This article is part of our How to start a business playbook, which covers topics like finding the right business idea, writing a business plan and finding small business loans.
When you’re building a new business, one of the most important considerations is how you’ll cover your expenses. Businesses of every age wrestle with balancing cash flow and investments—your small business is no different.
We know that a large percentage of new businesses fail within the first five years. The overwhelming majority of those businesses (82% of them) fail because they can’t get cash flow right. When expenses come due, you need to be able to pay them. It’s an issue of revenue, but it’s also an issue of timing. That’s what makes it so hard to build a healthy cash flow.
Whether you’re just getting started or have been in a business for a while, a small business loan is one of the ways you can balance cash flow, cover your costs, and invest in growing your business. In this guide, we’ll talk about:
- Determining if you really need a loan and if your business qualifies for one
- Understanding your options when it comes to lenders and types of loans
- What to expect during the loan application process
Do you need a small business loan?
How do you figure out if a small business loan is right for you? The first step is to assess your expected costs. How much money will you need to set up the business (from registering your business to hiring employees to renting a retail space)? The average small business owner needs about $10,000 to get started, but that can vary widely from one industry to the next.
Write down each cost and add them all up. Once you have an idea of your initial startup costs, consider how long it will take for you to break even and turn a profit. You’ll need enough cash to cover regular operating costs (like website hosting, purchasing inventory, and payment processing fees) during this time, so add that amount into your total startup costs.
For some businesses, that might be an awful lot of money—much more than you have in your rainy day savings account. Depending on the type of business you’re launching, there may not be so many upfront or standard operating costs. For example, as a freelance writer, my startup costs were less than $100. If that’s the case, you likely don’t need a small business loan (at least not right now.)
If your business doesn’t need a loan, skip right on to the next chapter.
Will you qualify for a small business loan?
Now that you’ve established your business actually needs a loan, let’s find out if you’re likely to qualify for one. Every lender has their own set of requirements that businesses must adhere to get approved for a loan, but there are some common threads throughout most of the lending industry.
- A good credit score: If you’re launching your first business, lenders will look to your personal credit score. They’re looking to see how you manage debt and how reliable you are about paying it back. If your FICO score isn’t looking so hot, try Experian’s tips for improving your credit score before you apply for a loan.
- Years in business: This is where many new businesses get stuck. Lenders want to see a history of business success, so it’s often harder for brand new businesses to get a loan. But that doesn’t mean startups can’t get one. Strong experience within the industry can make up for a fledgling business.
- Strong business revenue: Again, a tough one for startups and new businesses to achieve. If you’re just getting started, highlight your revenue growth, instead of the total amount—lenders want to see you’re on track for success.
- Ample collateral: In the event that your business fails for any reason, lenders want to ensure they can get all or at least part of their money back. That’s why having collateral (like real estate or machinery) makes your loan application more attractive to lenders.
Every lender has unique requirements for small businesses to get approved for a loan. If you don’t meet all the requirements above, don’t fret—some banks and most alternative lenders are flexible.
If you don’t meet any of the requirements, a business loan may not be right for your business. If that’s the case for you, look into some of these other small business financing options:
Understanding your loan options
Types of lenders
When you’re ready to apply for a small business loan, you have a few options for where to look. You can get a loan from big banks, local banks, credit unions, or alternative online lenders. Each of these will have their own loan requirements and standard terms, so it’s important to weigh which one is right for you.
Here are a few things to consider:
Large, multinational banks are often the first lenders that come to mind. They include banks like TD Bank, JPMorgan Chase, Scotiabank, and Bank of America. Working with a big, well-known bank means you can be confident everything is on the up and up with your financing. Traditional banks loans also tend to carry some of the lowest interest rates available to small businesses.
While their size can be a benefit for you, the borrower, these banks actually have the lowest loan approval rate—greenlighting less than 26% of loan applications as of June 2018. Meaning your chances of successfully scoring a small business loan are small.
Local and community banks
Local banks are exactly what they sound like: small institutions that operate in a relatively small geographic location. That includes the single location bank in your hometown and some smaller chain banks. For example, in Boston, we have Commerce Bank & Trust Company, Eastern Bank, and Blue Hills Bank.
Community banks are one of your best options for a small business loan. With approval rates nearing 50%, you’re much more likely to get approved for a loan from a local bank. They still carry the lower interest rate of a traditional loan and the approval process can be quicker and more flexible at these smaller institutions.
Credit unions are similar to local banks in their size and loan approval rates (around 42%), but there’s one important difference: credit unions are typically nonprofit. As such, loan interest rates tend to be lower at credit unions, the approval process is often faster, and you can even apply for a smaller and more flexible loan amount.
