Improve Your Ability to Get a Small Business Loan

Are small business loans tougher to get?

Is it just your imagination or are small business loans more difficult to get than ever? And if that’s true, how can you improve your chances of getting a loan?

A recent Harvard Business School working paper (2.9Mb PDF) discusses the current state of small business lending. Although focused on the US I suspect its findings reflect much of the wider world.

I won’t keep you in suspense. Yes, small business loans are more difficult to getwith “…every major survey point[ing] to credit access being a problem…” with the result that “small business loans…are down about 20% since the financial crisis [of 2008]”.

There are several reasons for this including:

  • A “dampening effect of increased regulatory oversight” causing banks to assess businesses more stringently.
  • Banks are consolidating and becoming larger with the effect that underwriting decisions are increasingly centralized and based less on “‘softer’…criteria such as knowledge of the borrower from a long term relationship”.
  • Small business loans are typically more time-consuming and less profitable for banks. “As a result, banks are less likely to engage in lending at the smallest dollar level.”

Tougher access to business loans is a significant problem for entrepreneurs because “bank credit…is one of the primary sources of external financing for small businesses…”. But you already knew that! So what’s an entrepreneur to do?

How to improve your chances of getting a small business loan

Many factors relating to the availability of small business credit are beyond your control but there are still things you can (and should) do to improve your chances:

I. Understand your lender

Think of your lender as another supplier that you need to negotiate with. The better you understand them, the better those discussions will go. Here is some insight to start you off.

Just as you sell widgets to make money, loan officers sell loans to make money. She WANTS to provide you with a loan. But just as you won’t sell to those who won’t pay you, neither will your loan officer.

She will use a checklist called the “5 Cs of Credit” to assess your business’s credit worthiness:

  1. Character refers to the reputation of the business’s management and includes things like stability, experience, track record and behaviour (especially in times of difficulty).
  2. Capacity is the ability of your business to repay the loan. This includes assessing future cash flows and your business’s debt-to-income ratio. In short: will your business generate enough cash to pay the loan back.
  3. Capital is calculated as your business’s net worth: how much it owns minus how much it owes.
  4. Collateral refers to business assets that could be sold by the bank to help repay the loan in the event of non-payment.
  5. Conditions describe the environment in which your business operates including competitors, customers, regulations, your overall industry, and the broader economy.

Banks and other lenders further reduce their risk by specializing in certain industries or providing certain kinds of loans. For example, many lenders prefer not to deal with startup restaurants because of the industry’s high failure rate; other lenders, however, welcome restaurants and have tailored their offerings to meet a restaurant’s unique circumstances.

Take some time to learn about small business lending and then use this understanding to prepare for your first meeting. Your new lender will appreciate it.

II. Speak your lender’s language

Banking and business use money to keep score and have an extensive money-based language. Entrepreneurs – you! – must use this language to be heard and understood. If you don’t, potential lenders will assume you’re not in the game.

Your lender will want to see a complete set of financial statement projections(income statement, balance sheet, statement of cash flows) that show reasonableassumptions with appropriate cash flow and debt coverage. They will be pleased that your tax returns are filed on time. They will be delighted that you get monthlyworking statements and work closely with a bookkeeper and accountant.

Intuit, the makers of QuickBooks software, conducted a study showing that 83% of small business owners can’t pass a basic financial literacy test. Set yourself apart from the majority of small business owners: learn the language of business and make it easier for your lender to understand you – and lend you money.

III. Optimize your personal credit score

Most startups and many small businesses rate poorly on one or more of the 5Cs. This makes them ineligible for a business loan. Your loan officer will try to compensate for this by asking you to personally guarantee the business loan. This is normal and you should expect it.

For the bank to accept your personal guarantee they must be comfortable with your personal credit history. For many banks, the most critical factor used to determine this is your personal credit score.

In the US the personal credit score (often called a FICO score after the company who invented it) is a number between 300 and 850 that indicates the likelihood that you’ll repay a loan. Many banks, especially larger ones, have thresholds below which they will not lend.

Therefore, you must know and understand your personal credit score before visiting your loan officer. You should also review the details that make up your credit score, confirm that they are accurate, and correct any errors. This can be a time-consuming process so start immediately.

A breath of fresh air…

Lenders often complain about entrepreneurs who show up unprepared when looking for a business loan. Improve your chances significantly by understanding your lender, learning to speak her language, and having a solid personal credit score.

You and your lender will then have a very productive first meeting. Good luck!


First published October 8, 2014