Since World War II, millions of businesses in the United States have started out with a business loan from a bank. Access to loans is a critical part of starting and growing your business. Today, the situation has changed. Small businesses and start-ups have a much tougher time getting bank loans these days, for a few reasons.
- First of all, bank lending standards are much tighter now than they were even just before the Great Recession. Banks insist on higher credit scores, more collateral, more documentation, and more information about the industry.
- Second, very few bankers understand the “new economy”. They understand real estate and hard assets, they understand restaurants and coffee shops, but they don’t understand technology, the Internet, or businesses that rely heavily on intellectual property, so they don’t lend to “asset light” businesses until they have strong cash flow.
- Third, there are far fewer banks than there were 30, 40 or 50 years ago, and very few banks today have any real ties to the communities where their clients are. That means local bankers have less involvement in lending decisions, which are often made hundreds or thousands of miles away by underwriters who know nothing about your neighborhood or possibly even your city.
I cannot even guess how many entrepreneurs have called me and told me they want to get a bank loan to start their business. I generally ask them a few pointed questions, and then tell most of them that their odds of obtaining a bank loan are very slim. They usually blame me.
The purpose of this article is twofold:
- First of all, help entrepreneurs decide if bank financing is right for them.
- If their answer is yes, then guide them through the “loan application process”.
Is Bank Financing Right for You?
Unfortunately there is no simple answer to this question. I wish there was, but that is just not the real world. Here are a few things bankers look for when they consider a business loan application. Note that I am referring to business loans for start-ups or small businesses, not for companies with a long track record, middle market companies, or large companies. For the most part, this article applies to start-ups with no revenue, or to businesses with up to a few million dollars in revenue that do not have a long track record or consistent, accurate financial records. Start-ups are almost always harder to finance than existing businesses, but that is not always true. Most banks balk at companies with less than two years of operating history. Banks tend to be more forgiving with businesses that have at least a few years of operating history, but you should realize upfront that even if the bank says no collateral is required, they will often require a personal guarantee. In other words, if the business goes under, you are personally on the hook for the balance of the loan.
15 Questions to Answer Before Seeking a Bank Loan
What is the money for?
Is it for working capital or operating expenses (such as rent or salaries)? Or is it for hard assets such as equipment, machinery, or real estate? Alternatively, is it for construction (which eventually leads to a hard asset such as a building)? It is generally more difficult to get money for working capital or operating expenses than for construction or hard assets, especially for start-ups. Banks want to hold on to something they can sell in case you default. It is a lot easier to sell a building, a plot of land, or a machine than it is to sell an idea or a concept.
How much money do you need (relative to the scale of the business)?
If this is going to be a $5 million business within 3 years (and you have evidence to back that up) — and you only need $50,000 — your chances of getting a loan are much better than they would be if you needed $500,000 to start a million dollar business.
Along the same lines, how long will it take you to pay the loan back?
Generally, the faster you can pay it back, the better. But there are exceptions, such as real estate or slowly depreciating hard assets. But one case where a bank loan is almost never a good idea is a high tech company where it takes four to five years before you generate any revenue.
Do you have collateral to secure the loan?
If you own a house and the equity in the home (market value minus what you owe) is $500,000, but you only need $100,000, then you should have little trouble getting the loan.
Do you have cash available to supplement the loan?
For example, suppose you estimate you need a total of $250,000 to start your business. If you tell the bank you can invest $150,000 in cash, so you only need $100,000 from them, they will be much more interested than if you tell them you have $10,000 and they will have to lend $240,000. The banks want you to have skin in the game, so the more you can put up relative to the amount of the loan, the more likely it is the bank will lend you the money.
What is your credit score?
If your personal credit score is about 700 (or above), then this is in your favor. If your credit score is below 600, then your odds of getting a loan are very low (unless you have significant collateral, or some other positive offsetting factor).
Do you currently have a job with a good income?
If so, and if you can keep that job for the first year or two after starting the new business, your odds of getting a loan are much improved.
What type of job do you have?
It matters. Most banks love doctors because they have high salaries, excellent job security, and tend to be low risk clients. Retail store clerks, on the other hand, have low salaries, minimal job security, and tend to be higher risk clients.
Do you have any business partners?
If yes, this could be good, or it could be bad. If one (or more) of your partners is well off, has collateral, and has a good credit score, then this is definitely in your favor. But if one (or more) partners has bad credit, this could hurt your chances of obtaining a loan.
Do you have a business plan?