Most credit unions are staples in their communities—meaning they offer educational resources like workshops, networking events, and other help for small businesses.
Alternative and online lenders
When the recession hit in 2011, lending from most traditional banks plummeted, and the rebound has been slow, to say the least. In the wake of this financial reality, online and other alternative lenders sprung to take their place. Today, alternative lenders approve small business loans at a whopping 60.7%.
Online lenders are the easiest way to get a loan, and they’re often the most flexible about loan requirements, the approval process, and repayment terms. That said, alternative lenders also charge the highest interest rates, meaning you end up losing out as you pay back the loan amount.
Types of loans
Once you decide where to secure a loan, it’s time to look into the different kinds of small business loans you can get. There are many different types of loans available to businesses—from government loans to working capital loans to franchise startup loans. Which loan you choose will depend on:
- Your business
- Your funding needs
- How you’ll use the money
- Which lender you choose
Here, we’ll focus on three of the most common loans for small businesses: traditional loans, SBA loans, and lines of credit.
Traditional small business loans come in a variety of forms, depending on your capital needs and what you’ll use the money for. They include:
- Working capital loans: These are short-term loans that help lubricate your cash flow and cover operating costs as you grow revenue. They can be invaluable if it takes longer to turn a profit than you expect, but also tend to come with higher interest rates and shorter repayment terms.
- Equipment loans: If your business requires you to make large equipment purchases, an equipment loan makes it easier for you make those upfront purchases while stretching out the repayment over time. These are also one of the easiest loans to get.
- Merchant cash advances: This type of loan is essentially an advance on future credit card sales you expect to make. The loan amount is based on your typical monthly credit card transactions, and repayment comes out of future transactions. Like working capital loans, though, these can come with sky high interest rates.
- Professional practice loans: Designed for professional services businesses, this type of loan can help you cover the cost buying a practice or real estate, refurbishing office space, or refinancing other debt. These are typically used in healthcare, accounting, legal, and insurance fields.
- Franchise startup loans: Just as it sounds, this type of loan covers the startup costs of opening a franchise. Whether you need working capital or upfront funds to pay franchise fees, buy equipment, or building a store, a franchise startup loan will cover it.
- Invoice factoring: If your business offers length payment terms to customers, you can get a loan for the value of your outstanding invoices. The money is repaid as the invoices come due, plus a fee. Much like a cash advance, this type of loan can have interest rates as high as 30%.
Lines of credit
A line of credit is fundamentally different from other types of loans because you don’t borrow a fixed lump sum of money and then repay it all. With a line of credit, you gain access to a certain amount of capital, but you only withdraw it as needed. As you withdraw, you only pay interest on the money you take out—not the entire amount available to you.
Lines of credit are often easier to get approved for and typically don’t require any collateral. This type of loan can run anywhere from 90 days up to several years. They offer longer and more flexible repayment terms and are a good option for working capital, easing cash flow, and covering day-to-day expenses. Lines of credit aren’t ideal for larger amounts and purchases, like real estate or expensive equipment.
When your business is brand new (or your personal credit score needs some work), lines of credit can be an easy way to build up your credit score as you make timely interest payments. However, if you use the full amount or fail to repay as you go, it’s easy to end up with a huge debt on your hands when the full line of credit comes due.
Small Business Administration (SBA) loans
If you’re doing business in the United States, you can access loans from traditional lenders that are guaranteed by the U.S. Small Business Administration (or SBA). The SBA doesn’t lend money. Rather, the administration works with lenders to set business-friendly guidelines for loans—reducing risk for lenders and making it easier for small businesses to get approved.
SBA loans come with some additional requirements your business must meet, but they’re more accessible to business owners with less than stellar credit scores or little to no collateral. The SBA currently offers four types of loans. These are the three most important ones:
- 7(a) loans: The 7(a) Loan Program is the SBA’s flagship program. You can use (7)a loan money for almost any purpose. The basic idea is that the SBA guarantees these loans, so lenders are able to offer more flexible options, longer repayment terms, and larger amounts of money. These loans can range anywhere from $500 right up to $5.5 million.
- Microloans: Typical banks operate as for-profit organizations, so they’re more inclined to lend larger amounts of money that lead to the most profit for them. With SBA microloans, you can access a smaller amount of money that keeps the interest you owe low and the repayment terms more manageable. These loans vary in amount but the average SBA microloan is about $13,000. You can use microloans for almost any business expense except debt repayment and real estate.
- Real estate and equipment loans: For larger expenses like real estate and equipment, the SBA offers the CDC/504 Loan Program. You can use 504 loans to buy a building, land, or machinery, build or renovate facilities, or refinance debt resulting from a business expansion. Their chief benefit is that they’re long-term loans with a fixed interest rate, and you can borrow up to $5.5 million.
