While there are scenarios out there where the small business loan genuinely destroyed the business it “served,” a variety of things have to go wrong before the business fails, business loan terms notwithstanding.
What is the role of a small business loan when a small business fails? Are the terms of the small business loan responsible for a business going under?
The true reason that a business fails is less about the loan and more about unexpected costs. If a safety net of cash exists – possibly even cash acquired through a loan to make up the deficit created by unexpected costs – then the business survives. If not, the business fails.
“Good cash flow management begins with having a clear understanding on where cash enters and exits your business.” – John Rampton, Entrepreneur.com
When a small business loan destroys a business, the destruction often occurs because the entrepreneur failed to understand all costs associated with the loan they acquired. If the entrepreneur failed to take into account all loan-related costs, it is likely that they also failed to prepare for other costs: financial emergencies, product malfunctions, rising costs in raw materials, etc.
But this does not have to happen to you.
To keep from watching your business sink under the financial strain of unexpected costs, consider these taking these steps.
Step 1 – Evaluate your current costs for operating the business before you shop for a small business loan.
Do you know the number one mistake entrepreneurs make when securing a small business loan? It’s not accepting a high interest rate; it’s securing too much (creating overbearing monthly payments) or securing too little. The process for a getting a small business loan can be quite involved, and you will likely NOT be able to get one loan right after another. You may only get one shot every few years to get the funding you need. Make sure you know what you need.
Have you launched the business yet? If not, then most of the costs you need to consider pertain to startup costs.
You should consult an attorney and an accountant to help you build your projected financials: how much are those professional fees?
Are you purchasing a franchise? If so, what is the franchise fee?
Will you need training or certifications? How much will the travel and other associated fees cost?
How much are your secretary of state fees and operating licenses? If you are forming a DBA (doing business as…), how much will your local register of deeds charge you to form your DBA?
Will you run your business from home or do you need a store front? What will the lease payment be? Security deposit?
Are you purchasing commercial property and are there renovations?
Will you have a starting inventory?
What kind of equipment and software will you need?
Have you bought a Quickbooks online subscription yet? You really should.
Do you need to hire anyone? If so, what will you pay them?
What are all the different kinds of insurance your business should have, and how much are the premiums?
How much should you set aside for emergencies and/or unexpected costs?
Most importantly, what are your recurring monthly costs? It is wise to add to your startup costs at least 9 months worth of operating expenses.
Network with other small business owners, get quotes from insurance agents, and begin recording each number as best you can into a spreadsheet. Download and input those numbers into our Startup Costs Spreadsheet. When estimating a cost, do your best and guess slightly high. Better to over-estimate and be surprised by lower costs down the road.
If you are already in business, you should know every single one of your costs. In reality, most business owners just do business while looking to see that they still have money in their account. Print out the last six months bank statements. What costs did you prepare for? What costs did you not expect?
Enrolling in Quickbooks online is an extremely valuable investment. Merge your online accounts with your Quickbooks account. Label every single transaction! Go to “Reports,” then “Profit & Loss – Customize.” Customize your report to “Year to date” and “Columns: Month.” Quickbooks will automatically show you all your monthly operating expenses. If you carefully labeled every transaction, you will likely find expenses that surprise you.
Sobering yourself to your operating expenses on a regular basis will put you in a mindset to know what your costs are at all times. Understanding the full costs of operation will equip you to shop for a small business loan. Only after understanding operation costs can you evaluate what loan-related expenses you can afford and where you should employ them. All loans have costs that most entrepreneurs fail to consider. Even SBA loans come with closing costs and fees for services on top of the interest rate.
“Without accurate cost information, it’s impossible to set proper prices, forecast performance, isolate areas that negatively impact cash flow, or determine what to stop doing, what to automate, how to allocate funds, or how best to manage budgets.” – Bob Prosen
Step 2 – Have a plan to become profitable.
You should not launch a business expecting to have to borrow for the life of the business. If you need a small business loan, it is likely because you are either launching your business for the first time or needing to seriously improve your business situation. There are many great reasons to secure a small business loan, but all of them will fall under one of two categories: startup loans or existing business loans.
