- Poor credit history and low cash flow can prevent small businesses from securing loans.
- Before applying for a business loan, make sure your financial documents are in order and that you understand what lenders need from you.
- A good business plan makes your business attractive to lenders, giving you a better chance of getting a loan.
Business loans can be essential to launching a startup or expanding an existing company, with funds often used to secure inventory, purchase equipment, rent operational space, hire employees or cover a host of other expenses. However, business loans can be difficult for new companies to get. Be aware of these eight roadblocks that can keep you from getting approved for a small business loan.
1. Poor credit history
Credit reports are one of the tools lenders use to determine a borrower's credibility. If your credit report shows a lack of past diligence in paying back debts, you might be rejected for a loan.
Paul Steck, COO of Spread Bagelry, has worked with hundreds of small business franchisees, many of whom have bad personal credit as a result of illness, divorce or other extenuating circumstances.
"Sometimes, very good people, for reasons beyond their control, have credit issues, and unfortunately, that's a real barrier to entry in the world of small business," said Steck.
It is difficult to qualify for a small business loan with a credit score lower than 700.
"A score of 720 seems to be the magic number, above which your likelihood increases dramatically and below which it decreases dramatically," said Brian Cairns, founder of ProStrategix Consulting, which provides a host of services to startups and small businesses.
If your score is under 700, Cairns recommends you focus on fixing it if you can. Begin by checking your personal and business credit scores to ensure they are accurate. If you find any errors, correct them before beginning the loan application process. You can order a free personal credit report yearly from each of the three credit-reporting companies on AnnualCreditReport.com or individually from each credit-reporting agency – TransUnion, Equifax and Experian. To check your business credit score, contact Equifax, Experian and Dun & Bradstreet.
Additionally, you should build a strong personal credit score and drive down any debt prior to applying for a business loan.
"The better your personal finances are upfront, the more likely you are to be approved for a good loan option," said Jared Weitz, CEO and founder of United Capital Source, a lender for small and midsize businesses.
"Most loans require some form of down payment, and this is typically varied based upon the borrower's financial history and the collateral put up for the loan," Weitz added. "Based on this, most loans range from zero to 20% down payment for the loan."
If your credit is still far from ideal after you take these steps, consider nontraditional financing options – which tend to place less emphasis on credit scores – before giving up on getting a loan.
"Angel investors, or individuals interesting in backing the business in exchange for a share in the eventual revenue, can be a way to help get your business off the ground," said financial attorney Leslie Tayne of Tayne Law Group.
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2. Limited cash flow
Cash flow – a measure of how much cash you have on hand to pay back a loan – is usually the first thing lenders look at when gauging the health of your business. Insufficient cash flow is a flaw that most lenders can't afford to overlook. Therefore, it's the first thing you should consider to determine if you can afford a loan.
"Really thinking through that cash flow equation is like preventative medicine for your business," said Jay DesMarteau, head of regional commercial specialty segments for TD Bank. "You can either wait until your business gets sick, or you can do things to prevent it from getting sick."
One of the preventative measures DesMarteau recommends is to calculate your cash flow at least quarterly. If you take that step, you may be able to optimize your cash flow before approaching potential lenders.
To figure out how large of a loan payment you can afford, divide your net operating income by your total annual debt to calculate your debt service coverage ratio. You will have a ratio of 1 if your cash flow is equal to your monthly loan payments. Though a ratio of 1 is acceptable, lenders prefer a ratio of 1.35, which demonstrates you have a buffer built into your finances.
"If you're not sure of your current financial position or capacity, sit down with a financial planner to help you gain the perspective you need and create an action plan to address any lacking areas," said Chad Rixse, director of financial planning and wealth advisor at Forefront Wealth Partners.
3. Lack of a solid business plan
Having a plan and sticking to it is much more attractive than spontaneity in the finance world. It also gives you a better chance of getting a business loan.
"Lenders want to see that you have a well-thought-out plan for your business," Tayne said. "Applying for a loan with no business plan or with a half-baked plan will not bode well."
It isn't uncommon for very small businesses not to have a formal business plan – or any plan at all – but you'll still need to put in the time and work to develop a comprehensive business plan before ever walking into a lender's office.
"If you don't have a documented plan in place, with financial information and projections, your chances of receiving the big loan you want will dwindle," said Weitz.
A standard business plan includes a summary of your company, market, products and financials. If you're not sure your plan is persuasive enough to sway the lender, consider seeking the advice of a business plan expert who can review it and offer feedback.
