It is time to think differently about alternative financing options! I would like to highlight banking criteria for loans, show you why many small business loans are declined and offer insights into the opportunities and risks inherent in alternative financing solutions.  


Small Business Financing Needs

In order to find the best fit in a funding source, it is important to understand the reasons why financing is necessary. Examples of financing needs include:

  • A funding gap: Improve the cash flow from accounts receivable and inventory to support payroll and operating expenses
  • Capital Expenditure - the purchase of furnishings, equipment or software
  • Finance Growth
  • Manage collection delays
  • Acquisition Financing

Bank Financing Criteria

Typically, a business first pursues bank financing, which engages strict credit criteria. Banks typically look at the 5 C’s of Credit:

  • Credit: Analysis of business and/or personal credit
  • Character
  • Cash Flow: Shows the capacity for debt repayment
  • Collateral: Provides a secondary repayment source should the borrower become unable to make payment on their loan.
  • Capability: Management assessment

Bankers are driven by the questions: ”Can the borrower can repay the loan? Can the borrower do so on time? and Can he can make the borrower pay if necessary?” 

Many entrepreneurs find it personally offensive when their loan request is turned down. However, a declined loan request does not mean anything is wrong with the business. It simply means it does not fit within the bank’s risk parameters at that time.

The Disconnect 2012 – Why Banks are saying “No” more often to Small Businesses

1995 through 2006 was marked by unprecedented easing of small business lending standards. Some Banks made loans with very limited documentation requirements. The loan to value of the supporting collateral (LTV) rose from 60% to 80% in conventional lending times to as high as 100%. It all ended with the banking meltdown in 2007, which resulted in a cry for stronger banking regulations and a retreat to more conservative credit standards.

Simultaneously, over the past few decades small businesses in the U.S. moved away from manufacturing toward the services sector. Such service businesses do not have as much hard, common collateral, as their manufacturing counterparts. So when a service business applies for a bank loan without tangible collateral, their application is often declined due to this mismatch.

SBA Solutions

To induce banks to lend more, the SBA created several programs:

  • 7(a) program: A small business may use the loan proceeds to establish a new business or to fund the acquisition, operation, or expansion of an existing business.
  • 504 program: This program provides a long-term, fixed-rate financing solution used to acquire fixed assets for expansion or modernization.
  • CapLines program: This program is designed to help small businesses meet their short-term and cyclical working capital needs. 
    • The contract loan program is used to finance material, labor, and overhead needs for a specific contract or contracts.
    • The seasonal line of credit is used to support buildup of inventory, accounts receivable or labor and materials above normal usage for seasonal inventory. 
    • Working capital line is a revolving line of credit that provides short term working capital. 

These programs provide access to capital to borrowers who may have some financial weaknesses and/or collateral shortfall. The SBA guarantees 75% to 90% of the loan, which makes banks more comfortable extending credit to a company that otherwise would not fit within their credit parameters.Despite the loan guarantee, not all banks participate in the program offerings. And even with the participating banks, borrowers still need to qualify on “The 5 C’s”. 

When applying for the SBA backed loans, borrowers need to prepare for a lengthy loan process that typically lasts four to six weeks. Some programs have variable rates, which bear the potential for an interest rate increase. Often personal assets can be required for collateral.

If a business is unable to obtain a bank loan, alternative financing may be a solution. Alternative options can also help businesses that are not willing or able to overcome the obstacles of the SBA programs.

Alternative Financing Options

Family and Friends

Sometimes an early stage entrepreneur may look to a wealthy family member who can provide flexible financing options with terms no commercial source can compete with. Family members typically do not charge interest, may allow deferred payments and often require no collateral. A unique risk of this funding source is that if things do not work out as planned, they may affect family dynamics.

Home Equity

Home equity loans are usually very cheap and allow for flexible financing terms. They may be as low as prime +/- 1%, have a 25 year term, and allow for easy access to funds. These loans are based upon the home equity and personal income, not on the business’ financial strength. However, in the current housing market not many homes have enough equity available. They also bear the risk of personal liability (including foreclosure) if the business fails.