Best to recognize from the get-go: unless you have a nice nest-egg of funds for a down payment or unless you are willing to leverage your personal borrowing power, you will not be able to get a business loan for your startup. Banks don’t lend to startups.
You basically have two options: unsecured lending based on your FICO score or the government co-signing your loan (SBA loan). Some entrepreneurs leverage their personal real estate with refinancing and then fund their business, but it is not always wise to risk your home to launch a startup.
Lenders offering unsecured loans only care about your monthly income and your FICO credit score. Some lenders invite you to express your projected income (what you expect to make in your new business venture), but many will want to see personal bank statements demonstrating your current income. Unsecured loans are based primarily on good credit scores (FICO scores 680 or higher), not on business plans or pro forma statements.
By contrast, SBA lenders care about your down payment amount and your plan to become profitable. If you can demonstrate notable cash on hand and a solid plan for profitability, the government will “co-sign” for you.
The key to your profitability is your break-even point (BEP).
Whether or not a lender cares to see your projected financials, you need to have a plan for yourself to go from start to profitability. After calculating your startup costs and operating costs, then calculate your break-even point.
A break-even is the point at which your revenues match your costs. Calculating your break-even can be complicated, but we have included an Excel Break-Even Calculator here. Become acquainted with business funding terms. In addition, be sure to thoroughly understand the following:
Fixed Costs: These are your costs that stay the same month-to-month such as rent, utilities, etc.
Variable Costs: These are costs that rise with more sales and fall with lower sales. This could be labor required per sale, the cost of the product sold (know as COGS, costs of goods sold), gas costs per delivery, etc.
Price: If you have not figured your prices yet, you can use the break-even calculator to play with numbers and arrive at a fair price point. Make sure to define your price model. Is it a simple price tag on a product? Is an hourly rate? Is it a subscription?
Plug these numbers into the formula for a Break-Even Analysis to know how many unit sales (or sales in $$) your business requires before you break-even. Once you understand how much you need to sell in order to pay for your costs, add a profit amount into your Fixed Costs to arrive at the number you need to achieve your profit goals.
With assistance from an accountant, begin building your projected financial statements, your “pro forma.” The goal of your pro forma financial statements is to demonstrate your business growth from launch to achieving your profitability goals.
Taking an example from a local bar: if in your break-even analysis you have $7,500 per month of fixed costs, your cost per sales unit (variable costs) is $1.14, and your average price per drink is $6, then your break-even is $9,260 sales per month or 1,543 drinks sold per month. That means that at $9,260 your sales cover all the costs of the business for the month.
If you decide that you plan to make $10,000 per month in gross profit (profit before taxes and loan payments), then your break-even adjusts to $21,605 sales per month or 3,601 beers sold per month.
Your pro forma financials should itemize all costs and projected sales for 3-5 years. By the time you arrive at year 3 (ideally), your pro forma financials demonstrate an average of $21.6k in sales per month.
An existing business shopping for a small business loan is looking to make big changes. If you are a profitable business looking to expand, then your job will be far easier. You have better information to create optimistic pro forma sales numbers.
Diagnose the problem.
Any time you are looking to expand your business, you are problem-solving, even if the “problems” are good ones like high demand or insufficient supply or space for your business.
If you are a mediocre business looking to become a great business, you will likely need a major overhaul, including rethinking your costs and your current price point. You will need to play with the break-even formula and arrive at new financial goals. You must involve your accountant in your plans for renovating the business.
When developing plans to revamp the business, consider all your costs:
Are you paying more than you should for certain things?
Are you offering what the customers want?
Are your prices too high for customers or too low for your business to be profitable?
Take a look at past bank statements: what costs are taking you by surprise?
If you hire managers, can you verify everything they tell you?
Take note of the problems you’ve identified. Be specific. Specific problems are ripe for specific solutions.
Specifically address the solution to the problem.
If your business is failing to keep up with demand, then the solution may be more staff, more equipment, or a new location. If your business is mediocre, then the solution may look like reducing costs, redesigning the product, allocating more resources to marketing or new staff, etc.
Itemize each solution and estimate each solution’s cost.
Identify the cost and profitability of each solution.
If you employ a new solution that costs you $5,000 a year, how will that investment lower your costs or raise your revenues in the long run for a total utility that is greater than $5,000?
