What is a business loan?
A business loan is an agreement by a bank or financial organization to lend money to a business. The borrowed money and interest charges must be repaid according to the terms of a loan agreement. Application fees and loan origination fees may also apply.
Loans are one of the most common ways for a business to raise capital to fund operations or finance the purchase of assets. By giving a business access to additional capital, a business loan lets a company invest in equipment, staffing, inventory or facilities to support growth of the business.
While borrowed funds and interest charges must be repaid, taking on debt does not dilute the owners' stake in the business. The ability to retain full ownership often makes borrowing an attractive alternative to equity financing, which requires shareholders to give up a portion of their ownership in the business in return for funding.
Loans are utilized by businesses of all sizes, from small retail stores and service organizations, to large manufacturing companies and multinational corporations. As a practical matter, however, banks concentrate most of their lending on larger businesses; access to traditional lending is limited for many small businesses.
The limited availability of traditional bank loans for small businesses has created a need for alternative lending options. Venture capitalists, hedge funds and private investors who take a different approach to business lending often back these financial organizations. They focus on the cash flow and growth potential of the business rather than the owner's credit score or personal assets.
How large is the business loan marketplace?
In 2012, The Wall Street Journal reported that U.S. banks had more than $1.45 trillion in business loans outstanding, returning total volume to the levels seen prior to the Great Recession. The growth in business lending has been driven by increases in loans to large businesses, while lending to small businesses has declined significantly.
According to FDIC data, the share of nonfarm nonresidential business loans going to small businesses has declined from 51 percent in 1998 to just 26 percent today. And Businessweek reports that small business lending declined by 27 percent from 2008 to 2013.
Data from the Small Business Administration indicates that more than 99 percent of all employer firms are small businesses, but the Federal Reserve Bank of St. Louis reports that only 5 percent of all loans made by large banks go to small businesses.
Types of business loans
There are several types of loans available to businesses, ranging from traditional loans and business credit cards offered by banks, credit unions and commercial finance companies, to revenue-based funding offered by alternative lenders and business funding companies. In addition, small businesses may benefit from special loan programs offered by the Small Business Administration (SBA).
Bank Loans: Traditional loans offered by banks such as Wells Fargo and PNC Bank usually offer fixed payment terms for both short- and long-term loans. Short-term financing is often structured as a line of credit and usually must be repaid within one year. Long-term bank financing includes loans and leases with repayment terms that extend for a period of years.
SBA Loan Programs: The Small Business Administration was formed in 1953 to improve the funding options available to small businesses. SBA loans are made by SBA-approved lenders and are partially guaranteed by the SBA, which reduces lenders' risks when they provide financing to small businesses. The borrower negotiates specific loan terms with the lender. SBA loan programs include:
- SBA 7(a) General Small Business Loan Program. Offers up to $5 million to start a new business or assist in the operation or expansion of an existing business. Repayment terms vary from seven to 25 years.
- SBA 8(a) Business Development Program. Designed to assist socially and economically disadvantaged businesses; provides up to $4 million to companies that provide goods or services, or $6.5 million to manufacturing companies.
- SBA Microloan Program. Provides loans up to $50,000 for small business start up and expansion. Microloans are administered by nonprofit community-based organizations, which usually require collateral and a personal guarantee from the business owner. The average microloan is $13,000.
Business Credit Card: One of the most common financing options available to small businesses is a business credit card. These are essentially personal credit cards with the business name on them, relying on the owner's personal credit history for approval and credit limits. According to U.S. Census data, between 9.5 percent and 17.7 percent of businesses with 49 or fewer employees use a credit card to finance their operations or expansion. Bankrate.com features a search tool that makes it easy for business owners to search for business credit card offers.
|No. Employees||Pct. Using Credit Card|
Small business alternatives. According to a leading index reported in The New York Times, big banks approved less than one out of five small business loan applications in early 2014. Fortunately, alternative funding options are accessible to small businesses. While bank loan underwriting relies heavily on personal credit scores and personal collateral, alternative lenders evaluate the cash flow, growth potential and overall strength of the business. As a result, alternative loan options have much higher approval rates. These funding options include:
- Business term loans. Many alternative lenders offer a true business loan with a set repayment date and fixed daily or weekly payments that are based on an evaluation of business revenue. No personal collateral is required.
