BUYER’S GUIDE: Business loans
Some well-financed soul out there probably wants to lend money to your business. The question is, who is this person, and on what terms?
We recognize that small business loans can be difficult to find these days. We want to make the process easier and more transparent for you.
We describe the process of most small businesses’ search for a loan, starting at the gold standard – an old-fashioned bank loan – through other alternatives from nonbank lenders, so-called “hard money” lenders and asset-based lenders.
This buyers guide will address some of the most common questions small business owners ask when seeking a commercial loan, including:
Small business loan
Financial institutions can also call these term loans or business venture loans. These loans are often larger than line of credit borrowings, and require at least as much documentation. Unlike corporate credit cards and lines of credit, borrowers usually draw down the entire amount of small business loans for a major purchase. The loans usually have a much longer repayment term than a line of credit. A Small Business Administration-backed loan is different from a general business loan. If you default, the SBA will cover part of the loss to the bank from an SBA-backed loan. But the application process is substantially more involved – so much so that many banks will not offer SBA-backed loans. Depending on the size of your business, a typical non-SBA-backed small business loan will require the “personal guarantee” of the owner of the company. This means that if a company defaults on the loan, a lender will be able to approach the owner for the money – it makes the owner personally liable for the loan performance.
Line of credit
This type of loan is designed to finance short-term working capital needs – inventory purchases or operating expenses. You wouldn't use this kind of loan for big purchases. But businesses with choppy sales patterns – big gains during the holidays and weak sales in the summer, for example – tend to want lines of credit to smooth out their operating finances. You generally need to be a profitable business that can demonstrate positive cash flow to receive a line of credit loan. Lines of credit come in two varieties: secured and unsecured. A secured line of credit uses your inventory or other property as collateral. An unsecured line of credit does not.
The application process takes longer and requires more documentation than that for a corporate credit card, but the interest rate is lower and the amount available to borrow is usually much higher. Lines of credit can generally be renewed annually. The interest rate is fixed, unlike a credit card.
Corporate credit cards
A business credit card works more or less like a personal credit card. It's a revolving loan with a set limit. It's usually easier to qualify for a business credit card than a business loan, assuming your company's credit is pretty good. Unlike business lines of credit, you usually don't have to reapply for a credit card every year. Credit cards make it easy to keep your business expenses separate from your personal expenses, if you're disciplined about using your business card only for business spending. The incentives offered by credit card companies – free flights, cash-back discounts – can be useful for small businesses. And a credit card, used wisely, can help manage cash flow. However, the interest rate on a credit card is usually higher than available rates for lines of credit or small business loans. The loan limit is lower. Business credit cards can be lost or abused by unscrupulous employees. And, most of the time, your bank will require a personal guarantee to put you on the hook for repayment if your company can't pay the bill – there's no limited liability for a corporate credit card.
Commercial Real Estate Loans
This is a mortgage, more or less just like your home mortgage, with three major differences. First, commercial real estate loan are generally considered more risky than home loans … even these days. Thus, lenders will tend to require a larger down payment. Also, lenders evaluate commercial real estate as much by the expected future cash flow from the property as by its relative value and likelihood of appreciation. Finally, commercial property loans tend to be shorter term than home mortgages. Each of these factors will influence a lenders’ decision to finance property.
Hard Money Loans
These are loans made against the equity in a business, either its real estate or other assets. It’s a cornerstone in the asset-based financing industry, along with merchant cash advances and factoring (two forms of finance that are not lending, strictly speaking, but have similarities to lending.) Hard money loans are almost always made by nonbank lenders, and generally carry interest rates several points higher than standard bank loans. Borrowers who can’t obtain bank financing are candidates for these loans.
Businesses seek bridge loans to sustain short term financing in between major financings. The loan is a “bridge” between one state of stable financing and another, when, for example, a firm is reaching the maturity date for a bank loan, but hasn’t yet secured funding for a refinance of the debt, sold assets to cover the loan or placed a bond. Bridge loans are more expensive than most traditional financing, but are meant to be a short-term stopgap.
This is a loan for building a new facility, office space or other commercial property. It differs from a commercial real estate loan because of the increased risk. Often, lenders disburse this kind of loan in stages of construction, with each phase of completion prompting a new disbursement.
