Starting or growing a business takes money, which means entrepreneurs often need to explore outside sources of funding. Sometimes, it makes sense to find investors to share the financial risk. But if you don't want to give up any profits or can't find anyone to invest, borrowing may be your only option.
If you decide to take on debt, following these six steps will help you to find the right loan without jeopardizing your company's future with debt that's too expensive to repay.
1. Determine how much you'll borrow
Before borrowing, develop clear objectives so you'll know the minimum debt needed to accomplish your goals. If you're purchasing new equipment, for example, price out the exact total cost.
Make sure you can afford to borrow the necessary amount by determining your debt-service coverage ratio (DSCR). Lenders may have slightly different formulas in calculating a company's DSCR. But the basic formula is to divide your organization's annual net operating income by its total annual debt obligations, including principal and interest.
If your DSCR is less than one, you have negative cash flow because company income isn't enough to repay debt. Getting a loan will be difficult. Typically, lenders want to see at least a 1.35 DSCR, which would mean that if your organization's annual net operating income is $70,000, you wouldn't want to borrow more than around $51,800. However, the higher your DSCR, the better your chances of being approved for a loan on favorable terms.
If borrowing would put your DSCR below 1, think carefully about taking out a loan if doing so means your business will owe more in debt payments than it makes. You may want to forgo the expenditures or scale down your plans until you become more profitable.
2. Boost your credit score
Ideally, your business will operate long enough and become successful enough that the company will get its own credit score and be able to qualify for a loan on its own. Building a business credit score requires your company to establish its own identity, including having its own tax ID number or employer ID number, obtained from the IRS. You'll typically also need a business credit card in the organization's name that's always paid on time.
Many companies, however, don't have established credit, so they cannot obtain a business loan without a guarantee from the owners. In other words, you'll probably have to "co-sign" for the company's loan, putting your own credit on the line. If you'll be applying for a loan and your credit matters, do all you can to boost your own score before applying. This means paying down debts so your credit utilization ratio is low, and always paying bills on time.
3. Prepare a business plan
Lenders generally want to see a business plan before giving companies a loan. Your plans should be as detailed as possible, and include financial projections, market information, and comprehensive details about the products or services your organization provides.
Lenders look to your plan for assurances you have a carefully executed strategy for growing your company and making it profitable. Realistic financial projections give lenders confidence that you know how to repay what you've borrowed without undermining your company's chances at profitability.
4. Determine if you qualify for an SBA loan
For many company owners, one of the best options when borrowing for business purposes is to qualify for a loan backed by the Small Business Administration (SBA). SBA loans are issued through partners, with the SBA guaranteeing loans between $500 and $5.5 million to reduce risks for lenders, thus allowing for lower interest rates.
Borrowers have multiple options for SBA-backed loans, including microloans with a six-year repayment term to allow new businesses to borrow up to $50,000; 7(a) loans that allow companies to borrow up to $5 million; and 504 loans, available for up to $5.5 million for smaller businesses with a net income under $5 million and a net worth below $15 million.
SBA loans are available only if you've invested your own money in your company and if you can't get financing under similar terms using other means. You can find a list of SBA lenders using its lender match tool.
5. Explore all borrowing options
When borrowing for a business, explore SBA loans, as well as other sources of funding from banks, credit unions, peer-to-peer lenders, and online lenders. Many offer dedicated small-business loans to buy commercial real estate, purchase equipment, or provide operating funds if you struggle with cash flow.
One type of financing you'll want to think twice about is a home equity loan. While you'll be personally responsible for repaying any loan your business takes out if you are a sole proprietor or a co-signer, a home equity loan carries a level of risk that unsecured debt doesn't. Your credit could be hurt if your business doesn't repay money you borrowed, but your house isn't at risk in most circumstances unless you've taken a home equity loan.
6. Compare loan terms carefully
As you consider financing options, make sure you get the best deal overall for your business. This means you'll need to compare interest rates, repayment terms, origination costs, and whether pre-payment penalties apply. By looking at the total cost of the loan, as well as whether monthly payments are affordable, you can secure financing that works for your organization.
Make sure borrowing is best for your business
As you compare loan options and see how much borrowing will cost, you can make a more informed choice regarding whether your company should take out a loan or you should explore other ways to grow. You take a big risk when you borrow, but the rewards can be worth it if you're smart about the process.