Are Bank Loans a Viable Funding Option For Startups?
Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
Bank loans are generally high on the list of considerations when startups require capital. Because they’re such a well-known option, many entrepreneurs simply assume that they’ll be able to obtain capital from a bank at some point to help fund their endeavor. Bank lending, however, is not guaranteed and the process can be difficult for many startups. Here’s what you should bear in mind if you’re interested in applying for a bank loan:
Bank Loans by the Numbers
According to the National Small Business Association (NSBA), 22% of small businesses surveyed for their 2016 Year-End Economic Report see the lack of available capital as a challenge to their future growth and survival, an increase of 3% from the previous year. Thirty-one percent of businesses report that they’re unable to obtain adequate financing.
The ability to obtain needed capital is of critical importance for small businesses. As key community employers, small businesses rely on capital for expansion, to provide employee benefits, and to help meet financial requirements during periods of low cash flow. Almost half of small businesses surveyed by the NSBA utilized some form of bank loan within the previous year in order to ensure that they had the financing they required to succeed. While bank financing can take time to secure, it has proved invaluable for many small businesses in need of capital.
The approval rating for loans differs by originators. According to the Biz2Credit Small Business Lending Index, which measures loans on the site, big banks approved 24.1% of small business loan applications in March 2017. Small banks approved almost 50% of loan applications they received in the same month, while institutional lenders approved around 63%. Alternative lenders approved 58% of small business loans in March 2017. Credit unions, which many small business owners tend to overlook, approved almost 41% of small business loan applications received. While there are sites that provide small businesses with the ability to request funding from numerous organizations simultaneously, it’s important to specifically target the bank or company from which you’d most like to secure funds in order to ensure that you meet their requirements.
Banks are more likely to provide loans to proven businesses versus startups that have yet to prove their unique value propositions. Having an established cash flow illustrates that a company can repay their financial obligations and, ultimately, banks are primarily concerned with being repaid and making money. To that point, 64% of approved SBA 7(A) loans are made to existing businesses.
It’s also clear that where you apply for a loan and the current stage of your business both matter. Thankfully, banks have made it easier for small businesses and other loan applicants to determine their eligibility by posting many of their requirements online. Take time to view the different loans available in your area. You may want to begin with the institution where your business banking is done.
Types of Bank Loans
Banks like to brand their loans differently, however, there are generally three categories of loans: long-term loans, short-term loans, and lines of credit. How you intend to utilize the loaned funds has implications with respect to the type of loan you should seek. For example, if you’re planning to purchase large equipment, you may require a long-term loan. If you want to stabilize your cash flow, a line of credit may be useful. (Please note: a line of credit does not equate to a business credit card.)
Larger loans will require more paperwork and, generally, more processing time. Additionally, most larger loans are only made to existing companies.
Long-Term Loan
Long-term loans have a lengthier repayment period and are often for larger loan amounts. These loans may be secured or unsecured. Commercial mortgages may also fall under this umbrella. Terms vary by institution.
Short-Term Loan
Short-term loans may also be known as microloans. They are usually for less than $100,000 and must be repaid within a short period of time, most often four years or less. These loans may be secured or unsecured. Terms vary by institution.
Business Line of Credit
A business line of credit functions like a blend of an ordinary bank account and a credit card. It can be secured or unsecured and has a limit. The money may be accessed as needed by writing a check or using a debit card. Payment is made only on that portion of the credit in use.
Before Applying, Ask Yourself…
Before beginning the application process, make sure to ask yourself the following questions:
- Why do I need the loan?
- Will the loan help me generate more money?
- How much money do I need?
- Do I have enough cash flow to repay the loan?
- What can I offer as collateral?
- Are the terms of the loan acceptable?
Understanding how the loan will fit into your business and whether you’ll be able to increase your revenue thanks to the influx of capital are both extremely important points for which you need to account. If a loan won’t help you to make more money, either by facilitating your purchase of equipment to make your process more efficient or by enabling you to purchase more goods, consider carefully whether you should be seeking a loan at all. Ensure that you’re comfortable with the repayment terms and that you understand any associated penalties.
