CHAPTER TEN: Part A – Do you need a loan to start a business but you have no idea how to go about it? If YES, here is a beginner’s guide on how to get a small business loan.
In previous chapters of this ebook, we discussed the various ways of raising capital for your business that fall under equity financing. In this chapter, we will be discussing another major business financing option; which is debt financing.
What is Debt Financing?
Debt financing simply means raising capital for your business by taking loans. When you borrow a certain amount of money to start or expand your business, and this money has to be paid back along with interest within a specified period of time, what you have taken is a loan.
What makes a loan different from the equity funding options explained in previous chapters is that the lender does not hold shares in your business. Rather, the lender’s reward for helping your business is the interest that you will pay back along with the loan.
Loans have a language of their own. Being the one borrowing the money, you (or your business) are the borrower or debtor. The bank or other source of the loan is the lender or creditor. The specified period you have to pay back the loan alongside the accompanying interest is the term or period of the loan, or the loan’s maturity. And the amount you borrowed from the lender is the principal.
Table of Content
What Does It Take to Get a Small Business Loan in USA?
Accessing funds for starting a new business is usually the major impediment that is faced by a lot of potential entrepreneurs who wish to become self-employed. In the list of options that are available for sourcing funds for starting or expanding a business, loans are quite popular but in recent times, obtaining a loan in the United States has become more challenging due to tight lending standards of banks.
Typically, small business loans are used to setup a business, purchase equipment, purchase real estate or expand a business that is already on ground. Survey that was carried out by the small business association (SBA) discovered that 69 percent of small businesses used one form of financing or the other in the year 2016, including loans, credit cards, venture capital, crowd funding among others. The remaining 31 percent were not able to obtain adequate financing.
Additionally, data that was gathered by the SBA in 2016 opined that there were 28.8 million small businesses which accounts for about 99.7 percent of all businesses in the United States of America. However, big banks only approved loans for about 24.1 percent of all those who applied for small business loans. Smaller banks on the other hand have a better approval percentage of 48.9 percent. Alternatively, lenders approved 58.2 percent of loan requests.
There are two types of loans, based on the sources you obtained them from:
Types of Business Loans
- A commercial loan is one you obtain from a private institution such as a bank or a government-owned loan agency, such as the Small Business Administration, or SBA (in the U.S.)
- A private loan, on the other hand is one you obtain from your best friend, your uncle, or your father-in-law.
In both cases, the basic rule applies. That is, you will pay back the loan within a specified period along with some interest, which may vary from lender to lender. Loans can also be classified based on how they are released to you—into two main types:
- A lump-sum loan, where you get all the money you need at once and then repay it.
- A line of credit, where you are only allowed to use up the funds gradually until you reach a certain limit. (For example, if you receive a $10,000 line of credit, you can take $4,000 initially and reserve the rest for another time).
Obviously, your first line of defense when you need to take a loan for your business is to approach your relatives and friends. It could be a wealthy cousin or a well-connected father-in-law. Getting a loan from these people is always very easy, and they won’t demand crippling interests.
Only when you cannot get loans from your close ones should you consider taking a commercial loan, because they involve lots of formality and protocol. Two forms of loans will be our focus in this chapter:
3 Reasons Why You Probably Need a Loan for your Business
“Business is all about risk. If you want to be rich, you must take risk, either with your money or with borrowed money. In all, take risk.” – J. Paul Getty
In the world of business, entrepreneurs are constantly in the game of raising capital. Some entrepreneurs, especially small business owners, avoid going into debt. There is nothing wrong with borrowing funds for your business provided the money will be used to solve the problem it was borrowed for. Without wasting much of your time, i want to share with you 3 reasons why entrepreneurs borrow money for their business.
a. For Normal Business Operation-: Sometimes in business, the initial capital raised, which includes the entrepreneur’s money will not be enough to cover the basic expenses of the business. Most of the money raised will be tied down in assets such as machinery, operational facilities and inventory. So an entrepreneur may resort to borrowing short terms loans to cover operational expenses such as payroll, logistics and unforeseen miscellaneous.
b. To Pay Off Debts-: If an existing business has strong cash flow, the entrepreneur can capitalize on this to borrow long term loans which will be used to pay off short term debts. This can only be achieved if the business has strong cash flow and potential to grow or expand.
c. For Expansion-: This is a major reason entrepreneurs borrow funds for their business. If an entrepreneur perceives an opportunity outside the industry of his business, and the feasibility shows there is a chance for success, the entrepreneur can borrow funds to diversify or expand his existing business. An entrepreneur may also borrow funds for acquisitions if the existing market of his business is saturated.