Angel and Venture Capital Loans
Most of the time, angel investors and venture capitalists trade cash for equity, not debt. But a surprising number of these investments are loans. According to research in the Entrepreneurship in the United States Assessment, a survey of investor behavior, debt accounts for about 40 percent of the money invested by angels to startups. About 14 percent of angel investments are pure debt. Convertible bonds that allow a lender to take equity in the company later have fallen out of favor among some professional angel investors, but are still relatively common.
These are loans to purchase equipment. These loans tend to be easier to make for lenders, because the equipment can be valued with relative accuracy and serves as collateral on the loan.
We’ve been told with uncharacteristic bluntness from lenders – particularly alternative financing lenders – that demand for loans remains high right now. For example, most lenders today will charge a fee to take a loan application.
“Today, with lenders, they’re not going to do the due diligence without a fee,” William Morgenstein, president of Florida-based financial services firm Marquesa Funding. “They’re inundated as it is. They’re not going to do it without getting paid for the underwriting.”
Firms like Marquesa, which deal in alternative financing for small and medium sized businesses, have no shortage of applicants these days, he said.
On some level, even as borrowers are weeding out lenders, the lenders find themselves weeding out borrowers. For Morgenstein, a few questions can immediately eliminate a potential client. “Misstatements. Checking out facts, asking someone what their credit rating is,” he said. “You’ll ask someone what their credit rating is and they won’t know or will tell you something vague – a good broker will sense something that isn’t forthcoming and you have to drop that right away.”
Experience is a second factor, he said. “They go into business, but they have no background for it,” Morgenstein said. “They might be good at certain parts of it but don’t have the business background – the lenders today won’t go for that at all.”
Morgenstein also likes to see some skin in the game – financial evidence that a borrower stands to gain from the business, and has something tangible to lose if the business doesn’t perform. Lenders are also looking very hard at cash flow, he said. “They’re less worried about the (profit and loss) statement. More important is the cash flow statement.”
Below, we’ve listed the most common factors cited in lenders’ decisions to offer credit to a business.
Your business’ credit: Lenders will review your firm’s credit rating with Experian, Dun & Bradstreet and other rating agencies, to see who you are doing business with, how long you’ve been in business, your company’s payment record, and how much debt you’re carrying. Experian releases a monthly report describing credit and payment patterns in the US.
Different credit rating agencies use different models, of course. According to Experian, firms with delinquent accounts are an average of 6.3 days beyond terms. About 12.7 percent of their accounts payable are delinquent and about 5.7 percent are more than 90 days late. If your company is performing worse than this, you’re in the bottom half of the lending pool.
Here’s a sense of how lenders view your credit score, from one of our partners, OnDeck Capital. OnDeck has a tool to help businesses determine what kind of credit they can obtain.
Your credit: Particularly true with alternative lenders, your personal credit record can be a flag for a loan to your business. If you’re having trouble making payments on your own debts – late car payments, mortgage payments, student loans or credit cards – then lenders may believe that you might allow your business loans to default before your personal loans. Oddly enough, the evidence appears to be exactly the opposite: a recent Experian presenter noted that business owners more often allow their personal loans to default before their business loans, possibly because many business owners would rather take a hit on their own credit than jeopardize their source of income. Credit scores below 680 are considered subprime, and will probably take you out of consideration for an SBA loan.
Collateral: Different kinds of lenders will appraise the value of your collateral differently. Conventional lenders can make judgments about the value of your business and its assets based on the present value of its future cash flow. Hard money lenders are far more interested in the straight sale value of your property, and typically lend at a lower loan to value rate than conventional lenders.
Loan to Value Ratio: LTV Ratio is the amount you plan to borrow, divided by the value of the thing you plan to purchase. If you’re buying property, or a business, then that value is used in the denominator. If you’re borrowing money to finance working capital, then this calculation become more complicated, and some lenders will throw it out entirely, in favor of a different ratio. Most conventional lenders will require a loan to capital ratio under 60 to 70 percent. SBA loans allow for much higher values, up to 100 percent.
Equity: This is a similar consideration to collateral. Lenders want to know that the borrower has “skin in the game,” or that the borrower serves to benefit from the transaction.
