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Debt is a Useful Tool for Business Growth, But Not all Loans are Good Loans

Getting financing for your business is not an easy task and often requires understanding as much about the banker/investor as it does about the process of presenting yourself in the best possible financial light. Funding your business takes more than a great vision for success. It takes a clear and comprehensive financial plan. The more organized your plan is, the better your chance of getting financing.

Understand your financial condition and be able to show it to your lender

Money is loaned and funding is priced in terms of risk. The higher the risk, the higher the interest rate. The lender wants to be re-paid and needs to be shown how the money will be paid back to them. A lender looks for; Positive and growing sales trend with realistic projections.Net Profit which is adequate to re-pay the loan. Sales (product and services only) minus Direct Costs minus Overhead Expenses equals Net Profit.Positive equity on your Balance Sheet. Assets minus Liabilities equals Equity.Collateral (something to secure the loan that can be liquidated) in case of default on the loan such as equipment, real estate or accounts receivable. The higher the risk, the more liquid the collateral must be. For high risk loans, accounts receivable is more desirable as collateral than undeveloped land. The lender can liquidate these and get their money back faster than more long-term assets such as real estate. This varies from market to market.A personal guaranty of the borrower as secondary collateral.Solid credit and business history with no objectionable items (such as defaults on previous loans or bankruptcies).Borrowers who know how much money they need, how they will use it and how it will be paid back. Remember: debt gets repaid out of Net Income, not as a percentage of Gross Revenue.Opportunities to fund growth, not business losses.

If all the above meet the lender’s criteria, you should be considered a relatively safe risk and could qualify for conventional financing. Although you might qualify, certain lenders only lend in certain industries. Each lender is different.

Loans to Consider

Use a conventional lender (bank, mortgage company, or credit union) if you have an existing business with three years of profitability and positive equity. If your personal credit score is less than 650 or there are issues on your credit report that cannot be explained away, don’t waste your time going to a bank for funding; you will be rejected.

Some desirable loans that you should consider are those that will have a monthly payment that doesn’t change every month. The term of these loans is considered long-term as they are re-paid over a period that is longer than 12 months. These loans include:

  • Secured Line of Credit

  • Construction Loans

  • Real Estate Mortgages

  • Long-term Commercial Loans

  • Equipment Leases and Notes (capitalized)

  • Landlord Financing for Tenant Improvements

  • Seller Financing

Also, you can be sure that you will have adequate Net Income to make this monthly payment and still have money left over for operating capital. These loans are relatively predictable and allow you to grow equity over time as the loan is re-paid.

Some Creative Alternatives

When you borrow money from non-bank lenders there are far less rules and regulations, but the interest rate is usually higher. Before you seek these types of financing, be honest with yourself as to why you are unable to get conventional financing. Some of these alternatives are what is known as “Peer to Peer” lending. While some of the lenders might be banks, many are individuals who invest through online peer-to-peer platforms offering a variety of loan options. One of these platforms which is becoming increasingly popular is Crowd Funding such as GoFundMe, KickStarter and IndieGoGo. These might be viable options.

Some people borrow against their inventory, others create debt (bonds), some have lenders assume some existing debt while others borrow against their accounts receivable (lines of credit or factoring). As these loans are riskier, they are not cheap and are sometimes 10-20 points above conventional bank financing.

Loans to Avoid

Have you received those flyers, faxes or e-mails that offer up to $500,000 for working capital with no collateral or personal guaranties and promise a fast turn-around for funding? If you do burn it and run. This type of loan is being increasingly offered by credit card processors (including Square, American Express and Capital One). Credit Card Merchants and processors are not conventional lenders, they are considered asset-based lenders. An asset-based line of credit (ABL) is considered alternative financing and is available to borrowers who may not qualify for lower rate, conventional financing.

This type of loan uses your accounts receivable as collateral. In our industry 90-100% of our sales are paid for using credit cards. The lender calculates the loan amount plus interest and collects their payment every time they process one of your credit card collections. I have seen them withhold between 10% and 20% of the amount of the credit card collection. They then “rebate” you the remaining 90% - 80%. Debt should be repaid from Net Income not Gross Sales. In the following example, I will use a 10% withhold to show debt service. Businesses and practices in our industry operate on a Net Profit of 5% to 20% of Gross Revenue. That means that when you collect 100% of the money earned for Product and Service sales, after all Direct Costs and Overhead Expenses are paid, you have between 5% and 20% of your money as Net Profit to pay your debt and generate operating capital. Let me show you the math regarding how these loans erode your profitability and will put you out of business.

It doesn’t work for you and it does work for the lender. They get their money plus interest before you get the money for your sales. Don’t do it. There are always other ways to borrow money if you are profitable and get creative.

The Details

There is no one way to finance a business venture; borrowers need to know there are creative methods of funding. Financing takes many forms and is available from a wide range of sources including banks, credit unions, and family members. Lenders loan to credible borrowers with a feasible plan.

Prior to meeting with a lender, know your credit score and be prepared to answer questions regarding derogatory credit issues before presenting your application. Assemble your information including a completed loan application, an executive summary of your business plan, income tax returns (corporate and personal), financial statements (income statement and balance sheet), personal financial statements, a credit report, and a cash flow budget.

Business funding is not difficult if the borrower is organized, informed, creative, and realistic. You believe in your dream; now it’s up to you to put the financial pieces together so a lender will believe in you too.


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