4 S0urces of Small Business Loans in USA
Even though small business loans can be difficult to obtain, here are a few options that can be exploited as potential sources of small business loans in the United States.
- Peer to peer Loans
in recent times, peer to peer loans have become very popular in the United States. This type of loan is one which you get from any of your peers. If you have a decent credit history, you can then convince your peers that what you have in mind is worth loaning you the money to start.
Peer to peer loans allow entrepreneurs to finance their businesses by borrowing from individuals without the use of financial intermediaries. When making use of a peer to peer loan, you would have been able to eliminate the middleman from the process.
How to Get Small Business Peer to Peer Loan
There are also peer to peer platforms that are available that help to connect borrowers to investors. On these platforms, borrowers are able to take loans from individual investors who are willing to lend a given sum of money to them at a stated interest rate.
The profile of the borrower is usually displayed on the peer to peer platform and investors can go through their profiles to access if the borrower is worth lending to. Typically, a borrower may receive all or part of the fund he or she seeks from one investor.
If one investor is not able to provide the borrower with the complete loan, he can still be funded by one or more investors to get the remaining sum. Irrespective of if the loan has multiple or single sources, it still has to be repaid on a monthly basis.
The lenders gain in the form of the interest that will be generated form the loan which on a normal basis will exceed what they would have received if they had just saved the money in a savings account. On the other hand, the borrowers gain in the sense that they would have received the much needed finance that they can use to startup their business which they might not have gotten from established financial institutions. In addition, the borrowers also get a better interest rate than they would have gotten if they had taken a loan from the bank.
Peer to peer intermediaries are profit oriented companies that provide a platform which pairs borrowers to lenders. Any individual or business that needs to borrow money from investors on their platform will first have to file an application to them and they will then access their credit worthiness and thus assign a credit rating to them which will in turn determine what the interest rate of the loan will be like. The monthly repayments of the loans are also made through the peer to peer companies who process the payment and then forward it to the lenders.
Lending club, one of the largest peer to peer lending platforms in the world offers loans ranging from $1,000 to $35,000 to individuals and $15,000 to $350,000 for businesses which can be repaid over a period of 36 to 60 months. The interest rate they fix on the loans can vary between 5.32 percent and 30.99 percent depending on the credit worthiness of the borrower or the loan grade.
It should be however noted that peer to peer lending is not allowed in all states of the America such as Iowa, North Carolina et al due to their state regulation. Therefore if you intend to take a peer to peer loan, endeavor to ensure that it is permissible in your state.
- Friends and family
Friends and relatives who are well to do can constitute a viable source of loan for your business. They know, believe in you and see your determination and are more likely to easily support your endeavors if they have the wherewithal. Friends and relations are more likely to offer flexibility in their loan structure than a normal lender would. For example, they may be willing to accept a lower interest rate than you can get from elsewhere.
Even though an informal relationship is likely to exist between you and friends and relations, their investments should be viewed through a business prism; that is, the investment will be treated like that of any investor.
The government is yet another viable source of loan that can be used to start a small business in the USA. The government gives out money that does not have to be paid back in the form of grants. However you will find out that the government will make you work really hard before you can get your hands on this kind of fund and on top of that, you will only have a 10 percent chance of getting the money.
You can slightly increase your odds by hiring a grant writer. Once you have done that however, the money is no longer free. Most federal grants are given to fund research and not to new business creation.
How to Get SBA Loan
One of the best avenues to get a government loan is to apply for an SBA loan. The SBA is an independent Federal Agency that was set up to foster small business development. It is important to realize upfront that when you apply for this type of loan you are not really applying to the small businesses association. SBA loans are actually dispensed by banks and other special lending institutions.
