Even when times are good and profits are rolling in, only a small minority of small businesses owners can raise debt or equity from banks or investors outside their circle of family and close friends. And when a business begins to lose money, there is close to a zero chance of finding an arm's-length investor.
While getting a traditional loan in a poor economy may be next to impossible for small businesses, there are a few other financing opportunities out there.
Borrowing from family and friends is sometimes possible, but not often sensible unless someone you are close to personally has both deep pockets and business experience. Take into consideration that if you borrow money from a parent or other close relative, everyone in your family will know about it and a good many will disapprove, especially if the lender is elderly and other family members hope to inherit. If you really can repay the loan promptly and in full, all may be well, but if not, you are at high risk of becoming the family goat.
Somewhat paradoxically, your best chance of success will likely be to approach friends or relatives who have lent you money in the past. Especially if you have paid some of it back, these people will already be your supporters. And your chance of hearing a "yes" will go way up if you can convince the potential lender that you won't ask yet again.
If, given these warnings, you still plan to pursue this approach, we recommend that you present the potential lender with a formal business plan. It should include a profit-and-loss forecast and a cash flow analysis that you have already vetted with your advisory board and that clearly demonstrate how and when your business will return to profit. Assuming your future business prospects look good, two things may help seal a deal.
First, offer an interest rate that fairly compensates the lender for taking a substantial risk. Given the rocky economy and the amount of risk involved in lending to a financially challenged small business, 12% to 16% might be reasonable (though to keep the IRS happy, the rate should not be much higher than what a bank might offer you).
Second, even if you have known the lender all your life, prepare a formal business promissory note setting forth how and when the money is to be paid back and at what interest rate. Or a service like Virgin Money can help you create a loan proposal, formalize the loan, and set up an electronic funds transfer. For more information about formalizing loans from friends and family, see our article on borrowing money from friends and family.
Third, for larger loans, it's routine to offer the lender the sweetener of a small equity stake in your business. Explaining how to do this (typically by organizing as a small corporation and issuing the lender warrants, which can be converted to stock at a preset price) is beyond the scope of this book, but something a small business lawyer can help you with.
One innovative company, OnDeck Capital, offers loans up to $100,000 based on a business's cash flow and/or credit card transactions. OnDeck collects the loan repayments by automatically debiting your bank account for a small amount (typically $100) each day. Although there is obviously a coercive aspect of this approach, at least it assures that you won't get behind on loan payments. OnDeck's small loans are easier to qualify for than a traditional loan and more quickly processed, but interest rates aren't low—usually 18% to 20%—and you still must have sufficient cash flow to repay. OnDeck requires that business owners sign a personal guarantee, meaning your house, savings, and other assets are at risk if your business fails while you still owe them money.
Another alternative form of "social financing" has also developed in the past year or so: Peer-to-peer lending sites pair up borrowers who list their loan needs with private investors who are willing to offer loans at certain rates. The social lending websites getting the most press are Lending Club, Prosper, and Loanio. With the country in such a credit crunch, these online services may be worth looking into.
Factoring involves selling current accounts receivable to a business (the "factor") that will pay you immediate cash and then collect the debts when they are due. In a typical transaction, the factor will promptly pay you 60% to 80% of an invoice, with the balance held in reserve. If the factor collects the debt in full, it will release the reserve, less its fee, which normally amounts to 1% to 5% of the debt.
Factoring probably sounds good so far, but there are several downsides. First, factors' fees amount to a relatively high interest rate, certainly far higher than a bank would charge for interest on a line of credit (but because factoring does allow you to show a lender a stronger cash position, it may help you retain a line of credit otherwise in jeopardy).
Second, factors normally won't advance money on overdue or otherwise dicey receivables, including receivables for goods that can be returned for credit or are perishable or receivables from risky customers. In short, a factor isn't interested in your credit history (as a bank would be), but in its estimate of your customers' ability to pay. For example, if you are a small clothing manufacturer who is owed money by Macy's, a factor would likely advance you most of the money due on that invoice, but would refuse to purchase a similar invoice for goods you sold to several boutiques with questionable credit histories.
