In the last article in our series on financing your business, we looked at how to finance an existing business with merchant cash advances and factoring. In today’s article we are going to continue this series with a look at how to get a small business loan from a bank.
Banks don’t like lending to small business and are doing less and less of it.
Getting a “small business loan” is becoming harder and harder. In 2009, there was $326 billion in non-real estate related small business loans. That number has declined in each subsequent year for which there are numbers. In 2012, there was only $280 billion in such loans outstanding, according to a Small Business Administration (SBA) report.
Many of these loans may not even be to what you or I would consider a small business. To be categorized as a small business loan, the amount of the loan simply needs to be less than $1 million dollars, regardless of the size of the business. When the amount of the loan is dropped to $250,000 or less, there is only $167 billion in small business loans outstanding. This is less than 8% of the total amount of business lending made by banks.
How to get a small business loan from a Community Development Financial Institution (CDFI)
If you’re a new business with less than two years of proven revenues, your only option for a small business loan maybe going to a community development financial institution (CDFI). These non-profit financial institutions, funded in part by the Small Business Administration (SBA), were originally started to provide loans to businesses and nonprofits in communities underserved by banks. However, as more and more small businesses don’t qualify for bank loans, they have expanded their offering.
Here is a list of community development financial institutions. You should first look towards a locally based CDFI, as many are limited to helping businesses within a certain geography.
The Process of Getting a Small Business Loan from a CDFI
A CDFI will require you fill out a loan application, provide a business plan, sign a personal guarantee and in many cases put up personal collateral just like a bank to get a loan. While a CDFI will only make loans to businesses that they have a high degree of confidence will be repaid, they have more flexibility to approve loans and will often work with the applicant to get their loan approved.
Recently, I talked to one women who received a loan from a CDFI to open a coworking space. (A coworking space provides desk space, conference rooms, and internet access for rent to freelancers, start-ups and small companies.) The woman, who had years of experience in a related field, tried for three months to get a bank loan without success at which point she turned to CDFIs. She got a loan from a CDFI, however, had to agree to personally guarantee the loan, put up her condo for collateral and not to take a salary from her business for a year.
The process of getting the small business loan took a couple months. After the initial application, the loan officer assigned to her asked her lots of questions. He was particularly interested in supporting facts for the assumptions in her business plan, like how much she could charge and the potential size of the market for her business.
The loan officer then presented the application to the loan committee, which laid down the collateral and business requirements mentioned above, as well as requested more information. She then communicated with the loan committee via the loan officer, and was finally approved after several back and forths with the committee. While she was approved for the loan without the company having any history, the process of getting the small business loan was rigorous, and required her to put up her home as collateral.
How to Get A Small Business Loan Or Line Of Credit From A Bank
- Don’t even bother if your business is less than 2 years old.
- You’re going to need to have a business plan and detailed financial data.
- You’re going to have to personally guarantee the loan and in many cases, pledge personal collateral.
The bank is going to run your loan application and financial data through a computer. If your business doesn’t meet certain criteria, such as numerical ratios, the loan will automatically be rejected. The most important ratio is debt service coverage ratio (DSCR)
Definition of Debt Service Coverage Ratio:
Total Net Cash Income (your annual profits after subtracting non-cash additions to income, before income taxes) Divided By Your Debt Service (the amount of the money you will need to pay in interest and principal over the year).
To approve your loan, most banks will want see that you have a debt service coverage ratio of 1.25 or higher.
Let’s say your business is making profits of $50,000 per year. Banks will generally not provide you a loan which will require more than $40,000 in payments per year. How big a loan can $40k in annual payments support? About $250,000 (assumes a 7 year terms, 10% interest rate, and the loan paid over during its life).
To figure out the size of the loan that your business might qualify for, you can use a mortgage calculator to figure out the payments. You should keep in mind that business loans are generally for much shorter periods of time than home loans. Typically, a business loan will be for 3 to 10 years. Additionally, business loans typically carry a much higher rate of interest.
What if your business does not yet have a positive net income or not enough to take the size of the loan you want?
This is where your business plan comes into play. You must be able to convince a banker (who are an extremely skeptical bunch) that the loan will put you in a position to generate more cash flow and income. The bankers look closely at your business history to see if the numbers support this assertion.
First and foremost banks want to make sure the business has enough cash Flow, but they also want to make sure they can collect in the “worst case” scenario.
The DSCR is only one of many financial ratios which banks carefully scrutinize. Other ratios measure the banks ability to collect on the loan if the borrower is unable to make payment from cash flow.
If the loan is for the purchase of real estate, the bank will generally not want the loan-to-value (LTV) to be more than 0.8. In other words, the loan should be for less than 80% of the value of the property. When commercial real-estate is not supporting the loan, banks want the business to have an even lower debt to assets ratio. The closer this ratio is to 0.5, the more likely a bank will approve the loan.
Other Factors That Go Into Getting A Small Business Loan Approved
- The background of the owners (including credit history).
- The experience of the executives.
- The amount of investment that the owners have put into the business.
- The amount of personal collateral that the owners are willing to pledge to secure the loan.
These factors are explored in detail the article Borrowing Money For Your Business from the SBA.
That’s our article for today. If you have any comments or questions please leave them in the comments section below. Also be sure to stay tuned for my next article where I will begin our series on how to market your business offline..