What the SBA does is that they guarantee repayment of up to 90 percent of these loans if you the borrower defaults. With this guarantee, lenders are much more willing to lend the credit to people who are not very credit worthy and as such will find it difficult to get a conventional loan. The terms and interest rates are also much better.
It should be however noted that the SBA is not a Santa Claus. They will not just give out guarantees of 90 percent repayment without requiring that the loans be 90 percent collatarized. Some SBA lenders require 100 percent collatarization.
This means that if your business fails, you will lose the “valuable” that you used as collateral such as your house et al. The SBA also decreases risk of losing money by requiring you to put up 20 percent of the capital to fund your business. With this in mind, you should only borrow the money if you are confident that you can repay it.
SBA loans come with rules on what you can or cannot use them for. SBA loans can be used to purchase real estates, existing businesses, construction costs, machinery and office furniture. You cannot use an SBA loan to reimburse funds that you owe to anyone. Borrowed funds cannot be used to repay delinquent taxes. In addition, SBA loans cannot be used to facilitate a partial change in business ownership if it does not clearly benefit the business.
In other to get an SBA loan, you would first have to meet the prerequisite qualification.
- First you must have tried and failed to obtain a loan from the private financing sector
- Your business must meet the SBA size requirement because SBA loans are for small businesses only.
- Your business may need to meet their criteria depending on the type of loan. The SBA has a wide variety of loans for various purposes. You would have to carry out research to find out which of their loans is best suited for you.
- Your business also needs to meet lender qualifications.
When you have meet these qualifications, you can now apply for an SBA loan for your business. There are 5 steps to securing your SBA loan:
- Find a match: first you will have to find a match. To do this, you can either go to sba.gov and make use of their tools to connect SBA borrowers with SBA lenders or you can go to your preferred SBA lender (which may or may not be a bank).
- Talk to your SBA lender: before you start putting anything together, you should first consult with your SBA lender to ensure that you are not just wasting your time and resources.
- Prepare your SBA application: the SBA application process can be a little bit complicated, but the SBA provides application templates that you can easily use as a guide. Your application should include your personal financial statements, your business financial statements, projections, tax returns and ownership breakouts. It is advisable to check with your SBA lender to ensure that you are not missing out anything because any omission can delay your application process.
- Submit your SBA application to your SBA lender for a pre-view: next your will have to submit your SBA application to your SBA lender for the initial review. Your SBA lender will go through the application to determine if you will be given the loan.
- Term sheet: the SBA lender will then issue you a term sheet that contains a summary of the most important attributes of the loan.
- Deposit: the deposit will bring to an end the evaluation phase. The deposit will cover third part reports such as appraisals.
- Underwriting and approval: next, the SBA will appraise the file that has lender documents.
- Due diligence and closing: once you have gotten the approval, you will still need to go through due diligence. There are various third party reports such as appraisals, valuations, environments impacts at al., then you review and sign your documents and you are funded!
The entire process can take one or two months to be completed.
- Commercial banks
Sometimes small businesses turn to commercial banks to secure the loans that they need for their businesses. However, commercial banks do not usually grant them the loan due to the risk that they perceive is inherent in small businesses.
Here are 5 easy ways by which you can improve your chances of getting a loan from a commercial bank.
- Firstly, you must understand that banks give people loans in anticipation that they will pay back the loans. This therefore implies that they will only give loans to businesses purposes that they have accessed to be sound. A commercial bank will only give you loan when you have provided proof of a good businesses plan that will help you to put the loan to good use.
- Next, you will have to consider the reputation that you have amassed for yourself. Do you have a reputation of borrowing from banks and not repaying in the past? If you have a track record of defaulting on loans or if you issue bounce cheques, most banks will not be willing to lend money to you.
- You then have to consider the accounting system that you have in place in your business. If you do not have an accurate accounting system, most banks will not be willing to give you a loan. For instance, the accounting system you make use of will reveal that the owners account and the account of the business are separate. In addition, the banks will still need to see accounting documents such as profit and loss accounts, the balance sheet, the cash flow statement and other such documents which you make use of in running your business.
