"The small business lending market is booming, and it's not the traditional banks that are benefiting.", Donna Fuscaldo from Fintech wrote in her article PayPal'sLatest Milestone: $10 Billion In Small Business Loans published in Forbes this month. It's not just PayPal' that's booming: Stripe®,YapStone®, Braintree®, Adyen®, Lending Club®, and Kabbage® are all jumping in.
Remember the housing boom and financial crash of 2008? It's not that bad, but it is buyer beware. These are great companies, but with all this competition, these small business lenders may be willing to provide loans to business who really aren't ready for them.
Before seeking a loan, it is important to know how you will use that loan to get a greater return (grow faster) than the interest rate being charged. This is where a little planning upfront can save you a lot of pain later. Luckily, there are a couple of easy tools you can use to lessen your risk and to gauge how ready you are to capitalize on this small business lending boom.
Right now, in a booming small business lending market, lenders might be more willing to allow less rigorous plans. You might think that's a good thing, but it's not.
Remember, if you can't grow faster than the interest rate, you're losing money. More importantly, defaulting on easy money is just as damaging as defaulting on hard.
A business plan requires a business model. Your business model can tell you whether or not you have a good chance to grow at the rate you need to grow in order to beat the interest rate. Without one, itâ€™s much riskier.
It's unlikely that you will qualify for a low interest rate from a small business lender if your personal credit score is less than 700 even in a booming small business lending market.
For instance, a score of 720 seems to be the magic number. Above which, your rates start to decrease, and below which, they increase fairly dramatically. If your score is under 700, you probably should focus on fixing your score, first. Then, you are ready and in a better negotiation position. If not, then be ready to pay high levels of interest even in a booming small business lending market.
Why does personal credit matter? Because, these small business lenders will determine your ability to pay based on your credit worthiness. If you are over-leveraged, behind, or defaulted with your personal debt, whatâ€™s to keep you from doing it with business debt where your personal risk is lower?
The most important financial test is your debt to income ratio. Your what? This is basically a fancy term which looks at how large of a loan you can afford based on your profits. Fair warning, there's a little math ahead, but it's not too bad. Plus, it's important.
You calculate this ratio by dividing your total profits by your total debts.
If the number you get is less that 1.2, you probably should stop here. Most banks look for a DCR of 1.2 to 1.25. They may be willing to go lower in a booming small business lending market. But, expect higher interest rates.
Importantly, these tests exist for a reason. They measure the amount of stress that you are putting on the business. That's why they are even more important in a booming small business lending market.
If you passed test 1, then how much should you target borrowing? The equation is below.
But, let's look at an example: Say you made a profit (net operating income - NOI) of $100,000 last year, and are carrying $15,000 in current debts in credit cards, other loans, accounts receivables, etc., then the amount a small business lender offer would be around $65,000:
If you've been in business less than 2 years and/or you lack collateral to off set the debt, the annual total debt will include your personal debt as well. So, it's always good to drive down your personal debt if possible before engaging with a small business lender.
If so, you're not alone. Unfortunately, this is really important to understand. The last place anyone wants to be is swimming in debt from a small business lender. We've helped numerous small businesses deal with small business lenders.
Brian Cairns, CEO of Prostrategix Consulting. Over 25 years of business experience as a corporate executive, entrepreneur, and small business owner. For more information, please visit my LinkedIn profile