If you’re looking to gain anything over 25$, you’re going to be asked where the money is going. This fact can be applied towards family and friends, but especially if you are asking for a loan from a bank.
There are a number of things a bank (or other financial institution) will want to know before they will be willing to fund you.
Why do you want (or need) a loan?
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Capital Investment
Capital Expenditures are things like the purchase equipment or items used to produce your product or service. These might include computer equipment, office furnishings, or production equipment. Depending on the type of business, it might also include medical or diagnostic equipment. Generally, it does not include consumables, which are part of the operating budget.
These expenditures usually have a longer economic life and are “depreciated” over time.
This means the cash goes out the door today, but you can only write it off on your taxes over time. This can create “cash flow” problems even if you are “profitable.” These items end up as Assets on your Balance Sheet unless you are able to fully expense them.
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Working Capital
This is typically used to pay expenses needed to run the business: pay employee wages, rent, and office supplies. It can also include maintenance costs. Sometimes, you will need cash to purchase raw materials used in production or build-up inventory for future sale. Be careful, this can create “cash flow” problems as well. These expenditures reduce your net income and are usually accounted for as expenses on the income statement.
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Pay past bills or repay past loans
Put bluntly, this is a giant RED FLAG! This generally means that you have not become profitable with the previous round of funding. A financial institution may view this as “throwing good money after bad.”
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Pay yourself a salary
This is another no-no. Banks are very wary of lending money to simply put in your pocket. They expect you to boot strap and put your sweat equity into the company before you use their money to pay yourself.
Can you afford it?
Loans come with fees and payments. If it is a Line of Credit, these are typically interest only, but term loans are amortized into fixed payments. Where will that cash come from? This is particularly of concern with a working capital loan.
They don’t want you using their loan money to pay them back.
Banks may have a loan coverage ratio requirement so you will have a cash buffer to make payments. What does your past, present and projected income stream look like? This issue can be a real deal killer if you are a startup and have no track record. In this case, a very thorough analysis and Pro Forma income projections will be key. You can make the numbers say anything and the banks know this. Be realistic.
Five Documents Required for Organizing a Business
How are you going to repay it?
This is the key question you will have to answer. Banks want their money back with interest. If you have a very strong personal net worth and income, you may be able to get a signature loan, but this is rare during initial startup. Banks generally want collateral to secure the loan. This can include real estate, trade equipment, and inventory.
Unfortunately, if you are a startup, you likely don’t have much, which is a major hurdle to getting a loan. Particularly with real estate loans, the bank may evaluate your loan to value ratio – a.k.a a measure of how much of your skin you have in the game.
Realistically, bank financing for small businesses is a fairly difficult and often lengthy process (if you can get it at all). Because of this, the Small Business Administration (SBA) has created programs to facilitate the process. Regardless, understanding and preparing for the process is key to receiving funding.
