add an additional location across town. The value of the new location will extend beyond the term of the loan, and the longer term will likely reduce the periodic payment by spreading the payment requirement over a longer period of time.
On the other hand, a six-month term loan might make more sense for borrowing to purchase inventory or launch a new marketing campaign. Because the interest payments are amortized over a shorter period of time, the shorter-term loan could come with a higher (and maybe more frequent) periodic payment, but a lower total cost—enabling you to maximize the value of your inventory purchase or marketing campaign.
I’m convinced this is a good first question because it will help you determine the loan term that makes the most sense for your business.
2. How much do I intend to borrow? I disagree with the idea that you should borrow as much as you can every time you can. There are costs associated with borrowing that need to be considered, and borrowing more than you really need could even put your business at risk. What’s more, by answering the first question, you should be able to determine exactly what you need to borrow. That should be the loan amount you’re seeking.
This will also help you determine where to start your search. Different lenders not only make different types of loans—the available loan amounts also differ. For example, traditional lenders, like your bank, prefer to lend in larger amounts—think $500,000 rather than $50,000. This makes it difficult to get a loan of $25,000 or $50,000 at the bank.
This has become problematic for many small businesses that don’t need such large loan amounts. The SBA recognized this a couple of years ago and removed fees on SBA-backed loans under $150,000 to encourage their participating banks and credit unions to make more of those loans.
Fortunately there are other options, including online lenders that regularly make small business loans in amounts more consistent with the short- and long-term needs of the average small business owner—loans of less than $150,000.
Loan amount is question number two because it also helps you determine where to look. It may even help you avoid wasting time looking for financing in the wrong places.
3. What does my credit profile look like? Lenders are trying to make decisions regarding whether or not you’ll make timely loan payments in the future based upon what you’ve done in the past. Although they may ask the question differently, they really want the answer to three questions:
1) Can you repay a loan?
2) Will you repay a loan?
3) Do you have a plan in place to ensure you’ll be able to make each and every periodic payment on time regardless of what happens within your business?
Most lenders ask about your revenue and cash flow to answer the first question. They often rely on your credit profile to evaluate the answer to question number two.
Most business owners are aware of their personal credit score (which will likely be part of the equation when a lender evaluates your loan application), but don’t realize their business credit behavior is also monitored by business credit bureaus.
The three largest business credit-reporting bureaus (although there are others) are Dun & Bradstreet, Experian and Equifax. All three of them, in addition to other online services, will make your business credit profile available to you at no cost or a modest fee. Getting acquainted with your business credit profile, and creating a relationship with the credit reporting agencies, is important not only because it helps you prepare for a future business loan application—it will also help you ensure the information the bureaus report about your business is accurate and up to date.
Parts of your business credit profile are culled from the public record and include information about your industry, how long you’ve been in business, the nature of your business, and other public financial data. It’s not uncommon for errors within the public record to negatively impact your ability to access credit, so it’s important to make sure your profile is accurate and up to date.
Because traditional lenders tend to focus on your personal credit score and collateral, you should know that bankers prefer a 700+ personal credit score (although in some circumstances they will go as low as 680). The SBA’s minimum threshold is usually 650. Online lenders, which may weigh a personal credit score differently than traditional lenders (and don’t typically require specific collateral to secure a loan), will sometimes lend to a business if the owner has a lower score—provided they can demonstrate they have a healthy business and can service the debt.
Understanding what your profile looks like will help you look in the places where you’ll be more likely to find success. And, if you can successfully answer these three questions, including having a plan that demonstrates how you will make each and every periodic payment in a timely manner, it will provide more options for your business when you need additional capital.
4. Is my business’ financial house in order? This is an important question. And, depending upon the lender you choose, you might need a business plan, Profit & Loss Statements, Cash Flow Statements and other financial data when applying for a loan. Online lenders often require less paperwork, but regardless of whether or not your lender requires this information, it’s important for you to have these documents available and that you understand what they say about your business.
Some of the documents you might need when applying for a loan at the bank or with the SBA could include:
- A well-formed and detailed business plan that explains why you need the financing, exactly what you will do with the loan proceeds, and how you expect your business to benefit from the purchase may be required for a loan at the bank
- Business financial statements for up to the last three years, including balance sheets and profit and loss statements
- Tax returns for the business and its owners for the past three years
- A debt schedule
- Personal financial statements for all the business owners
- The lease for the business premises, if applicable
- Financial projections for three years showing what you expect revenue and expenses to be and demonstrating that operations will be able to repay the proposed loan
- Resumes for all the business owners and key employees
- Information about the assets to be purchased, including a copy of the sales contract or purchase agreement, if applicable
The information many online lenders require usually includes at least the following:
• Your Social Security Number
• Your Business Tax ID
• Connection to your business bank account, or paper bank statements (for certain lenders)
• Financial statements may be required (for larger loan sizes)
As mentioned earlier, lenders are looking for borrowers who will be able to make all their periodic payments in a timely fashion. I once spoke with a loan officer who said, “If I know more about the health of a business by looking at the financial documents than the business owner does, I’m likely not going to approve a loan.”
The greater your understanding of the financial side of your business, the more likely you’ll be able to make decisions and take actions that will allow you to successfully make all your periodic payments in a timely fashion. If you’re unsure about the financial reports and what they are telling you, you should consult a trusted advisor, like your accountant or CPA, to explain them to you.
Knowing the answers to these four questions won’t guarantee your success with a lender, but it will help you identify options that could be beneficial to you and your business.