It is a well-known fact that small businesses (SMBs) are at the core of the US economy and are the largest employer in almost every sector.  Despite this, it has been proven to be extremely difficult for business owners to find favorable financing to sustain and grow their business.  In fact, many have found that it is far more difficult to finance their operation than it is to run it.  In this piece I’ll discuss how to get funding for a small business and the many financing options that are available to SMBs.

Recently, a business owner asked me about which type of financing was best for him.  The obvious answer is: the type of financing for which you will qualify.  But this answer not only creates the first obstacle you’ll encounter on the road to funding, it will also set the tone for your capital search. Obviously, the primary goal is to find the type of financing that offers you the most money for the lowest cost and the longest repayment terms – with the fewest downsides. The reality is that this set of terms will vary wildly depending upon the credit quality of the applicant.  A problem for many SMB owners is that they develop a preconceived notion of what their financing SHOULD look like as opposed to what it will REALLY look like based on the credit quality of the borrower.

The first thing you should do when embarking on your search for financing is ask yourself one question – Am I bankable? This is a broad term that indicates if you can go to your bank and obtain a loan or equipment financing under traditional terms or with the benefit of an SBA Guarantee.  In my years of experience in business finance and as a SMB owner, I can say that the vast majority of SMBs are NOT bankable, even when they have heard their banker say that they could obtain a loan.  Terms for traditional financing are rarely presented realistically during the application process and most applications are rejected because the borrower cannot meet the requirements of the lending institution.

The second thing you need to do is to remember to be objective and determine exactly where your chances lie for approval on various products and with the different types of lenders. You must accept that there is a risk pricing differential with different types of financing and with different lenders. The easier the credit terms and the quicker the origination usually spell out more expensive financing. In many cases, it is worth the cost – as other lenders wouldn’t fund you at any cost.

The third thing you need to do is obtain as many offers as possible –  don’t be insulted by an offer to finance even if it is onerous and seems outrageous.  You can always pass.  In evaluating the offers, you must remember the Golden Rule of lending applies – “He who has the gold – rules!”

Obtaining Small Business Financing That’s Best for You.

The basic understanding for this guide is that you are already an operating business. Start-ups are an entirely different discussion. So, if you have been in business for at least 1 year, read on!

SMB financing options cover a wide spectrum – from traditional banks, credit unions and non-bank institutional lenders to non-traditional lenders, alternative finance companies, crowdfunding platforms and friends and family.

Banks, Credit Unions and the SBA may offer lower rates and longer terms, but the obstacles to obtaining one of these loans are considerable. On the other end of the spectrum are alternative finance companies, equipment leasing firms and even your personal credit cards, which all share the same features.  They are far more expensive than traditional bank financing – but they are readily available and far easier to get approvals.  The true value of money is in its availability.  What good is a 6% loan from your bank if you can’t get approved for it? On the other hand, if you are a high credit quality business – why should you short cut yourself for high cost financing?

Let’s see if we can help you manage your expectations and give you some insight into the lenders perspective.

What do the banks and SBA want?

I have spent many years around bankers and have asked a number of them what qualifications are needed for them to consider lending to an SMB owner.  They always offer the obvious response: everyone has their own unique circumstances underwritten at application. But almost every banker I have spoken with talks about the “Five C’s of Credit”.  This is a basic set of criteria that they all use when evaluating a company for a loan:

1. Capital – Lenders want to see that you have skin in the game. How much hard capital have you put into the business? They don’t care about sweat equity – they want to see the cash.  Most lenders want to see between 10 – 40% of the total capital in the business coming from the owners. They want to see that there are hard and soft assets from machinery, equipment, real estate and some will even consider proprietary IT technology. They want to share the risk with you, and your investment insures you will suffer too if the business fails.

2. Collateral – these lenders are “risk averse”. They want to know that if, for some reason, your business fails to pay back the loan that they can attach assets and liquidate them to offset the debt. This is one of the reasons that they want to see meaningful assets in your company before lending to you. Not all loans require collateral, but if you want favorable terms, you should expect it.  In the case of SBA Guarantees, you will be required to pledge not only the business assets, but all owners holding 20% or more of the business must pledge their personal assets as well.  Homes, cars, cash, jewelry – everything. If you can’t pay back the loan, you could lose everything.