- Revenue-based financing. Provides an immediate infusion of capital in exchange for a fixed percentage of future business revenue. Used by business that invoice their customers, especially growth companies and seasonal businesses.
- Merchant cash advance. Up-front funding is provided in exchange for a portion of future credit/debit card sales. Automated repayment adjusts up and down with daily sales volume.
The most common uses for business loans.
As previously noted, more than $1.45 trillion in business loans was outstanding at U.S. banks in 2013. What is all that money used for? Just about any business expense you can imagine. Typically, there are different uses for short-term borrowing and long-term borrowing.
Short -term loans are most often used to finance operations.
Long-term loans are most often used to finance asset purchases.
Alternative loans are available to small businesses for any purpose.
- Emergency repairs
- •Unexpected tax bills
What it takes to qualify for a typical bank loan.
Since large banks approve fewer than 1 out of 5 small business loan applications, it's essential to understand what it takes to apply and qualify for bank financing. While every situation and application is different, here is a checklist of items that are required for most bank loan applications:
- Personal information: You will probably be asked to provide personal information such as past addresses, criminal record, education, and employment history.
- Business plan: A business plan should include a complete set of financial projections, including a profit and loss statement, cash flow projections and a balance sheet. Many traditional banks will want to see additional information in your business plan, so it's a good idea to review SBA business plan resources.
- Personal credit history: Most banks will need to pull your personal credit report as part of the application process. Be sure to check your credit report from all three credit rating agencies and correct any errors before submitting your loan application.
- Business credit report: If you've been in business for a while, your business may have its own credit report, which shows how your business has been paying obligations over time. Many traditional business lenders will ask for your EIN number and contact the business credit reporting agencies (Dun & Bradstreet www.dnb.com and Equifax Business www.equifax.com/business/small-business) to run a credit report on your business. Just like your personal credit report, it's a good idea to review your business' credit report and correct any inaccuracies before submitting your business loan application.
- Bank statements: Many bank loan applications require a full year of personal and business bank statements.
- Tax returns: Most conventional lenders require you to submit at least three years of personal and business tax returns. Alternative funding resources may not require as much tax information.
- Personal financial statement: Many bank loan programs require applicants to submit a personal financial statement. You may need to work with an accountant to prepare your financial statement.
- Legal documents: Most banks will require you to submit your business license, incorporations documents (if applicable), franchise agreements, relevant third-party contracts, commercial lease agreements or other similar documents. Alternative business funding companies generally will not require these documents.
- Collateral: Traditional banks will usually require the applicant to put up personal collateral as security against the amount being borrowed by the business. It's worth noting, however, that many of the newer alternative lending programs were designed specifically for small businesses that prefer not to offer the owner's home or personal property as collateral.
How to choose the right business loan.
Selecting the right financing option will help ensure that you get the funding you need, when you need it, with repayment terms that work for your business. These questions will help guide your choice:
- What do you need financing for? If you need money for seasonal payroll, inventory or other operational expenses, you may want to consider short-term financing such as a line of credit or merchant cash advance. Capital expenses for real estate, major equipment purchases or other fixed assets may be eligible for long-term financing.
- How soon do you need financing? Most traditional bank applications can take weeks or months for approval and funding. If you need money immediately, it may be a good idea to consider revenue-based financing or a merchant cash advance, both of which can deliver funds in just a few days.
- Do you have personal assets that you want to use as collateral? Most traditional bank loans require the small business owner to supply personal collateral, which decreases the bank's risk in the event of a default. If you prefer not to use your personal property as collateral, you should consider alternative funding options that do not require collateral.
- How is strong your credit history? If your personal credit score is excellent, your business may be a candidate for traditional financing. If there are a few blemishes on your credit report, however, you will need to consider alternative funding options such as revenue-based financing or merchant cash advance, which place more emphasis on the strength of your business and less emphasis on your personal credit score.
- How steady is your cash flow? If you have steady cash flow throughout the year, your business will be a good candidate for revenue-based financing. If your cash flow is highly seasonal, choose a merchant cash advance, which features a variable repayment amount that tracks your actual sales volume.
How to apply for a business loan.
