Every small business owner that has been in business long enough will eventually run into a cash flow issue requiring a small business line of credit. Just like running a business is learned over time, learning what a bank or alternative lender will look for to approve your small business line of credit will also take some effort.
The purpose of this article is to give you some insider experience from a serial entrepreneur that has worked with traditional banks and alternative business financing companies for over 25 years. My hope is that through my experiences you will know better how to position your company to get the best small business line of credit, small business loan or revolving line of credit and how to not waste your time applying to lenders who will never approve your business.
The Difference Between a Business Loan or a Business Line of Credit
A business loan is a term loan that is spread out over a long period of time with a fixed monthly payment. A business term loan is usually a larger, lump-sum amount of money that is most often used to purchase equipment, inventory, or other large, fixed business expenses. A term business loan is typically not used for working capital because it must be taken all at once requiring you to pay interest on the whole amount regardless if you use the funds or not.
A small business line of credit is often used for a business’s short-term, working capital requirements. Working capital is what is required to run your day-to-day business. A small business line of credit is most often used because of the delay in when your clients pay you versus the immediate expenses that you must pay daily/weekly to run your business.
The small business lines of credit work by giving the business owner a preapproved amount of money that you have access to whenever your business needs cash. You can use as much of that credit limit as you like whenever you like. The repayment terms usually include the ability for you to pay the line off whenever you like in one lump sum or to make a minimum monthly payment. Unlike a term loan, you only have to pay interest on the money outstanding when it is used.
What Will A Traditional Lender Look For To Approve Your Business
A traditional lender is most often associated with a commercial or local bank. Banks are the first place that most business owners turn to for a business loan or a small business line of credit. However, what you should know is that traditional banks are the hardest to be approved for when it comes to a business loan.
What most business owners don’t know when they first approach a bank is that all banks want collateral to back up any loan or credit line. This is called a secured loan or secured business line of credit. Collateral can be in the form of equity in a home, business real estate, a business’s accounts receivable, or any liquid assets.
An unsecured business line of credit is extremely hard to obtain from a bank and is often approved based on the following factors:
- How is the overall economy doing?
- What industry are you in?
- How long has your relationship been with the bank you are applying with?
- What is your and your business partner’s personal credit score? (requiring 750 or higher)
- How big are your bank balances and cash flow running through the bank?
- How strong are your financial statements?
- What are your total capital needs?
- What is the loan amount you are seeking?
- What is your current annual revenue, gross profit margin, and net profit margin?
- Who are your clients?
In general, once you decide to apply for a business loan with a bank, you will be asked for the following:
- An extensive loan application with both personal and business information
- Financial statements such as income statements, balance sheets, AR/AP reports, tax returns, etc.
- Permission to run a personal credit check (banks will be looking for at least a 680 credit score)
- You will need to pay an application fee and a yearly maintenance fee
It used to be that traditional banks were the cheapest place for business owners to get a business loan from but over the years, online lenders have become much more competitive and in some cases can be even cheaper based on usage.
Online Lenders Can Be The Best Small Business Line of Credit Option
Due to the 2001 recession when banks stopped lending, online lenders came into existence. An online lender is a public or private company that uses investors’ money to lend out instead of bank depositors’ funds. Over the last 10 years online lenders have become the go-to source for the best small business lines of credit, business loans, cash advances, and Merchant cash advance because of the following reasons:
Based on the use of the business loan, online lenders can be cheaper
- Traditional banks charge application and annual fees. Most online lenders do not
- Many online lenders provide unsecured business loans and unsecured line of credit
- Personal credit scores required for online lenders are often much lower than banks
- Online lenders often take 1-3 days to approve a business loan versus weeks from a bank
- Online lenders require fewer documents such as bank statements & tax returns
- The application process to get an offer from an online lender is often very simple
- Online lenders are willing to work with less established businesses
- Due to the 2020 pandemic, many banks are now not approving any new business loans or small business lines of credit.
- You are not required to have a bank account with the online lenders
- Some online lenders will not require a personal guarantee
When Should A Business Owner Avoid a Business Line of Credit
A business line of credit should only be used when a business is profitable on a cash basis. Credit lines are most often used due to the need for some businesses to pay for expenses upfront (i.e. payroll) while waiting to be paid from their customers. If a business is not growing then the profits from the business should eventually allow for the line of credit to be paid down.
If you have a bank line of credit for your business one of the key factors the underwriters will look for to not only approve your credit line the first time but yearly is if you have the ability to pay the credit line down to zero during a 12 month period. If you can not pay the credit line down then you will probably not be approved. Many banks will require a 30 days period yearly where the line must be paid down to zero.
The biggest mistake that small business owners make is to be too reliant on their credit line. A credit line should be a cash backup plan for emergencies or opportunities. At some point, you should be able to pay the credit line back.
If you are unable to pay the credit line down over a period of time then the bank will require that you “term out” the line of credit. This means that your credit line will move to a term loan and you will have a fixed monthly payment plus interest. You will no longer have access to your business line of credit at this point.
Are Credit Cards a Form Of A Business Line of Credit?
Credit cards can be used as a business line of credit but there are some serious consequences if used too often:
- Credit cards for small businesses are always personally guaranteed thus they will affect your personal credit score
- Credit cards charge higher interest rate often between 21%-28% interest
- Credit cards often have a very low approval amount which may not be enough for businesses
- Getting multiple credit cards over the years has become harder
- Credit cards are personally guaranteed so if you close your business you are still responsible
- The cash advance feature of credit cards is often much less than the purchase credit limit
- Business credit cards under the business name with no personal guarantees are very hard to be approved for
What Is Invoice Factoring and is Factoring a Replacement For a Line of Credit
Invoice Factoring is a very old form of business financing that has been around for centuries and is less popular than it used to be due to the expense and terms required. Some small businesses that are in the business-to-business space use Factoring by going into a contract with a Factor who will advance funds against a credit-approved invoice. For example, let say you invoiced ABC client for $10,000 for work you just did. A Factor will give you a cash advance of up to 80% of that invoice or in this case $8,000. Once ABC client has paid the invoice, your Factor will keep his fee and send you the rest.
The good thing about Factoring is that it can be an endless supply of financing for your business. It also can be good if you have a poor personal credit score and are unable to get other financings.
The bad thing about Factoring is that you need to be in the business-to-business space. You also have to be prepared for the idea that you are going to have to get your client to agree to send their payments directly to the Factor which shows that your company may not be stable. Another issue can occur if your Factor deems some of your clients, not creditworthy. Lastly, Factoring is very expensive and is a long-time commitment that could be very challenging to move away from.
Business Financing is Autodidactic Which Means Self-taught
Like everything you have done as a business owner you have had to learn on your own and getting a business loan is no different. You have to dive into it, ask the right questions, and learn as you go. Many business owners are more interested in running their business than they are in lining up financing but as your company continues to grow, business financing will become a bigger part of your job and your business.
The biggest concept in understanding being approved for the best small business line of credit is the concept of collateral, personal credit score, and personal guarantees. If you understand those three components then it will go a long way to determining who you approach for a business loan.