A bank loan is an ideal source of funds to start and grow a business. Although it must be repaid with interest, entrepreneurs don’t have to worry about giving up an ownership stake in their businesses.
However, getting approved for a small business loan is a difficult process. Banks and other lending institutions are extremely thorough in their lending review practices and are often hesitant to loan small businesses because of higher failure rates. In the United States, for example, banks rejected 61 percent of small business loan applications in 2013, according to a survey published by Pepperdine University.
So, how can small business owners improve their chances of securing a loan? What is it that lenders look for in a loan application? This article is a complete guide on how to position yourself as a competent entrepreneur and prepare a loan application that can win them over. Keep reading!
Ensure Your Business is Profitable
Banks prefer lending money to profitable businesses that have been in operation for at least two or three years. As such, the first step to making yourself a deserving loan applicant is to ensure your existing small business is turning out decent profits.
Building a profitable business from scratch requires a solid business plan, sufficient startup capital, unique product line and a dedicated management team. Once the enterprise is up and running, focus on increasing its market share and improving the cash flow.
Build a Close Relationship with Your Bank
Strong bank-client relationships reduce the risks in small business lending. A lending institution is more likely to approve loan applications made by customers it knows well. Research the market and identify the best bank to open a business account, so that you won’t need to switch to another bank later on and start building a new relationship all over again. But if your business is big enough and can afford to maintain two or more business accounts in separate banks, do it. When the time to borrow comes, you will have more options.
Nonetheless, the ideal bank should be located near your business, have a rich tradition for supporting small businesses and provide services at affordable rates. Avoid large banks as they typically focus on giving loans to medium-sized and large businesses.
The best way to grow a strong relationship with a bank is to maintain an active account with a healthy balance. Make regular cash deposits and, if convenient, allow your customers to make payments directly into the account. Build trust by communicating openly with the bank officials. If an account manager calls to ask why the account has been dormant for a while or to enquire about any other issue, give an honest answer.
As you strive to build the transaction history of your business account, don’t forget to also improve your personal credit score. Pay your bills on time, apply for credit only when you need it and clear all credit card debts. It is common practice for bankers to check the personal credit scores of business loan applicants.
Get Familiar with the Bank's Loan Approval Criteria/Requirements
Loan reviews are similar to job interviews, where job seekers must know the level of qualifications, skills and experience the employer is looking for. It is, therefore, necessary to understand your bank's criteria for loan approval. Visit the credit department and ask the loan officers about the lending process for small business loans.
Try to establish the common reasons why the bank rejects applications. Beyond obtaining insider information, reach out to other small business owners who have successfully secured credit from the bank and learn from their experiences. For example, ask whether they were approved on a first, second or third attempt, and how long they held an account with the bank before seeking a loan.
Although different banks have different eligibility criteria, they generally need to know:
- Purpose of the loan – There are a lot of reasons why a small business owner may need a loan; to procure raw materials, merchandise, production equipment or office furniture, open a new retail store or business unit, hire more employees or settle a compensation claim. Prospective lenders will view your loan application in favorable light if you plan to use the money in revenue generating activities like purchasing raw materials. However, if you intend to pay off claims or spend loan proceeds in activities that don’t bring value to the business, chances of rejection are high.
- Applicant experience – Lenders prefer loan applicants with substantial entrepreneurial experience because they know what it takes to start and grow a profitable business, and are unlikely to mismanage finances. If you run a specialty business - like a chocolate company -, the bank may also consider whether you have any professional training in chocolate making.
- Repayment ability – Bankers use cash flow statements to determine whether a business is capable of repaying the amount of money it’s seeking. When money coming into the business is much higher than money flying out, your application stands a greater chance of being approved.
- Collateral – Profitable business can experience fluctuations or even fail. Lenders can’t solely rely on your cash flow and profit projections to approve the loan. They usually need a tangible asset, such as land or machinery that can be seized or sold off if you are unable to repay the loan. As an applicant, having sufficient physical assets and personal financial reserves means you can still afford to service the loan if the business fails.
Get the Documents Ready
Lenders require borrowers to submit several documents. These include:
- Business plan – Your business plan identifies all the owners or partners in the business and outlines your objectives, growth strategy, product and service offerings, financial projections and financing needs.
- Personal identification documents (ID/passport) and utility bills for address verification
- Cleaned up personal and business credit history reports
- Personal and business bank account statements
- Entity proof – Business registration certificates, franchise agreements, relevant operating licenses and other business identification documents
- Latest annual income tax returns (personal and business). Some banks may require tax returns for the last two or three years.
Document requirements vary from lender to lender, so be sure to obtain a comprehensive list from your prospective lender and include them in the application. Avoid simple typing or entry errors and ensure documents that need to be certified by competent authorities are indeed certified. An incomplete application will only make the review process longer.
Don’t Borrow More Than You Need
Before borrowing, you should have a good handle on how much cash the business actually requires. Borrowing beyond your current requirements forces lenders into giving your ability to repay a second look. As a rule of thumb, the loan amount should not exceed your annual cash flow projections. For example, if you expect to incur $100,000 in expenses and generate $250,000 in revenues within a year, then you are justified to borrow around $100,000.
Consult Loan Experts
Small business loan consultants specialize in assisting entrepreneurs to secure credit facilities. Although some consultants work as in-house employees in various lending institutions, others practice privately. They inform clients on the banks offering the best interest rates, shed light on the application procedures of various banks, determine the amount of money a business needs to borrow and fill out application forms. If you choose to work with a loan consultant, find one with vast professional experience and good approval rates.
Seek Alternative Lenders
Commercial banks aren’t the only providers of small business loans. In the US, the Small Business Administration offers a variety of low-interest business loans, including real estate and equipment loans, disaster loans and general purpose loans. In the UK (England, Scotland, Northern Ireland and Wales), startups can secure loans worth up to £25,000 . Besides government-sponsored loans, small business owners can secure loans from building societies, community banks and credit unions. Although application requirements for commercial banks and alternative lenders are usually similar, the latter have higher approval rates and are ideal for entrepreneurs seeking smaller amounts of money.
Regularly Check Application Status
After submitting your application, don’t sit back and wait for the lending institution to communicate its decision. Follow it up! Even though many institutions review applications on a first-come, first-served basis, regularly checking the status of your application maintains a communication channel with the loan officer. Although you cannot influence the outcome of the review, an open line of communication encourages the officer to contact you if there is an issue that needs clarification, instead of immediately rejecting the application. Either way, you should get a decision within two to four weeks.
Whether you are a growing or an established small business, securing a loan to fund your operations can be a challenging task. The trick lies in demonstrating to potential lenders that you are an experienced and creditworthy business owner. With the tips fleshed out in the article, you are no doubt in a better position to present yourself as a competitive candidate and prepare a loan application that will get lenders nodding in approval.
Have you ever applied for a small business loan before? Share your experience with us in the comments section below.