Cash flow: Only predatory lenders will want to make a loan that hurts a client more than it helps. Cash flow is a yardstick. Put simply, a lender wants to know that you’ll be making more money with a loan than without it. It’s another way of looking at your skin in the game. If your company lacks the cash flow to pay off the loan, you may not be a candidate for that kind of loan.
Debt Coverage Ratio: The DCR is Net Operating Income divided by your annual loan payment, and represents the amount of money you can reasonably expect to afford to pay on business loans. Depending on the lender, DCR can be more important than your loan to value. Most lenders are looking for a DCR of 1.2 or better, which is to say, operating income at least 20 percent greater than your total debt burden. Expect to have to justify your income and expense projections with some rigor.
Application history: Normally, shopping around widely for a good loan makes perfect sense. Not so for business loans. Potential loan clients have inundated lenders with competitive offerings. When a lender does a credit check on an application, that lender can see a record of all the other credit checks that other lenders have performed, regardless of whether a loan was approved or denied. Lenders tell us that seeing multiple credit checks by their competitors is a red flag – it’s an indication that the client may have been turned down during the diligence process by other lenders.
Lenders view the following signs as red flags:
· Over-borrowing or under-borrowing.
· A change in ownership.
· A weak or inexperienced management team.
· Aggressive tax management on financial statements.
· Multiple business incorporations by the same owner in different states.
· No fixed address for the business.
· A weak or nonexistent business plan.
· A lack of references.
· An effective tax rate far below the industry standard
· Improper or aggressive capitalization of expenses.
· Lying to your broker or lender about your credit score before a credit check.
· Writing off personal expenses as business expenses.
· Selling off property or equipment without adequate explanation.
· Allowing property or equipment to become fully depreciated without capital expenditures to replace the losses.
· An unexplained slowdown in your company’s cash cycle or operating cycle.
Multiple complaints on Internet scam boards: Any company doing enough business is bound to draw complaints. But lenders – especially alternative lenders who don’t have to answer to a regulator – should be treated with caution when a complaint on sites such as RipOffReport.com, the Better Business Bureau or Complaints.com are recent, repeated and plausible. Maybe it’s just one angry former customer, or someone with unreasonable expectations, or an online shakedown artist. But check the boards anyway, and pay attention to the tone of the complaint.
A lender comes from nowhere with a deal in hand: Lenders say they’re beating potential customers away with sticks. While it might seem a little shady, the fact is that most finance-providing businesses cold-call from time to time. That's not to say that all of them have great offers for you. The safest thing to do is to get a contact number for the salesperson, research their offer and, if you like it, call them back to do business with them. Sure, the call may be the tip of a scam, but it only takes a small amount of diligence on your part to figure that out. Something to raise your suspicion is if a financing company makes ....
A request for a big fee up front: This is the classic advance fee scam, perfected by nameless spammers from sub-Saharan Africa. A lender will offer an oversized loan at an attractive rate of interest and quick closure. All that is necessary is a nominal fee to cover administrative costs -- $1000, $5000, or in one case noted on RipOffReport, $300,000. The check gets cashed (or the wire transfer completes), and then … silence.
Terms “to be discussed later”: You should negotiate all your terms up front. Forms that have blanks or contain untrue information that the lender’s people “will fix later” are a serious problem. A legitimate lender will want you to be completely honest. Being asked to lie on forms or to other people about your assets, the appraisal of your property or your financial condition exposes you to potential fraud liability.
Forms vary by program and lending institution, but they almost all ask for the same information. You should be prepared to answer the following questions:
· Why are you applying for this loan?
· How will the loan proceeds be used?
· What assets need to be purchased, and who are your suppliers?
· What other business debt do you have, and who are your creditors?
· Who are the members of your management team?
Most applications will also require a battery of financial information about you, your firm and your plans. Here are the most common elements:
Personal Background: Either as part of the loan application or as a separate document, you will likely need to provide some personal background information, including: previous addresses, names used, criminal record, educational background, etc.
Resumes: Some lenders require evidence of management or business experience, particularly for loans that can be used to start a new business.