If you have a professional, well-written business plan with reasonable financial projections, accurate industry market research, and attractive charts and tables, this increases your chances of obtaining a bank loan. If your business plan is sloppy, unattractive, and uses outdated market research, your chances of obtaining a bank loan are probably lower.
Do you have a feasibility study?
Many banks do not require a feasibility study, but some do. A concise professional feasibility study will almost always be in your favor. If you do go ahead with a feasibility study, be sure to engage an unbiased professional, not a relative or a friend.
Traditional business or new concept?
Is this a “traditional” business that most people can quickly understand, or is it a new concept that requires more explanation? A “traditional” business might be a gas station, a carwash, a restaurant, a bed and breakfast, a construction firm, or a coffee shop. Whereas a new concept might involve a new type of medical technology, a new social media business, or a new pest control chemical manufacturing process. Generally, traditional businesses have a much higher chance of landing a bank loan than any business based on a new concept.
Do you have a relationship with this banker (or someone else at the bank who has some influence with them)?
In an ideal world, bankers would lend money based on a combination of objective and subjective criteria, but would be minimally influenced by friends. Yet bankers are people too, and most bankers will lean just a little more favorably toward someone they know and respect than a complete stranger.
Does this bank have a history of lending to small businesses like yours?
And if so, do they tend to make loans about the size of the one you need? This is not always easy to determine, but you can start by going to www.sba.gov and researching SBA preferred lenders. Not every bank gets involved with SBA loans, and even if they do, they may not have any experience with your industry, or they might do very large, or very small loans that do not suit you. The better the fit between your businesss and the bank, the better your chances of getting a loan. I remember speaking to a small business banker at one bank years ago who told me she loved restaurants and her boss loved art galleries. Another banker told me he loved lending to gas stations.
Have you done your homework?
Most bankers will not look as favorably on your application if they don’t think you have done your homework. Prepare as much as you can before you talk to them. Research the various loan options and prepare at least a few questions before you meet with them. It can’t hurt, and it might just help.
Now that you have thought about all of these factors, you need to decide if your situation is a good fit for a bank loan.
The Loan Application Process, or One Million and One Ways to get Rejected
If you’re still reading this, you are presumably still interested in pursuing a bank loan for your business. In this section we will go into a little more detail on how the loan application process works, and show you some of the traps bankers have prepared for you.
The Door is Open
First of all, I have NEVER heard a banker tell me his or her bank is ***not*** lending. According to bankers, they are ALWAYS lending. Their door is always open. They LOVE to lend money. And the fact is, this is absolutely TRUE (except when it isn’t). What is really true, is that banks are always willing to lend money as long as there is no risk. If you are a multi-millionaire with perfect credit, extensive liquid and slowly-depreciating hard assets, and all of your money is in this particular bank, you can get all the loans you want. But if you don’t fit that profile, and you actually need the money, the bank might not be quite so accommodating. So when a banker tells you they are lending and you are a good fit, take it with a large grain of salt. Remember, the banker you are talking to will probably not be the one who makes the final decision. And even if he or she does make the final decision, that won’t happen until they have gone through their “due diligence”, which often takes months.
The Low-Down on Credit Scores
One of the most important changes to the banking industry over the past few decades has been the rise of automatic scoring systems. There are three national credit reporting agencies in the United States: Equifax, Experian, and TransUnion. Each of these agencies gathers information about you and prepares a proprietary “credit score”. The agencies are all independent, so the scores will often be different, partly because they might not have exactly the same data, and partly because they interpret the same data in different ways. The “standard” credit score is the FICO score (Fair Isaac Company). This score ranges from a low of 300 (terrible credit risk; forget about getting a bank loan) to 850 (excellent credit score; most banks will lend to someone with an 850, even if other indicators are not perfect).
First of all, note that the credit reporting agencies are supposed to invest a great deal of time, money and resources into getting accurate data on the people they report on (basically everyone in the United States who has ever owned a credit card, mortgage or had any other debt). But the fact is they do a rather poor job at it. Most people have errors in their credit file. These can be relatively minor such as a misspelled employer name to extremely serious, such as an incorrect name, address, loan information, etc. If you have a common name, such as John Smith, there is a small chance that your credit information may be mixed with another John Smith’s information. If the other John Smith has defaulted on a loan, recently filed bankruptcy, or owes hundreds of thousands of dollars in credit card debt, even if you are as pure as the driven snow your credit report could be contaminated, so instead of having a score of 850, you might have a score of 550. So be sure to check all three credit reports and scores to make sure your credit file is correct. If it is not, you will have to contact the offending agency and file a correction. You can try their online tool to do this, but in my experience they rarely work. The only way to be sure it is done properly is to write to them and then recheck your report in a few weeks.
