Many or all of the products featured here are from our partners who compensate us. This may influence which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own.
No one likes rejection. Whether it’s a “no” from your dream job, the person you love or the bank, it stings.
And if you’re a small business owner, you might know the feeling all too well. Of small businesses that applied for financing in the first half of 2014, only half received any amount, according to a survey by the Federal Reserve Banks of New York, Atlanta, Cleveland and Philadelphia.
NerdWallet asked lending experts the burning question so many small business owners want answered: Why are small business owners turned down for small business loans?
1. Bad credit or no credit
A credit score is a measure of a person’s or business’s creditworthiness. Banks generally look at both personal and business credit scores to make lending decisions and set interest rates. Every individual and business has multiple credit scores, reported by various credit bureaus. The three main personal credit bureaus are Equifax, Experian and TransUnion, and the major business credit bureaus are Equifax, Experian and Dun & Bradstreet.
Each credit bureau calculates credit scores slightly differently, and it’s not always clear which lenders look at which scores. Generally, a credit score can be low for several reasons, including bankruptcy, and late or missed payments to lenders, credit card issuers and vendors. Some businesses are simply too new to have established any credit history.
“The most common reason [business owners get turned down for loans] in our community is having no credit history or a low credit score,” says Ximena Arias, financial services manager at the Mission Asset Fund. The San Francisco-based Mission Asset Fund facilitates lending circles – a zero-interest peer-to-peer lending program – and reports the loans to some credit bureaus. This helps low-credit borrowers boost their credit scores and become eligible for traditional loans.
To raise their personal and business credit scores, business owners should make payments on time, spend well under their credit limit and keep credit accounts open.
2. Lack of collateral
Banks often require collateral – physical property that can guarantee a loan if it’s not repaid – before they agree to lend. However, new businesses may not have equipment or real estate to offer as collateral, or they may not be willing to use their personal assets (think: homes and cars) as collateral.
“The amount a bank will lend depends on the value of your assets,” says Stephen Sheinbaum, founder of Merchant Cash and Capital and Bizfi. “Homes and cars are the most common form of collateral, but if you don't own anything that the bank views as valuable, you will have trouble securing a bank loan.”
Sheinbaum’s companies are two online lenders that have emerged in the last decade to offer funding alternatives to bank loans. Merchant Cash and Capital provides online merchant cash advances, and Bizfi is an online marketplace for small business financing options. Online lenders typically offer loans at higher interest rates than traditional bank loans, but often don’t require collateral.
3. Weak cash flow
Banks want to see that businesses have enough money to make monthly loan payments in addition to covering rent, payroll, inventory and other costs. However, many small businesses struggle to keep enough cash in the bank even if they’re profitable, often because they have to pay third-party suppliers upfront before they get paid for their product or service.
Business owners need to understand how much money is flowing through their operations. If more money is going out than coming in, they need to make changes.
“If your business has too tight of a margin, work toward lowering expenses or finding ways to grow revenue before applying for a loan,” says Jay DesMarteau, head of small business banking at TD Bank.
Although cash flow is still a challenge for many small businesses, it’s improving for some. Fifty-eight percent of the 601 small businesses surveyed in April 2015 for the Wells Fargo/Gallup Small Business Index say their cash flow was “very good” or “somewhat good” in the past 12 months, up from 50% last year.
4. Lack of preparation
Some businesses get turned down for small business loans because the owners aren’t prepared.
“Many businesses simply aren't savvy about the application process and believe they can walk into a bank, fill out an application and get approved for a loan,” says Mark Palmer, managing director and analyst at BTIG, a global trading, brokerage and investment firm.
Before applying for a bank loan, businesses should have a written business plan, financial statements or projections, personal and business credit reports, tax returns and bank statements, according to the United States Small Business Administration website. They should also have copies of relevant legal documents including articles of incorporation, contracts, leases, and any licenses and permits needed to operate.
5. Seeking small loans
Most small businesses seek loans of less than $100,000, according to a 2014 Harvard Business School working paper by Karen Mills, former SBA administrator. However, banks want to underwrite larger loans because it’s more profitable for them. It costs a bank about the same amount to process a $50,000 loan as it does a $1 million loan, but it can make more money by underwriting the latter.
So although it may be tough to get a bank loan as a small-business owner, online lenders such as OnDeck, Lending Club and Dealstruck have emerged to offer the small-dollar loans that traditional banks aren't willing to underwrite. The SBA also guarantees microloans up to $50,000.
6. Risk-averse banks
Lending to a small businesses is risky for banks. Since the 2008 financial crisis, many banks have raised their lending standards to avoid taking on such risk.
“Post-recession, banks became more risk-averse and unfortunately, small business loans are inherently riskier than large business loans or even consumer loans,” says Rhea Aguinaldo, manager of entrepreneurship for the Small Business Majority, a national advocacy group for small businesses.
Some small business owners have better luck getting loans from community banks, where they have relationships with the bank staff.
“Small businesses tend to have better results if they are known by the banker,” says BTIG’s Palmer.
Image via iStock.