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The Credit Process: A Guide
For Small Business Owners


Some say owning a home is the American dream. Millions of small business owners will argue, however, that owning one's own business is really the American dream.

But while it offers rewards, owning a business is not easy. Entrepreneurship has its problems, and a critical—and sometimes fatal—one for small businesses can be the lack of access to the financial resources to keep the dream going.

The purpose of this article is to assist small business owners or entrepreneurs who are seeking outside financing for the first time. Our goal is to highlight information that prospective borrowers need to know about the credit process before they apply for a loan.

While a comprehensive discussion of accounting, finance, and marketing fundamentals is beyond the scope of this booklet, we have presented an overview of these concepts as applied to a small business. The sources and types of funding typically available to small businesses are covered along with a discussion on creating a business plan.

Sources and Types of Funding

Where to Borrow

Getting credit for a business can be a dilemma because until you've developed a good track record with business credit, many commercial banks and other traditional lenders will be reluctant to extend credit to you.

In order to identify the type of financial institution most likely to lend to your business, it's helpful to pinpoint which of the four early stages of development your business is in.

Stages of a Developing Business

Stage one businesses are start-ups.

Stage two businesses have business plans and product samples but no revenues.

Stage three businesses have full business plans and pilot programs in place.

Stage four businesses have been in operation for some time and have documented revenues and expenses.

Lenders suggest that rather than approaching a bank, owners of businesses in stages one and two should seek financing from informal investors. Such sources of funding may include friends or relatives, partners, local development corporations, state and local governments offering low-interest micro loans, private foundations offering program-related investments, credit unions featuring small business lending, and universities with targeted research and development funds.

Lenders say that businesses in stage four, and some in stage three, are sufficiently developed to approach a commercial bank or another traditional lender for a loan.

If your business is in stage three or four and you intend to approach a commercial bank, lenders suggest that you first submit an application to a bank with which you have an established relationship. If you do not have an established relationship with a bank, lenders recommend that you ask an experienced accountant or lawyer to contact a bank and present your proposal.

Also, keep in mind that you must choose a legal designation—sole proprietorship, partnership, or corporation—and execute the necessary documentation for your small business before approaching a bank or another lender.

Reason to Borrow

There are three major reasons why businesses borrow; the first and most common reason is to purchase assets. A loan to acquire assets could be for buying short-term, or current, assets—such as inventory—and would be repaid once the new inventory is converted into cash as it is sold to customers. Or, the funds could be for the addition of long-term, or fixed, assets, such as equipment.

The second reason is to replace other types of credit. For example, if your business is already up and running, it may be time to take out a bank loan to repay the money you borrowed from a relative. Or, you may wish to use the funds to pay suppliers more promptly to get a discount on the price of the merchandise.

The third reason is to replace equity. If you wish to buy a partner's share in your business but you don't have the cash to do it, you may consider borrowing.

Loan Types

The purpose of your loan is critical in determining the type of loan you request. You also should make sure that the timing of the repayment schedule on your loan matches the incoming cash flow you will use to make the payments.

There are a number of loan types available to commercial borrowers, including lines of credit, seasonal commercial loans, installment loans, collateralized loans (which are secured with assets), credit card advances, and term loans. Regardless of the type, most loans have the following features.

Common Loan Features

  • Loans are long term or short term.

  • Interest rates vary depending on the term, type,
    size, risk of the loan.

  • Repayment may be a lump sum or on a monthly
    or quarterly schedule.

  • Payments may be delayed until the funds
    help your business generate cash flow.

  • The loan may be committed, meaning the bank agrees
    to lend to you under certain terms as you need funds
    without requiring you to re-apply each time.

  • Some loans require that you maintain compensating
    balance levels in a deposit account.

Loan Agreements

You also should be aware that the lender will expect you to agree to certain performance standards and restrictions in order to ensure that your business can repay the loan. These restrictions, known as covenants, representations, and warranties, commonly include the following.

Common Loan Restrictions

  • Maintenance of accurate records and financial statements
  • Limits on total debt
  • Limits on total debt
  • Restrictions on additional capital expenditures
  • Restrictions on sale of fixed assets
  • Performance standards on financial ratios
  • Current tax and insurance payments
  • Restrictions on dividends or other payments
    to owners and/or investors

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