A bank is a place that will lend you money if you can prove that you don't need it. - Bob Hope
Information in this article is provided for general educational use only. No responsibility is assumed for any problems associated with the use of its content. One should seek the advice of their financial and legal counsel in every step of purchasing a business.
Most small businesses are funded through financial institutions. They provide loans or lines of credit that come with a repayment schedule. The starting point is a well prepared business plan. Business plans let lenders determine whether a business is likely to succeed based on information provided. They will review the prospective company’s cash flow, collateral, asset liquidity, financial statements and projections.
In addition to the business plan, creditors may evaluate the applicant by using what is known as the 5c's of credit. This method of evaluating a borrower incorporates both qualitative and quantitative measures to ascertain the chance of default. The 5c's are:
1. Character refers to a borrower's reputation.
2. Capacity measures the ability to repay a loan by comparing income against recurring debts.
3. Capital any assets the borrower puts toward a potential investment. A large contribution means the buyer is assuming more of the risk and will lessen the chance of default to the investors and creditors..
4. Collateral such as property or large assets pledged for the payment of a loan in case of default.
5. Conditions the terms of the loan, such as the interest rate and amount of principal and the state of the economy that will influence the lender's desire to finance the borrower.
Financial institutions are hesitant to provide loans to small businesses because of a history of high default rates. The SBA reduces the risk by guaranteeing the loan.
The 7(a) Loan Program is SBA’s primary program for helping start-up and existing small businesses. Proceeds may be used to establish a new business or to assist in the operation, acquisition or expansion of an existing business. When a business applies for an SBA loan, it is actually applying for a commercial loan which are then made by its partners (lenders, community development organizations, and micro-lending institutions), structured according to SBA requirements. The requirements of eligibility are based on prospects of the business, not the owners.
• Don’t have to give up part of the business to obtain funding
• Available to companies that can’t get funding from other sources.
• Loan maturities are based on the ability to repay, the purpose of the loan proceeds, and the useful life of the assets financed.
• Both business and personal financial resources are reviewed as part of the eligibility criteria. If these resources are found to be excessive, the business will be required to use those resources in lieu of part or all of the requested loan proceeds.
• They provide limited networking or mentoring opportunities.
• May require personal collateral such as home.
SBA loan guaranty requirements and practices can change as the Government alters its fiscal policy and priorities to meet current economic conditions. Check their website www.SBA.gov for general information on loan programs.
There is a persistent belief that some entity of the federal and state government is out there handing out free money for people who want to start small businesses. Nothing could be further from the truth. Moreover, as it relates to financing, the government does not care what race, ethnicity, or gender you are. Grants to start a “for profit” business are virtually non-existent. Grants, when available, are usually awarded to non-profit businesses or companies involved in specific businesses that the government wants to encourage. These would include such things as renewable energy, education for at-risk youth, etc. There are also special program for groups such as veterans, disabled persons, and so forth.
For qualified persons, federal, state and local governments offer a wide range of financing programs to help small businesses start and grow their operations. Government grants are funded by tax dollars and, therefore, require very stringent compliance and reporting requirements to ensure the money is spent in accordance to the grant provisions.
• They can provide large monetary awards with just one proposal.
• Most grants do not have to be paid back.
• Those who receive government grants may find it easier to raise money from other government and private sources.
• Grants can be prestigious and give a business instant credibility and public exposure.
• Preparing government grant proposals require research and planning and are not easy to write.
• Government grants come with requirements to spend the funds according to a complex set of regulations and laws.
• Government grants are highly competitive - many organizations are going after the same funds.
Seller financing is the process by which a person who is selling a business extends credit to the person buying it, using the business as collateral. The buyer makes a down payment and installment payments until the loan is fully repaid. For sellers such an arrangement can aid the sale of their business if the buyer has difficulty obtaining a loan. For the buyer, seeing that an owner is willing to finance the sale of a business can indicate that they are confident of the business's ongoing profitability.
• Both the buyer and the seller can saves in fees that are connected with bank, home equity or refinancing loans.
• The buyer can negotiate interest rate, repayment schedule, and other conditions of the loan.
• The buyer can request special conditions for the purchase, such as inclusion of equipment.
• The buyer does not have to qualify with a loan underwriter.
• The buyer could pay the loan in full but still not receive legal rights due to other encumbrances not divulged by, or unknown to the seller.
• The buyer could make payments faithfully, but the seller might not make payments on any debts that may be in place, thus subjecting the business to foreclosure.
• The buyer might not have the protection of an appraisal to ensure that the business is not over priced.
• The seller could choose which collateral to best secure their interest until the loan is paid.
In order to protect both the buyer's and seller's interests, a legally binding purchase agreement should be drawn up with the assistance of an attorney and then signed by both parties.
Friends & Family
Family and friends may provide a loan depending on your reputation with them. This method of financing typically comes without much legal expense,
• Fewest contractual requirements.
• Available quickly.
• Limited one-time source of funding generally less than $50,000.
• Maintaining your relationships with friends and family especially if you lose their money.
• Unless properly structured in writing, there may be controversy as to how the money was obtained. Was it as a gift, a loan or an investment?
Micro-loans are available through certain nonprofit, community-based organizations that are experienced in lending and providing management assistance to small business. Micro loans are generally available to people who have been rejected for loans due to lack of collateral, steady employment and a verifiable credit history.
• There are fewer requirements for applying for a micro-loan, making it easier to secure one.
• Micro-loan lenders help mentor businesses.
• Micro-loans are easier to pay off.
The Disadvantages of Micro-Loans:
• Micro loans have high interest rates but lower than credit cards.
• Many applicants for the limited funds.
• The amount loan is limited to usually less than $50,000 and may not be sufficient to purchase a larger business.
• At least two years of demonstrated experience in the specific industry of your business.
• Positive cash flow sufficient to pay the loan.
• Good credit history or an acceptable explanation of negative marks.
• Collateral or a co-signer to cover the amount of the loan.
• A realistic business plan with projections acceptable to the lender.
• A reasonable expectation that the micro-loan will not be used for living expenses.
For more information go to the SBA website, SBA.gov, which has a list of micro-loan intermediaries
Unsecured Business Loans
Unsecured business loans also called Signature loans. The lender only takes the borrower’s word for it. Generally no collateral is required. The borrower signs a promissory note stating the terms and conditions, that the loan will be paid back usually no longer than 2 years.
• Application approval time is within 48 Hours.
• Funding is 3 to 5 days.
• Credit requirements are lax.
• No collateral is required.
• Personal guaranty required.
• The lender will also want a co-maker or guarantor to sign the note pledging to pay the loan in the event default.
• The lender takes higher risk compared to secured loans so the interest rate tends to be higher.
• Loans that end up in default go through an aggressive collections process that can double the outstanding balance and harm a borrower’s credit history.
However, people who do not have any collateral to pledge or cannot obtain a loan from other sources may find an unsecured loan appealing.