Small business loans can be hard to get. But why?
Banks look at a range of criteria when qualifying clients and may deny small businesses due to short time in business, poor (or lack of) credit history, personal credit history of the owners of the company, weak cash flow, lack of collateral, or simply because the lender has allocated their resources to more profitable accounts.
Even loans issued by the SBA (U. S. Small Business Administration) can be challenging. There are specific requirements to meet, and the application and approval process can be long and cumbersome. Additionally, the recent Paycheck Protection Program loans, while no longer available, taxed the resources of the SBA, resulting in additional delays.
Four Reasons Banks Turn Down Applicants for Small Business Loans
- Poor credit history – There isn’t a standard set minimum credit score needed for small business loans, but banks prefer a small business owner with higher personal scores (think 700+) as an indication that they are likely to pay back their debt. Because of this, small businesses typically have a hard time getting a bank loan without a reputable credit history or established creditworthiness. This doesn’t necessarily mean that they have bad credit due to previous late payments, but simply because they haven’t been in business long enough.
Furthermore, banks put more emphasis on credit than character. So, regardless of the overall strength of the business and opportunities presented, companies may need to find an alternative lending source where credit history is not as imperative.
- Weak cash flow – Banks consider healthy and well-established cash flow as one of the key indicators in the ability to pay off existing debts. Business owners may have difficulty getting a loan from a bank if the company’s operating costs outweigh the money that is entering the business. Oftentimes small businesses experience this problem for a number of reasons: seasonal business fluctuations, slow paying customers or high debtor (customer) concentrations. Most of these are inevitable for smaller companies and hinder them from getting the funding they need to survive, let alone grow.
- Lack of collateral – Lenders prefer to work with companies that can pledge collateral (assets such as equipment or property) to secure the loan. The lack of collateral can significantly affect the ability to qualify for a loan. As a result, banks often ask for the business owner to pledge their home or other assets as additional collateral!
- Resources allocated to more profitable accounts – Banks are more likely to extend their efforts and capital to companies that generate more revenue for their institution. Not only do small businesses seem like riskier clients, but they are also simply not as profitable as larger businesses.
The Good, the Bad and the Ugly Alternatives to Small Business Loans
The Good: Invoice Factoring and Asset-Based Loans
When a bank loan is not an option, small businesses should consider working with alternative lenders, such as those that offer invoice factoring or asset-based loans. These companies typically put less emphasis on credit history and time in business than do banks and because they don’t have the lending covenants of banks, they can be more flexible in their lending criteria.
Invoice Factoring Defined
Invoice factoring is not a loan and is for B2B (business-to-business) companies that invoice their customers and receive payment on terms. The company actually sells their unpaid invoices to a factoring company, who pays them a significant portion (typically 85-to-95%) of the invoice up front. The factoring company then collects payment from the invoiced company and pays the client the remainder of the invoiced amount less the factoring company’s fees.
There are several reasons a small business can benefit from financing their invoices versus getting a loan. Here are reasons to consider invoice financing over a small business loan:
- There is a possibility of outgrowing a loan.
As businesses grow, they will likely need additional capital to keep up with that growth. Traditional lenders, however, might not be willing to increase capital as freely as a small business requires. It is a lot easier for a company to increase capital through factoring, as long as their customers are creditworthy.
- Loans increase debt.
Unlike a traditional loan, financing accounts receivables does not require a business to “borrow” money. With factoring, the factoring company purchases invoices, providing you the liquidity needed to run the business. This could be a great debt-free option for growing a business, especially if the business is borrowing money for other business necessities such as equipment.
- Businesses that experience seasonality may struggle to keep up with monthly payments. Factoring can be an alternative financing solution because it allows companies to submit invoices as they are generated.
- Loan approvals can be slow.
One major perk about factoring is the speed of funding. If you have invoices for credit worthy customers (debtors), factoring companies may be able to extend credit in as little as one day. Additionally, once you’ve established a relationship with your factoring company, approvals for additional credit for new or existing debtors can be completed within a few hours or sometimes instantaneous.
Asset-Based Loans Defined
Asset-based loans (ABL) are a type of revolving line of credit, secured by various types of collateral, most often accounts receivable, inventory, and equipment, but can also include real estate. ABL provides a continual stream of cash for operations and can be a good option for companies that have cash tied up in accounts receivable, equipment, raw material or finished goods inventory.
The initial application and approval process can take longer than a simple factoring approval, but once approved, ongoing funding is fairly simple and quick. Most asset-based lenders require periodical physical inventory checks of the secured collateral in order to make adjustments to the available credit line.
The major benefits of invoice factoring and ABL are:
- Cash flow will improve
- Funding grows as the business grows
- Getting started is fairly easy
The Bad: Peer-to-Peer Lending and Crowdfunding
Peer-to-peer lending and crowdfunding are not practical options, and they aren’t always the most reliable. For one, you have to market yourself in order to get investors. If an investor decides to take stake in your business, they will also want some sort of return in its success. Secondly, money coming in through these sources is not consistent and forces companies to eventually seek other funding options.
The Ugly: Merchant Cash Advance
Merchant cash advances should be the ABSOLUTE LAST OPTION for small business owners, and business owners should be fully aware of how MCAs work before getting into a contract. MCA loans come with high interest rates that are often impossible to calculate. They may seem enticing with easy approval and the quick influx of cash, but MCA loans can be a debt trap. Once an MCA agreement has begun it can be difficult to get out of.
Alternative Lending for Small Businesses is a Viable Option for Companies that Cannot Get a Bank Loan
Small business owners do not always have to go through a traditional bank to get the money they need to grow their companies. There are many options for alternative financing that business owners should consider before applying for a loan or even if they’ve been denied a business loan from a bank.
To learn more about invoice factoring and asset-based loans, visit www.commercialfund.com.
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