Even if all of your data is correct, you can still be a very good person and still have a tarnished credit score. One of the ways the credit reporting agencies take advantage of consumers is to play games with their credit limit and interest rate. Suppose you have just one credit card, and it has a credit limit of $1,000. This is the maximum amount you can spend with your credit card. Now suppose you get some unusually high bills for a few months, and your credit balance increases to $850. Then you have used 85% of your credit limit, so your credit utilization is 85%. That raises a red flag at all three credit reporting agencies, because they now assume you are spending more than you can afford, so your credit score drops. When you credit score drops, you are considered a higher risk, so if you get any new credit cards, they will be at a higher interest rate. A higher interest rate means your credit card purchases cost you more (unless you pay the balance in full), so it is now harder to pay your monthly bills, and you start down the slippery slope of greater credit card debt.
It was not so long ago that one could call up the credit card company (a bank), ask them to lower your interest rate or increase your credit limit, and if you were lucky, they would do it. But that was then, and this is now. Today if you try to speak to someone, they will usually be a low level person with no authority. They will make small talk and “put in a request”. But usually nothing will happen. If you are persistent, you can ask to speak to their supervisor. Often this person has no authority either. You can keep moving up the food chain until you find someone who does have actual authority. And then they will probably turn down your request. So once your credit utilization and interest rates go up, it is very difficult to get them to come back down again. The only way I know of is to pay off the credit card in full and then threaten to cancel it. This might get their attention; but then again, it might not.
One of the worst mistakes is to pay late. If you pay late, the bank can increase your interest rate and your minimum payment. Your credit score will also suffer.
Applying for other Credit
The credit agencies keep track of your credit inquiries, and the more you make in a fixed period of time, the more it can affect your credit score. Do not apply for multiple loans or credit cards at one time. It is much better to spread the applications out over time, say 2 or 3 per year.
One of the tricks banks now use is to develop their own credit scoring system. The advantage to them is complete lack of transparency — they make up the rules and don’t tell you, so they control the game. Consider the following situation. You have been gradually improving your credit score and removing incorrect or negative factors from your credit report. Your three major agency scores are 720, 685 and 670. You receive a letter from a bank telling you that you have been “pre-approved” for a line of credit up to $150,000. You fill out the application, confident that you will be approved. Four weeks later you receive a form letter from the bank telling you that your application has been denied:
“Thank you for your recent credit request/application. Your request for a credit card or increase in credit line was carefully considered. However, we regret we are unable to approve your application for the following reason(s):
- Proportion of Revolving Balance to Credit Limits Is High
- Too many accounts with balances
Our credit decision was based in whole or in part on information in a report from Experian (or Equifax or TransUnion)
The consumer reporting agency played no part in our decision and is unable to supply specific reasons why we have denied credit to you. Blah blah blah.”
So what happened here? We’ll never know the specific reason. But the most likely reason is that the bank developed their own proprietary credit score, which gave the two factors listed above more weight than any of the three major reporting agency scores. You can’t really find out what happened, because the bank will not reveal their methods. Note that the way the system is set up today, there is no transparency and no accountability. It works well for the banks and the credit reporting agencies. But for you? Not so much.
Playing the Game
Despite all of this, there is a way to “beat the system”. It doesn’t work every time, and the rules could change over time, but the general principles should stay the same. The idea is to figure out what the banks want, and give it to them.
For instance, banks like to see activity on their accounts. They prefer a customer who regularly uses a credit card or a line of credit and then pays it back quickly than someone who rarely uses it, then generates a large balance and pays that back slowly. So one way to increase your credit score is to spend a little, pay it back, spend a little more, pay it back, etc. Be sure to stay below the credit utilization triggers, typically around 30%, although if you go higher once in a while that is fine, as long as you pay it back in full each month, or over a few months.
Unfortunately, banks are simply not serving “main street” the way they I believe they should. They don’t even serve most high flying entrepreneurs very well. But that doesn’t mean you should not try. I have seen some extremely risky businesses get loans, despite all the odds.
And be sure subscribe to a credit reporting service such as FreeCreditReport.com, freecreditscore.com, or CreditKarma.com and monitor your activity and your scores carefully.