Wait a minute. Are you sure you really need a bank loan?
A lot of people make mistakes with bank loans. Just so we’re clear before we go further into this article, a bank loan is not the only way to raise the capital you need to start and grow your business. In fact, bank loans are probably one of the more expensive and difficult ways for startups and small businesses to raise capital. Unlike family, friends and investors who can wait for your business to turn a profit before they get their returns on investment, bank loans and interest must be paid as soon as they fall due, whether your business makes a profit or not. And if you’re not careful, high bank interest rates can wipe out all the profit your small business makes. So, you need to think again before you answer this important question: Are you sure you really need a bank loan?
If you want to know about other simple and effective alternatives to raise capital for your business, check out this article: ‘10 guaranteed ways to raise the capital you need to start up your business.’ However, if you believe a bank loan is the way to go for your small business, please read on…
What kind of small business loan should you apply for?
There are different types of loans offered by banks and the first step for a serious entrepreneur is to know the right one for her business. Depending on your needs and the type of business you want to start, there are basically two main types of small business loans: overdrafts and term loans. Let’s look at what they are and how one is different from the other…
An overdraft is a type of loan that allows you to withdraw money from your bank account even if you have little or no money in it. So, if your bank approves an overdraft of $50,000 for your business, it means you will have access to this money even if your account balance is zero. Overdrafts are usually short term and last for about six months to one year before they are renewed. As a result, they should only be used as working capital for business activities that are short term in nature such as paying staff salaries or purchasing goods to be supplied to a customer.
One of the benefits of a bank overdraft is its flexibility. You only pay interest on the amount of the overdraft you use; if you don’t use it, no interest is paid (except for some bank charges that may apply). However, its disadvantage is that it is only available to solve short term capital needs. Never use a bank overdraft to purchase equipment or lease a property which has a longer term than the overdraft itself. Using a (six-month) bank overdraft to pay for a two-year office lease is trouble. Go for a term loan instead!
Unlike overdrafts, a term loan is a sum of money released to you by the bank and starts to accrue interest from the moment you receive it; whether you use it or not (unless the bank agrees to a delay). This type of loan is best for long-term projects and can last from two to ten years, depending on your needs and terms of the loan. Just know that the longer the loan lasts, the more interest you will have to pay over time. Term loans are best for projects or buying items that have a long life span. This makes it ideal for purchasing equipment, leasing a warehouse, building a factory or buying a delivery truck for your business. No matter what you decide to use it for, just make sure it’s spent on an item that helps your business to make money.
Term loans are paid back to the bank in fixed monthly installments over the term (duration) of the loan. So, if you’re given a 3-year term loan, you will have to pay a fixed amount every month for 36 months until the full amount (including interest, fees and charges) have been repaid.
The reason why banks don’t like to give loans to small businesses…
Now that you’re convinced you need a bank loan and also know the type of loan you want, it’s time to reveal the reason why banks don’t like to give loans to small businesses and startup entrepreneurs. They call it ‘high risk.’ This simply means there is a high likelihood that something may go wrong with a small business and make it unable to pay back the bank loan (plus interest). If your bank believes that giving you a loan is a ‘high risk,’ your loan application will surely be denied! Unless you can do, show or prove something that reduces the risk to a low level, very few banks will want to give a loan to a high risk business.
Think about it for a moment. Banks make over 80 percent of their money from interest charged on loans given to customers. The more interest that is actually paid back, the more money the banks make. This is why they prefer to give loans to ‘low risk’ customers. This is the reason why banks keep running after large companies, multinationals and successful businessmen to give them loans? Just recently, Africa’s richest man – Aliko Dangote, secured a $4.25 billion bank loan to build an oil refinery in Nigeria. Getting any size of loan you want is very easy when you’re already successful – whether you’re a big company or an individual entrepreneur.
Banks will run themselves over to give loans to credible and successful companies because they are considered ‘low risk.’ These companies have a proven business that makes money. They also have a reputation at stake which makes them more likely to pay back their loans. But you’re different, you’re a startup – you still have to prove that your business WILL make enough money to pay back a bank loan. Until you can prove that you’re no longer a ‘high risk investment’, banks are likely to consider your small business loan application as a gamble.
Let’s look at five effective ways to reduce the risk in your loan application and ensure that it gets the approval that you need to secure that small business loan.
5 ways to improve the chances of getting your loan application approved...
