Introduction to commercial lending
From startups in the earliest planning stages to established companies looking to expand, all kinds of businesses take out loans. Commercial lending can be used for initial expenses, financing ongoing operations, or major investments in equipment. After qualifying for a loan, businesses make monthly payments that include a portion of the original amount borrowed - the principal - plus interest to the bank or other lender.
If you're looking for a business loan, there are some important steps to take before you apply. Lenders will expect you to prove your commitment to the business and demonstrate that you'll have the ability to pay them back: they're in the commercial lending business to make money, not to provide a service to struggling businesspeople.
It's also important to know that every commercial lending application you submit will be listed on your credit record - if you're turned down by one lender, the next will see that you were declined already, which further reduces your chances. For this reason, you should make sure to do everything you can to get it right the first time.
Getting approved is a major hurdle, but BuyerZone can help. This BuyerZone Buyer's Guide provides tips on ways you can try to improve your chances of securing a loan, whether you need $10,000 or $1,000,000, so you can take your business to the next level.
Reasons to take out a business loan
The most common - and generally the easiest - reason to get a business loan is for expanding your business, either by opening new locations, entering new territories, or otherwise increasing the scope of your current operations. Lenders see that your business is succeeding and are willing to loan you money to do "more of the same."
While expansion is probably the most common reason for applying for a business loan, here are a few other ways companies use the extra financing:
- improve facilities and conduct renovations
- invest in major equipment
- boost working capital
- build up inventory
Often, even businesses that have enough capital for an expansion or equipment investment opt for a loan instead. This leaves them with the operating cash to cover unexpected expenses, while the new income generated by the purchase or expansion covers the cost of the loan.
Unfortunately, the time when you need money the most is when it's hardest to get a loan: during the startup phase. You simply won't get a new business loan by walking into a bank with an idea and enthusiasm - and the same goes for buying an existing business. You need to demonstrate an understanding of the industry, business acumen, and commitment.
Surprisingly, lenders are routinely approached by would-be business owners who have little or no specific knowledge about the industry they want to enter. Don't make this mistake. Instead, prepare an in-depth analysis of your market, projected expenses and income, and other details. Show them you're committed by doing the research before you ask for a loan.
It helps if you and your management team have experience in the industry, especially ownership experience. Prior success running other types of businesses can help, too, but the more relevant your experience, the better.
Many lenders will also expect to see that you've made a personal financial commitment to the business, and they'll ask how much of your own money you're investing. You won't necessarily have to put up your house as collateral - but some lenders may require it.
Types of business loans
Standard business loans can take on several different forms in specific situations:
Term loans are the most common general purpose loan. They're used for working capital, expansion, refinancing, and acquisitions. You'll repay them monthly over a term based on the expected lifespan of the assets you're purchasing. This straightforward loan is most common for larger amounts.
Short term loans are almost always set up for terms of one year or less, and are repaid in a lump sum at the end of the term, instead of monthly. They're usually for smaller amounts - less than $100,000 - and are best for seasonal inventory buildup or small investments with quick returns.
Equipment financing is generally easier to obtain then general lines of credit, simply because the equipment you buy serves as direct collateral for the loan. It's also less risky, in that if you are unable to make your payments, you don't have a lien against your entire business or your personal real estate: all you lose is the equipment you bought. Depending on the size of your business, equipment financing can cover huge expenses into the millions of dollars.
Lines of credit are more general business loans that are often set up to insure against cash flow problems. Instead of getting a check for the full amount of the loan, the financial institution will allow you to borrow up to a certain amount per year - you take out the money in increments as you need it. The flexibility comes at a cost, though: if you don't repay the loan balances fairly quickly, they can quickly become more expensive than other types of loans. Avoid using a line of credit for significant business improvements: they're designed for temporary cash shortfalls.
Credit card advances - in lending, this phrase does not mean taking out cash through your business credit card, although many businesses do that. Instead, it's a loan based on your track record and your expected future business. It's a good choice if your business has at least a three-year history of accepting credit cards. Because the credit card sales are such a good estimation of your future earnings, you'll be able to get a fairly good rate on a loan against your expected income.
While there are stringent federal guidelines about how banks and other lenders conduct business, there are no definitive standards as to how the various types of business loans are structured: terms and conditions may vary from one lender to the next, and minimum and maximum amounts can differ. Be sure you know exactly what conditions apply to each loan you're considering.
Another option for many small businesses is factoring, also known as receivables financing. Factoring is basically selling your invoices to a third party: instead of waiting for your customers to pay, you can get the funds immediately - minus a small fee (3% to 5%) due to the factoring company. Typically you'll receive 80% of the invoice value upfront and the remaining value once the client pays.
Your business might be a good candidate for factoring if you have:
- Fewer than three years in business
- Good growth prospects but less than stellar cash flow
- Active accounts but slow paying customers
What are your chances?
There are several key areas that lenders use to evaluate potential borrowers.
- Credit. For established businesses, the lender will focus on the company's credit and outstanding accounts. For businesses less than three years old, your personal credit will also be evaluated.
