Obtaining a Loan for Your Startup
If your new business is like most startups, you're seeking somewhere between $5,000 and $50,000 to get it off the ground. After exhausting your personal savings and loans from relatives and friends, your first instinct might be to get a bank loan or an SBA loan. Before you act on this instinct, let me tell you about three common misconceptions about bank financing for business startups.
1. If you need money, you can get a loan from the SBA. Type "SBA loan" into Google, and you'll find hundreds of websites purporting to facilitate loans from the SBA. The fact is, the SBA doesn't make loans. Visit the SBA's website, and it clearly states that the organization is not in the business of making loans.
Instead of direct lending, the SBA provides credit guarantees to banks and other institutional lenders who provide loans to business owners. The credit guarantee enables banks to make loans that are somewhat more risky than they would otherwise make. (Read this column for more details on SBA financing.)
In the past year, there have been many new developments regarding SBA financing including the proposed elimination of the Microloan program for loans under $35,000. If you're seeking a small loan, you should be aware of these developments by reading about this topic before approaching your banker to request a loan application. Typically, the SBA guarantee cannot by used by startup businesses without three years of sales history.
2. If you don't score high in each of the four Cs of credit, you can forget about getting a bank loan. Forget about the four C's of credit. In the past, banks made credit decisions based on a loan applicant's credit history, cash flow, collateral and character. Today, most financial institutions ignore three of the four Cs; they tend to focus only on your credit history in evaluating your creditworthiness. There are several reasons for this shift, but perhaps the most significant is the increased automation of the underwriting process at banks. It simply takes too long and costs too much to assess the character of each loan applicant, while someone's credit history is cheaper to obtain and may be a better indicator of the statistical likelihood of repayment.
This shift to automated credit decision-making is particularly true for small loans. For loans over $250,000, many banks are willing to expand underwriting criteria and spend time to meet applicants and understand their businesses. For smaller loans, the decision-making process is much like applying for a credit card: impersonal and automated. In fact, most large banks today are organized such that the managerial oversight for business loans under $250,000 is part of the consumer-lending function rather than the commercial lending function.
3. Banks don't care about you--just the state of your business. Wrong again! Since small loans are managed by the consumer-lending function at most banks, your personal credit history is the single most important criteria in determining the likelihood of you obtaining bank financing for your business.
Remember: Your business isn't the borrower; you are. And if you're borrowing less than $250,000 and your company doesn't have a long, audited history of profitability, your bank will require you to personally guarantee the business loan. A personal guarantee is a scary thing to sign. I know this firsthand because I've signed a few of these personal guarantee documents and they always make me shudder a bit. It's ironic that you can spend thousands of dollars in legal fees to incorporate your business in order to limit your personal liability, but it's virtually impossible to get bank financing without risking your personal credit.
In my view, there are some promising trends that will help entrepreneurs get bank financing without risking their personal credit: (1) Some data companies are establishing business credit ratings that are distinct from personal credit ratings; (2) some banks are specializing in small-business lending and recognizing the value to the entrepreneur of protecting his or her personal credit rating; and (3) some companies are helping startups to establish and improve their business credit rating.
In the meantime, understanding that landing a startup loan is much like obtaining a credit card will help establish your expectations and, hopefully, simplify the process.