You should also be prepared to explain how you plan to use the money you want to borrow.
"Applicants can position themselves much better by being able to call out exactly what they need and what they need it for," said Bernardo Martinez, the former U.S. managing director for Funding Circle, a small business loan platform.
"Instead of asking for $100,000 in working capital, if an applicant says they need $33,000 for inventory in advance of their busy season, $37,000 for new hires, $20,000 for upgrades to their store and $10,000 for advertising, we are much more confident in their ability to effectively deploy the funds," Martinez added.
At the bare minimum, loan applicants should be prepared to explain why they want a loan and how they plan to repay it.
4. Too many loan applications
Some business owners assume they can cover all their bases by applying for multiple loans at one time. This way, they can pick and choose from a range of potential offers. However, opening too many loan applications at once can be a red flag for credit bureaus.
Before approaching potential lenders, business owners should have their act together. That means having all the paperwork necessary for your loan application on hand.
"One of the things that can be a problem when applying for a loan is if business owners don't have the documentation that the bank will require," Steck said.
Obligatory documentation often includes a detailed business plan and proof of collateral; extensive financial records such as income tax returns, personal and business bank statements, loan history, and a balance sheet; and legal paperwork, such as franchise agreements, business licenses and registrations.
There are many resources that business owners can refer to when putting together their loan applications. The Small Business Administration, for example, provides a highly detailed loan application checklist for borrowers. Using these resources decreases your likelihood of coming across as disorganized or unprepared.
Careless errors will land your application in the rejected pile. "Filling out the application incorrectly or omitting information is another common mistake that can lead to your application getting denied," Tayne said.
Tayne also pointed out that sloppy bookkeeping and inconsistent business practices, such as mixing business and personal bills together or not filing tax returns, can prevent you from getting financing. She advises taking the time to gather all the necessary information, fill out the forms completely, and read over your application before submitting.
6. Failure to seek expert advice
When you apply for a business loan, lenders want to see that you've sought guidance from knowledgeable advisors.
Accountants can be an important source of advice for small business owners, according to Stephen Sheinbaum, CEO of Circadian Funding, which helps small and midsize businesses obtain working capital. He has collaborated with the CPAdirectory in the past.
"But there are many other places to find good people to talk to, such as the Service Corps of Retired Executives (SCORE), a free mentoring service that is supported by the Small Business Administration," he said. SCORE connects you to retired businesspeople with experience in your market. "This is important because they will know about the kind of capital that is most important to people within your industry."
Sheinbaum also recommends that business owners get financial advice from business networking groups and conduct research on the websites of the leading alternative funders, since many have detailed resource sections for small businesses about the many kinds of available capital and the best ways to prepare for funding.
7. Failure to shop around
Finding a lender can feel so daunting that it might be tempting to sign up with the first one that comes along. But blindly pursuing one loan provider without exploring your other options is a mistake. Take the time to research a variety of traditional and alternative lenders to find the best fit for your business.
Financial institutions in the community where you plan to do business are an ideal place to start looking for a business loan, according to Logan Allec, a CPA and founder of the personal finance site Money Done Right. "Start with a community bank or credit union that is more invested locally, as they may have certain programs to be able to work with new local businesses."
The SBA also provides federal backing for some businesses to receive loans through partner financial institutions. "This can be an excellent avenue to explore if you are having trouble finding a traditional lender for your business," Allec said.
Other alternatives to traditional lenders are online lending platforms, peer-to-peer lending sites, and your own network of friends and relatives. If you pursue this last option, Allec suggests working up an official, notarized agreement to avoid any misunderstandings or conflicts down the road between all the involved parties.
When shopping around, you can also request that each lender help you calculate the annual percentage rate of their loan offer.
"The APR tells you the true cost per year of borrowing money; it takes into account your interest rate plus any additional fees and charges," Martinez said. "This will help you make an apples-to-apples comparison of different loan offers."
So much of the application process for a business loan is methodical, directed by the orderly presentation of concrete documentation, that it's easy to forget there is an innately emotional component to this process as well. Too many business owners simply don't demonstrate why they, rather than someone else, are a good candidate for a loan. They approach lenders with an apathetic attitude, according to Steck.
In addition to making a sound business case for why you should qualify for a loan, you need to exude enthusiasm and faith in your venture to draw in the lender and makes them a believer. To do this, you must tell a story about your business that the lender finds compelling.