How to prepare your loan application
Once you’ve decided what type of loan is best for your business and where you’ll get it, it’s time to prepare your application and figure out what to expect during the loan application process.
Step 1: Gather all the documents you’ll need
The first step is to gather all of the documents and information you’ll need to submit along with your loan application. These documents give the lender a look into your business, financial, and personal history—helping them determine if you and your business are a good candidate for a loan. Here’s an overview of all the information you should have ready for the lender to look at.
Business information and legal documents
Before giving you a loan, lenders want to understand what your business is, where you came from, and what you do. They want an overview of your business and your history as a business owner. They also need to know how your business is set up since that can affect the type of loan you qualify for.
Here’s what business information and legal documents to prepare:
- Business overview and history
- Business licenses, incorporation documents, and franchise agreements
- Business address, contact information, and tax ID
Financial documents and history
Arguably the most important part of your business loan application is the financial information. Your business’ financials are where lenders spend the most time and they’re an integral piece of lenders’ decision.
How does your business make money? How do you manage that money? Are you profitable? If not, when will you be? Lenders want all these answers and more, so they’re looking for your:
- Financial plan
- Business and personal income tax returns (for at least the last three years)
- Profit and loss statements
- Cash flow statements
- Balance sheets
- Financial projections
Contact information is important for obvious reasons, but that isn’t the only personal information lenders need. They’re also looking to find out about your personal finances and your relevant experience and education in the industry.
Lenders want to see how you handle personal financial obligations and why you’re uniquely qualified to make your business a success. If you’re just launching the business, your personal history is even more important (because your business doesn’t have any history, financial or otherwise.)
Have ready your personal…
- Work experience
- Credit score and history
Step 2: Be ready for the loan officer’s questions
Now that you have all your documents together, it’s time to prepare for the questions a potential lender may ask. The documents you submit include some of this information, but you should also be able to speak to your business plans and financials if the loan officer asks.
Some of the questions to prepare for include:
- How much money do you need? You should have an answer to this question going into the application process. If you’re just launching, it’s likely based on the total startup costs we calculated earlier.
- How will you use the money? Lenders want to understand what you plan to do with the money so they can see how it will improve your business’ financials—and whether you’ll be able to pay back the loan when it comes due. How you’ll use the money also determines which types of loans are available.
- How will you repay the money? The loan officer will want to hear a detailed plan marrying your financial projections with the repayment terms. How will you get the money to repay the loan and interest?
- What will you do if you can’t repay the loan? If your business falls on hard times and you can’t repay the loan, what will you do? Do you have business insurance that can cover your debts? Can you put up collateral to guarantee repayment?
- What collateral can you offer? Speaking of collateral, many types of small business loans require some collateral—especially if you don’t have a proven track record of revenue. The lender will want to know what you can offer as collateral and its value.
- Explain any blips in your business or personal financial history: A loss in your third year of business, a dip in your personal credit score, a late student loan payment…none of these precludes you from getting approved for a loan but the loan officer will definitely want to hear more about what happened.
- Be able to speak to your expertise and industry knowledge: This is extra important for startups and new businesses. Without a proven track record of business success, your personal experience and relevant time in the industry are what must convince lenders your business is a good risk to take.
Step 3: Ask the right questions
When you’re looking for a small business loan, it can seem like you’re the one who has to impress the lender. That’s true to an extent, but it’s also your job to vet lenders and ensure they’re a good fit for your business. It’s also important to ask the right questions so you can be sure you’re choosing the loan product that works for your business needs.
Here are a few questions you should definitely ask:
- Do you offer a loan term that fits my needs? You know how much money you need, how you’ll use it, and when you should be able to repay it. Once the loan officer has that information, ask about what loans are available to meet those needs.
- What are the interest rates? The total cost of the loan? Interest rates and repayment terms all add to the total cost of your loan. It’s vital that you have a clear understanding of how much the loan will cost your business (and what your other options might be.)
- How long does the loan application process take? It’s best to know how long the process will take up front, so you can plan your business financials. Not to mention, if you need money yesterday but the lender takes six months to approve applications, you may need to find a different lender.
- Do you report to the business credit bureaus? This is particularly important for new businesses. Just like when you graduate college with zero credit history, your business needs to be deliberate about building up your credit score. If a lender doesn’t report to business credit bureaus, your timely loan repayment won’t contribute to your score.
The funding your business needs to grow
A small business loan can offer the cash you need to get started or provide that extra push to take your business to next level. Taking out a loan has its pros and cons, and isn’t right for every small business—but if it makes sense for you, a business loan can be an invaluable way to grease the financial wheels of your business.
If that sounds like just what your business needs, you have this guide to help you make it happen.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.