Business Plan: All loan programs require a sound business plan to be submitted with the loan application. The business plan should include a complete set of projected financial statements, including profit and loss, cash flow, and balance sheet.
Personal Credit Report: Your lender will obtain your personal credit report as part of the application process. However, you should obtain a credit report from all three major consumer credit rating agencies before submitting a loan application to the lender. Inaccuracies and blemishes on your credit report can hurt your chances of getting a loan approved. It’s critical you try to clear these up before beginning the application process.
Business Credit Report: If you are already in business, you should be prepared to submit a credit report for your business. As with the personal credit report, it is important to review your business’ credit report before beginning the application process.
Income Tax Returns: Most loan programs require applicants to submit personal and business income tax returns for the previous 3 years.
Financial Statements: Many loan programs require owners with more than a 20% stake in their business to submit signed personal financial statements. You may also be required to provide projected financial statements either as part of, or separate from your business plan. It is a good idea to have these prepared and ready in case a program for which you are applying requires these documents to be submitted individually. Many loan programs require one year of personal and business bank statements to be submitted as part of a loan package.
Accounts Receivable and Accounts Payable: Most loan programs require details of a business’ most current financial position. Asset-based lenders will probably want to see this before almost any other documentation. Before you begin the loan application process, make sure you have accounts receivable and accounts payable.
Collateral: Collateral requirements vary greatly. Some loan programs do not require collateral. Loans involving higher risk for default require substantial collateral. Strong business plans and financial statements can help you avoid putting up collateral. In any case, it is a good idea to prepare a collateral document that describes cost/value of personal or business property that will be used to secure a loan.
Legal Documents: Depending on a loan’s specific requirements, your lender may require you to submit one or more legal documents. Make sure you have the following items in order, if applicable:
· Business licenses and registrations required for you to conduct business
· Articles of Incorporation
· Copies of contracts you have with any third parties
· Franchise agreements
· Commercial leases
Organizing Your Documents
Keeping good records is essential for running a successful business, and especially critical when applying for a loan. Make sure required documents are orderly and accurate. All information you provide will be verified by your lender and the organization guaranteeing the loan. False or misleading information will result in your loan being denied. Finally, make sure you keep personal copies of all loan packages.
The US Small Business Association doesn't actually make loans – it backs the loans made by banks to small businesses which might not otherwise qualify for financing.
The SBA has three basic loan programs, the basic 7(a) loan for most small business, the CDC/504 program for businesses expanding their manufacturing operations with equipment purchases, and the relatively new microlending program. Other programs exist – check www.sba.gov for more details.
Basic 7(a) Loan Program
The most basic and most used loan, of SBA's business loan programs, is the 7(a), which are only available on a guaranty basis. This means they are provided by lenders who choose to structure their own loans by SBA's requirements and who apply and receive a guaranty from SBA on a portion of this loan. The lender and SBA share the risk that a borrower will not be able to repay the loan in full.
The SBA looks at the repayment ability from the cash flow of the business, as well as good character, management capability, collateral, and the owner's equity contribution. If you own 20 percent or more of your company, you are required to personally guarantee payback of an SBA loan for your company.
All businesses that are considered for financing under SBA’s 7(a) loan program must meet SBA size standards, be for-profit, not already have the internal resources (business or personal) to provide the financing, and be able to demonstrate repayment. Your company and its affiliates can’t be worth more than $8.5 million and average net income after federal income taxes (excluding any carry-over losses) for the preceding two completed fiscal years can’t be more than $3 million.
Some business have additional considerations for SBA-backed loans:
The SBA's 7(a) Loan Program has a maximum loan amount of $2 million dollars with a maximum exposure of $1.5 million. Thus, if a business receives an SBA guaranteed loan for $2 million, the maximum guaranty to the lender will be $1.5 million or 75 percent. SBAExpress loans have a maximum guaranty set at 50 percent. The maximum length of a SBA-backed loan is generally 25 years for real estate and equipment; and, generally, seven years for working capital.
