Just a decade ago, banks were the only source of capital for small businesses. When the financial crisis hit, banks stopped lending to small businesses and the online alternative lending industry was born. Today, small business loans are available from many sources. Businesses need capital to expand, fund acquisition, research and development, branch into new territories, enhance sales and marketing efforts, hire new people, and even address cash crunches.
In this article, we highlight different types of small business financing and some practical steps needed to get a business loan. While doing this, we have tried to give you a full insight into the lending process.
There are multiple types of small business loans and funding available. The options vary depending on your business needs, the length of the loan, and the specific terms of the loan. Below are all of the small business financing choices available out there:
- Small business term loans: Term loans are typically for a set dollar amount (e.g., $500,000) and are used for business operations, capital expenditures, or expansion. Interest is paid monthly and the principal is usually repayable within 6 months to 5 years (which can be amortized over the term of the loan or have a balloon payment at the end). Term loans can be secured or unsecured, and the interest can be variable or fixed, usually fixed in most cases. They are good for small businesses that need capital for growth or for large, onetime expenditures. Able offers term loans from $25,000 to $1,000,000 with payment schedules from 1 year to 5 years. These loans typically get funded in 2 to 4 weeks.
- Working capital loans: A working capital loan is a debt borrowing vehicle used by the company to finance its daily operations. Companies use such loans to manage fluctuations in revenues and expenses due to seasonality or other circumstances in their business. Some working capital loans are unsecured, but companies that have little or no credit history will have to pledge collateral for the loan or provide a personal guarantee. Working capital loans tend to be short-term loans of 30 days to 1 year. Such loans typically vary from $5,000 to $100,000 for small businesses.
- SBA small business loans: Some banks offer attractive low-interest-rate loans for small businesses, backed and guaranteed by the U.S. Small Business Administration (SBA). Because of the SBA guarantee, the interest rate and repayment terms are more favorable than most loans. Loan amounts range from $30,000 to as high as $5 million. However, the loan process is quite time consuming with strict requirements for eligible small businesses. These loans typically take 3-6 months to fund.
- Equipment loans: Small businesses can buy equipment through an equipment loan. This typically requires a down payment of 20% of the purchase price of the equipment, and the loan is secured by the equipment. Interest on the loan is typically paid monthly and the principal is usually amortized over a two- to four-year period. The loans can be used to buy equipment, vehicles, and software. Loan amounts normally range from $5,000 to $500,000, and can accrue interest at either a fixed or variable rate. Equipment loans can also sometimes be structured as equipment leases.
- Small business line of credit: Under a small business line of credit, your business can access funds from the lender as needed. There will be a cap on the dollar value of funds accessible (e.g., $100,000) but a line of credit is useful for managing a company’s cash flow and unexpected expenses. There will typically be a fee for setting up the line of credit, but you don’t get charged interest until you draw down the funds. Interest is typically paid monthly and the principal drawn down on the line is often amortized over years. However, most lines of credit require annual renewal which may require an additional fee. If the line is not renewed, you will be required to pay it in full at that time.
- Accounts receivable financing: An accounts receivable line of credit is a credit facility secured by the company’s accounts receivable (AR). The AR line allows you to get cash immediately depending on the level of your accounts receivable, and the interest rate is variable. The AR line is paid down as the accounts receivable are paid by your customers.
- Small business credit cards: While some business owners may be wary of using them, small business credit cards can also act as short-term small business financing. Interest rates will vary depending on the credit card issuer, the amount available on the card, and the creditworthiness of the holder of the card. Many small business credit card issuers require the principal owner to be co-liable with the company. Issuers of small business credit cards include American Express, CapitalOne, Bank of America, and many others. Many credit cards offer promotional introductory rates of 0% for a short period of time (6-9 months). Cash-back and rewards programs allow you to earn rewards from purchases on the credit card.
Now that you know the different business lending products available and their typical uses, let’s look at the different types of business lenders out there.
There are more lenders than ever before willing to lend to small businesses, and many of the lenders can be found online. Here are the main types of lenders:
- Direct online lenders: Also known as alternative lenders or online lenders, these companies make small business loans through a relatively easy online process. Most of these sites give you access to term loans, working capital loans, receivable financing and cash advances. Able Lending does term loans along with working capital loans and debt refinancing. There are a few marketplaces that offer you access to multiple lenders, acting as a lead generation service for lenders.
- Large commercial banks: The traditional lenders to the small business market are banks such as Wells Fargo, JP Morgan, and Citibank. These tend to be slower with more rigorous loan underwriting criteria.
- Local community banks: Many community banks have a strong desire to make small business loans to local businesses.
- Banks backed by SBA guarantees: A number of bank lenders issue loans backed by the SBA, and, as noted above, this backing allows the lenders to offer more attractive terms.
All these lenders will want to know how much funding you are seeking and how the loan proceeds will be used. You may want to borrow a little extra in case you run into a cash crunch that lasts a month or two. While looking at your loan file, there are several categories of metrics that lenders will calculate: liquidity, affordability, debt ratio, profitability and others.
