How to secure financing for your small business
Financing for a small business is most typically secured through traditional sources like banks, savings and loan companies or credit unions. These institutions will use different methods to determine whether or not you and your business are able to pay back the loan before lending you the money. Sometimes, traditional institutions will not loan startups money and so the business owner seeks to finance the company in non-traditional ways.
Traditional Business Financing
Traditional financial institutions make loans to small businesses for a variety of reasons -- for start-up capital, the purchase of equipment or, perhaps, a line of credit to finance the acquistion of inventory. Such financial institutions will make their decision to lend money of wide array of criteria that include the following:
Ability and Willingness to Repay
You must be able to demonstrate your company’s ability and willingness to repay a loan. Your ability to repay essentially means that your business is generating enough positive cash flow to pay the monthly payment as well as cover your general operating expenses. This positive cash flow can come from your normal operations or from some other source like purchase orders or signed contracts for a specific job.
Lenders also like to see that you and your business have paid past bills and loans as agreed and on time. This is typically accomplished by reviewing your credit reports. Yes, all lenders will review the personal credit reports of the owners of a company as well as those of the business, if any. Lenders may also call on your suppliers and other vendors to see how you have paid them in the past.
In the event that your company is seeking a loan to complete a specific job, the lender may also check the credit and past payment history of the person or organization that contracted you to complete the specific job.
FICO scores below 640 are immediate grounds for denial. FICO score should be in the 700s or higher. Anything in between is questionable.
Lastly, if your business is already carrying a lot of debt, lenders may baulk at your request. Lenders feel that you are simply working to repay loans instead of building the future of your company. The more you rely on debt, instead of equity, to finance your business the more risk you face and the higher risk for the lender. A quick look would be to divide total liabilities to equity. Anything 3.00 of higher is a big red flag.
If your credit or your business’s credit has blemishes, you have two options. First, if the blemish was based on a unique situation, say medical bills, explain this situation up front. Being honest with your lender will go a long way in building trust and credibility. Second, before applying for a loan, work diligently to repair your credit. I would suggest starting with the credit reporting bureaus first. If you then think this is outside your expertise or just do not have the time, contact an organization that can help. A quick search engine search is all you need to get started.
Lenders typically like to see three (3) sources of repayment. The first and most important is cash flow – described above. Second, is usually based on the collateral securing the loan. Lenders look for assets that have resell values that meet or exceed the amount of the loan. Should the loan not have specific collateral (like an equipment loan) or is under collateralized, the lender will require a blanket lien against all the business’s assets. As a third source, lenders typically turn to personal guarantees. This shows the lender that the business owners are willing to risk their own personal assets to grow the business. So, be willing to provide your potential lender with at least three sources of collateral.
Regardless of your business concept, if you cannot execute your plan, it will never work. Your business must demonstrate that the owners have the necessary expertise to run and grow this type of business. Managing a medical office does not necessary mean that you can design, produce, and sell software. If the business owners cannot specifically demonstrate that they have skills in marketing, management, finance, and accounting, then they must show that they have either hired these skills in house or outsourced these tasks.
Alternative Business Financing
If you cannot secure financing from traditional lenders, there are other sources of financing:
It never hurts to work with your suppliers. Ask for better terms; either more discounts or longer time for payment. Here you can reduce your overall costs or allow more time to collect money from your customer before payment is due to these suppliers. Now, your suppliers may baulk at this discussion as they are probably feeling the same pinch as you are. However, impress upon them that it does their business no good (short term or long-term) if you go out of business, have to cut back your standard orders, or are forced to find other suppliers who offer better terms.
In conjunction with trade credit, do all that you can to collect your receivables from your customers, as soon as possible. If your suppliers offer you discounts for early payment, offer the same to your customers (just maybe not at the same magnitude) or offer discounts for cash. This allows you to collect payments faster as well as reduce you costs by paying less for the goods you need to run your business. Just remember, cash is always king.
Receivables and/or Purchase Orders
If your business has accounts receivables sitting on its book just waiting to be collected, you maybe able to get cash for those assets NOW. There are cash advance companies (not banks) that specialize in purchasing your receivables. These companies will purchase your invoices for up to 90% of their amount. They will then work with your customers to collect these receivables (saving you both time and money on collection). When the invoices are paid, these companies will refund to you the remaining 10% of the invoice amount. This type of funding is great for struggling companies as these cash advance businesses will focus more on your customers’ credit and business strengths than your.
Many of these same companies will also finance your purchase orders. If you place an order with your suppliers and agree to pay for their goods over time, these cash advance companies will finance these agreements. This could allow your business the opportunity to take advantage of trade discounts (percentages off the purchase amount) as your company will have immediate cash to satisfy your supplier. This is very similar to having a line of credit with your bank but as an individual credit facility for each purchase.
If your business accepts credit cards, there are companies (again, not banks) that may advance cash to your company based on your FUTURE credit card receipts. These facilities are only paid back when your business generates credit card sales. Thus, if you have a slow month, you are not stuck with a huge monthly loan payment. As your credit card sales ebb and flow, your repayment of these advances will ebb and flow in tandem.
If you have retirement funds, it is possible to fund your small business using your IRA or 401(k) funds. There are several companies that can set up a specialized structure which allows you directly invest in your new business using retirement funds — without taking a taxable distribution or incurring penalties. This strategy has pros and cons. On the positive side you are investing in yourself, so you don't have to worry about increased overhead from loan payments. You also don't have to worry about qualifying for a loan, selling your business to investors, or how good your credit is. However, the positive is also the biggest negative. If your business fails you could lose your retirement savings.