Interest rates may be fixed or variable. Fixed rate loans of $50,000 or more must not exceed Prime Plus 2.25 percent if the maturity is less than 7 years, and Prime Plus 2.75 percent if the maturity is 7 years or more. For loans between $25,000 and $50,000, maximum rates must not exceed Prime Plus 3.25 percent if the maturity is less than 7 years, and Prime Plus 3.75 percent if the maturity is 7 years or more. For loans of $25,000 or less, the maximum interest rate must not exceed Prime Plus 4.25 percent if the maturity is less than 7 years, and Prime Plus 4.75 percent, if the maturity is 7 years or more.
The CDC/504 loan program is a long-term financing tool for economic development within a community. The 504 Program provides growing businesses with long-term, fixed-rate financing for major fixed assets, such as land and buildings.
Proceeds from 504 loans must be used for fixed asset projects such as purchasing land and improvements, including existing buildings, grading, street improvements, utilities, parking lots and landscaping; construction of new facilities, or modernizing, renovating or converting existing facilities; or purchasing long-term machinery and equipment.
The 504 Program cannot be used for working capital or inventory, consolidating or repaying debt, or refinancing.
A Certified Development Company is a nonprofit corporation set up to contribute to the economic development of its community. CDCs work with the SBA and private-sector lenders to provide financing to small businesses. There are about 270 CDCs nationwide, with each covering a specific geographic area. For more information, look here: [http://www.sba.gov/services/financialassistance/sbaloantopics/cdc504/index.html]
The Microloan program provides very small loans to start-up, newly established, or growing small business concerns. Nonprofit community based lenders make these SBA-backed loans to eligible borrowers, up to a maximum of $35,000. The average loan size is about $13,000.
The maximum term allowed for a microloan is six years. Interest rates vary, depending upon the intermediary lender and costs to the intermediary, but generally these rates will be between eight percent and thirteen percent.
Each intermediary lender has its own lending and credit requirements. However, business owners contemplating application for a microloan should be aware that intermediaries will generally require some type of collateral, and the personal guarantee of the business owner.
Currently, microlenders can be found in every state except Alaska, Rhode Island, Utah and West Virginia. Rhode Island is currently being serviced by South Eastern Economic Development out of Taunton, Mass., and a portion of West Virginia is being serviced by Washington County Council on Economic Development out of Washington, Pa. For more information, look here: [http://www.sba.gov/services/financialassistance/sbaloantopics/microloans/index.html]
SBA Loan Application Checklist
Application for Business Loan - SBA Form 4 (This form should be completed by you, the business owner.)
Lenders Application for Guaranty or Participation - SBA Form 4i (This form should be completed by your lending institution.)
Statement of Personal History - SBA Form 912
Personal Financial Statement
Personal Financial Statement - SBA form 413
Business Financial Statements
Detailed, signed Balance Sheet and Profit & Loss. Statements current (within 90 days of application) and last three fiscal years Supplementary Schedules required on Current Financial Statements.
Projected Financial Statements
Detailed one year projection of Income & Finances (please attach written explanation as to how you expect to achieve same).
Ownership and Affiliations
A list of names and addresses of any subsidiaries and affiliates, including concerns in which the applicant holds a controlling (but not necessarily a majority) interest and other concerns that may be affiliated by stock ownership, franchise, proposed merger or otherwise with the applicant.
Business Certificate / License
Certificate of Doing Business (If a corporation, stamp corporate seal on SBA Form 4 section 12).
Loan Application History
By Law, the SBA may not guarantee a loan if a business can obtain funds on reasonable terms from a bank or other private source. A borrower therefore must first seek private financing.
A company must be independently owned and operated, not dominant in its field and must meet certain standards of size in terms of employees or annual receipts. Loans cannot b made to speculative businesses, newspapers, or businesses engaged in gambling.
Applicants for loans must also agree to comply with SBA regulation that there will be no discrimination in employment or services to the public, based on race, color, religion, national origin, sex or marital status.
Business Income Tax Returns
Signed Business Federal Income Tax Returns for previous three (3) year.
Personal Tax Returns
Signed Personal Federal Income Tax Returns of principals for previous three (3) years.
Personal Resume including business experience of each principal.
Business Overview and History
Brief history of the business and its problems. Include an explanation of why the SBA loan is needed and how it will help the business.
Copy of Business Lease (or note from landlord) giving terms of proposed lease.
For purchasing an existing business:
Current Balance Sheet and Profit & Loss Statement of business to be purchased.
