Basic principles of credit

The federal and state governments have a vested interest in encouraging small businesses to flourish and grow. It is these businesses which form the backbone of the American economy and indirectly strengthen its social fiber. The government thus encourages banks and other financial intermediaries to lend to small business through various incentives. However, good intentions are not always enough. Before you apply for any loan, you should understand the basic principles of credit, commonly known as the five C’s of credit. These are the underlying tenets on the basis of which banks approve or reject any type of loan (business or otherwise):

Character - How reputable is the borrower? This can be gleaned from your credit report and past business history.

Capacity (to repay) - Would you be able to make the interest payments and pay back the loan? This is determined from your company’s balance sheet and cash flow or even from a proposed business plan.

Capital - How much of your own money you have on the line. The banks would be willing to partially fund the financial requirements, with the rest of the capital being put up by the entrepreneur. They would want the borrower to fund a part of the business through equity contributions.

Collateral - What assets can you provide to the lender as security? This can be physical property or even intangible assets like business receivables. You don’t always have to provide collateral, but you will have a smoother experience in getting a loan approved if you do.

Covenants - These are conditions which specify the use of the loan. For example, the bank may ask you not to take any other loans until their loan is repaid or only use the loan for specific things like buying inventory. These covenants are determined on a case to case basis.

Types of Small Business Loans

Grants

Grants are essentially non-repayable funds which are disbursed by any government or private agency for a specific purpose. Since grants do not have to be paid back, they are the first source of funding that you should research. The catch with grants is that they are only made for specific projects which are expected to have a social impact or research opportunities. Many grants are targeted specifically towards minorities, women or veterans. It is generally a good idea to search for any available grants before looking at other options.

If you feel that your project or idea qualifies for a grant, here are some links to start you off:

  • Grants.gov - A government database of available grants.
  • Women’s Business Centers - State wise listing of Women Business Centers which offer assistance to female entrepreneurs.
  • Economic Development Agencies - State and local government sponsored agencies which offer not only loans but other assistance like training as well.

These are great starting points but there are hundreds of other grants which you can search for locally and on the internet. That being said, don’t be discouraged if you can’t secure a grant for your business. There is a lot of competition for grants since it is a free source of funding and they are only available for very specific projects.

Crowdfunding

Crowdfunding is a novel concept in the world of finance. Over the last few years, it has exploded into mainstream finance and overtaken some traditional sources of venture capital funding. There are dozens of crowdfunding platforms (like kickstarter.com, indiegogo.com etc.) and each is suited to specific types of business ideas. Here are some pointers:

  • Crowdfunding usually requires a flashy new product and you have to generate sufficient hype or excitement around it on the internet in order to succeed.
  • Crowdfunding can be time consuming since you have to spend a considerable amount of time on your crowdfunding campaign rather than focusing on the actual business.
  • You would have to pay a fee to the platform or website where you register your product - this can amount to a total cost of between 10% to 15% of the total funding raised.
  • Success is not always certain or even likely - it depends more on your marketing skills rather than the quality of the underlying product.
  • A crowdfunding campaign can be structured as a loan (debt crowdfunding) or even as a donation or rewards based campaign. Do your research before you dive in.

Note: Equity crowdfunding is specific type of crowdfunding where you have to give the investors a share of your company in return for funds and it is, therefore, not a loan.

SBA loans

SBA loans are one of the most popular funding option for small businesses looking for some capital. They offer a decent rate of interest and, if you have the proper paperwork and some collateral, are unlikely to be rejected.

Loans are made by regular banks and a portion of the loan is guaranteed by the Small Business Administration (SBA) and this gives lenders some confidence to offer better rates to small businesses. As an example, current rates for the SBA 7(a) loan program range between 6% to 9% per annum. Here are some tips if you want to go in for an SBA backed loan:

  • SBA 7(a) loans are general purpose loans that can be utilized for working capital, expansion, debt refinancing etc.
  • There are certain criteria which have to be met like having a business running for at least 2 years, the business being profitable, the owner having a good personal credit score and so on.
  • The loan might require a down payment and some form of collateral to secure the loan. Down payment is only required if you are buying something like equipment or real estate. The collateral requirement depends on the strength of your business and might even be waived off.
  • There are specific loan types available for exports or working capital lines of credit. You should match your requirements with the type of loan for the highest chance of approval and to get the best deal.
  • There are additional costs associated with loan processing and disbursement. These are usually represented as a percentage of the total loan and are deducted upfront. Please check for all such charges before going ahead with a lender.
  • Different banks might have different criteria for disbursing SBA loans. It is best to shop around in your area for the best possible terms.
  • Loan approval can be a lengthy process taking several weeks and some back and forth. It is best to plan ahead.

