The ability to access credit is one of the most important hurdles for small business owners to overcome. When seeking business financing, it is important to keep in mind the key items every bank will consider when analyzing a loan application. Best known as the “5 C’s of Credit”, these key items are Capacity, Collateral, Capital, Conditions and Character. Understanding how a request for a loan is viewed by a lender will better prepare the small business owner for the loan application process. Many small business owners have what a bank might consider as a deficiency in one or more of these “C’s” that might disqualify them for financing. It is important for small business owners to be aware that a local banking relationship is important and their local community bank might be an excellent solution for their financing needs, however, local banks are not the only choice for small business financing. There are alternative forms of financing a small business owner may need to consider to obtain the capital they need to grow or sustain their business when conventional bank financing is not available or not a good option.
First, let’s look at the traditional “5 C’s of Credit”
Capacity represents the business’ ability to repay debt. Banks will review historical and projected financial performance to determine whether they feel that the business can repay the requested loan. The business cash flow must meet a ratio above the proposed debt repayment to ensure repayment even if there is a decline in performance. The lender may also look at alternative sources of revenue that could support repayment of the loan such as a borrower’s income from another business or employment, a spouse’s income or investment income that the borrower may have.
Collateral is security for the loan as a secondary source of repayment. In most instances, collateral consists of the business assets being acquired with the requested loan, assets that the business already owns as shown on its company balance sheet, personal assets of the business owner or other securable assets. When looking at the loan to value or LTV (the percentage of the loan to the total collateral values), banks may often discount the current market value of the collateralized asset to what they might consider to be the assets liquidation value. Although real estate may or may not be discounted drastically from its appraisal, this revaluation is often true as it applies to equipment and business inventory. As a result, banks will not lend “dollar-for-dollar” when assets are being acquired. Thus, banks may require additional collateral to secure the loan.
Capital represents the equity invested in the business by the owners or the liquid assets held by the business or the business owner. Capital provides a cushion for a business to rely on during periods when cash flow is tight. Liquidity (cash or assets that are easily converted to cash such as stocks or other securities) is an important aspect of the lenders underwriting. Also, banks will ensure that the owners have sufficient personal investment (“skin in the game”) to remain dedicated to and focused on the business should difficult times arise. Depending on a number of factors, banks often look to the borrower to put in from 10 to 40% of the money needed in a transaction, with the bank providing the rest of the funds needed.
Conditions include a broad spectrum of issues relating to a borrower’s loan application and may vary from bank to bank. For example, it may speak to the economy in which the business operates. With a commercial loan, the lender may look at the national and local economy and whether or not this is a good time to make a loan to a specific type of business. Other issues may include the time in which the business has been operating as an ongoing business (“time in business” or “TIB”), the industry type (SIC code) or the specific type of property involved in the transaction. Additionally, there can be implications that may not be directly related to the borrower that may cause the bank to decline the loan application regardless of the borrower’s good credit or the quality of the collateral. For example, if the bank has a high concentration of loans in that industry or that property type or their institution has had several loans defaults in a specific industry or property in recent years, then they might not be comfortable making the loan. Banks will attempt to identify the main risks for the business, the industry, as well as the local and national economy. Once these risks are identified, banks will judge whether they feel the business is prepared to mitigate these risks as much as possible. The terms of the loan, such as its interest rate and amount of principal, also influence the bank's desire to finance the borrower. Conditions also refer to how a borrower intends to use the money. For example, a borrower may apply for a commercial real estate loan to buy their business location or a specific piece of business equipment or perhaps to expand the business and open a second location. A lender may view these loans in a different light than if it was a working capital loan that could be used for anything. In the situation of commercial loans, use of the loan proceeds is very important to the lender.
Character covers the “people” aspect of business lending. Banks will assess the business owner’s management ability, experience in the industry, business references, credit (both personal and business) and general integrity. Banks want to feel confident that the business owner will stand by the business obligations in tough times. The bank will look at the borrower's reputation or track record for repaying debts. This information appears on the borrower's credit reports. Generated by the three major credit bureaus – Experian, TransUnion and Equifax – credit reports contain detailed information about how much a business owner has borrowed in the past and whether the loans have been repaid on time. These reports also contain information on collection accounts, judgments, liens (including tax liens) and bankruptcies, and they retain most information for seven years. The Fair Isaac Corporation (FICO) uses this information to create a “credit score”, a tool lenders use to get a quick snapshot of creditworthiness before looking at credit reports and proceeding any further with a loan application. Although many banks will look at the big picture rather than focusing on just a personal credit score, they all have a minimum credit score that they require of a borrower. While it will vary from bank to bank, a minimum FICO score between 680 and 720 is quite common.
What are the alternatives?
Each of the 5 C’s plays a vital role in a lender’s decision or “underwriting” process. However, if a business is lacking in one area, it does not necessarily mean that a loan will be denied. But it does indicate that the business may need to be stronger in other areas to make up for the deficiency. In the financial market’s today, there are other lending sources and even third party resources available to help small business owners to mitigate any shortcomings in some of the areas mentioned above.
When Collateral is not available or it is limited, an excellent resource to consider is the U.S. Small Business Administration (SBA) which partners with participating banks. The SBA (www.sba.gov) is an independent agency founded in 1953 with a focus to aid, counsel and protect small business interests. The SBA’s 7(a) loan program provides a percentage guarantee on the loans provided by the participating banks. Depending on the loan amount, the SBA will guarantee between 50% and 85% of the loan, through what is known as the 7(a) loan program. With the benefit of an SBA 7(a) guarantee, banks may be more willing to finance a business with weaknesses in certain of the 5 C’s of Credit. Banks will traditionally consider using the SBA if the borrowing business is a start-up, has inadequate collateral, has insufficient equity, or if a longer maturity is needed. Many local community banks do not offer SBA guaranteed financing. Although most local banks prefer to work on loans of at least $300,000, SBA loans are available under the 7(a) program down to $50,000 and under that amount through the SBA Micro Loan Program which has a ceiling of $50,000. Specific national lenders specialize in the smaller SBA loans.
