While poor management is the most frequently cited reason businesses fail, inadequate or ill-timed financing is a close second. Whether you're starting a business or expanding one, you will need ready access to cash at all times, and you will need to manage that cash well.
In order to avoid common mistakes in borrowing money, such as securing the wrong type of financing, miscalculating the amount required, or underestimating the cost of borrowing money, it's important to manage your existing funds wisely.
Before Inquiring About Financing, Ask Yourself the Following:
- Do you need more capital or can you manage your
existing cash flow more effectively?
- How urgent is your need? You should plan your
borrowing activities well in advance of your cash needs, as you can obtain the
best terms when you are not under pressure.
- How great are your risks? All businesses carry risks,
and the degree of risk will affect the cost of borrowing and the available
financing options.
- For what purposes will the capital be used? Any
lender will require that you are requesting the capital to fulfill very
specific needs.
- What is the state of your industry? Depressed,
stable, or growth conditions require different approaches to money needs and
sources. Businesses that prosper while others are in decline will often
receive better funding terms.
- Is your business seasonal or cyclical? Financing
options for seasonal needs are generally short-term.
- How strong is your management team? The quality of a
company's management is the most important element of the application package
that lenders consider.
- How does your need for financing fit with your business plan? If you don't have a business plan, make writing one your first priority. All capital sources will want to see your business plan, regardless of whether you are starting up or in a growth phase.
Types of Financing
- Equity Financing - "Equity" is the net investment of
owners or stockholders in a business. "Equity financing" is financing in
exchange for stock and/or options in the business, without any guaranteed
return, but with the opportunity to share in the company's profits. Most small
or growth-stage businesses use limited equity financing. This type of money
often comes from non-professional investors such as friends, relatives,
employees, customers or industry colleagues.
- Venture Capitalists - These are institutional risk takers and may be
groups of wealthy individuals, government-assisted sources, or major financial
institutions. Different investors expect different levels of involvement in
managing a business in which they invest. Relinquishing some decision-making
power and some potential for profits are the main considerations of equity
financing.
- Debt Financing - There are many sources for debt financing: banks, savings and loans, commercial finance companies, credit unions, micro/community lenders, state and local governments and the U.S. Small Business Administration (SBA) are the most common. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller. Traditionally, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Very small businesses should consider credit unions and micro/community lenders as a viable option.
The Six C's of Loans
The six "C's" listed below are an easy way to remember lenders' considerations when evaluating any loan application. For a partial list of banks, microlenders and credit unions and what they are looking for, review SBS' Financing Resources.
- Credit History - Your credit history is a record of all of your credit-based transactions. If you have ever applied for a credit card, an auto loan or a loan from a bank, then you have a credit history. This is recorded in a "credit report." All lenders use this credit report to determine your credit history and evaluate your record of repaying credit. Some will place more emphasis on your "credit score" - a number grade that summarizes your overall likelihood of repaying credit. Others weigh particular individual items most heavily, such as your total outstanding credit, the length of time of your credit, your dependability of making payments, the type of credit, etc.
Your credithistory could make the difference between your getting approved or denied for a loan. It will also affect the interest rate you are offered. Therefore, it is good practice to review your credit report before you apply for a loan so that you are prepared for lenders' likely questions. (Appendix A summarizes how to obtain and correct your credit history.)
- Character - Loan officers look for evidence of your trustworthiness. Your application can be rejected even before lenders review your business proposal if they find evidence in your background suggesting lack of integrity.
You can expect lenders to look to your business plan and references for answers to questions such as "How long have you lived in your current home? How long have you been in business? Do you live up to your obligations? What is your standing in the community?"
- Capacity to Manage the Business and to Pay - As poor management is the foremost reason for the failure of new businesses, lenders will evaluate a company's business owners or management team carefully. Loan officers will want to know business owners' professional background, previous business experience, relevant education, and previous successes.
As part of this analysis, lenders will seek to determine the capability of your business to turn a profit. They will ask, "What is your ability to repay the loan? How are the loan proceeds to be used? How will they be repaid?" Lenders are particularly interested in (a) how soon you can generate a positive cash flow; (b) when you will show a profit and what amount; and (c) whether various assets will be financed via debt or equity. The answers to these questions come from a review of your financial statements, particularly your cash flow statements, profit and loss statements and personal and corporate tax returns. Demonstrate that you can manage cash during slow periods as well as growth by tracking cash in- and out-flows, creating a cash reserve fund, aggressively collecting accounts receivable, and regularly liquidating old and unused inventory.
- Collateral and Guarantees - "Collateral" is something of value that you pledge to support the repayment of your debt. "Co-signers" are people who pledge to repay your loan if you cannot. Co-signers or collateral are considered secondary sources of repayment, or a lender's "safety hatch." Lenders will normally want the collateral to be valuable enough to cover any losses and be easily convertible to cash. Looking at your projected cash flow and list of assets, lenders will ask, "How can you be sure of your ability to repay the loan? What can you offer the bank as an alternative source of repayment?" In most instances, the bank will require the personal guarantees of all principals. In addition to providing another source of repayment, it also shows your commitment to the business. The more money owners have invested or are willing to invest in their business, the easier it is to attract other sources of financing.
- Context of the Business - No business exists in a vacuum, and loan officers will look at a number of external factors that may affect your business. They will pay particular attention to potential economic, legal, labor, supplier or environmental problems. Expect questions such as "What is the state of the economy? Are there environmental issues to be concerned about that may put the business at risk? How could these affect the financial condition of your business?" Loan officers tend to consider loan applications more favorably if (a) you are introducing a new product or service for which there is an obvious demand; (b) there is little competition; (c) your market is composed of small independent businesses; (d) there tends to be a lower rate of failure in your type of business, and/or e) you have a high gross profit margin.