- You should then consider how well you know the industry. If will be a lot more easier to convince commercial banks to lend to you if you have a concrete understanding of the industry and the value that you will be able to bring to it. For instance, do you know who your major competitors are, what is your competitive advantage, how to break into the market and get ahead of your competitors.
- Lastly, you should be consistent if you intend to get a loan from commercial banks. A lot of intending borrowers just go to a bank or two and then they give up. In should be noted that different banks have different areas in which they tend focus. Some businesses also prefer to lend to only big businesses will others tend to have small businesses bias.
7 Tips to Help You Get a Small Business Loan as a Beginner
Always bear in mind that start up business loans are similar with personal loans. Banks and other financial institutions do not want to lose money and asking them to give you start up business loans could be tough. However, if you would have given a chance to have that start up business loans that you are dreaming of, then that’s very lucky of you.
When obtaining start up business loans, it is better to get a professional financial advisor to guide you in getting that start up business loans. That financial advisor will explain to you all the things that you need to know about start up business loans, how to get one and what the repercussions are in obtaining specific start up business loans.
Your financial advisor would help you to gather the necessary facts about the business, prepare the papers if necessary, and even back you up to get those start up business loans in order for you to start your business. Your financial advisor will also teach you how to maximize your money-making potentials in order to pay your loans in due time and even to obtain more loans for your business expansion.
Nevertheless, your financial or credit history will also predetermine the ease or difficulty of obtaining any kinds of loans. That is why, it is very important to pay your early loans, both the principal and interests in due time to avoid penalties and not to have a bad record from any financial institutions.
On the other hand, being a homeowner can give an edge to obtain a business loan. You can use your own house and lot to serve as your collateral for your business loan. For banks and non-bank lenders, as it was mentioned before, are conscious about their return of investment. So if you want to obtain that loan easily? Here are some tips that will help you:
a. List down all your assets and liabilities-: It is important to check the things with value at hand as these things would serve as collateral or payment in case you default on the loan terms. Just keep your fingers crossed for the worst thing not to happen, this is in case you cannot pay the loan or credit anymore. Cars, jewelries, and equipments that can be turned easily into cash can be enlisted as part of your assets. Your outstanding loans and credits would go to the liabilities’ list.
b. Ensure that you had a good income record throughout the year-: Since start up business loans are considered as part of the “high-risk brackets” in terms of financial loans, banks and non-bank lending institutions are very cautious in lending money to new business persons. If you can show the management of the lending institution that you can pay, then there’s a little chance that your business loan would be denied.
c. It is important to give them the exact blueprint or financial plan of your business so that they would know where you will be using the money that you are loaning. It is good to give them the breakdown of the proposed allocation or distribution of the loaned funds in order to give the bank management enough reason why they should take heed to your request.
d. If your business is already established, apply for a loan when your business is doing well and not when you are desperate for finance. Lenders do not like to see desperation in a business owner or a business that has a declining bank statement. In this vein, you should always look ahead to try to anticipate your needs for a loan be it for an expansion, marketing campaign et al. You would want to appear as healthy as possible when you go to apply for a loan.
e. Put together a use of funds statement: every lender will try to ensure that the borrower has a clear cut idea of what he wants to do with the loan. You should endeavor to have a detailed breakdown of how you intend to spend the loan and the potential impact it will have on your business.
f. Be honest: oftentimes some business owners lie about their gross annual revenue in other to increase their chances of getting a loan. However, if it is found out that you lied on your application or that you overstated significantly on your gross annual revenue and your bank statement does not match up to that, you will run into a lot of trouble.
g. Have a legible writing: this may sound silly but a legible writing can go a long way in helping you get a loan. Your application is the first impression an underwriter will see so you must have an easy to read handwriting.
h. Be realistic: try as much as possible to be realistic in your expectation. Don’t ask for a million dollars if your company is just averaging $10,000 a month.
In conclusion, it should be noted that lending trends change from time to time and as such you should try to determine the best source of a loan considering the current economic situation.
Also, a combination of the various sources of loans may be the best for your business if a single source is not able to raise the amount of money you need to start up. When you are funding your startup business, aim to get more than you need. If your business requires $50,000 add a few extra thousands to it and make that your funding goal.