Credit Cards

Credit cards have the advantage of low minimum payments. Moreover, personal income and credit score are relevant for their approval, rather than business financials.

Yet, a significant drawback to credit cards is that lines are only available in relatively small amounts that successful businesses quickly outgrow. Quickly changing terms upon non performance may also pose a cost risk. It is crucial to read the small print to avoid expensive surprises.

Angel Investors

Angel investors finance growing small businesses in their early stages and take equity in the company. Investors usually look for a return on investment of 20% to 25% and tend to support loan needs in the range from $100 thousand to $2 million. They may also provide strategic consulting to the small business. However, it can be difficult to find the right partnership.

Venture Capitalists

Venture capitalists help small business get access to funds and provide management expertise in exchange for part of the ownership of the company. They often focus on specific industry niches and provide small businesses with much needed market intelligence.

In some cases the money comes in easily, which tends to create a lack of urgency with the business owner. For example, this was happening in many businesses during the Dot-Com bubble.

This is equity financing, which means the founders’ ownership is diluted by the venture investors’ ownership, so in the long run, this can be very expensive financing. Poor performance can cause entrepreneurs to lose control or even their ownership of the business.

Venture capitalists typically have a three to five year timeline to return their investment.

Equipment Leasing

Equipment leasing typically finances up to 120% of the needed loan, including soft costs. Usually no down payment is required. The entire lease payment may be tax deductible.

Yet, this form of financing can be expensive compared to purchasing the equipment. Even though the borrower has no ownership of the equipment, he remains responsible for maintenance and upkeep of the equipment.

Asset Based Lending

Asset based lending is a specialized loan that provides funding limited by a borrowing base, which is compromised of advance rates applied to the accounts receivable and the liquidation value of inventory. This form of financing provides working capital for businesses which otherwise could not qualify for a line of credit. Asset based lending allows the line to increase as the company’s working capital needs rise.

Asset based lenders extensively scrutinize the assets through independent appraisals and collateral audits supported by strong reporting systems. Additionally, collections and sales are reported on a daily or weekly basis. Interest rates on asset based lending facilities typically run from prime plus 1% to 4%. Additional fees, often as much as or greater than the interest, are also necessary to secure assets and manage collateral (e.g. collateral monitoring fees, field exams).

Invoice Factoring

Invoice factoring, often simply called factoring, is a method of generating cash for your business by selling your accounts receivable for 75 % to 90% of their face value to a finance company. It is not a loan. Instead, it is a purchase of an asset (the invoice) by an investor or finance company. Factors focus on the quality of the receivables, rather than the credit worthiness of the borrower. This funding source allows quick access to funds and allows borrowings to increase rapidly with business growth.

The borrower’s clients are notified to make payment to the factoring company. With responsible and reasonable notification and verification practices, this does not harm customer relationships. The finance company even assumes many of the tasks associated with the collection, allowing the business owner to focus on their workload rather than chasing after payments.

However, if the account debtor (the borrower’s client) neglects to pay their invoice by a predetermined date or fails to pay altogether, the borrower will owe the factor for the balance. 

Costs vary widely but are comparable to pricing for non-bank asset based lending services.

Positioning Your Company for (Credit) Success

No matter what option a business owner chooses, they need to position their company for credit success before the loan need arises.
To get prepared a business owner should:

  • Speak to several lending professionals well before the loan is needed
  • Invest in the company’s accounting infrastructure
  • Provide a complete loan package: This will raise your credibility and speed up the process.
  • Be upfront regarding any issues with your financials: Remember, character is an important part in the lending decision process
  • Understand the loan decision and if declined, stay in touch with the banker
  • Choose trusted advisers with an understanding of your Industry and your target market

Conclusion

It is important to select the right form of financing that fits your business type and needs. Alternative financing options, though more expensive than bank financing, may be available to a small business despite a lack of collateral or weak financials. Start the loan process early to position your company for success.