Best Practices to Follow Before Applying for a Small Business Loan

Applying for a small business loan can be easy if you do it correctly, but there are many mistakes that small business owners make when they start the business loan application process.

Mistakes in a business loan application draw out the process and can even result in your loan application being declined or a delay in your business loan approval. In this article, I'll discuss the best practices and common mistakes in order to help business owners avoid them when applying for a loan. Taking the appropriate steps and avoiding these mistakes will save you time, effort, money, and many headaches!

1. Understand your needs.

More than ever, business loans are readily available for small business owners. However, that doesn't mean that every option is optimal for your business. Before starting your research and looking for a business loan, plan out how you'll use your loan proceeds. Will you use the money for equipment, or working capital? Do you have an expansion plan that requires funding? This is an essential step to take before analyzing your business loan options, because you need to search for loan structures that align with your intended use of the proceeds.

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Example: Need money for inventory

Nancy owns a retail store that needs to purchase inventory for the holiday season. There is a three-month period from the time she orders the inventory to the time that it's sold. Once the inventory is sold, Nancy won't have to use an inventory loan until the next holiday season.

In this situation, Nancy wants to search for a business loan that she can repay in three months and use again for the next holiday season. She should search for a business line of credit that enables her to draw what she needs during the time she needs it, pay it back, and stop paying interest until the next time she needs it.

If Nancy started a broad search for business loans and ended up applying for a term loan to be repaid over multiple years, it would not align with her needs. Why would she pay interest for multiple years for inventory that churns in three months? By understanding her needs and researching her options, Nancy avoids unnecessary documentation, wasted time, credit pulls, and potentially getting stuck in the wrong loan product.

Example: Need money for new equipment

A second example of this would be if Nancy was looking to purchase equipment for the store. The equipment has a 10-year lifespan and doesn't immediately result in revenue for the company. In this scenario, Nancy would want to use long-term financing with low monthly payments.

Keeping payments low with a long-term equipment financing program will have little impact on cash flow, and it provides the necessary equipment for the store. Long-term needs require long-term financing, and short-term needs require short-term, flexible solutions.

2. Learn the types of business loans to consider.

To help you understand the different options, here is a list of business loan programs and brief details about the products.

Business line of credit

For alternative lines of credit under $250,000, the process to apply can take just 24 to 48 hours. If you are applying for a bank line of credit, the process will require a full document package, including your financials, and can take as long as 45 days.

Business lines of credit are sometimes secured by specific assets, but they are more often based strictly on a business's established cash flow. For that reason, these are typically better for established businesses that operate in a sound industry and have reliable cash flow.

Asset-based loans

Asset-based loans rely on your business assets for collateral and are typically structured as an interest-only line of credit. The main assets used are accounts receivables (invoices), inventory and equipment. You can expect the process to take 15 to 30 days from application to closing.

Like lines of credit, asset-based loans are usually better for established businesses – especially those that have uncommitted assets that they can pledge for a loan. Businesses that have unencumbered assets can often borrow 80% to 90% of their value using an asset-based loan.

Business term loans

Terms for these loans range from 24 to 60 months and take 10 to 14 days to complete the application and funding process.

Conventional term loans are usually only for businesses with good or excellent credit. To qualify, businesses usually need to have been in operation for at least one or two years. If they do qualify, they can often borrow 75% to 80% of their project cost for up to five or even 10 years.

Small business bridge loans

Bridge loans often have a quick and easy approval process of 24 to 48 hours, but they also have higher rates and shorter terms, ranging from six to 24 months.

These loans are intended to serve as a stopgap for established businesses that need short-term financing to take advantage of an opportunity. With a bridge loan, business owners can borrow up to 80% or 90% of their project costs.

These loans are typically not for new businesses, because the lender needs to be confident in the business's ability to secure long-term financing that it can use to pay off the bridge loan.

Invoice factoring

Invoice factoring, in many respects, is similar to asset-based lending and business lines of credit. The time frame from approval to funding ranges from seven to 21 days,  

Unlike many other types of loans, factoring is generally accessible to new businesses, because lenders are typically more concerned with the client's likelihood of paying their invoice than the borrower's creditworthiness. With factoring, businesses can typically borrow up to 85% or 90% of their invoice value without waiting for their client to pay.

Equipment financing

These loans are ideal for companies that need equipment costing $250,000 or less. The process from application to funding can be completed in three to five days. For larger equipment needs, the process can take 14 to 21 days.

Equipment financing is one type of loan that business owners can typically get quickly, especially if they use in-house financing. Since it's secured by equipment, it's usually an option for newer businesses. While in-house financing options may lend up to 100% of equipment cost, 80% to 90% is more common.

SBA loans

SBA loans are loans issued by banks and community development corporations (CDCs) and guaranteed by the SBA. To qualify for SBA financing, a business must have been in operation for at least two years, and the owners must have a credit score of at least 620 (640 in some cases).

When a business gets an SBA loan, everyone who owns 20% or more of the business must sign a personal guarantee. Loans can go up to $5 million and last 15 to 25 years, depending on the loan program you use and what you're financing.

Small business credit cards

Small business credit cards are just like personal credit cards – they're issued based on the business owner. For that reason, they're typically good for newer businesses that only need limited credit (up to $20,000) to finance normal day-to-day purchases.

Small business owners can get credit cards quickly, even when they're just starting out – especially if they have good credit and income outside of the business. However, if you need to finance something bigger than inventory purchases or other small daily expenses, a credit card probably won't be sufficient.