Fortunately, it’s not an entirely sad situation; risks can be reduced. Entrepreneurs who can successfully apply any of the five ‘open secrets’ we’re about to reveal will significantly increase the chances of getting the loans they want from their banks. In the bank’s eyes, these methods increase the likelihood that your business can and will pay back the loan (of course, with the interest).
#1 - Get a supply contract (or purchase order) from a credit-worthy customer
One of the big risks that worry your bank about your loan application is the ability of your small business to sell enough products or services that will make money to repay a loan. A supply contract from a creditworthy customer (usually a company or organization with good business performance) proves to the bank that somebody is interested in your products and is willing to pay (and can pay). (photo credit: utilityassist.co.uk)
One of our best examples in this regard is South African entrepreneur, Anna Phosa. From a small pig farm which she started in 2004 with $100 and only four pigs, she received a $2.5 million dollar loan from South Africa's ABSA Bank to enlarge her piggery business. This loan became possible because Anna secured a contract to supply 100 pigs a week to Pick ‘n Pay, one of South Africa’s largest supermarket chains. With a contract in hand and a credible large company behind her, Anna had significantly reduced the high risk that would have made her loan application difficult to approve. From just four pigs, her new farm, which sits on a 350-hectare space, now holds nearly 4,000 pigs at a time. She currently employs about 20 staff and has become something of a celebrity pig farmer on the continent!
#2 – Pledge your property as collateral (or security)
If a bank loan is your preferred source of capital, you may have to pledge something of value to the bank which it can sell to recover the loan and interest in the event that you cannot repay. Collateral is usually any item of value such as real estate (buildings and land), cars, expensive jewelry and shares that are quoted on the stock market.
The collateral you pledge remains yours until you are unable to repay the loan. At that point, the banks will move to sell the property to realize the loan amount and interest you owe them. Banks often insist that the value of the collateral you pledge is the same value (or more) of the loan amount you are applying for. To confirm that you have the right to pledge an item or property as collateral, banks will often want to see an evidence of ownership. If the item is not yours, the banks would want to see a Letter of Consent from the owner that gives you the permission to use the asset as collateral for the loan.
Warning: Using your property as collateral for a loan is a very serious decision that could have life changing consequences for you (and your family). You should make sure that the business you need this loan for is sound and will make enough money to repay the loan and any interest it accrues. If you’re not certain about this, you can choose from other less risky ways of raising the capital you need to startup and grow your business.
#3 – Do you have a good credit history?
If you have taken out a loan before and paid it back with all the interest and no delays, it often signals good behaviour and creditworthiness to banks. Banks and other lending institutions can verify your credit history and gauge the ‘riskiness’ of giving you a loan. If you have been coming up short on a loan you took out previously with another bank, this may show up in your credit history and reduce your chances of getting your loan application approved. If you have a poor credit history, the banks may insist on collateral or other forms of security for the loan.
Credit reports and background checks are not yet common in Africa. However, as our continent gets more connected and information sharing becomes easier, banks, cooperatives and other lending institutions will be able to share your credit history and information. In the future, credit reports will play a huge role in determining if your loan application will be approved or rejected.
#4 – A detailed business plan always helps!
To convince the banks that lending you money will not be a gamble, it helps to present a detailed and well thought-out business plan. What will your business be about? Is there a market for your products and services? What is your plan for marketing and selling your products? What background and experience do you have to make the business work? What will the loan amount be used for?
The more of these questions you can answer, the more comfortable and convinced the bank becomes. Your business plan should be a road map that shows the bank that a lot of thinking and planning has gone into your business idea. Most small businesses and startup entrepreneurs do not do a good work of presenting detailed information about their business to the bank.
Writing a business plan can be a simple or complex affair depending on the type of business and who the business plan is meant for (you, banks, investors, business partners etc). We shall cover the full details of writing a winning business plan (including sample templates) in a follow up article.
#5 – Get a guarantor to cover you
A guarantor is a person who guarantees to pay the bank in the event that you are unable to repay the loan and any interest it accrues. A guarantor is often someone who is wealthy or has valuable assets that can be used as collateral (or security) for the loan. Having a guarantor to back up your loan application reduces the likelihood that you will not be able to pay back the loan. This usually gives banks the assurance they need to classify your loan application as a ‘low risk’. And depending on the policies of the bank, your loan application would be approved.
Have you had any problems getting your small business loan approved?
If you’re like many startup entrepreneurs and small businesses, you may have been unlucky with your small business loan application. What were the problems you faced? Have you used any of the methods discussed in this article to help you secure a business loan? We would love to hear from you.
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To your financial success!