Wells Fargo made news when they pledged to loan $100 billion to small businesses by 2018. One reason for the spike in financial support may be the role small businesses play in job creation and stabilizing the economy. More than 7 million of the 11 million jobs created during the economic recovery were created by startups and small enterprises.
While it’s nice to know borrowing money for your business is an option, particularly when you need it to keep your venture afloat or scale it bigger, it’s important to know what borrowing money entails.
It can be nerve-wracking deciding whether to take out a small business loan. What if you pick the wrong type or get in over your head and can’t pay it back? Do your research and ask questions to make an informed decision.
When a Loan is Necessary
Despite the promising landscape for small business lending, taking out a loan is a major decision not to be taken lightly.
First, figure out if your business needs third-party lending in the first place. If your business has stalled and can no longer scale without more funding, a business loan could help you hire help immediately and increase your profits faster.
To determine if getting a loan is a good move, first take a look at your growth pattern. If your volumes have stayed steady but not grown, additional capital could help. If your growth pattern indicates a decline in sales, an added loan payment will make your conditions worse.
Next, consider all your funding options; a small business loan is just one. You might find friends and family, an investor or crowdfunding is a better fit for your business and its current funding needs.
Don’t assume you can turn things around with an infusion of cash, especially if your sales are dismal and your business shows signs of flatlining. Come up with a plan of how a loan will actually improve your business and impact your bottom line — e.g. expanding to a new location, purchasing new equipment or hiring a team to grow your sales.
Say, for example, your cupcake store is a fixture in the community with lines wrapped around the block. Your growth pattern is steady, but you’ve hit a wall and can’t make any changes toward expansion until you have more capital. In this case, seeking out a loan could be in your business’s best interest. You can purchase new equipment — like bigger ovens or a larger mixer, in addition to hiring more employees — all to help you keep up with the demand.
Types of Loans
Not all loans are created equal and what you choose will impact your long-term financial goals. If you’ve decided a loan is the right step for your business, you need to figure out which one is best. Here are a few types of small business loans and their pros and cons.
Small Business Administration (SBA) loans usually guarantee that between 75 and 90 percent of a loan will be repaid, making it easier for lenders to get on board and take a chance on new businesses. However, an SBA loan typically requires more paperwork and fees, has strict terms on what you can use the loan for, and usually requires a longer approval process.
Traditional bank loans are often the lenders behind SBA loans, but also work directly with small businesses. Commercial bank loans’ interest rates are usually lower than their SBA counterpart, and have a faster approval process. However, repayment terms are shorter and it can be more difficult to get approved.
Alternative lenders were once known for extending loans to businesses without a sparkling credit history and having a quick turnaround time to accommodate those in need of fast cash. While these statements still remain true, alternative loans, or online loans, have significantly expanded their purpose and their appeal.
Advantages of online loans include a high approval rate for new small businesses, especially for those that don’t have a lot of credit history. The application process and final funding also take far less time and paperwork than traditional loans.
Before a lender buys in, they’ll want to know how much money you need and how it will be used. You won’t know your funding options until you determine what you need the money for, especially if your lender dictates how money can be used.
Sometimes these alternative loans have higher interest rates than traditional loans, but not always. Do your homework and always go with a reputable, established company.
Qualifications and Documentation You Need
Small Business Administration loans and traditional lenders usually require a business plan, and will look at how you actually plan to spend the loan.
Request your credit score
Request a free, personal credit report from AnnualCreditReport.com. Pay close attention to any negative or outstanding issues on your report. Attend to outstanding debts or fix errors immediately with the credit bureau. A higher credit score often translates to lower interest rates — as well as banks being more eager to lend to you — when you need to borrow.
Generate financial reports
Once you’ve determined the type of loan that’s right for your business, meet with a trusted financial professional to assist in generating a detailed cash-flow report. Your accountant or bookkeeper can help figure out how to collect more cash through receivables, work out longer payment terms with vendors and offer clients a discount for paying upfront.
These financial reports can help consolidate the information — referred to as the five C’s — required by lenders during the credit underwriting process.
- Capital is the money your business needs to produce products and services, as well as maintain your operations. Your accountant or bookkeeper can help identify how to improve your cash flow to keep more capital in your business.
- Capacity reflects the maximum output a business can produce within a set period of time or in consideration to current resources. Automate or outsource tasks to improve your business’s capacity and ultimately increase your bottom line.
- Collateral gives lenders added security; it guarantees you have an additional way to repay to your loan. Your business equipment and accounts receivable can be used as loan collateral. Your financial professional can help prepare the documentation to identify the value of your collateral, as well as ways to improve it, like shortening the period to collect receivables.
- Conditions set the terms for the loan you want and what your business needs to do to qualify. In some cases, you may be required to fall within specific cash-flow ranges. Your accountant can help secure credit from current vendors to keep more cash in your company.
- Character of a business often reflects the character of its owner — from loyalty to trustworthiness and reliability. The Equal Credit Opportunity Act only protects against discrimination for race, color, religion, national origin, sex, marital status, age and whether you get income from a public assistance program. It doesn’t protect against character. Ultimately, if the bank doesn’t trust you — in person or on paper — they’re less inclined to loan you money. Your financial professional can provide valuable insights when negotiating the terms of the loan.
The Fine Print
Before you sign on the dotted line, you’ll want to know the nitty-gritty details.
Find out if prepayments or early repayments are allowed. See if you can take out extra cash or refinance your interest rate later on. Your business could benefit from an amortization schedule that helps spread out loan payments. Payments can often be structured to make higher payments at the beginning to pay down the principal and lessen the interest paid over time.
Decide on a fixed versus floating rate. Banks typically want floating-rate loans because they’re easy to set up and have a higher potential for profit. A fixed-rate loan can help keep payment stable during economic uncertainty. An accountant can help calculate which will benefit your company in the long term and balance it with how the loan will affect your cash outlay in the short term. A cap for your floating rate can keep the interest on your loan from skyrocketing.
Taking out a loan without doing research can place a catastrophic strain on your business. Thoroughly explore all available funding options and understand how a loan will impact your immediate and long-term bottom line. With careful planning and consideration, a business loan can turn your business into a success.