For many entrepreneurs, the search for financing is stressful and challenging. For most, they have had bad experiences going to a bank or working with a broker. With this step by step guide, I will put you in the driver’s seat while applying for financing. Knowledge is power and power gives you control over your destiny.
Let’s look at the basics before we get into the details. This way you can understand the complete picture. Before you apply, you should have a plan and know certain things about your business. Simply put when you have a plan, you position yourself to get the best terms with the least amount of stress possible.
Before applying, you need to know how much you actually need and what every dollar is going to be used for. I can’t tell you how many times people apply for financing without a plan. It usually sounds like “I want $250,000 or more at the lowest interest rate”. This is coming from a business owner that has $15,000 in monthly revenue and can’t afford to pay back $250,000, let alone $50,000. When pressed on what they are using the funds for, usually business owners will say “working capital”. This doesn’t help their chances at all.
An entrepreneur with a plan would say I’m looking for $75,000. I need $25,000 for marketing over the next 6 months and $50,000 for equipment (i.e., 2 lifts, tire balancer and an alignment rack). Once pressed on how this will help their business, they have projections that show that this $75,000 investment will allow their auto repair shop to increase from $80,000/month in revenue to $100,000/month; a 25% increase in revenue on a monthly basis. This creates a compelling argument to whomever is reviewing their application. It shows there is a plan in place and the funds are being put to good use.
Having a plan in place isn’t enough, however. There are certain metrics that you need to know before applying to give yourself the best chance at receiving optimal terms. Here’s a list of things you should know before applying:
- Credit- both personal and business
- Time in business
- Cash Flow
- Last two years of Financial statements – (Business tax returns and financials)
- Projections
Let’s dig deeper into each one of these areas as they are what will determine the outcome of your application.
Credit is a major driver of the approval process, and far too many people don’t know their current credit score. Personal credit scores taken off of credit karma are often 10-50 points off what the actual score is. It is important to know where your credit stands before applying. For example, a score of 720+ should get approved for the best rates and terms offered. A score between 650-720 should qualify for a line of credit, term loan, equipment financing and most other programs. If you fall below 650, you are taking a chance applying for the better programs and will most likely be looking at some less desirable loans or a working capital advance. A score below 500, will not qualify for a traditional advance; and, if approved for any type of funding, it would be very short term and very expensive if it’s approved at all. Business credit is used to underwrite a few types of programs and will usually not take the place of personal credit. The reason here is that an underwriter wants to look at a full picture. If the business owner isn’t paying his personal bills, it could be a sign that the business isn’t truly supporting him and could be about to fall apart.
Unfortunately, most businesses fail in the first 2 years. The longer a business has been open, the stronger the businesses application looks. A business that isn’t opened a full year is considered very high risk. A business that is open 1-2 years is still considered high risk but has a much higher chance of approval. Once a business has been open a full two years, the risk is much lower and the business owner should be able to qualify for all types of financing programs.
Cash Flow has a lot of different metrics that an underwriter will look at. The first and most basic is the monthly revenue that goes into the business bank account. The next thing underwriters will look at is how many deposits were made. The more deposits there are, the more consistent and balanced the business is considered. A business with a few deposits (8 or less) is considered riskier because they appear to have only a few clients compared to a business with, let’s say, 30+ deposits. The next thing an underwriter will look at is average daily balances, meaning how much cash is usually kept in the business bank account at all times. In this situation, the higher the average daily balances the better. It shows a business can handle larger payments and be approved for a higher loan amount. Underwriters will also want to see how many negative days, if any, there are. Negative signs show stress on the business bank account and will hurt an application. Typically underwriters don’t want to see more than 5 negative days in any month and an average of less than 3 negative days a month over a 6 month period. Negative days will lead to returned checks and overdraft charges, both of these impact the application negatively. The next thing an underwriter will look at is consistency of business revenues. Businesses that have large swings are considered slightly riskier than businesses that have steady and predictable revenues on a monthly basis. The last thing to consider is the business on an increasing revenue trend or decreasing revenue trend. A business that appears to be increasing will score much higher than a business that has decreasing revenue over the prior few months.
What are underwriters looking at when they look at your tax returns? They are essentially looking at how profitable your business is. They are looking at how much you claim and how much the business writes off. Underwriters want to see who owns the business in addition to any potential changes in ownership over the past 2 years. Most importantly, underwriters are evaluating your business’s ability to service debt. Most businesses want to pay as little in taxes as possible, so owners write off as much as possible bringing taxable exposure as close to zero as possible. The problem with this lies in the fact that it could show that the business can’t service new debt depending on how it’s done. There are certain numbers that you should strive to hit in terms of profit if you want to be able to borrow, for example, from the SBA. SBA loans have stricter guidelines than other programs. Therefore, to keep this simple and straight to the point, if you claim $45,000 in profit for two years in a row with steady or increasing revenues you should qualify for an SBA loan of $350,000 over 10 years. This assumes that your business hits all the other metrics we’ve discussed. If you plan on needing more than $350,000, you need to hit higher levels of profitability.
Projections are important for your business because they provide a roadmap of what you are striving to achieve. They also help an underwriter see what you plan on doing with the funds requested and if you can comfortably service the debt load. Projections are analyzed when it comes to start-up SBA loans, SBA Acquisition Loans (when you are using your current business to purchase an existing business) and capital raises. Most projections are written 1-5 years in the future. I would recommend that you use them, even if you aren’t looking into getting financing now. Start by writing down your goals for the next 5 years, then put them into excel and break them down into smaller, actionable and achievable steps to hit on a weekly/monthly basis.
Now that you have the cheat sheet for getting your business ready to apply for financing, you are ahead of your competition. It’s time to start looking at what you could use capital for- to grow and scale your business. When you’re ready, find me and we’ll get to work.