"'I'm going to do this, and I'm going to be the best in the whole wide world' – you have to go into it with that sort of mentality, and a lot of potential borrowers don't do that," Steck said.
Weitz echoed this sentiment. "The more prepared, serious and passionate you appear about your business, the more trust a lender will have with approving you for the loan."
What are the different types of business loans?
Depending on your needs, you have many kinds of lending options. Here's a brief overview of the most common types of business loans.
These small business loans are processed by participating lenders – which are often banks – but, because they are guaranteed by the U.S. Small Business Administration, lenders have more confidence in repayment. Even if the borrower defaults on the loan, the lender will still get back up to 85% of its money from the government. The maximum loan amount you can receive for an SBA loan is $5 million. SBA loans are desirable for small businesses because the rates and terms are lower and more lenient than many other options.
Typically offered by banks and online lenders, short-term loans range from $5,000 to $250,000. They are generally repaid in less than a year. It takes up to two days for borrowers to receive funding from this type of loan.
Long-term business loans
Instead of providing funding for startup costs, long-term loans are meant to help grow established business. They are often not fully repaid for several years, but they have low monthly interest rates. You can generally secure long-term loans of up to $100,000 from banks.
Online or direct alternative lenders are often willing to provide financing options for borrowers with bad credit. With these lenders, your credit score isn't the determining factor for approval. Instead, they consider your cash flow and recent bank statements to determine your eligibility for the loan. While you can typically be approved quickly, you are likely to face high interest rates and/or brief payback periods.
Secured loans require collateral from the borrower, which can be property, vehicles, equipment, stocks or other assets of value. Offered by banks and credit unions, secured loans are often easier for new businesses to get and have lower interest rates than unsecured loans. Loan amounts typically range from $50,000 to $100,000.
Unsecured business loans don't require collateral, but because this makes the loan riskier for the lender, interest rates are often higher, and borrowers must have high credit scores to qualify. Unsecured loans are usually offered by online lenders – including peer-to-peer lenders – and by banks and credit unions as personal loans. Loan amounts can go as high as $50,000.
Merchant cash advances
Merchant cash advances are available from dedicated merchant cash advance companies and some credit card processors. It's a loan against your business's future earnings that you repay through a percentage of your credit card sales. It is a fast way of securing funding because it doesn't require collateral, which means quicker turnaround for approval, but interest rates can be very high. It's typically used by retail stores or restaurants. Merchant cash advances can range from $5,000 to $500,000, and repayment terms vary between three and 18 months.
Equipment financing is a loan from online lenders that you take out to purchase tools or other equipment for your business. It doesn't require a down payment, which helps you preserve your capital and maintain cash flow. The equipment you buy is considered the collateral for this type of loan, which means that if you default on the loan, the equipment you bought will be repossessed. Loan terms range from two to 10 years, and amounts range from $100,000 to $2 million.
Invoice factoring is when your company sells its invoices to a factoring company for cash. This helps you maintain cash flow for your business. The factoring company gets paid once your customers pays their balance. Invoice financing helps you avoid cash shortfalls, but it's usually more expensive than other types of funding. It also limits the control and communication you have with your clients. For example, you can't decide how the invoice company collects invoice payments from your customers.
How do you apply for a business loan?
When you apply for small business financing, it's important to understand what information small business lenders need from you so you can gather the appropriate documents. Typically, you will need these documents:
- Up to three years of financial statements or tax returns
- At least three months of bank statements
- Accounts receivable reports
- Proof of ownership
Your credit score and history will be taken into consideration, so it's helpful to have good credit, which usually means a score in the range of 690 to 850. Scores below 689 are considered fair credit, and those below 300 are considered bad credit.
Cash flow is another important factor for business lenders, because they want to ensure you have enough revenue and sales to pay them back. Your debt-to-income ratio is also vital – the more debt you have, the more difficult it will be to get approved. For new small business loans, lenders prefer a 1.35 debt-to-income ratio.
Lenders want to see that you have a strong business plan and blueprint for continuous profit, showing them that you can repay the loan. This is especially important if your new business doesn't yet have steady cash flow.
Some lenders will request collateral. As mentioned above, collateral can take many forms – property, vehicles, stocks or any asset of value – but you must understand that if you fail to repay the loan, the lender will keep the assets you pledged.
After you submit your business loan application, depending on the lender and the type of loan, it can take days, weeks or even months to get approved.
Paula Fernandes and Elizabeth Peterson contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.