Loans are also available up to $500,000, or even $1,000,000 in some instances, for working capital through the new “Online or Alternative Lenders” that came into being during or since the past recession. These loans are made based primarily on the business cash flow and the ability of the business to pay off the loan in a short period of time (2 months to 5 years). The alternative lenders look at current cash flow to determine the viability and size of a loan. These loans are generally available for borrowers with both good credit and positive credit scores as well as borrowers with credit challenges and low credit scores.
When one of the Conditions of a loan application is that the funds are needed quickly, that may preclude a local bank from making the loan. However, speed in funding is a hallmark of Alternative Lenders. The cost for the loan is likely significantly higher than from a traditional bank, but if a business owner factor the opportunity that may be lost without the financing, the higher cost of the loan may make sense.
“Time in Business” (TIB) is another requirement that traditional banks have historically used in their credit underwriting logic as a hedge to mitigate the risks associated with an early stage business. Yet with today’s shortened path to financial success, many non-bank lenders may not place as much emphasis on time in business (perhaps 6 months or even less in some situations) if the business is doing well and has sufficient cash flow to service the debt. And of course, this is exactly when a business needs financing the most. Also, as expensive as debt may appear, it is always cheaper than equity obtained from outside investors if the business succeeds.
The providers of Merchant Cash Advances (MCA), advancing funds as a percentage of projected future credit card receipts of a small business, provide an alternative to overcome many of the deficiencies that may factor into the denial of a bank loan application. TIB isn’t a big factor with an MCA nor is the personal credit of a business owner. The future credit card receipts become the collateral for the “loan” (actually an advance).
Almost all lenders want to see a favorable Capacity and a strong indication that the borrower can repay the debt. However, there are circumstances when a borrower can’t show adequate Capacity. In those situations, if the borrower has a FICO credit score of at least 700 and their personal credit utilization is under 30%, business credit cards can be a great alternative financing solution for a small business. Credit utilization refers to the amount of personal credit a small business owner has and how much of that credit are the currently using. If that ratio is under 30%, they may be able to secure business credit (credit in the name of the business) in the form of multiple business credit cards totaling up to as much as $250,000. These credit cards, with very competitive interest rates, will often not reflect on the personal credit of the borrower and can help build business credit history for the small business. Local banks that issue credit cards most often will limit the amount of credit issued on their credit card to a much lower amount than is actually available in the marketplace.
When a local bank is unable to make a loan due to lack of Capacity (cash flow available to repay a loan), a small business owner can turn to an Asset Based Lender (ABL). These non-bank lenders make creative commercial loans based on the collateral value of the assets on the balance sheet as opposed to a working capital loan based on cash flow performance. These lenders will need unencumbered security to the asset but first position lenders are often flexible to carving out specific assets. As an asset based lender, they will monitor the value of the pledged collateral more closely than traditional banks. This allows the ABL to finance businesses that do not qualify for loans from traditional bank because their balance sheets and/or historic income statements do not meet credit standards. Therefore, asset based funding is an excellent resource for working capital lines of credit to fund growth, acquisitions, leveraged buyouts, and financial turnarounds. Financing using only accounts receivable, purchase orders in hand, inventory and equipment or a combination of these business assets can be a very favorable alternative form of financing with many benefits over traditional bank financing.
Equipment leasing programs from firms that specialize in that form of alternative business financing is another excellent source of funding for small business owners. Some equipment leasing firms look to the Capacity of the borrower with less focus on the asset being leased. Other leasing firms look more to the equipment being leased as the Collateral for the lease (basically a loan) and less on the Capacity of the borrower. Due to the small size of the transaction (a Condition), many local banks may not be interested in financing equipment for a small business customer. Fortunately, there are equipment leasing firms for every size and type of business equipment in the marketplace.
Regarding Character, most national and local banks have minimum credit criteria for small business owners seeking a loan, even for a commercial real estate investment. If a borrower credit score does not meet that minimum threshold, the bank is likely unable or unwilling to extend credit regardless of any other considerations. When a business owners credit profile does not meet the minimum standard of their business bank, there are other traditional lenders around the country who are very comfortable looking at a much broader credit criteria than most local banks. The appetite for loans varies from bank to bank, so someone looking for commercial real estate financing, for example, should work with an advisor who can help them secure the financing they need regardless of the borrower’s credit profile.
Another popular resource for small business owners is the SBA 504 loan program. When dealing with long-term equipment or owner-occupied real estate purchases, the SBA 504 loan program is geared towards reducing the traditional required down payment. Traditionally, banks require between 20%-30% as down payment. The main benefit of the 504 loan program is the borrower is required to put in as little as 10% towards the project and the SBA will provide up to 40% of the purchase (up to $2 million) on a longer-term (20 years for real estate and 10 years for equipment) basis.
In today’s economic environment, access to credit has become more challenging. Business owners must not only be more familiar with the financial standards required by banks, but also more educated about the resources available to them. Most banks want to help businesses reach their goals and create success through the implementation of a viable financing plan. However, when the local bank is unable to provide the requested credit or terms, alternatives to their local bank may make more sense for today’s small business owner or real estate investor. A qualified debt advisory professional can be a very valuable resource for business owners and investors to navigate through the many options in lenders and funding sources available in today’s marketplace.
Jim Albertson is a principal with the Central Funding Exchange™, a financial services firm that works with small businesses and investors, providing debt placement and debt advisory services nationally. firstname.lastname@example.org