A bank loan is an ideal source of funds to start and grow a business as, although it must be repaid with interest, entrepreneurs don't have to worry about giving up an ownership stake in their company.
However, getting a small business loan can be a complicated process. Big banks and other lending institutions are extremely thorough in their lending review practices and are often hesitant to loan to small businesses because of higher failure rates. While these figures are generally improving – especially in the US – there are no guarantees that your application will be successful.
Small Business Loan Approval Rates by Lender Type (December 2019)
Bizz2Credit Small Business Lending Index
So, how can small business owners improve their chances of securing a loan? What is it that lenders look for in a loan application? To help answer these questions, we've compiled a complete guide on how to position yourself as a competent entrepreneur and prepare a loan application that can win lenders over.
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 is to ensure your existing small business is turning out a decent profit before beginning the application process.
Of course, this is easier said than done, but without proof of a return on investment, lenders are less likely to be interested. To reach this point, you will need a solid business plan, sufficient startup capital, a unique product line and a dedicated management team. Once your enterprise is up and running, you can then focus on increasing its market share and improving 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 that it knows well. Research the market and identify the best bank with which to open a business account, so that you won't need to switch to another bank later on and have to repeat the process. That said, if your company is big enough and can afford to maintain two (or more) business accounts in separate banks, then do it. When the time to borrow comes, you will have more options.
Nevertheless, your bank should ideally be located near your business, have a reputation for supporting small businesses, and provide services at an affordable rate. Although, as mentioned, the acceptance rates of large banks (i.e. over $10bn in assets) are on the rise, it's better to avoid these as they are typically focused on lending to medium-sized and large businesses.
Once you've selected a bank and opened an account with them, the best way to cultivate a strong relationship is to maintain an active account with a healthy balance. Make regular cash deposits, try to avoid incurring charges, and, if convenient, allow your customers to make payments directly into the account. Build trust by communicating openly with bank officials, too. If an account manager calls to ask why your account has been dormant for a while, or enquires about any other issue, give an honest answer.
As you strive to solidify the transaction history of your business account, don't forget to improve your personal credit score, either. Pay your bills on time, apply for credit only when you need it and clear all credit card debts as promptly as possible. After all, it is common practice for loan managers to check the personal credit scores of business loan applicants.
Get Familiar With the Bank's Loan Approval Criteria
In a sense, loan reviews are similar to job interviews, where candidates must know the level of qualifications, skills and experience the employer is looking for. In the same vein, it's necessary to understand your bank's criteria for loan approval. Visit their credit department and ask about the lending process for small business loans.
Most importantly, 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:
- The Purpose of the Loan – There are many reasons why a small business owner may need a loan, but prospective lenders will view your loan application more favourably if you are planning to use the money for revenue-generating activities, such as purchasing inventory. 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 higher.
- Applicant Experience – Lenders prefer loan applicants with substantial entrepreneurial expertise because they know what it takes to start and grow a profitable business, as well as being less likely to mismanage finances. If you run a speciality business – such as a chocolatier, for instance – the bank may also consider whether you have any professional training in that particular field.
- Repayment Ability – Bankers use cash flow statements to determine whether a business is capable of repaying the amount of money it's seeking. To put it simply: when money coming into the company is much higher than the money going out, your application stands a greater chance of being approved.
- Collateral – Profitable businesses can still experience fluctuations, or even fail. Therefore, lenders can't rely solely on 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:
- A business plan that identifies all the owners or partners in the business, and outlines your objectives, growth strategy, product and service offerings, as well as your 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.
- Proof of entity, such as business registration certificates, franchise agreements, relevant operating licenses and any 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 beforehand and include them in the application. Shoddy or incorrectly submitted paperwork can hinder the process and even suggest a lack of professionalism on your part, so avoid simple typing or entry errors, and ensure that any documents requiring certification by competent authorities are indeed certified thus.
Don't Borrow More Than You Need
Before borrowing, you should have a good handle on how much cash the business 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 specialise 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 even help you fill out application forms. If you choose to work with a loan consultant, find one with vast professional experience and reasonable approval rates.
Seek Alternative Lenders
Commercial banks aren't the only providers of small business loans. In the US, for instance, 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, startups can secure loans worth up to £25,000. Besides government-sponsored loans, small business owners can also obtain 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 Your 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.