- Cash flow. This includes audited results and detailed future projections. Many lenders require a cash flow that is 1.25 times the total cost of the company's total and expected debt.
- Collateral. Real estate, valuable equipment, or other property can be used as collateral that the lender can seize if you default on the loan. In some cases, contracts for future work can be used to guarantee loans.
- Management. Your management team's ownership experience, tenure with the company, and familiarity with the industry will all affect your chances.
- Capital and equity. This is the total value of your cash on hand, equipment, facilities, and other tangible assets. "Debt-to-equity ratio" is often used as a rule of thumb - lenders will look for situations where your total debt is no more than 3 or 4 times the equity.
None of these have hard-and-fast rules, however. Other factors such as proven profitability and the quality of your business plan will contribute to the lender's decision. There are several steps you can take to improve your chances of getting the loan you need:
Establish trust. The first thing you'll want to do is try to establish a relationship with the lender sitting across from you. The more they know you as a person, the more they'll trust you. And when it comes to asking for money, nothing is more important than trust.
Refine the business plan. Make sure your business plan is optimistic, but don't sugarcoat potential problems or risk. Be thorough about your plans for the future, address contingencies, and talk about the qualifications of your management team. The business plan is one of the primary documents that lenders use to gauge the stability and future of your business.
Payback. Of course the main thing weighing on the mind of the potential lender is how you are going to pay them back. One step beyond that is how you are going to pay them back if your numbers fall short of your projections. Addressing both of these issues thoroughly can help put their mind at ease.
Choose the right size loan. Avoid asking for more or less money than you need. You shouldn't write your business plan to justify the amount you want - instead, use your business plan to determine how much you need.
Find the right lender. Some lenders focus on small business loans - these are your best chance for success if you fit the mold. If they're familiar with your industry, all the better. The next section talks more about evaluating lenders.
Sources for business lending
The first stop in applying for a business lending should be the bank that already handles your finances. With your current bank, you have the advantage of familiarity: you've established a relationship and shown that you're a reputable business. Banks also usually have slightly better rates for commercial loans than other types of lenders.
The tradeoff is that banks are pickier about who they lend to. They may require more collateral, lower debt to equity ratios, or more proven success than other types of business lending. Often they'll decline commercial loans to companies that have been in business fewer than five years.
There are many other types of business lending. The main distinguishing feature is whether they offer secured or unsecured loans. Secured loans are those that are backed up directly by collateral: real estate, securities, or the equipment the loan is being used to purchase. Unsecured loans are more typically offered by banks, while independent financial organizations are more likely to offer secured loans.
These independent companies are more likely to take business lending risks on startups and smaller businesses than banks. Often they specialize in particular industries, types of loans, or business sizes.
Try a broker
If you're turned down by your bank or just think you're likely to be, look into business loan brokers. As the name implies, brokers don't lend money directly - instead, they'll assess your situation and decide which lenders are most likely to accept your application.
Brokers are often a good source for commercial loans for startups or other higher risk businesses. Because the brokers bring in lots of business, they can sometimes get approvals that you wouldn't be able to get on your own. In addition, they'll also usually provide advice on your paperwork and give you other help in getting the loan.
However you can expect to pay a higher rate for a broker's services, both because they need to markup the loan from the provider and because they're taking greater risks.
Choosing a commercial lender
Almost any commercial lender can provide funding for a profitable company with 10 years in the business. However, if that describes your situation, you won't need much help in finding a lender! More common are small businesses that want to grow or companies facing some business challenges they need to overcome.
Unfortunately, some banks just don't make an effort to reach out to small businesses. Others might not want to take a risk with a less established company or be able to handle the size loan you need. However, there are commercial lenders out there for almost any type of loan - it's just a matter of finding them. It's important that you evaluate prospective lenders just as carefully as they're evaluating you.
The right type of loan
Each financial institution will focus on different types of loans. Some prefer to focus on real estate loans: mortgages and leases. Others may emphasize equipment loans or ongoing lines of credit.
Each commercial lender will have a different attitude towards risk, as well: more conservative commercial lenders such as banks will avoid riskier loans, while other lenders may take on more risk as part of their philosophy. Deciding what type of loan you need and honestly evaluating your situation can help you choose the right type of commercial lender.
The right size
Rarely are commercial lenders too small for small to medium sized businesses. If they don't have the cash to handle your loan directly, they may break it into smaller chunks and have other lenders take on parts of the debt. This doesn't usually affect the total costs of the loan - the broker works out the fees with the participating banks.
On the other side of the coin, if a bank is too large, you run the risk of getting lost in the shuffle. You'll want your questions regarding the details of a loan to be answered thoroughly and in a timely fashion, and sometimes, large banks are not able to provide such service to small businesses.
How well do they know your industry?
If the commercial lender has a good understanding of your industry and how your type of business works, it can be much clearer to them how the loan will be repaid. If, however, they don't have any experience with your industry, they may be wary of your ability to pay them back.
Even if they're not familiar with your business, don't give up. Take a little extra time to answer their questions and clarify any misconceptions they may have. The better you can explain your business, the more confident they will be in your plans to pay them back.