One metric, more than any others, stands out as one of the most important on any small business loan — both for the lender and for you, the business owner: affordability, measured by either debt service coverage ratio (DSCR) or debt to revenue ratio (DTR).
Why Is Affordability So Important?
Simply put, affordability is what makes or breaks a business. More than any other metric, it determines whether your business can support the loan or additional debt. If you saddle your business with debt you can’t afford to pay back, you’re headed for trouble.
Affordability can be determined by the APR or total interest paid, the amount you want to borrow and the term or length of the loan. Too many borrowers zero in on the APR or total interest paid on a loan while ignoring the other two factors. What makes short-term loans (usually under 12 months) and merchant cash advances so problematic is not the APR per se (though most are higher that 30%), but rather the term. A $500,000 loan isn’t very useful if you are required to pay it back over 12 months but it can be more affordable if you have 4 to 5 years to pay it back. Knowing all this, it’s fairly obvious to assume that if a bank or lender thinks that your affordability metric isn’t good enough, then you won’t be getting the loan.
Most lenders, including Able will look at a lot of information on the borrower before they decide to move ahead with a business loan:
- Credit score/credit report: Lenders will review your credit report, credit score, and history of making timely payments under credit cards, loans, and vendor contracts. So review your personal credit report and clean up any blemishes that you can.
- Outstanding loans and cash flow: Lenders will review your outstanding loans and debts to determine that your cash flow will be sufficient to pay existing loans and obligations as well as the new loan contemplated.
- Assets in the business: Lenders will review the assets in the business (particularly current assets such as cash and accounts receivable) to see if there is a good base of assets to go after in the event of a loan default.
- Time in business: Lenders will tend to look more favorably on businesses that have been operating for several years or more.
- Investors in the company: Lenders will view the company more favorably if it has professional venture capital investors, strategic investors, or prominent angel investors.
- Financial statements: Depending on the size of your loan, your financial statements and accounting records will be reviewed carefully by the lender. So make sure they are complete, correct, and thorough—including balance sheet, income and loss statements, and cash flow statements. The lender will analyze your cash flow, gross margin, accounts payable, accounts receivable, EBITDA, and more, so be prepared to answer questions on those topics. Able and most other online lenders need financial statements for the past 2-3 years and year-to-date financials for the current year (balance sheet, profit and loss or income statements, cash flow statements, shareholder equity). Some banks may ask for projected financial statements (so that the lender can get a sense of your expected future operations and cash flow). Consider having your accountant look over your financial statements to anticipate issues a lender may raise. Lenders prefer financial statements that have been audited by a certified public accountant (CPA). But many small businesses don’t want to incur the costs of an audit, so one alternative is to have the financial statements “reviewed” by a CPA (which is cheaper and faster). However, some lenders may not require either audited or reviewed statements.
- List of executive officers and their background
- Legal structure (such as LLC, S corporation, C corporation)
- State filings for the company, such as a Certificate of Incorporation, foreign corporation filings, and good standing certificates
- Potential collateral available for the loan
- The tax returns of the company for the past 2-3 years (signed copies with all attachments and exhibits)
- Business bank statements
To make sure the proposed business loan is the sensible option for your business, you will need to analyze the key terms proposed by a lender. Here are the key terms to review before signing the dotted line on your small business loan contract:
- What is the interest rate on the loan and how can it vary over time?
- How often is the interest payable (weekly or monthly)?
- When is the principal due or how is it amortized over the life of the loan? You need to be comfortable with the combined interest and principal payments from a cash flow perspective.
- What is the loan origination fee?
- What other costs or fees are imposed (such as underwriting fees, administration fees, loan processing fees, etc.)?
- What are the circumstances when the lender can call a default on the loan?
- Is there any security or collateral required?
- What periodic reports or financial statements are required to be provided to the lender?
- Are there limits on how the loan proceeds can be used?
- Can the loan be prepaid early without a penalty? And if there is a penalty, is the penalty reasonable?
Usually as stated before, a lender will do the affordability calculations for you to determine the loan amount you can afford to pay back. A small business lender will also perform due diligence, which can include reviewing the information available online about the business and its principal owner. The more educated you are about small business lending options and procedures, the more likely you will be successful in obtaining a loan.
Finally, once you have chosen the best option for your business, give yourself a pat as this is a big step in your entrepreneurial journey. While you are now thinking of your growth, you want to do these things on a monthly basis.
- Make sure you are on top of your periodic payments and try not to miss them.
- Make sure you are looking into your P&L, balance sheet and cash flows monthly if not regularly to be on top of your company’s health. This is a good habit nevertheless.
- Make sure that you don’t borrow excessively on your personal credit lines.
- Make sure that you follow the terms of your loan when it comes to additional debt as some lenders would not permit that without their permission.
- Revise and standardize your contracts so that you get paid on time.