3. Capacity – This is a measure of your ability to pay the loan back. A lender must have a realistic expectation that the borrower does indeed have the capability to repay. Lenders rely on numerous metrics and factors in determining your “capacity”. First among these is your personal credit score. Even though this would be a business loan, the main driver of an SMBs success is the owner. If you don’t pay your creditors for personal debt, it is a reasonable conclusion that you won’t pay your business debt. To get to the next step with a bank you will need a strong FICO of over 700 with no liens or judgments. This is very rare among newer or struggling entrepreneurs.  The bank will also look to your current vendors for your payment history. A prime factor is the Debt Coverage Ratio demonstrating that you generate more income than necessary to pay off your debt. Most lenders look for 1.25x or higher, which relates to the big driver of cash flow of the business. They will look at average daily balances, number of NSFs and general liquidity. If you have cash, then they know you can pay back.

4. Conditions – This looks at the reason for the loan (what the money will be used for) and if the bank feels that you will be successful in reaching your goals. The bankers will look at everything from the economic conditions in general to those in your local area. The industry you are in is also a strong indicator of success. The “SIC code” of your business provides risk assessments for your business – and it can work with you or against you. Most importantly, the bank wants to understand the purpose of the loan and if the proceeds will help you grow the business as opposed to adding to your debt load. You will need to provide an explanation for the amount you need, why you needed it, details on how you plan to spend it and the benefits you expect to gain from the loan.

5. Character – This is a difficult factor to evaluate, but the bank is basically trying to determine if you are of good character and can be trusted to perform. This can be very subjective and often determined by the bankers that you speak with in preparing your application.  They want to know as much as possible about the person behind the business. Are you a novice or a seasoned professional in your field? What is your background? Did you have prior achievements they should know about? Do you have strong professional references from vendors, customers or credit providers? Do you have any blemishes that would influence the decision-making process like arrests, DWI or old tax problems?

What types of Lenders do I have to choose from?

• Large Commercial Banks- These are the big guys. You know them – JP Morgan Chase, Citibank, Wells Fargo, Bank of America. These banks all have assets greater than $10 Billion and are large bureaucratic machines. While the largest banks account for about 40% of SMB loans, they do very little lending to Mom and Pop businesses or those that fall within the agriculture industry. Community banks are far more active in those sectors. Large banks are better for bigger, more established companies who seek over $250k in loans. This is their true minimum lending floor – it’s simply not worth their time processing smaller loans.

• Mid-Tier Regional Banks- These multi-branch banks have a great deal of local power and are more receptive to the needs of their SMB customers. They have strong asset bases but practice the same strict underwriting practices as the larger banks. Their local knowledge makes it much easier to communicate with them and many are strong SBA partners which can be immensely helpful.

• Small Community Banks and Credit Unions – These are the grassroots institutions for true SMBs to work with. They still believe in the value of knowing their customers and their community, and work hard to build strength in all. This is where most of the US agriculture loans are originated. However,, smaller community banks are finding it hard to compete and are closing at a regular pace. This requires them to be more conservative, which can influence the outcome of your loan request. Only 40-45% of their loan applications are approved.

• Non-Bank Financial Institutions – Access to these lenders is usually limited to higher growth specialty finance. These groups rarely, if ever, consider Main Street businesses. Large firms like CIT or Apollo will provide multi-unit franchise financing for restaurant or hotel chains, but not loans to single unit operators. These groups include private equity firms, hedge funds, family offices and high net worth individuals. You must be well prepared with strong documentation and the ability to pitch your deal and defend your representations with facts. This is not for financial amateurs or novices.

• Alternative Finance Companies – Over the past 15 years, this has been the fastest growing sector for SMBs to access capital. Factoring companies, merchant cash advance, FinTech online lenders and equipment leasing firms all fall into this category. Most of these companies lend from banks and take on the credit risk for the performance of their clients in return for higher fees.  The main attractions are speed, less documentation and higher approval rates. They will often look for a blanket UCC security agreement over the assets of the company, but do not require the hard-collateral pledges that banks and SBA require to provide loans. Their cost of capital is high because they take considerably more risk to provide financing than banks do.

