Borrowing money is usually the last thing a business owner or aspiring entrepreneur wants to do. But just like an annual physical exam is good for you, sometimes a business owner must borrow money to grow a business, start a new venture or simply survive hard times. For those who have never approached a bank for a business loan, the process can be confusing and intimidating. Knowledge of the loan process is key to overcoming that apprehension.
So how does it work? The starting point for every business loan is writing a business plan, describing how you intend to operate your company for the next three to five years. Gone are the days when you can visit with a banker for 15 minutes and walk out with a check. Preparing a business plan forces you to think about operational details and create financial projections. When your plan is ready, make an appointment to speak to a banker with whom you would like to form a long-term business relationship.
When assessing the merits of a loan request, the banker will focus on three main issues—good credit history, equity investment by the owner and collateral. What credit score is considered “good enough?” While this varies from bank to bank, a score of 700 or better should result in a serious evaluation of your loan request. Occasionally, those with scores as low as 650 earn a seat at the table. If your credit score is less than 650, you should take steps to repair your credit history before seeking a business loan.
Bankers usually insist that business owners also have some “skin in the game,” meaning that the owner has personal funds invested in the venture. The amount of equity bankers expect owners to invest varies from deal to deal, but the general rule is 20 percent of the total funding needed. This percentage varies up and down depending on the industry, perceived risk involved and strength of the business concept. To improve your chances of securing financing, show the bank that you have a secondary source of repayment of the debt—some source of funds other than the business itself. The income of a spouse not working in the business is a good example.
How much collateral will the bank require? Banks become much more willing to make a loan when the value of the collateral pledged is equal to or greater than the loan amount. The value placed on each asset for collateral purposes is determined by the bank. The purchase price or fair market value of the item does not determine its collateral value. For example, banks commonly value inventory at around 55 percent of its purchase price, and accounts receivable at 85 percent of face value.
You want me to do what?
So, you are at the closing table with a great business plan, good credit score, collateral, and equity invested yourself. It’s a “done deal,” right? Unfortunately, no. At some point in the process, the bank will require you to sign a “personal guaranty” of the debt. Many entrepreneurs labor under a misunderstanding that their business can borrow money without subjecting the owners to any personal debt risk. Additionally, most banks expect the borrower to pledge personal assets as collateral, often including a second lien on their home. Try selling that one to your spouse. When borrowing money for your business, be assured that you are jumping in with both feet!
What if you are a little light on collateral, your credit score isn’t quite as good as the banker would like, or the bank thinks your business idea is a bit too risky for them to make the loan? Fortunately there is a solution available to bankers in these situations. When a bank perceives a loan to be too risky, there are many federal, state and local loan programs the bank can use to enable them to proceed with the loan. Below left is a chart describing just a few of the many government loan programs available to area banks.
At the federal level, the Small Business Administration (SBA) has far more loan programs available than those listed. All SBA programs work in a similar fashion—the bank loans the money and the SBA guarantees (essentially co-signs your loan) repayment of 50 to 90 percent of the loan amount. If the borrower fails to pay, the SBA pays the bank. The borrower first must obtain loan approval from the bank. If the bank agrees to loan the money, it will obtain the SBA’s signature on your behalf. An owner investment of 20 percent is usually mandatory.
State, county and city loan programs generally operate in similar ways. A bank must be the “lead lender,” loaning the majority of the amount requested and analyzing the borrower’s creditworthiness. The governmental body will loan the remainder, up to the maximum applicable to that program. One big advantage of these programs is the low interest rate charged, usually below the prime rate. Locally, Peoria, Tazewell and Woodford counties have loan programs, as well as the cities of Peoria, East Peoria, Chillicothe, Makinaw, Pekin, Eureka, El Paso and Metamora. iBi
Ken Klotz is director of the Turner Center for Entrepreneurship at Bradley University, which provides business counseling, technical assistance, training and educational activities for individuals interested in owning their own businesses.
Financing options can be confusing. For help in sorting out the possibilities, contact the Turner Center for Entrepreneurship at Bradley University by calling 677-4321.