Factoring transactions basically fall into two broad categories, recourse and nonrecourse. In recourse factoring, the company selling its receivables is on the hook to repay the factoring company all money advanced, plus fees, if the customer doesn't pay. In the more common (and expensive) nonrecourse factoring, the factor assumes the risk of nonpayment.
Factoring has been traditionally used in the garment and other goods businesses, but today it is also used by architects, contractors, and others in the construction industry, as well as by trucking and other transportation businesses. Even service businesses and those awaiting payment on government contracts are using factors. Simply search online for "receivable factor" to find a long list of factors and websites.
Many small businesses have never had a bank line of credit, or if they did, they lost it as soon as their business began to tank. But if yours is an exception and, despite having financial problems, you are still considered bankable, chances are you won't keep your credit line much longer unless you act quickly. That's because, as you probably know, most lines of credit have what are called covenants—loan conditions that let the lender cancel your credit line if your business is out of compliance. The most common covenants require that you meet or exceed a particular financial ratio designed to assure the bank that you'll be able to repay the loan. For example, banks typically require that a borrower maintain a two-to-one ratio of earnings (minus expenses and taxes) to loan principal. Another common covenant requires a small business to maintain a ratio of assets to liabilities of at least two to one. In addition, most banks include catch-all language that allows them to revoke your credit line if they are uncomfortable with your business prospects—for example, if there is any "material adverse change" in your business.
Most line of credit agreements require that you inform the bank as soon as you know that you might not comply with a covenant, or if your business has suffered any "material adverse change." It follows that if, for any reason, you are worried about getting your line of credit renewed, or if you see you'll have a problem meeting your covenants, your best approach is to set up a meeting with your bank as soon as possible. Along with the usual required financial reports and accounts receivable and payable schedules, you'll want to present a business plan for the next year with a convincing budget that shows your business making a profit in the near future. The more you show the bank that you are actively addressing your profitability problem, the likelier it is to keep working with you.
For instance, if your sales are down significantly, be prepared to show the bank that you are making corresponding cuts in costs, such as suspending employee benefits, making layoffs, eliminating travel and entertainment expenses, cutting the staff development budget, and so on. It will also be extremely helpful if you can show the bank that new money is coming into the business from you or another investor. So if a relative is willing to lend you $50,000, get this commitment in writing before you sit down with the loan officer.
Keep in mind that you'll need to walk a fine line when discussing your financial problems. On the one hand, you'll want to convince the bank that you would have met your covenants had your business not been blindsided by the extraordinary economic downturn, but on the other, you'll need to show that you now have a convincing plan to survive it.
Don't be tempted to misrepresent your financial condition. If, in applying for a loan or trying to keep your line of credit, you overstate the value of your assets, inflate your income, or fail to disclose all of your existing debts, you can be guilty of fraud. And fraudulent debts can haunt you for years, even if you later file for bankruptcy.
What about the possibility of, instead of talking to your bank when you first realize that you'll fail to comply with a loan covenant, immediately drawing down the line and using the money to pay your creditors? If your business is a corporation or an LLC, this is usually a poor idea, because you will be substituting your personal legal obligation to repay the bank (by using the credit line) for your business entity's obligation to pay unsecured creditors. If your business fails, you are personally on the hook for all loans and accounts you have personally guaranteed, but not those exclusively in the name of your corporation or LLC.
Protect your bank account! If you owe money to a bank on a loan or credit line, it's often wise to keep your checking and other accounts elsewhere. This is because the fine print of your loan or credit line agreement probably gives the bank the right to grab without notice ("offset," or "setoff") funds in your checking account. True, this might violate yet another covenant that requires you to keep all funds in their bank, but if you lose your line of credit, this will be the least of your worries.