Previous two years Federal Income Tax Returns of the business.
Propose Bill of Sale Including: Terms of Sale.
Asking Price with schedule of:
· Machinery & Equipment
· Furniture & Fixtures
It’s counterintuitive, but shopping around for a business loan can hurt your chances of getting a good deal. Many people know that a credit check can temporarily depress your credit score. But the nominal drop in a FICA score doesn’t convey the actual damage done to your chances of securing business credit, particularly from an alternative lender. Lenders say multiple credit checks from potential buyers are a red flag.
“You see this person, and you see that they’ve gone to four different people,” said William Morgenstein, president of Florida-based financial services firm Marquesa Funding. “The risk is too high. Bang, you’re out.”
There’s a difference between a hard credit check and a soft credit check, however. A hard credit check requires your permission and your social security number. Soft credit checks require no permission or SSN, and any number of soft credit checks may appear on your report.
Either credit check can adversely affect your credit profile. The effect is simply more formal in the case of a hard credit check.
To limit this damage, you should begin looking for a lender through your existing financial network first. Lenders that know you and your business may be more willing to discuss your credit profile informally before making hard credit checks. Recommendations from your network of business contacts can also allow for informational conversations before a credit check.
Bank loans and rates
Loan rates fluctuate, of course. On any given day, different banks may offer a different rate to the same borrower, and the same bank may offer somewhat similar terms to very different borrowers. However, some trends are common. Most business loans to small businesses in the US are tied to the prime rate, plus some amount. Some loans are tied to the LIBOR, or the London Interbank Offering Rate.
Annual fees tend to be between one and two percent of the loan amount, and generally no less than $100 in any case.
Smaller banks tend to offer loans at higher interest rates than large banks. In the Federal Reserve’s most recent Survey of Terms of Business Lending, smaller domestic banks offered loans at an average rate of interest of about 5.11 percent, compared to 3.42 percent for large domestic banks. Smaller banks tend to be more willing to underwrite a loan, however, if the bank clearly understands your business and its operating environment.
Smaller banks offer smaller loans. The average loan size at a large domestic bank in July was $451,000. For small banks, the figure is $98,000. For low-risk loans, the average at large banks was $1.5 million; at small banks, $69,000. For loans in the “other” category (read: high risk), large banks offered average loan sizes of $428,000 at an interest of 3.27 percent. For small domestic banks, the average was $105,000 at an interest rate of 5.4 percent.
Smaller loans carry higher interest rates. The average loans between $7,500 and $100,000 carried an interest rate of 4.66 percent. For loans between $100,000 and $1 million, the rate dropped to 4.06 percent. For loans greater than $1 million, the rate dropped to 2.97 percent.
Smaller banks require more collateral. Large banks required collateral on loans about 57 percent of the time. Smaller banks required it about 88 percent of the time. As the size of a loan increases, the requirement for collateral decreases.
Nonbank lenders and rates
Nonbank loans can come from individuals as lenders, microlending companies, specialist financial organizations, and other sources.
The peer-to-peer microlender Prosper.com offers some insight into the interest rates smaller companies can expect to find for smaller loans in the marketplace.
Prosper Statistics December 2009
Prosper uses a combination of credit ratings and its own data around loan performance to determine the expected losses associated with a loan. Prosper’s rating’s range from AA – the highest credit rating, for loans with a loss risk of under 2 percent – to HR, or high risk, for loans with an expected loss rate greater than 15 percent. Looking at the methodology for determining a Prosper Rating, we found important break points in risk when borrowers crossed 690, 702 and 724 on Experian’s 600-990 business credit rating scale.
Estimated Avg. Annual Loss Rate*
· estimated average annualized net loss rate
Corporate Credit Cards: Rates for a business credit card tend to be higher than those for business loans, equipment and property loans or lines of credit, but lower than some alternative sources of capital. Qualifying for a business credit card often requires a reasonably long operating history, an established relationship with a bank, or some kind of security – often a personal guarantee on top of your firm’s pledge to repay. Corporate credit card APRs, as of August 2010, varies between 11.25 and 15.24 annual interest at the standard rate. Default rates after a missed payment can reach 30 percent. At limits greater than $10,000, lines of credit become better financial options, when available.
