Key considerations around financing for small business

Many types of businesses require funding to get started, to grow, or to operate on a regular basis. For most business owners, their experience with obtaining financing is limited to buying a personal vehicle or buying a house, but how does obtaining business financing differ from these typical borrowing experiences?

Too often, I've had clients come to me after obtaining financing to let me know the agreement has already been locked in and here is the contract. When reviewing these debt documents, I key in on a few primary metrics including: total origination fees, stated interest rate, term, whether stated or variable, and any balloon payments. Too often, these agreements create great upside to the lender or loan originator while not fully providing the intended benefit to the business. Below I'll expand on these considerations further and provide examples of real life scenarios I've seen and how they could have been improved upon with a different lender or structure.

Payment Processor Loans or Merchant Cash Advance

For a business that utilizes a payment processor or financial software (think Square, Jobber, PayPal, Stripe, QuickBooks etc.) the business owner will receive regular marketing communication offering quick, easy financing to grow your business. These offers truly are quick and easy, but they come at a pretty steep cost. In reality, these are not really loan products and are generally not regulated products. These arrangements are effectively secured by your future cash collections.

The payment processor has direct access to your cash flow, giving them the data to pretty accurately predict your ability to repay and requires you to give them the authority to directly take repayment off the top of your revenue collections. This information on your financial standing and first access to every dollar of collections they process significantly reduces their risk. You would think that would result in a lower cost to your business, but that is far from true.

These products don't have a traditional amortization schedule, nor a stated interest rate. They are structured in a way that builds the fee into the repayment terms, never truly telling the borrower the equivalent interest rate being charged. One example is a $100,000 cash advance with repayment totaling $112,000. This equates to a simple interest rate of 12%, if the term is a full 12 months (more on the term later). The effective interest rate, assuming equal payments over a 12 month period, jumps up to over 23%.

The other key aspect that is often overlooked is the actual term of these arrangements. Most business owners benefit more from longer term funding, these payment processor products generally result in quick repayment, usually less than 12 months. The repayment is generally tied to a percentage of your gross processed revenue, which may be based on daily collections and repayments. If you have a really good month in the beginning of this arrangement, you could end up paying 25% or more of your total borrowing. You just lost the benefit of 25% of your borrowing, and you significantly increased your effective interest rate. If the opposite is true in month two, where your collections are lower, you are still required to pay the minimum amount identified in the agreement, even if you paid excess in month 1. In practice, I've seen the average term on these arrangements to be roughly 8 months, increasing the borrowing cost to around 35%, well above a typical credit card interest rate.

Needless to say, it pains me each time a client tells me they borrowed money from their payment processor, I don't think I've seen a scenario where I recommend this type of arrangement to my clients.

Specialty Finance Companies - Typically Unsecured

Generally, specialty finance companies are going to have comparable terms to the payment processor above, without having their hand in the cookie jar. These arrangements are generally unsecured, no collateral required, with limited documentation requirements and quick financing decisions. Where this arrangement can be better than the payment processor option is when you have a fixed term that exceeds 12 months and a stated interest rate. You may still be locking in an unfavorable rate, but if you are able to utilize the funds for a longer period of time and increase your rate of return by investing in your business, these arrangements can be beneficial.

If you are considering this type of arrangement and don't fully understand the terms, seek review by someone outside of the lender to independently confirm the pros and cons of your specific terms. There is usually room for negotiation with this type of lender.

Traditional Financial Institution Loans

Where the above options are generally quick, easy access to cash, borrowing from a traditional bank is not quick and requires a greater level of documentation. Every business should have a banking relationship that is the right size for their business. Your business may be better serviced by a local / smaller bank or credit union, where they will work with you and your specific situation to find an option that works for you. If you bank with a larger national bank (Chase, Bank of America, Truist, etc.) you want to be sure you have a local account manager that is easy to work with and willing to be straight with you on what is a good option for you.

These arrangements require a higher level of documentation, including business financial statements, personal financial statements, business and personal tax returns, personal guarantee, etc. If you don't have an experienced accountant in your corner, gathering this data could seem like a tall task. Our bookkeeping services always including maintenance of accurate business financial statements within your preferred accounting system, which is most often QuickBooks Online for our client base. We can also guide you through pulling data relevant to your personal financial statement.

I'll break these bank products down further into two buckets - Line of Credit and Term Loans.