• Crowdfunding – Crowdfunding appears to have key advantages of being quick and easy to raise money, but it really isn’t as easy as it appears. First, you need to determine the type of crowdfunding you wish to pursue. Rewards based platforms solicit donations for worthy projects or companies in return for “rewards” that you provide. Typically these are discounted products or services that your business normally sells. Debt and equity crowdfunding involves high levels of transparency and reporting as well as time consumption and expense. Depending on the platform you choose, you can have access to thousands of investors, but you will need to give up a chunk of ownership if you succeed in raising the capital. Many Crowdfunding platforms have specific rules governing time limits and funding goals. If you don’t reach your goal after a specified time, you lose. Or you may encounter an “all or nothing” funding policy, precluding you from accessing capital raised beneath your goal. Some users have been disappointed to realize that often the success of the campaign revolves around their social network. This means that you are really doing a “friends and family” round – but incurring fees.

• Independent Brokers – There has been a dramatic explosion in the number of independent brokers/“finance advisors” who are marketing loans, lines of credit, invoice factoring, receivables financing, cash advances, equipment leasing and other products to the SMB community. Some brokers are reputable and can be extremely beneficial in expediting the process of finding financing. They can look at the overall parameters and know where to place the application for fastest approval. On the other hand, there are bad players who are only interested in their own enrichment. Some ask for retainers up front and fail to deliver. Buyer beware. Know who you are dealing with. Look for complaints and ask a lot of questions before trusting your financial information to an unknown outsider.

• Friends and Family – This is one of the most common places where SMB owners seek seed money or general working capital. While this can offer few obstacles to funding since this is a supportive and familiar lender, failure to perform can negatively impact your relationship with these people for the rest of your life.

• Personal Savings, Home Equity and Credit Cards – Before draining your savings, your business plan should reflect cash reserves to carry both you and your business through hard times. Most businesses have ups and downs. The failure to plan for this can be catastrophic. The use of funds from a Home Equity loan or Line of Credit can be a very useful tool in supporting your business.  Interest rates are relatively low and the money is not being lent on the qualifications of your business. It is being given to you against the equity value of your home. The downside is that if your business fails, you could lose your home as well. Also, some SMB owners feel it is reasonable to finance their business with their personal credit cards. This can cost upwards of 29% compounded, which is a formula for disaster.

• Landlords and Real Estate Developers – If you have a brick and mortar business and you need to make improvements to the space you are occupying, landlords and developers often provide “tenant improvement allowances” or TIAs for businesses to enhance the overall building. This is usually paid back in the form of additional rent or larger escalations in annual increases.  This can be a good way to access capital for betterment and improvements, but sometimes the escalations exceed the business’s ability to pay.

• Wholesalers, Suppliers, Purveyors – Every time a Wholesaler/Supplier extends you terms to pay for your supplies, you are receiving a de facto loan. This allows you to pay for goods after you have had the opportunity to sell them at a marked-up rate. There have also been instances where primary suppliers have made direct loans or investments in SMBs that are material to their business.

• Government Business Development Agencies – Depending on the type of business you have and the location, various state and local economic development agencies offer loan programs and grants. These opportunities are often very specific in their requirements, including formal financial statements and reporting. Most have extremely favorable rates.

Running the Process

The search for financing should be run as an organized process. Knowing what you know about your qualifications, your first decision is to target the groups to which you should be submitting applications for financing.  In this process of elimination, the lenders will decide to approve or decline your application. Depending on the offers, you then must decide to accept an approved offer or continue to shop – or if declined, where to apply next.

While each lender or equity investor assesses applications differently, there are numerous reasons why an application is rejected. Below are a few key reasons:

• Poor Credit Quality of the Owners and/or Business
• Poorly Prepared or Inaccurate Financial Statements
• Industry is a Poor Credit Risk
• Geography / Region has Economic Challenges
• Insufficient or Inconsistent Documentation
• Negative Cash Flow / Insufficient Sales
• Tax Liens and Judgments
• Undisclosed Negative Information about the Business or the Principals
• Seasonality of Business / Sales Instability

 If you have the time to actually shop for the financing you need, it is often best to aim high and hope for approval, then work your way down the waterfall. It may be labor intensive, but could provide you with lower cost, longer term and more favorable options. Your goal is to find the best deal you can, but be realistic and objective

In cases where any one offer is insufficient to satisfy your financing need, combining a number of approved options into a blended structure can give you a better cost structure. Smaller but lower cost personal or commercial loans can be supplemented with higher cost cash advances and equipment leases to give a blended rate that is much lower than the more expensive products.

Do your homework and be realistic in your expectations. Take the application process seriously and be as meticulous as you can. Good hunting!