A trustworthy partner
There are less-than-reputable firms out there who will try to take advantage of businesses in need of quick cash. In addition to checking references (see below) and with the Better Business Bureau, you should look for a lender who will act like a partner. Instead of treating you like a faceless account, they should take the time to answer your questions and help you through rough spots, instead of calling your loan or bumping up your rates the first time you're late with a payment.
A standard approach to evaluating any business purchase decision is to check references, and this applies to loans, as well. Have your prospective lender give you contact information for four or five references, preferably businesses similar to yours in size and industry.
When you speak to them, ask questions such as these:
- Did the commercial lender treat you fairly?
- Did you get the entire amount you needed?
- Did the commercial lender provide help on your application and paperwork?
- Have you had any trouble making loan payments? If you did, how did the vendor react?
- Would you work with this lender again?
Preparing for loan applications
Obtaining a commercial loan requires a great deal of legwork and preparation. These are some key documents you should have ready to present to the lending institution:
- your company's financial statements including balance sheet, income statement, and tax returns
- your personal financial statements and tax returns for the past three years
- monthly cash flow projections based on obtaining the loan
- thorough and detailed business plan
- specific details of how the loan will be used
- management profile
The organization and timely preparation of these documents will be a reflection of your business, so pay close attention to the presentation.
Note that one of the most common reasons businesses get turned down for commercial loans is that their accounting is sloppy or deceptive. Reducing your reported income is one way to avoid taxes, but it can also make your business look like a horrible candidate for a loan. Make sure your financial documents are reviewed by a qualified accountant before you take them to lenders.
Are you classified as an undesirable loan?
Even before you complete an application, you may be fighting a losing battle: some types of businesses are deemed "undesirable" by lenders. Addressing this issue will require a great deal of tact, but finding out the answer can save a lot of time and energy for both you and the potential lending institution. You'll have to go directly to the lender and ask whether your industry is classified as an undesirable loan.
This list can vary from one institution to the next, and can be based on risk factors (industries in decline or subject to strict legal controls) or ethical concerns (adult businesses, firearms, or alcohol/tobacco.) If your industry is classified as undesirable, you're going to have a very difficult time obtaining a loan.
Commercial financing rates and costs
When shopping for commercial financing, avoid focusing too closely on costs. On a loan of tens or hundreds of thousands of dollars, a difference of $50 or $100 per month will have little impact on your business, so you should choose the commercial financing that best matches your needs and seems the most trustworthy, instead of the lowest cost provider.
Business owners who aren't familiar with commercial financing tend to have unrealistic expectations when comparing interest rates, usually because they try to equate extremely low home mortgage rates to business loans. Banks are willing to offer 6% rates on home mortgages because the home itself will always be there and is almost guaranteed to go up in value, so their investment is fairly well guaranteed.
That's just not the case with businesses. Businesses can fall in value or even go bankrupt. To compensate for those additional risks, lenders have to charge more for commercial financing. Typical rates right now range from 8% to 14% - but you will always find higher and lower rates. In some cases, you won't even be quoted an exact interest rate. Instead, the lending company will simply tell you what your total monthly payments will be, including all fees and interest.
The most important step you can take when comparing commercial financing is to be sure you're comparing equivalent fees! When you get a quote, ask what your total monthly payments will be. Even if you are quoted interest rates, don't shop on those alone - some lenders will deliberately offer tempting low rates of 6% or 7%, then add steep fees to your monthly payments that bring your total back up.
In general, the best commercial financing rates can be obtained from banks that know you, and the steepest will be from small lenders who focus on high-risk or startup businesses. Often you will be able to negotiate some of the fees involved in the loan, but the interest rate is usually determined by a specific formula the lender has in place, so you usually won't be able to get that moved.
Many businesses use credit cards to finance operations at first - when you consider that many carry monthly finance charges of 18% and can jump to 25% or more after one missed payment, you can see why commercial financing is a better source of emergency funds.
In most cases, you'll have to pay an application fee, which in some cases may be non-refundable. If you must pay a non-refundable fee, make sure it's fairly low - less than $100, for most loans. Read the contract carefully to make sure there are no other hidden fees you'll be responsible for.
Small business loan tips
Early repayment penalties. Some banks charge a 2% to 5% penalty if you decide to repay the loan early. Repaying early can be a great way to reduce your costs, so if you're going to try to get ahead, make sure the contract allows it without penalty.
Start building relationships now. Personal relationships matter more than you might expect: a lender who knows and trusts you is much more likely to take a gamble on your small business loan. Take the time to talk to your primary business banker and get him or her on your side before you need a loan.
Avoid eating out. From pizza shops to gourmet bistros, restaurants come and go very quickly. Unless you have specific food industry experience, a great concept, and experienced staff lined up, you'll find it almost impossible to get a small business loan for a restaurant.
Don't pinch pennies. Saving every possible dime shouldn't be the emphasis of your search for the right loan. A small business loan that carries conditions you can live with from a vendor who will be on your side now and in the future is much more important than a small cost savings.