Updated: Jan 25
In my last article, I challenged business owners (especially new ones) with Three Questions to Consider Before Taking Out a Loan. Simply put, my argument is the best policy, as it relates to borrowing money, is not to do it at all. Having said that, I have worked in and alongside a number of organizations that have borrowed funds over the years and am very familiar with the process. So, if you have determined you need a loan, below are six steps in securing one for your business.
1. Determine the purpose of the loan
Knowing why you need the funds is critical. The method by which a bank lends funds is different based upon the need of the organization.
For instance, in a seasonal business where cash flow is negative for a portion of the year, the bank would likely provide a line of credit (LOC) with the general assets as collateral. A LOC is typically issued for a year or less on a fixed rate of interest. The business borrows funds as they need it up to the maximum amount and is expected to pay the balance at least once during the term of the note.
If the funds are for a new equipment line or expansion, the bank would likely issue an installment loan, where the equipment financed would be the collateral on the loan. The interest rate used could be fixed or variable and the term of the loan often extends for 3 – 5 years.
2. Determine the Return on Investment (ROI)
The purpose in borrowing money is to make even more money, right? Then it would make sense to use an ROI tool to determine whether the revenue to be generated outweighs the overall cost of borrowing over a period of time. A positive ROI means revenue will exceed costs, a negative ROI would suggest that it’s time to hit the brakes on the deal. There are many ROI tools on the internet available for your use.
3. Determine the impact on cash flow
Remember, when you decide to borrow, you are obligating a portion of your future cash flow to making payments for a period of time. Be sure to budget these payments into your cash flow to avoid creating an unnecessary loan default by not having funds set aside in advance.
4. Identify banking relationships
Every business has a bank with which they do business. Typically, it would make sense to approach this same bank to request a loan. Banking regulations, while far more constricting than times past, are still very flexible for smaller state and regional banks. Depending upon the size of the loan, I would do what I could to work locally. I’ve worked with a few national banks in the past and for the vast majority of the small businesses that exist in the U.S., they are just not the best fit.
It may be necessary to submit your loan request to several banks in order to get the very best deal. If you do that, just know that banks will work to sell you the total package of their services: checking, savings, electronic services, loans and even brokerage services. Be sure your lender has a great understanding of your business, what it does and how it works. Make sure you are comfortable with whom you’ll be working with and that the bank you choose has a long and positive reputation in your community.
5. Gather documentation
The scope and variety of the paperwork requested by the bank can be quite varied depending on a number of factors too numerous to mention here. Typically, you will need to provide the financial statements for the past 3 years, business and (likely) personal tax returns for the past several years, business forecasts for the current and possibly future years, inventory and fixed asset lists, to name a few. It can be a bit overwhelming!
6. Understand the terms of the loan
It is critically important to understand the terms of the loan, before you sign it. Make sure the length of the note fits your needs, that the interest rate is as low as you can get it and hopefully fixed for the length of the loan. Know what collateral is required for the loan. Know when the payments are due and if prepayment on the loan is acceptable. Remember, everything is negotiable!
Also, keep in mind that on some small business loans, banks require certain covenants that either restrict the borrower from borrowing more funds or require the borrower to report financial information to the bank on a regular basis. Some even require life insurance policies on the business owner, too!
Borrowing money is a serious business and requires the small business owner to really understand the purpose of the loan and the lending requirements that they will face in the financial market. A trusted CPA and banker are essential to making this process efficient and effective for you.
If you have questions or comments on this article, I welcome a discussion on the topic. You can leave comments at the bottom of the blog page. Don’t forget you can follow and reach me on any one of the social media sites listed below. Simply press on the preferred button. If you’d like to schedule a call, click on this link.
The next article in the Where Do I Start? series will address every small business owner’s biggest question, When Do I Get Paid? 5 Tips To Setting Up A Draw