Conventional commercial real estate loans and construction loans: When offered, these tend to be at rates of prime plus three to six percent. In August 2010, for example, that would be rates of 6.25 to 9.25 percent. Typical fees add one to two percent of the loan amount to the cost.
Bridge loans: Specialist firms offering bridge loans tend to present terms that are significantly higher than a comparable short-term bank loan. If a bank offers a 12-month loan at a 7 percent APR, expect a bridge loan to be around 10 to 11 percent, plus fees.
Equipment financing loans: Rates for equipment financing loans, vehicle loans and other similar loans tend to be at rates somewhat higher than that of a commercial real estate loan. As of August 2010, rates of 7.25 to 10 percent are common in the marketplace. Significantly, the loan-to-value for equipment loans is usually higher than that of commercial real estate loans – 80 to 95 percent LTV – because the equipment can be valued easily and serves as collateral for the loan.
Hard money loans: A hard money loan typically carries an interest rate of 11 to 20 percent. The range is broad because lenders evaluate collateral differently, and because the terms offered to clients can depend on other factors. Usually, the credit worthiness of a client is less important than the perceived value of the property used as collateral when determining interest rates. Lenders will generally charge a fee of 4 to 8 points points on the loan – lower points may carry a higher interest rate. Lenders generally offer loans between 40 and 70 percent of the value of the collateral.
Angel investment and venture capital: There is no “normal” angel investment rate – the reasons individual investors lend money to startups are too varied. However, many professional investors in startups use a rule of thumb for their expected return on investment for an equity stake: Given the high risk of failure, an angel investor will want the investment to be worth 10 times its current value in five years. That implies an annual interest rate of about 50 percent. Debt is less risky, in that a debt holder has a claim on the assets of a company in bankruptcy. How much less risky? That’s the main point of negotiation.
Small companies, firms with damaged credit and businesses in undesirable locations or industries can find it difficult to land a loan under the best of circumstances. However, other financial options exist, some of which have similar characteristics to loans but are not loans for legal or accounting purposes.
Accounts receivable factoring:
AR factoring, or invoice factoring, is the sale of your accounts receivable at a discount to face value to a financier. For example, let’s suppose you’ve sold a crate of goods to someone on credit with 30 days (net 30) to pay the bill. The common challenge lies in that your suppliers may need to be paid quicker than your client will be paying you.
However by using factoring, you can turn over that customer’s 30-day invoice to a financier, called a factor, who will pay you most of the debt’s face value.
Now you have cash in hand for the goods. Your customer owes the factor, not you. And you no longer have any financial risk associated with the transaction.
In one sense, invoice factoring is a type of outsourcing. Another company collects your receivables for a fee, paying you at the time of transaction. Unlike other funding options like a line of credit or loan, factoring doesn’t show up as a liability on your balance sheet. Depending on your industry, sales practices, and cash flow situation, factoring may be the solution for getting the most out of your cash flow. For other businesses, there may be other financing options available. We have a guide to factoring that explains the process in greater detail.
Merchant cash advance
A merchant cash advance is the sale of future credit card sales or other receivables. Companies with predictable cash flow from sales can use this practice to smooth out cash flow. Essentially, the financier offers money up front for the right to collect a portion of a company’s future sales. The financier generally replaces the merchant’s credit card terminal with one that can direct part of those credit card sales to the financier’s accounts. Often, this kind of financing is offered in conjunction with credit card processing services. Rates tend to be higher than traditional financial sources, but the service is usually available to any merchant processing more than $2000 to $3000 in credit card transactions each month.
401(k) rollover as a business startup
Several companies, such as Guidant Financial, offer entrepreneurs a way to convert their 401(k) into startup capital. The IRS calls the process a ROBS – a rollover as a business investment. The process requires a rollover of a business owner’s existing 401(k) account into a new plan in which the entrepreneur’s company stock is an investment option. Because of the tax issues, the process is legally complicated relative to traditional investment – an independent audit of the company is required, among other rules. The process can cost as much from $5,000 to $10,000 in fees. But done correctly, it can also eliminate penalties and fees associated with early withdrawal from a 401(k).