How to Finance Your Small Business
Commercial lending is very different from residential lending. It involves more risk to the bank and you should expect to pay higher interest rates. The credit requirements for the borrower are also higher than for residential lending.
Banks make their decisions based on:
• the borrower’s experience
• the borrower’s credit
• the available collateral
• the available injection (down payment)
• the historical financial condition of the business (for existing company)
Experience. Banks favor borrowers with management experience and/or experience in the industry.
Credit. Banks favor borrowers with a better than average (680+) credit score. Bankruptcy in the past 7 years dramatically decreases your funding options. Bankruptcy due to medical circumstances can be excused. You can check your credit score by yourself (see the list of sources at /serv04.htm). Self check is considered a “soft hit” and will not decrease your credit score.
Acceptable Collateral includes real estate (commercial and residential), equipment and inventory
Injection/Down Payment. Generally, banks expect you to spend some of your own money and take some of the risk. 100% financing is available only for existing businesses in need of expansion and for venture capital deals.
Financial strength of the business (if you’re purchasing an existing business). Think about it this way: you are not going to buy a car that is falling apart. Not surprisingly, banks will not invest in any businesses in financial distress. There are other ways to fix it.
While choosing bank, keep in mind that banks are specialized entities If you wanted Chinese food, you wouldn’t go to a steak house, would you? Banks are organized the same way. You will never find a bank that does all types of businesses and all types of loans.
Do your homework. Call the bank, ask for a business loan officer and describe your business type and your financial needs. Try to avoid banks that will give you a general answer: “We make our credit decision on a case per case basis”. Most likely you will waste money and most importantly your time.
In most cases it takes 5-7 business days to issue a commitment letter and 30 – 45 days to close the loan. Act in advance. Never shop for a loan under time pressure.
• Start-up Loans
• Expansion Loans
• Business Acquisition Loans
• Franchise Financing
• Commercial Real Estate Financing
Other ways of financing (outside of the scope of this article):
• Purchase Order Financing
• Account Receivables financing
• Contract Purchase
• Credit Card Financing
• Private money and VC
Loans can be secured and unsecured. Only a person with exceptionally good credit scores (680+) can obtain an unsecured loan. Secured loans are loans that are secured by collateral (real estate, inventory, equipment, etc).
Small business loans in the USA are available only to US citizens and Green Card holders with established credit (no bankruptcy or insolvency).
Let’s take a look at some of the basic loan types in details.
There are two types of start-ups: non-franchise start-up and franchise start-up. Franchise start-ups are easier to finance. For more information see Franchise Financing.
You can finance a start-up with unsecured loans, credit cards and secured loans. When you need a very small loan it is a wise decision to finance it with a credit card, home equity line or unsecured loan. It involves less paperwork and you can receive it faster. Interest rates that you will have to pay on, for example, a home equity line of credit are lower than commercial rates and are tax deductible.
General requirements for non-franchise start-up.
• Collateral is a must.
Collateral = (Real estate value*0.8 – Mortgage) + Equipment value *0.5 + Inventory *0.1
John Doe is planning to open his own bookstore. Here is the breakdown of the available collateral.
Residential Real Estate (existing) - $150,000 (appraised value)
Remaining mortgage - $100,000
Equipment value (to be purchased with loan money) - $40,000
Inventory value (to be purchased with loan money) - $75,000
Collateral = (150,000*0.8 – 100,000) + 40,000*0.5 + 75,000*0.1 = 47,500
You have $47,500 in collateral value. This is your available loan.
Some banks will finance up to 150% of collateral value. But as you can imagine it is hard to get this type of financing and it requires a perfect credit score
• As the borrower, expect to invest at least 30% or the total project cost. This investment cannot be money you have borrowed.. A home equity line is okay (but keep in mind that it will decrease your available collateral). If somebody gave you a gift, please make sure that you have a notarized document that the money is a gift and you do not have to pay them back.
Any business expenses that were paid by you during the initial stage can be counted towards the borrower’s injection:
• Travel expenses
• Legal expenses
• Business plan preparation expenses
• Equipment that will be used in the business
• Inventory expenses
Experience -- In most cases any management experience and/or industry experience is acceptable. Banks will not finance a change of career. For example, an experienced truck driver has no chances of obtaining a start-up loan to start-up a plumbing business. The way around this is to hire an experienced manager and give him 10% of ownership.
