Small business is big business. Small businesses account for a large portion of the private work force in the country today and have a high potential for growth as a sector of our economy. To fund that growth, small businesses need access to capital, either through loans or investment capital. However, small businesses, and especially new businesses, often do not have the collateral or credit history to qualify for financing. How can you help your dreams for your small business become a reality?
There are two main ways to acquire the capital needed to fund your small business. Equity financing is one way, whereby you sell shares of stock in your business to raise the capital needed to get off the ground or expand. The more common method to obtain cash is through debt financing, which means obtaining a business loan from a bank or other financial lender. However, without a proven track record, securing a business loan can be difficult. Following are insights into what banks typically look for when evaluating a business loan application: generally, banks look at capital, collateral, credit, and capacity to repay when evaluating a small business loan application.
Many entrepreneurs who want to start their own small businesses look to a bank to finance most or all of the capital needed to get the business off the ground. However, lenders are typically uncomfortable with business owners who are not strongly invested personally in their businesses.
Most of the money you need to start a business should come from you or your partners. You "put your money where your mouth is" by sinking what you have into your business, even if that means living on a shoestring or mortgaging your house. And, as your business grows, you should plow the profits you make back into the business, rather than pocketing the cash. This demonstrates your desire to grow and expand the business while keeping it healthy. By demonstrating such a personal financial commitment to your new business, you will be much more successful in persuading a lender to commit its resources as well.
As a start-up or relatively new small business, you may not have the collateral yet to offer as a guarantee for a loan. Your balance sheet may be the only indicator a lender may have to determine the quality and quantity of your collateral. Generally speaking, the amount of debt you and/or your business has should always be measured against the amount of assets you hold. Concentrate on the debt portion of your balance sheet, and evaluate the decisions you have made to create income or revenue from those liabilities, which in turn should create assets. If you have made sound financial decisions, it will typically mean an acceptable debt-to-equity ratio. Even if your business' total net worth (total assets less total liabilities) is small, producing a positive net worth is key.
If a lack of collateral continues to stand in the way of your securing a loan, there are resources to which you can turn for assistance. The government-backed Small Business Administration (SBA), for example, helps start-up and small businesses obtain initial financing by guaranteeing the loan. By acting as a "co-signer" for your business, the SBA helps to guarantee repayment to the bank.
Your personal credit history and that of your business are extremely important to lenders. Your ability to repay debts on a timely basis will be a key factor in whether your business obtains financing. Keys to maintaining a good credit history include saving money for the business, monitoring debt and controlling costs. If operating margins and overhead costs are controlled, your ability to manage assets and repay debts in a timely fashion is increased.
Capacity to Repay
In order to substantiate your ability to repay the loan, you must be able to show a lender that you can meet business expenses, your salary, and loan payments from the revenue your business generates. Typically, the capacity to repay is evaluated by previous financial statements and projected cash flow statements. If you are just starting your business, you need to produce a business plan with short- and long-term forecasts that project these future revenues. Although your credit history provides a snapshot of previous obligations, the capacity to repay measures the amount of financing requested against the current financial strength of the business and its estimated future financial success.
While all of the above criteria are important and necessary in evaluating your business, a lender will also look to you, the business owner, when determining whether to extend financing to your business. Your commitment to the business will, in many ways, affect the lender's commitment to your business. You must demonstrate your commitment to long-term planning and the amount of personal sacrifice that will be required to make the business successful. Rather than looking to the lender to shoulder the financial responsibility of getting the business off the ground, you should be willing to invest as much of your own capital as possible and use financing to leverage that capital to grow and expand the business.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.