The Bank Loan Application Process
To determine the precise application process for a particular loan, visit the bank’s website. More banks have become internet-savvy and understand the importance of having information readily available to small business owners. After all, doing so saves everyone time. While the loan application process differs from bank to bank, many require the same types of information, including tax returns, business plans, financial projections, bank statements, and credit reports. Some banks permit you to complete most of the process online, while others may require that you visit a local branch to discuss your plans. Bear in mind: this is not a quick process. It can take up to six weeks (and, in some cases, even longer) to receive a loan disbursement. For smaller loans, disbursement may be much quicker.
Do not hesitate to reach out to a live person at the bank. Most will be happy to help you.
What Banks Want to See When Reviewing Applications
Ability to Repay Loan
The most important factor a bank takes into consideration when underwriting a loan is simply whether it’s likely to be repaid. Banks will ask for business and personal federal tax returns and may ask for business and personal banking statements. They will want to see your financials and will often attempt to discern how your company makes money and whether it can earn enough to cover the loan amount within a reasonable period of time.
Credit History
Just as you have a personal credit history, your business has its own. Inevitably, banks will want access to this information. Experian, Equifax, and Dun & Bradstreet all provide business credit reports for a fee. Before applying for a bank loan, order a copy of your business credit report and ensure that it’s accurate. You should absolutely do the same with your personal credit report in order to ensure that there are no errors or other red flags. For new businesses, you yet won’t have a business credit score and will need to rely on the strength of your personal score.
Equity Investment
Banks want to see that you are personally invested in your company. In addition to the blood, sweat, and tears – which, unfortunately, cannot be measured financially – banks want to know that you have “skin in the game.” Showing that you’ve invested some of your savings or other capital into your business illustrates your commitment to making the business succeed. If you have money sitting in the bank and haven’t invested in your own company, a banker will invariably want to know why.
Collateral
Some business loans require collateral. This helps to secure the loan and assures the bank that you have the ability to repay. Larger loans are more likely to require some form of collateral such as a personal home.
Experience
It may come as a surprise, but banks also want to know what kind of experience you have with running a business or managing money. For businesses that are just starting out, experience can help to reassure a lending officer that you understand the risks you’re undertaking and can adequately manage money.
Banks may also require information about your management team or those individuals who’ll be authorized to handle the money.
Business Plan / Marketing Plan
Many banks will require that you submit your complete business plan, including the marketing details. Alternatively, they may require you to complete a template or form that essentially functions as a business plan and helps them to understand your business model and how you intend to raise revenue. In addition to evaluating your concept, they want to determine that you have a clear understanding of your industry and that you’re capable of executing your plan. The bank expects you to be an expert on your business and industry. You should have relevant industry and market data that demonstrates how your business will succeed and clearly outlines your target audience and how you intend to reach them.
Tips on Applying for a Bank Loan
Your business plan should explicitly state how your business makes money. The biggest concern banks have when they loan money to a small business is the business’ ability to repay that loan. Your business plan should clearly illustrate your current cash flow, how you make money, how you’ve spent money in the past, what you plan to do with the loan, and how you’ll repay the loan. Having a marketing or growth plan is essential for establishing your ability to repay the loan. Make sure that you perform adequate market research and describe your findings. Are customers lining up to buy your product? Let your prospective lender know about it!
Before applying for a loan, make sure that you fully understand both the terms and the application process. Investigate the different loans offered by the bank and ensure that the one for which you apply meets your needs. If the application requirements aren’t easy to understand, don’t hesitate to contact the bank and ask questions. This will save you both time and aggravation/disappointment in the long run and ensure that you only apply for suitable loan products.
As previously mentioned, take the (minimal) time required to run both your business credit history and your own. It’s better to ascertain beforehand that it’s error-free than to find out that you were denied a loan due to an error on your credit report.
Loans are not instantaneous. You never want to be in a situation where the success or survival of your business depends on your ability to secure a bank loan. Not only might this actually decrease your chances of obtaining a loan, but it also creates unnecessary stress on you and your business. If you’re aware of cyclical cash flow issues, plan accordingly. Understand that obtaining a loan can take up to a month and a half of your time and that there are no guarantees.
SBA-backed business loans provide entrepreneurs with another possible funding stream. I’ll be covering those loans separately in another post.
About the Author
Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).
Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.
Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.