Line of Credit

A line of credit is generally going to be most appropriate for a business that has regular ebbs and flows, where some months require more capital than others, whether it be for equipment purchases or to float payroll while waiting for customer payments. A line of credit will usually require renewal each 12, 24 or 36 months, this renewal period is a key risk with this type of borrowing, as the bank could decide to not renew, putting you at risk of not having flexible borrowing in place.

A line of credit will typically have an origination or renewal fee based on the total available borrowings, so right sizing your potential need is import to avoid overpaying at inception. Interest rates will fluctuate based on your risk rating and collateral position, but interest is only charged on the actual average borrowing outstanding each month.

Big picture, getting a line of credit approval takes some planning but can result in a reasonable cost for flexible financing availability. First step, establish a solid banking relationship with a business focused banker and keep your business financial records up to date.

Term Loans - Secured or Unsecured

Term loans are most commonly offered with collateral backing to offer some protection to the lender. The collateral may be based on certain assets of the business, such as a building or the business itself. For new businesses, service based businesses, or other business that don't have significant physical assets, obtaining a secured term loan is often more difficult. An unsecured loan may still be available, with approval heavily dependent on credit score, personal assets, and a personal guarantee. Unsecured loans will carry a higher interest rate than a secured loan.

Term loans may be structured around certain equipment as collateral. The most common example being a vehicle purchase or other business machinery. Similar to financing a vehicle for personal use, the borrower should ensure the term of the loan does not outlast the usefulness of the asset. Credit worthiness of the business or the owner will be a key consideration to the lenders decision to lend and the terms offered.

In my experience, deciding to make a purchase of equipment or a vehicle before figuring out the financing results in a higher borrowing cost. For instance, if you walk into a dealership and pick out a work truck you want then sit down with the financing manager, you have very little leverage to get a favorable interest rate, you essentially get what they have to offer that day. Whereas if you know you will be purchasing a vehicle 2 weeks or 2 months down the road, contact your banker, the one you built the relationship with, let them know your plans and see what financing options they can offer independent of the dealer. Same idea with purchasing any other type of equipment. The person selling you the equipment has a double incentive to help you buy the equipment, selling the actual equipment and selling you their preferred lender, who typically provides them a kickback.

Similar to a line of credit, the approval process for a secured term loan requires multiple steps and forms of documentation and a notable amount of time to get approval. Planning ahead and having your documentation in order can result in significant, long term savings for your business.

Small Business Administration (SBA) Loans

The U.S. SBA offers a government backed loan program offered from a variety of banks and specialty lenders. The U.S. Government steps in and backs your business borrowing in the form of either a secured term loan, working capital loan or line of credit. These loan programs open financing options to business owners that may not qualify with traditional lender loan programs.

While these programs increase accessibility of financing for business owners, they generally come at a higher total origination cost and a higher interest rate compared to conventional bank loans. Origination costs include a few different types of fees that I'm lumping generically into origination. The most recent quote I reviewed for a client carried a total origination charge of 4.5% and a variable interest rate starting at 9.5%. Ultimately, you want to be sure your SBA loan is right sized for your business and your long term financing needs to evaluate the true cost of the loan against potential alternatives.

SBA originators often generate a group of loans then sell them off to other investors, making money on the origination and on the sale of a loan with a guaranteed repayment. This does not directly impact you as a borrower, but it does offer some insight on the way the originator may view your loan file, and the limited risk to them.

Closing Thoughts

Running a business requires having the right balance of resources in your corner. I appreciate the opportunity to be a well rounded financial resource in the corner of our clients. When questions arise, I am a phone call or email away. Having a 10 minute conversation or reviewing a loan document to make a quick assessment of the reasonableness of the terms is always accessible to my clients.

We leverage experience gained from our current and former clients to benefit all current and future clients. If we see terms in the market that may be better than what you are being quoted, we can guide you toward those options. In addition, I'm actively building a network of a variety of lenders that my client base can leverage based on their specific need. I prioritize my client's interests when evaluating lending options. If you are getting a bad deal, especially something that borders on predatory, I will point that out and explain the concerns.

Contact us today to if you want an independent review of your lending quote or if your lender has asked you for business financial statements and you need some help ensuring they are accurately prepared. If you want a financial resource in your corner that is accessible to you, let's talk. At the risk of answering a Spam call, I generally answer the phone for unknown numbers. Our services are always customized to your specific needs with pricing that fits your budget.

Joe Gregor

joe@gregoracct.com

407-408-5688