The process of applying for a business loan varies quite a bit depending on the type of loan you choose for your business. Traditional bank loan applications may be started by phone or online, but you will almost certainly need to make a trip or two to a bank branch to meet with a loan officer. Business credit card applications are usually completed online or by mail; approval will be based entirely on your personal credit history.
The growth of web-based alternative lending options offers small business owners an opportunity to access a network of funding partners with a single online application. Using a network of funding providers greatly increases your chance of getting approved for funding. Look for a company such as LendVantage, which includes the finance industry's top small business funding providers, and carefully evaluates your needs to connect you with the right funding partner.
The reality of small business loans.
Everyone who dreams of starting a business must eventually confront the reality that it is not easy to obtain conventional bank financing. According to a report in USA Today, large banks approved just 17.6 percent of small-business loans applications at the end of 2013. Even community banks, which are generally more favorable to small business lending, reject nearly half of all business loan applications.
According to Bankrate.com, it is important for businesses seeking bank loans to target a large number of banks, since the odds of rejection from any single bank are relatively high.
Even when multiple banks are targeted, however, the reality is that getting approved for bank financing requires a strong credit history and a high personal credit score. Also, in almost all cases, personal assets will be required as collateral to reduce the bank's risk in case of default.
Even a strong business can be turned down for a business loan. This rejection is often the result of automated credit scoring, which takes place with no real evaluation of the business. Much like automated credit scoring that has been used in consumer lending for decades, the primary variable in business credit scoring is the business owner's personal credit score. Since very few business-specific factors are considered, automated scoring makes personal credit history more important than ever.
Why don't banks lend to small business?
Approval rates for small business loans have always been relatively low, and they declined significantly following the 2008/2009 financial crisis. According to SBA data, commercial and industrial lending to small businesses declined by more than 20% from 2008 to 2011, Similarly, the SBA reports that the annual number of loans of $100,000 or less declined by 77% from 2007 to 2011. And the situation has been slow to improve: recent reports indicate that big banks are still rejecting more than four out of five small business applications.
While the ongoing decline in traditional small business lending is partially explained by weakness in the economy, the reluctance of banks to lend to small businesses is also due to factors that preceded the recession. Some of the roadblocks include:
- Bank loan underwriting costs are essentially the same for a $10 million loan and a $100,000 loan, so most banks prefer larger loans that are more profitable.
- Traditional banks and financial institutions tend to have rigid underwriting requirements that do not favor small businesses.
- Many banks lack experience working with a wide variety of small businesses, making it hard for them to evaluate risks and opportunities.
- At most typical banks, underwriting decisions place more emphasis on personal credit history than cash flow and business strength.
- Almost all traditional banks require personal collateral to reduce their risk when lending to small businesses.
Repaying a business loan
Business loans offer a variety of repayment options, ranging from fixed repayment schedules to flexible repayment plans that automatically adjust to the business' sales volume.
- Bank loans
- Fixed monthly payment amount with a fixed term
- Business line of credit
- Regular monthly payments based on amount borrowed plus accrued interest; term negotiated as part of loan agreement
- SBA loan
- Fixed monthly payment amount with a fixed term
- Business credit card
- Minimum monthly payments based on spending plus interest; term varies according to card agreement
- Alternative bank loan
- Fixed payments with a fixed term up to 24 months; repayment may be renegotiated periodically to reflect actual business performance
- Revenue-based financing
- Automated daily or weekly payments made by ACH from business bank account; payments adjust to reflect actual cash flow; term varies based on revenue, usually four to 18 months
- Merchant cash advance
- Flexible repayment is a preset percentage of daily credit/debit card sales; no pre-set term but usually repaid in six to eight months
Alternative lending fills the void.
The reality that traditional bank loans are unattainable for many small businesses has created a need for alternative lending options. The key difference is that these alternatives evaluate loan opportunities based on the strength of the business rather than the owner's personal credit score. As a result, approval rates are much higher.
In addition to being more accessible, alternative lending options have been developed outside the traditional banking world, so they often offer customer-friendly features, including streamlined application processes, quick pre-approval, fast delivery of funds and flexible repayment options.
According to Businessweek.com, analysts estimate that alternative business lending reached $3 billion last year, mostly in loans of $100,000 or less, which is double the amount of similarly sized SBA loans for the same period. Experts predict double-digit growth for these small business loan alternatives.
- Business term loans
- Revenue-based financing
- Merchant cash advance