There are a number of government agencies which specifically assist different minority communities to secure a business loan:

  • The Minority Business Development Agency is a government agency which assists members of the minority communities to get in touch with the right local agencies in order to secure funding for their business.
  • The United States Hispanic Chamber of Commerce represents over 4.2 million Hispanic owned businesses and has over 200 local centers. It is an excellent place for entrepreneurs to share ideas, contacts and get the necessary information and assistance to start a business.
  • In addition, there are hundreds of state and local organizations that assist specific communities. For example, the Latin Business Association represents over 800,000 Latino owned businesses in California and The Latino Coalition assists its members to secure capital as well as contracts. You can find more such groups at the local and state level.

Microloans

SBA microloans are made for amounts under USD 50,000 and for a period not exceeding 6 years. Unlike regular SBA loans, you can’t use SBA microloans for buying real estate or refinancing debt. They are usually available for funding working capital requirements like inventories, wages etc. The interest rate is slightly higher than for regular SBA loans - usually between 8% to 13% per annum. Here is a government approved list of SBA microlenders.

In addition to SBA microlenders, there are certain other non-profit organizations which also provide small loans up to USD 50,000 at acceptable rates of interest. These organizations usually lend to projects which can have a positive social impact on a community. Some of the bigger microloan lenders are: LiftFund, Grameen America, Opportunity Fund, etc. Most of these are geared towards women or minority community entrepreneurs. For example, the Opportunity Fund claims that almost 88% of its loans have been disbursed to minority community borrowers.

Online business loans

There are some online options to get fast approvals on loans ranging from a few thousand dollars all the way up to half a million dollars in a matter of hours. These loans are offered by online portals which can approve a loan based on your credit score, business history and financial statements. The flip side is that these loans can be just as expensive as credit cards, if not more. We are talking anything from 15% to 50% per annum or more.

The actual interest rate would depend on your credit history and the strength of your company’s balance sheet. You are free to check your rate online but if it’s more than 5% higher than what you would get from you local bank, then you ought to avoid it. Such high interest rate loans are not recommended except in emergencies and for a very short period of time. Some online portals offering these types of loans are: Kabbage, Ondeck, Prosper and Fundbox.

Personal Loans and Credit Cards

If you have a good credit score, you can usually secure a personal loan or even get a credit card. Many business owners still use these methods for funding despite extremely high interest costs which can even crawl up to 30% per annum. Because of these high costs, these options are best avoided for long or even medium term use. If you are paying so much for a loan, you are not doing it right!

Things to keep in mind when applying for a loan

  • Keep your documents ready - These include financial statements, projections, income tax returns, business documents, details about owners etc.
  • Have a clear understanding of how much you want, why you want it and how and when you plan to pay it back.
  • Ask about interest rates and other fees like disbursement fee, processing fee, late payment penalties etc.
  • Check your credit score before you apply. Details about your credit score and how to analyze it can be found here.
  • See if you can provide some collateral - it will get you better terms and make the process a bit easier.

Conclusion and Some Final Thoughts on Debt

Debt is a powerful tool which allows you to leverage your own capital and create value. Even large multinational corporations take on loans and it is a perfectly healthy business practice. The real trick is to know how much debt your business can handle. Too much debt can spiral out of control, especially if there is some business or market stress. It is best to be conservative and have access to additional lines of credit in case of any unforeseen eventualities.

When you start searching for a small business loan, your main goal should be to match the terms of the loan to your specific requirements and to minimize the interest rate as well any fees. Your local chamber of commerce or credit union would be a great place to start. Although it might be tempting to get a loan online with the advertised “instant approval”, the high interest costs they charge are almost never worth it. Remember, if it sounds too good to be true, it probably is.