Microloans

Microloans can generally work for any small business, including ones just starting out. However, these loans only offer small sums – usually under $50,000 – and typically don't have very long terms. They're designed to help startups get off the ground – especially those that will have a significant community impact or cater to underserved communities.

3. Consider your fundamentals.

Before you decide on a loan type for your small business, make an honest assessment of your fundamentals. The length of time you've been in business, for example, will have a big impact on the types of loans available to you. If you have an established business that has been operating for years and has strong, reliable cash flow and excellent credit, you can probably have your pick of loans. But if you're a new venture, you don't have steady cash flow, or your credit is lacking, you may need to stick to invoice factoring or equipment financing.

Also consider your collateral available to pledge on a loan, as well as your industry. Many lenders can't or won't lend to businesses in certain industries. If your business is engaged in gambling, firearm manufacturing or sales, cannabis, or other "risky" ventures, you might need to find a specialty lender or stick with loans based on your personal income and credit.

4. Know your credit profile.

Two important factors that lenders look at are your personal credit score and your business credit score. Both credit scores are weighted heavily in the underwriting process, and each lender has different credit requirements.

There are dozens of free services (such as Credit Karma) where you can sign up and learn your credit score. It's prudent to check your personal credit regularly to learn what your current score is, where you need to improve and how to boost your score for the future. Your personal credit score is far more important than most people realize. It's a factor when you apply for a home mortgage, utilities such as cable and electric services, or a car lease as well as business loans. A good score will help you lower your monthly payments across the board.

It's more difficult to check your business credit score, but the factors that impact your business credit are the same ones that impact your personal credit.

Double-check that all of your vendors are paid currently, that your credit cards or loans don't have any past-due balances or late payments, and that your credit utilization (how close your outstanding balance on your credit cards is to the cards' limits) is as low as possible. Utilization is a major driver of credit scores; the higher your utilization, the lower your score. Common sources to check your business credit score are Dun & Bradstreet, Equifax and Experian.

5. Be proactive, not reactive.

A common mistake that small business owners make is waiting until they need money rather than planning ahead. Being proactive versus reactive can be the difference between approval and rejection.

Two things frequently occur when you don't plan ahead:

1. Poor cash flow. More often than not, a business's cash flow looks worse when the owners reactively apply for a loan rather than planning ahead. Business owners tend to use available capital up until there isn't enough cash flow to support necessary operations.
   Rather than waiting until this point, anticipate your cash flow crunches, and apply for a business line of credit or term loan beforehand.
   
   
2. Time constraints. Business loan programs that have lower rates and more attractive terms tend to require more documentation and take longer to approve. When you plan ahead, you give yourself the ability to apply for the most attractive loan programs, instead of programs that are fast but have less appealing terms.

6. Prepare your financials.

When you apply for financing, you will be asked to provide certain documents in order for the lender to underwrite your business. The required documentation depends on the type of loan you are applying for. As a rule of thumb, the larger the loan and the longer the term, the more information you can expect to be asked to provide.

Here is a breakdown of the documents you can expect the lender to require.

1. Business tax returns: Almost any business loan application will require the previous one to three years of your business's tax returns. Showing profitability on your business tax return will boost your chances of approval.
   
   
2. Personal tax returns: One to three years of your personal tax returns might be required for longer-term financing. This shows lenders your personal income and any other sources of income you have to enhance your credit profile.
   
   
3. Profit and loss statement: Also known as a P&L, this document will be required for almost all types of business loans. A P&L outlines both your business revenue and expenses. A frequent request is for your business's prior year-end P&L and a year-to-date P&L.
   
   
4. Balance sheet: A lender will require your prior year-end balance sheet and a current snapshot to understand what types of liabilities and assets you have in your business.
   
   
5. A/R aging report: For B2B businesses that sell on net terms, an A/R aging report is an important document that helps a lender understand who your customers are, if there is any customer concentration, and if your customers pay within terms.
   
   
6. A/P aging report: Opposite of the A/R aging report, which shows money owed to you, an accounts payable aging report shows lenders to whom you owe money, what your payment terms are, and if you are paying them on time.
   
   
7. Debt schedule: This document outlines all the outstanding debt that your company has. It shows your creditors, the original loan amounts, your current balance, interest rates and monthly payments.
   
   
8. Business bank statements: As straightforward as it sounds, a batch of your business bank statements helps lenders understand your cash balances, the frequency of deposits, and the historical cash flow trends of your business.

7. Take your time!

It's safe to say that nobody likes doing paperwork. Paperwork and administrative tasks don't generate revenue and, frankly, are boring. However, taking the time to fill out a business loan application correctly helps you avoid a lot of headaches. Rushing through a loan application almost always results in double the work. Forms need to be filled out correctly, paperwork needs to be accurate, and information needs to be consistent. This not only increases your chances of approval for a business loan, but also speeds up the process. When you supply organized, accurate, and clearly labeled paperwork, lenders tend to review your information before other businesses' loan applications.

8. Learn about the lenders you'll be working with.

Anytime you seek business financing, it's critical to know whom you are working with. In the business application process, you are supplying both personal and business information that should only be shared with reputable companies. There are many steps you can take to ensure that you are working with the best company. Here are three tips for working with a prospective lender:

1. Check the company's profile on LinkedIn.
2. See if the company has online reviews and what they say.
3. Ask for references. If the lending company provides a great service, it should be happy to provide client references.

A business loan can boost your working capital and take your company to the next level. There are many small business lenders that provide great solutions; just make sure the one you choose is right for you.

Dock David Treece contributed to the writing and research in this article.