Financing is one of those things that most business owners will need at some point during their business’s life cycle. Occasionally, businesses use venture capital (VC). To say that VC funding is rare would be an understatement. More common than VC funding is having an angel investor. Think about the men and women on Shark Tank: having an angel investor seems pretty cool, but even though that situation is more likely than working with a VC firm, it’s still pretty rare. What are the most commonly used forms of financing?
According to the Harvard Business Review fewer than 1% of U.S. companies have raised capital from VCs. It is also estimated that angel investors fund more than 16 times as many companies as VCs. Conversely, it is very common for small business owners out there to be using their own funds or credit cards as a vital part of their overall funding strategy.
If you are like a lot of other business owners who use credit cards and your personal savings to fund your business during the first 2-3 years of your operation, then what should you do NOW to plan for your future financing needs? Let’s answer that question.
#1 Learn about the FICO SBSS score, monitor it, and know how you can use it to your advantage
The rules for SBA loans changed on Jan. 1, 2014. Since that time, SBA lenders cannot get the SBA Guaranty on loans of $350,000 or less if they do not use the FICO SBSS score as part of their underwriting process. The FICO SBSS score, also known as FICO LiquidCredit score, is a scoring model that ranges from 0 to 300. It pulls all the personal credit and business credit data into one algorithm and generates the score. SBA tested the score for a long time before adopting it. FICO rolled out this scoring model over 20 years ago and it’s gone through several updates and iterations.
SBA requires a score of 140 in order to back the loan. However, most lenders have higher scoring requirements. If you would like to consolidate your credit card debt and pay it off with an SBA loan or if you need some additional working capital, this score will be the first hurdle you’ll need to clear on an SBA loan request of $350,000 or less. If you have a score over 170 you’ll likely meet lender requirements that are almost certain to be higher than the SBA ‘s 140. Keep in mind that your chances of getting the SBA loan will become much greater after you have filed a tax return and show a net profit. Startup SBA can be hard to find and exponentially more difficult to fund. Most SBA lenders simply aren’t set up to handle startup SBA requests in an efficient manner.
If you’re looking to pursue funding outside of an SBA backed loan, your business credit scores & ratings might come into play. Some lenders may pull your Dun & Bradstreet business credit file and others may use different business credit criteria. It’s advisable for business owners to be aware of the various companies that maintain a business credit file for their businesses and how those scores and ratings might impact their company in the future. I’ll cover how to build your business credit file in tip number 3.
#2 Treat Your Personal Credit as an Asset
It’s an unfortunate truth, but it’s true nonetheless. If your personal credit is damaged then your chances of getting low-cost financing decrease. If your personal credit is excellent then your chances of getting low-cost financing increase. The ideal marriage in the world of business financing is having excellent personal credit and excellent business credit. The closer you can get to that ideal scenario the better. Ask yourself a simple question: if one of the main reasons why businesses fail is due to a lack of access to financing and if good credit gives you more financing options and potentially lower-cost financing options then treating your credit like a valuable asset should be a priority for you?
#3 Build Your Business Credit File
Hit the fast forward button. It’s 3 years from now and unlike most startups, you’ve made it through and you’re still in business. Whether things are thriving or whether the business is struggling you’ll have a lot on your mind. Most likely, you won’t suddenly have time to do all the things you had on your to-do list as you were building the business the first few years. It doesn’t usually work that way. You’ll find that you and your business are the product of all the investments (time & money) you made during those first 3 years. Did you spend any time or resources investing in building your business credit file? There may come a time – maybe many times – when you’ll wish you had made this investment. It is one of those things that will probably always go in the “important” column on your list and may never go in the “urgent” column. If you don’t decide to do something about it, then it probably won’t happen.
#4 Learn about Cash Flow Calculations
This is a tougher one but it’s also a way you can get ahead in the credit and finance area. Banks and many lenders do what are called cash flow calculations. There are many variations but it’s pretty basic at it’s core. Look at your tax return and follow this formula:
- Net profit + depreciation + interest expense + executive officer compensation = Total Income
Add all monthly debt payments and take the monthly number times 12. You’ll have the annual debt payments (principal + interest). Add the new loan annual payments and you have your Total Debt.
- Total Income / Total Debt = Cash Flow Calculation or Income to Debt Ratio
Here’s an example:
Joe from Joe’s Plumbing had a $10,000 net profit on his last tax return. He got that from line 21 of his 1120 form. He had $6,000 in interest expense which he got from line 13 of his 1120. Then he had $2,000 in depreciation which he pulled from line 14 of his 1120. Lastly, there was $2,500 in Officer Compensation from the bonus he paid his top manager last year. He got that from line 7 of his 1120. So for the income it looked like this:
- Total Income = $10,000 + $6,000 + $2,000 + $2,500 = $20,500
Joe is applying for a $100,000 SBA loan. He is paying off all his debt except one equipment lease that is $200/month. So if he’s approved, he’ll have one loan for $100,000 and his equipment lease. The $100,000 loan will be $1,111 per month. So here’s the math on the total debt:
- Total Debt = $200 + $1,111 = $1,311 x 12 months = $15,732
Cash Flow Calculation = Total Income / Total Debt
- $20,500 / $15,732 = 1.30
Cash flow calculations above 1.25 will normally put you in the green zone and make it more likely for you to be approved. Of course, there are always other factors that can come into play. However, as a general rule of thumb, this is a good way for you to know not only how the lenders may look at your funding request, but it can also help you be confident in your ability to repay the money you’re borrowing.
In conclusion, if you want to be a business owner who has a handle on your credit and financing options, then these are four specific things to think about with regards to your credit and financing that may help increase your chances of success. Running a business requires a lot of care and attention, but the effects of some of your hard work are cumulative. If you start thinking about your future funding options now, you can help increase your business’s chances of enduring and, ultimately, succeeding.
Photo Credit: Christian Schnettelker, Flickr