Zeroing In on Outside Sources of Small Loans
When businesses grow faster than the capital they generate, they often turn to external sources for financing. But the savvy business owner, as outlined in the last installment of Entrepreneurship 101, will tighten up cash flow and narrow cash gaps before looking for outside financing.
Financing comes in the form of debt, such as loans, or equity, such as a piece of the business sold as stock or as a partnership.
Before asking for that money, a business owner needs to determine:
* What is the money needed for? (The answer yields the loan amount needed.)
* Is it a short-term or long-term need? (The answer determines the length of the loan.)
* What will the owner give up for the capital? Will the owner or the business itself take on the debt, or will the owner give up equity or management of the company? (The answer determines what sort of requirements the owner must adhere to in order to get the money.)
* What rate of return can be expected from the success of the business? (The answer indicates how much interest on a loan or how much of a return on investment money a business owner can afford to pay.)
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Based on your answers to the four questions, you can zero in on the sources of funding most likely to match: small loans, big loans, non-loan sources and equity.
For small loans--from $1,000 to $50,000--you will pay higher interest rates, from 12% to 22%, because the loans are usually short-term and it costs the lender as much labor to prepare as a longer-term, $1-million loan. Sources include:
Friends and Family: A bank may be the first place you expect to turn to for loans, but more than half of all small businesses are launched with money from the owner’s personal savings or from friends and family, said Debra Esparza, director of the USC Business Expansion Network, a program that counsels small businesses.
“The reality is, you always have to start with sources close-in, because they know you best,” she said. If those individuals won’t lend you the money you seek, it could be a signal to reevaluate your plans. Your business may be riskier than your friends and family can accept, or it may not meet their income expectations, she said.
“There’s no free ride just because they’re family members,” Esparza added. Even relatives and friends expect to be repaid or to receive a profitable piece of the business. To avoid disputes later, all agreements should be in writing.
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Family and friends typically lend $5,000 to $50,000, and sometimes more, depending on their financial status. They often will accept a return at only slightly above bank savings account rates of 5% and may wait longer for repayment. But in a family economic crisis, they might suddenly demand all the money back to meet their own needs.
Micro-Loan Programs: Micro-loans have become popular in the United States. They are based on India’s Grameen Bank program in which small peer-lending groups, usually consisting of women, take turns borrowing, paying back and lending to others in the group. In most programs in this country, however, the peer-group concept has been replaced by a requirement that owners complete business or technical training. Lenders are typically community development agencies that target specific geographical areas or groups, such as minorities or victims of disasters and economic downturns. Creation of new jobs is often a requirement.
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Loans range from $1,000 to $25,000, with some as high as $50,000, over one to five years at 12% to 18% interest. Besides business training, lenders require a cash-flow chart, financial statements and, sometimes, collateral. The assumption is that the business owner will seek the next loan from a traditional lender.
Credit Cards: Nearly a third of small businesses use credit cards to buy supplies and equipment. If you go this route, single out one credit card to use only for business purposes so that you will have a business record. Using a card can also ease the bookkeeping burden for small businesses, which can write one large check to the credit card company instead of numerous small ones to suppliers.
About 60% of businesses that use credit cards pay off the balances in full each month. This practice helps them avoid debt, which can mount up quickly because of the way credit card debt is structured. It works like this: The card minimum payment is typically set so low that it doesn’t cover the cost of the monthly interest charged. If a business owner pays only the minimum amount, unpaid interest is added to the principal owed.
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Interest is then charged on interest, thus increasing the debt without the card user even making any purchases. In this way, business owners can find themselves quickly burdened with enormous debt if they don’t make sufficient monthly payments.
Typically, credit cards extend debt of $1,500 to $15,000 at interest rates of 18% to 22%, plus fees for cash advances or renewing cards. The interest is calculated assuming that the principal will be paid back in three or four years, even though that may not happen.
Individuals: High-net-worth individuals are like friends, family and a very liberal bank rolled into one, Esparza said. But a small-business owner is usually referred to these people; these individuals are not on public lists. In most cases, they are professionals such as attorneys, accountants and doctors, with money to invest. They come from the same pool of business investors known as “angels,” but instead of taking a piece of the business as many angels do, these individuals are satisfied with getting interest on their loans.
Loan amounts can range from $10,000 to $100,000, with interest rates from 12% to 15% for one to three years. Besides connections to these people, a business owner needs a business plan and a cash-flow statement.
Special Bank Programs: Because banks have come to realize that small loans can be profitable, and because they have responsibilities under the federal Community Reinvestment Act, many banks are targeting certain groups or businesses for loans ranging from $5,000 to $50,000. With loans this small, banks make a profit by eliminating some of the human labor involved in evaluating the loan. They substitute computers in a process known as “credit scoring.”
In credit scoring, points are accumulated for income, years of experience in business, number of employees and other characteristics that banks prefer to keep to themselves. Once enough points are accumulated, the loan is approved. As with many computer programs, computer scoring means applicants must fit certain categories. Banks often lack flexibility to lend outside those parameters.
Typically, banks provide lines of credit or loans at prime interest rates (the most favorable short-term loan rate charged to corporations), plus 2% to 4%, with a loan fee of 1% or 2% of the total loan amount. Besides the basic application, a financial statement is required.
Exercise: Even if your loan request is small, you must present your business comprehensively and professionally. Prepare a business description, the reason you need the money, a brief history of the company, biographies and responsibilities of key managers and accurate financial data.
The USC Business Expansion Network is at 3375 S. Hoover Blvd., Suite A, Los Angeles, (213) 743-1726.
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Entrepreneurship 101
Chapter 4: HOW TO FINANCE YOUR BUSINESS
* How the Money Works in Your Business
* Taking On Debt: Small Loans
* Taking On Debt: Big Loans
* Taking On Debt:
Non-loan Sources
* Giving Up Equity
The Bottom Line
“Entrepreneurship 101” is a tutorial on how to choose, start, finance, plan and grow a business. The program, written by Times staff writer Vicki Torres, was developed by Debra Esparza, a faculty member at the Entrepreneur Program of USC’s Marshall School of Business. Esparza also heads USC’s Business Expansion Network, a community and economic development project that has counseled more than 5,000 small-business owners in the Los Angeles area over the last six years. BEN provides help with financing, business planning, accounting, marketing and other issues. The tutorial can also be found on The Times’ Small Business Web site at https://www.latimes.com/smallbiz.
