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As the recovery limps along, small business owners looking for bank credit and loan officers assessing their applications have their work cut out for them. The main hurdles: well-intentioned but disruptive government policies and tough bank examinations. “Regulators have gotten so afraid [of] bad loans that we leave many good loans on the table,” one institutional banker who interacts with hundreds of lenders across the country told me recently. “No one ever got fired for not making a good loan.”
Despite this difficult environment, finding credit these days is possible. To help entrepreneurs work around common roadblocks, I’ve assembled these tips from experienced individuals within the lending industry:
1. Focus on lenders unaffected by recent regulatory reforms.
Banks with assets greater than $10 billion have their hands tied. Provisions of the Dodd-Frank financial reform law require them to keep up to five times as much cash in reserves as they were previously required to hold. As a result, it’s probably not surprising that they are approving only 10 percent of small business loan applications, according to the August lending index compiled by Biz2Credit, a New York company that matches borrowers to a network of lenders. The index shows 44 percent of small business loan applications received by small lenders were approved.
2. When you can’t share a good financial story, bank on a creative lender.
When reviewing an applicant, bankers want to see a positive growth story. Most are forgiving of a bad 2009 (I mean, who didn’t have one?) as long as sales and profits have been moving upward since then. Unfortunately, many small businesses can’t show an uptick in business. More than 73 percent of the 1,000 loan applications analyzed in the Biz2Credit index reported declining sales for the first seven months of 2011. And even more showed declining profits.
In the absence of a good story, working with a lender that has the ability to be creative can be invaluable. While large banks will close the book on a loan that doesn’t fit the mold, regional and community banks, particularly those with experience in your industry or your local area will take more time to understand your business.
A smaller bank’s ability to get creative will be driven in large part by its rating from its bank supervisory authority, referred to as its Camel score in industry jargon. Banks get graded, and those scores determine how much a bank must put aside on its balance sheet for each loan it makes and the amount of scrutiny it faces from regulators.
Know that banks with low scores will face daily scrutiny, making them able to do little more than clean up an existing portfolio. While Camel scores are not available to the public, you can get a list of the most active lenders from the Small Business Administration. Chances are if they have been able to make loans with frequency in the past few months, they’re facing less regulatory pressure internally.
3. Industry experience and personal investment matters.
For borrowers seeking credit to buy a business or fund a startup, lenders will require them to have at least 3 years of industry experience and put skin in the game. For example, for a $300,000 loan, the bank will want to see the borrower have at least $100,000 of his or her own cash invested in the business or access to a similar sum in liquid assets or collateral, among other criteria.
In addition, showing that customers already exist for the product or service can help. “For those seeking leverage to fund a new business, it’s often easier to acquire credit to buy an existing business that has an established customer base than get a loan for a new startup venture,” says Rohit Arora, Biz2Credit’s co-founder and chief executive.
4. “Derogatories” on your credit report can do you in.
Bankers have learned the hard way that a FICO score is a poor indicator of creditworthiness. As a tool that is heavily influenced by consumer credit cards, a borrower using 10 cards regularly who makes minimum payments on the balances will have a better FICO score than a responsible borrower who relies on two cards, uses much of his available credit, but pays the balance in full each month.
“A 700 can turn into a 500 overnight,” says James Kim, senior vice-president for small business lending at Los Angeles-based nonbank lender Hana Financial. He says “derogatories,” such as bankruptcies and missed or late payments—particularly those on such essentials as home mortgages, student loans, and child support—will be scrutinized closely as an indicator of creditworthiness.
5. Show adequate ability to repay loans, and keep accounting transparent.
Banks want to make sure you can pay them back. They will want to see that you have a track record of making enough profit to cover operating expenses, interest, and principal payments, and have at least 20 percent extra for when things don’t go as planned. Businesses that operated at a loss in 2009 must show even better profitability in 2008 or 2010 to satisfy the bank’s focus on averages.
Lenders will also favor borrowers who show access to alternate capital in the event business goes south. Be sure to highlight if you have rental real estate that throws off cash, income from a spouse who works outside the business, or other sources for emergency capital. Banks may also seek access to such collateral as a second lien or third lien on a home.
Finally, while you may be tempted to make up for declining sales and profitability by maximizing tax deductions, moves like this will understate your documented profitability and ability to show debt service in the eyes of a lender for years to come (remember, they’re looking at your rolling average). Keep your books clean.