There is one question that is almost always asked when starting or expanding a business: “Where am I going to get the money? Many owners will find the solution is some type of borrowed capital. “Small business loan” is not a singular product, but rather a collection of products ranging from a line of credit to a multi-year term loan that may be government-backed, and the type you need will depend on the use of the funds.
This is a realistic perspective on how these loans are processed, what lenders are actually considering, and how to compile a loan application that is not rejected the first time around.
Why “What’s It For?” is before “How Much?”
The number always seems like the easier, “I need $50,000” but lenders and really your own thinking works better when you begin with the purpose. A loan to address a short-term cash flow problem is quite different from a loan for equipment or a second store front.
A line of credit may make more sense for short-term requirements, such as paying bills on inventory until they get paid, or paying employees during a slow period, instead of a lump-sum loan on which you have to pay interest right away whether you use all your credit or not.
A term loan is a more appropriate loan for larger, planned investments, such as purchasing equipment, renovating a space, or acquiring a new business, because the loan is granted a specific sum and paid back over a specific period of time.
The different kinds of main types you are going to encounter
The term loan is the simplest you take a lump sum loan and then pay it back in a fixed amount, usually in a range of one to a few years. These are good for particular investments that are only one-time and you have a vague idea of the amount you need.
Lines of credit are more like a credit card for your business; you are pre-approved for a certain amount, and only pay interest on the amount you borrow. They work best as a way to adjust cash flow peaks and valleys and not just to buy a single large item.
In the United States, loans that are partially guaranteed by the Small Business Administration (SBA) make lenders more inclined to provide better terms, lower interest rates and longer repayment periods than they might have otherwise. The downside is the application process is generally more complicated and may take longer to complete.
Equipment financing is actually for equipment, and the hardware is often the collateral, making it simpler to acquire for newer businesses as the lender has something tangible to fall back on if all goes wrong.
Merchant cash advances aren’t technically loans, but rather a sum of money given in advance based on your future sales, and paid back in a percentage of your card transactions each day. They are quick and easy to get, but frequently have a substantially greater effective cost than other alternatives, and it is important to understand the real cost before deciding to take one.
Lenders are really looking at
No matter which one you’re applying for, there are certain things that are important in general. The amount of income your business has generated and the consistency of that income can provide a sense to lenders whether or not they think you will be able to make the payments on your business loan. You can’t discount the value of time in business either – and a company that has been around for a couple of years and has regular income is seen as a much safer investment, even if both companies are making money.
Your own credit score is also important, particularly in the event of a new business as lenders may not have much history of your credit. Not just profit figures on paper, but actual dollars in and out of the business provide the lender with a sense of if the business is able to comfortably add a new monthly payment.
Why Preparation makes such a difference
Many loan applications are delayed or qualified loan applications are rejected simply because they are incomplete or poorly organized. The answer is that it really does make a difference whether the financial statements are clean, up-to-date, the use of the loan is explained, and there’s a realistic plan on which to repay the loan.
It’s often less trouble to be honest that you are a newer business, or that your financial standing isn’t as robust as you’d like, and explain it. It’s better to tell the truth than to try and make it up to the lender that you don’t have good financial standing, and it could grow, or a particular contract is coming in, or it is seasonal, etc. Lenders come across a lot of applications and those that expect questions stand out for the wrong reasons.
A word on Rates and Total Cost
As with personal loans, the advertised rate is not necessarily representative of the final cost of the loan. Some financing options may have origination fees, draw fees or other fees that affect the cost of borrowing. In particular, the merchant cash advance is a lot of times offered in terms that make it appear to be more affordable than it actually is when transformed to a similar yearly rate.
Prior to committing, it’s a good idea to ask specifically: What will the total cost be, including all fees, and what is the equivalent annual rate of return? When a lender does not clearly answer this question, then there’s something he or she is hiding from you.
The Bottom Line
A small business loan can be a beneficial tool, however, only when it is utilized for the right purpose. There’s a reason for each of these types of financing options for the gaps in cash flow, planned investment, and equipment financing, and choosing the wrong one can cost you more than a higher interest rate.
Make sure you understand what you are applying for, pull your financial records together and don’t hesitate to ask lenders specific questions regarding cost. Minimal up-front preparation can save lots of frustration, and cash, down the road.
Disclaimer:
The information provided in this article is general in nature, and not designed to provide financial advice. If advice is desired for a particular situation, seek advice from a licensed financial adviser or accountant.