With the aid of your accountant, use your last year’s profit and loss statement to create your pro forma statement after the solutions are put into place.
The Journey to Profitability
Most pro forma statements (projected sales against costs) resemble the graphic below (“J” curve). Whether a startup, acquisition, or renovation, the costs are always far higher than revenues initially. Over time, costs plateau while sales numbers rise steadily.
At some point, revenues begin to match and then dominate the costs. All growth after the moment of a business’s break even point is considered profitability.
Seasoned entrepreneurs know that this “J” curve to profitability can take anywhere from 1-5 years. Franchises tend to become profitable faster, sometimes within the first 6 months of operation. Starting a business from scratch will usually take longer to become profitable. Ideally, your business demonstrates profitability by year 3.
When constructing pro forma statements, make sure that your forecasts look realistic. In other words, your journey to profitability should look something like the “J” curve illustrated above.
Step 3 – Shop for business loans.
What is the best business loan? The loan that you qualify for.
Qualifying for loans depends upon either collateral (something you own considered valuable to a lender), credit history or both. Loans backed by collateral (property, equipment, accounts receivables, inventory, etc.) are secured loans. Loans backed by credit history are unsecured loans.
Learn your unsecured options first. Talk to your bank or speak with an unsecured credit line specialist. The best unsecured options come to those with credit scores 680 or higher. The most common example of unsecured loans are credit cards. While generally considered risky for consumer purchases, credit cards are often the smartest loan options for entrepreneurs.
If you have assets that can be put up for collateral, you may have more loan options, but should you default on your loan, the lender secures those assets. If you have cash on hand that can be issued as a down payment, consider an SBA loan. SBA loans will guarantee the best possible terms with FDIC-insured lenders.
Beware of Amassing Credit Inquiries
Applying for loans often means that you are having lenders pull hard inquiries on your credit. A large number of hard inquiries on your credit within a six-month period can make you appear desperate to lenders. They will flag you and decline your application.
If working with an unsecured credit line specialist, they can perform a soft inquiry on your credit (that will not show on your credit history) to offer you a pre-approval funding range. This can serve to inform your decision before actually submitting any applications.
Most borrowers know about interest rates. Lenders charge you a percentage of the loan balance you carry through an interest payment. The best loan interest rates are below 10% (understand what the prime interest rate is). The worst loan interest rates are above 20%.
Many lenders charge closing costs. It is not uncommon for entrepreneurs sign for SBA loans without understanding that the SBA lender charges them closing costs.
Many lenders also charge a fee for services. Unsecured credit line programs require a great deal of research and consultative services. Some SBA lenders will also charge a fee for services on top of closing costs and interest rates.
None of these costs are bad unless you fail to prepare for them. Depending on the business development manager, they may not volunteer all information regarding costs associated with the loan. Remember what we said at the outset: “when a small business loan destroys a business, the destruction occurs because the entrepreneur failed to understand all costs associated with the loan they acquired.”
Once you know and understand the costs for securing a loan for your business, include both loan costs and monthly payback into your pro forma statements.
Is your loan an installment loan with a set term (in years or months) and monthly payment?
Is your loan a line of credit with a minimum monthly payment but no prepayment penalties for paying the balance early?
Depending on the terms of the loan, you will want to plan your monthly payments. Be sure to include those payments in your pro forma statements. It can be helpful to sanctify a chunk of the loan toward monthly payments for the first 1-2 years.
If you are using credit cards with 0% introductory interest rates to fund your business, consider making 2-3 payments per month: first payment is minimum payment, each additional payment as small or large as you like. Set up automated payments so that you do not forget. Remember that credit cards are banks, and nurturing that relationship long-term affords you greater borrowing power in the future.
Step 4 – Take the calculated risk.
The reason that businesses fail is because the costs overwhelmed the revenues. If you know your costs, you are less likely to fail. By taking the steps above, you give yourself every opportunity to minimize your risks.
But there is still risk involved. You live for risk: that is why you are an entrepreneur. You know that if you succeed, you stand to gain far more than you risked in the first place.
The best way to minimize risk when securing a small business loan is to know your costs.
If you require more assistance in understanding how to build a pro forma statement or understanding the costs associated with a small business loan, contact one of our business development managers today.