- Conditions or Terms of Loans - The nature of your loan request is another important factor that could affect the results of your application. Lenders will want to know three important things: "How much money are you requesting? What will it be used for? For how long will you need it?" Lenders often prefer to approve loans for the purchase of items that can be identified, have lasting value and can be repossessed and sold if you cannot repay.
Appendix A: Credit Reports
What Information Is Contained in a Credit Report?
Your credit report includes your name, address, birth date, social security number, and the name of your employer. Various accounts with creditors (loans, credit cards, and certain other debts) are listed, showing how much credit has been extended and whether you have paid on time. If an account has ever been overdue or referred to a collections agency, this will be noted.
Public information such as bankruptcies, foreclosures, or tax liens will be included in your credit report. There will be a record of any request for your credit record within the past year and a record of any request related to employment for the past two years. It may also have information about your employment history, home ownership, income and previous addresses.
How Do You Get a Copy of Your Credit Report?
It is important to know what is in your credit report, and to correct any inaccurate information time to time. You have the right to obtain a copy of your credit report, and to have credit bureaus correct any inaccurate information in it. Negative information can make the difference between getting a loan and being denied, so it is crucial that you examine your credit report carefully and make sure it is accurate.
If you are denied credit (turned down for a loan or a credit card), you are entitled to a free copy of your credit report, as long as you request it within 60 days of the credit denial. You can also get your report free if you are unemployed, if you are receiving public assistance or if you believe your credit file contains inaccuracies resulting from fraud. The three largest credit bureaus are:
Equifax
P.O. Box 740241
Atlanta, GA 30347
(800) 658-1111
http://www.equifax.com
Experian
P.O. Box 949
Allen, TX 75013
(888) 397-3742
http://www.creditexpert.com
Trans Union
P.O. Box 2000 C
hester, PA 19022
(800) 888-4213
http://www.tuc.com
How Do You Correct Errors in Your Credit Report?
By law, credit bureaus are responsible for investigating and correcting inaccurate or incomplete information on your credit report. To have them do so, you must contact the credit bureaus in writing to inform them of the information you believe is inaccurate. In addition to your name, address, and Social Security Number, your letter should state each item in the report that you dispute, what you believe to be the correct information and why. Request a correction and include copies of any documents that support your position. You may want to enclose a copy of your report with the specific items circled. Send the letter by certified mail and request a return receipt so you can document that the credit bureau received your letter. Keep copies of all of your correspondence.
Credit bureaus are required to investigate disputes within 30 days (unless they consider your dispute frivolous). They must also notify the creditor involved, as well as all other credit bureaus, of the correct information. Finally, they must give you a free copy of your credit report if the dispute results in a change. We have included a sample dispute letter for your reference on the following page:
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Sample Dispute Letter |
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Complaint Department
Name of Credit Reporting Agency
Address
City, State, Zip code
Dear Sir or Madam:
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Your Name, Address, Date |
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I am writing to dispute the following information contained in my credit report. The items I am disputing are circled on the attached copy of my report.
This item [identify item by name, source, date, and type of item] is [inaccurate or incomplete] because [describe what is wrong and why]. I am requesting that the item be [deleted or changed] to reflect the correct information.
Enclosed are copies of [describe your documentation, such as payment records, receipts, canceled checks, court documents] supporting my position. Please investigate this matter and [delete or correct] the disputed item as soon as possible.
Thank you for your assistance with this matter.
Sincerely,
(Your Name)
Enclosures: [list what you are enclosing, with one item listed on each line] |
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What About Negative Information in Your Credit Report?
Negative information may appear in your credit report if you have been late in paying a bill, declared bankruptcy, had a loan go to a collection agency, etc. Most information - positive and negative - remains on your credit report for seven years. Exceptions to this rule are:
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Bankruptcy information may remain on your report for 10 years
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Information about a lawsuit or an unpaid judgment against you can be reported for seven years or until the statute of limitations runs out, whichever is longer Information about criminal convictions has no time limit
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Credit information reported in response to an application for a job with a salary of more than $75,000 has no time limit
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Credit information requested for an application for more than $150,000 worth of credit or life insurance has no time limit
What Is an Insufficient Credit File?
Many people are denied credit because they have little or no credit in their name. To build a credit file, you must borrow money and repay it according to the terms of the loan. You could obtain a credit card, use it a little each month and pay it off regularly to generate a credit history. (You do not build a credit history if you apply for a credit card but never use it. You must use the card and make repayments for a credit record to accumulate.)
How to Repair Your Credit History?
You may already have bad credit. Repairing your credit will take time and discipline. You may want to get counseling to assist you in consolidating your debt or creating a budget that allows you to pay your bills on time. A bad credit history can be caused by bills that have been paid late or not at all, inaccurate information or too much overall debt for your income.
How Does Being Married Affect Your Credit Report?
You are responsible for your own debts and any debts that you incur jointly with your partner (or anyone else). You are not responsible for your partner's individual debt. For example, if you and your partner have a credit card in both names, you are jointly responsible for the bills if you both signed the application.
What About Divorce and My Credit Records?
You are responsible for all joint accounts in which you both applied to be listed on the account. You are not responsible for your partner's individual accounts.
Many people find their credit history impacted negatively by a divorce. Bills get paid late when there is disagreement as who is responsible for to pay what; one partner may refuse to pay on joint accounts, or may try to hold the other responsible for all of the debts. It is important to apply for credit in your own name and build your own file. It is also important to discuss this issue with your attorney at the time of your divorce. If you divorce, you may want to close joint accounts or accounts on which your partner can sign.
Helpful Websites:
Adapted from material provided by the
Pace University Small Business Development Center. Author: Isabel M. Isidro.
Copyright 2000, PowerHomeBiz.com LLC.