These loans are available for established (at least 2 years old) companies for expansion, leasehold improvement, FF&E (furniture, fixtures and equipment) replacement, equipment purchase, refinancing (no credit card refinancing), property construction and renovation. You can receive up to 100% financing.
Real estate collateral is not always required. Some banks will accept a business’ performance (good will) as collateral.
Be prepared to provide 2-3 years of business tax returns. The rule of thumb is that if your taxable business income is dropping more than 5% each year you will not be able to get the loan. For some industries that are considered riskier than others (automotive repair, gas stations), only stable or increasing income will be considered.
Sometimes people think a business acquisition is the same as a start-up. This is not correct, since you are not starting from scratch. It is like the difference between making your own clothes and buying them from Sears.
You should expect to put down at least 20% of the total project cost. The total project cost may include additional working capital in some cases. If you do not have enough for a down payment, ask for a seller’s second. A seller’s second is a loan from the seller.
John Doe decided to buy a profitable bookstore down the road instead of opening the new one.
The purchase price: $500,000
John has only $60,000 (12%) for a down payment. However, the buyer thinks that he is a good match for the store in terms of experience and credit history. The buyer is also certain that the store profits will easily cover two loans. He agrees to give a $40,000 (8%) loan to John.
Now John has the minimum down payment of $100,000 (20%). The loan from the bank will be $400,000.
Banks favor buy-outs by existing manager/partner/shareholders with little or no down payment for an obvious reason: experience Real estate collateral is not always required. Some banks will accept business’s performance as collateral.
Be prepared to provide 2-3 years of business tax returns. Check financial documents by yourself first or ask an experienced CPA to do it for you. If the taxable profits are dropping more than 5% - choose another business to buy. You are not going to buy a broken car, so do not spend big money on broken business. Banks will not finance this project. The best way to find reliable business is to hire a business broker. Their job is to make sure that the business is in perfect shape.
Banks favor franchise businesses. But be aware that not all franchises are created equal. Get a copy of the Franchise Offering Circular. Under the FTC's Franchise Rule, you must receive the document at least 10 business days before you are asked to sign any contract or pay any money to the franchisor. Show it to your CPA and lawyer. Some banks rate franchises based on profitability and number of existing locations. Preferred franchises can be financed with no collateral and a lower down payment. Check with your local bank. Most franchises will be financed as a start-up (new location) or business acquisition (existing location).
Be aware that investing in a financially unstable franchise is a significant risk; the company may go out of business or into bankruptcy after you have invested your money. Relevant management or industry experience is a plus: however, some franchisors have such excellent training and support that banks will even fund an inexperienced entrepreneur.
When a bank requires relevant experience that you do not have, hire an experienced manager and give him/her 10% of the ownership. Don’t look at this as extortion. What is good for the bank is good for you. Banks base their requirements on statistics, which show that certain types of businesses, if run by an experienced person have approximately five times less chance to file for bankruptcy.
Commercial real estate loans are easier to obtain than business loans. Real estate is considered as very strong collateral. However, properties that are difficult to convert such as gas stations, c-stores, marinas, etc are hard to finance. You should find a bank that will do the loan for your particular property type.
The purpose of the loan can be for: purchasing, refinancing, cash-out refinancing or construction.
Refinancing and cash-out refinancing require no down payment. In all other cases expect to pay up 10% - 35% in down payment. SBA loans will finance up to 90% of the purchase price. However, income property like apartments, duplexes and B&B’s are not eligible for SBA financing (exceptions can be made for properties in rural areas). Some working capital can be obtained as a part of an SBA loan.
A seller’s second is an acceptable type of supplemental financing. The seller’s second is a loan from the seller and should not exceed 20% of the total purchase price. 10% down payment is a must, unless you are dealing with private lenders. Private lender financing is outside of the scope of this article.
Save this information and review it carefully when seeking financing for your business, and your search will be much easier.
Copyright 2005 by Marina Lando
Business Loan Quest, LLC
1251 NW Maynard Rd., PMB# 119
Cary, NC 27513
B: 919-469-1505 Fax: 919- 386-8013