When it comes to borrowing money, there is one debt financing options people typically think of. You go to a bank, you qualify, secure the loan by offering up your home as collateral and then you get your money. In this section we explore this and other options where you are borrowing money but will be required to secure the loan with an asset like your home, investment portfolio or the business itself.
Secured and Collateralized: Small Business Administration Loans (SBA)
What is a Small Business Administration Loan (SBA Loan)?
When people think about debt-financing through a secured business loan, the first thing that comes to mind is getting a loan from a bank. For many entrepreneurs taking a loan is the only way to obtain the capital they need to launch their business. After all, most of us don’t have hundreds of thousands of dollars sitting in our bank accounts. What these entrepreneurs don’t know is that the banks don’t want to lend them money. Which is why an SBA loan is a preferred business loan from a bank where the Small Business Administration guarantees a portion of the debt should the borrower default. Even with the SBA backing in place, 70-80% of applicants are denied.
In 1953 the Small Business Administration was created when President Eisenhower signed the Small Business Act with the goal of strengthening the economy by enabling the establishment and viability of small businesses. This gave banks a guarantee against a portion of debt should the entrepreneur default on their loan. Without this backing guarantee, banks would see small business lending as too risky and elect not to loan the prospective entrepreneur money, stifling small business.
The SBA has a variety of programs, but most entrepreneurs end up getting an SBA loan through one of two programs:
SBA: 7(A) Loans
This is the preferred loan by lenders and small business owners alike because it can be used for almost any business purpose; starting a business, purchasing a business or as expansion capital. They come with low-interest rates, a down payment requirement, longer repayment terms, a collateral component and have a cap of $5 million. This loan program can be combined with other funding options such as rollover for business start-ups.
SBA: Working Capital Loans
This loan offers an easy business financing option or entrepreneurs who need $150,000 or less in capital for business operation. They come with low-interest rate and close much faster, sometimes in as little as 45 days, and don’t require the 20-30% down payment and collateral component. They only require a 10% down payment are secured by business assets.
One huge misconception about an SBA loan is that the bank is loaning the money based on the business you are looking to start or acquire. People think if they can find or start the right business, then the bank will loan them money, no problem. However, they are evaluating you AND the business. Your 800 credit score is no guarantee, likewise having a business with great cashflows with a lower credit score – either way you will find it hard to get an SBA loan. This is where the 5 C’s come into play.
Capital is the amount of cash you have available to invest in the business. It is also seen as your down payment or equity injection. The banks typically won’t fund 100 percent of your business, so investing capital is always a requirement. The amount varies based on your business. If you’re hoping to fund a new business, banks prefer to see a 30% down payment, if you are acquiring an existing business they want to see a 20-25% down payment.
Credit looks at your credit score, debt-to-credit ratio and credit history. If you’ve filed for bankruptcy in recent years, this can have a negative impact on your loan eligibility. Most banks also look at your FICO credit scores, both personal and business. They require a personal credit score of at least 680 and a small business credit score of 160.
Capacity measures your ability to generate income that can be used to pay back the borrowed debt and is also known as cash flow. They look at your current income, anticipated income from the new business and your spouse’s income to assesses your cash flow. If you’re looking to start a new business, the lender will place more weight on your income outside of the new business. If you’re purchasing a business, the lender will look at the business’s tax returns from the past three years.
Character is the lender evaluating your experience within your industry or business in general. Having a strong personal character won’t help you get a business loan but having dings in your personal history can make it more challenging. You will be required to provide information regarding criminal charges, recent arrests, convictions and child support payments.
Collateral is usually required by the SBA to secure the loan. You need to be prepared to collateralize your home, property, etc. Luckily, you won’t typically be denied a loan if you have insufficient collateral if all the other four C’s are met. However, if you do have “worthwhile assets” they will require them for collateral.
The banks use a combination of the 5 C’s to evaluate your likelihood to succeed, which is your likelihood to make the monthly payment. As stated in the capacity section, there is an element around how your business can help service the debt, but that alone doesn’t get you a loan. You need to be the complete package because they are looking to minimize the number of people who default.
After going through the long and rigorous application process you will get your qualified loan amount deposited into your business banking account. Since it is a loan, you will be obligated to make monthly payments back to the lender, but it doesn’t grant the bank right to your business. You maintain ownership meaning profits beyond the amount owed are yours to keep.
When an SBA Loans Makes the Most Sense
When considering whether you should pursue debt-financing such as an SBA loan, one pertinent item to look at is your business model. If you can get your doors open and generating revenue quickly then an SBA loan could be a good option. Having that monthly payment back to back is an added line of stress and eats into your cashflow in the early stages of business when it is most critical. If you feel like it might be months before you’re able to generate the revenue needed to make payments and cover your other business expenses, consider a different funding option.
The application process for an SBA loan isn’t like a mortgage were you just fill out some forms and prove your income. Along with your application you must put together a business plan that proves to the bank you know what you are doing with the money. Since the SBA is a federal program, you can’t get a loan to start a business that isn’t legal on the federal level. They also care whether your business has a proven model, so when looking at franchise they look at the performance of the overall concept.
If you meet the key elements of the 5 C’s, then an SBA loan is a funding option worth exploring. However, there are a few baseline requirements that you need to meet, otherwise you will be wasting your time going through the application process. You need to have at least a 680 credit score and any bankruptcies need to be at least 7 years old. Your rap sheet needs to be free of any financially-related crimes and you need to have the means to come up with the 20-30% down payment. If you can’t meet any of the above requirements you are better off saving your time and exploring other options.
Not having a home to collateralize isn’t a deal-breaker for an SBA loan but it is typically a requirement for it to be collateralized if you do have one. This option only makes sense if you are comfortable with that. While people don’t like to think about what happens if you fail. Failure, when you have an SBA loan, has an impact beyond losing your business.
Need fast money to buy or start a business in a few weeks or months? Then don’t look at getting an SBA loan. The loan is backed by the government so expected increased paper works and endless amounts of hoops to jump through. If you have all your paper work in order and are a perfect candidate you might be able to get one completed in a month, but expect it take 4-6 months.
How to Get Started With an SBA Loan & Where to Find Resources
The best place to get started when considering an SBA loan is the SBA website, where you can learn more about how they program works and get some great resources. While in the research phase, make sure to check out Guidant Financials eBook, Everything You Need to Know About SBA Loans eBook.
Next you will want to find out whether an SBA loan is something you are qualified for. Here is a quick pre-qualification tool that will help give you a sense of your financing options. If you pass the pre-qualification, our SBA Loan specialist team at Guidant Financial can walk you through a questionnaire and let you know if they believe you are a good candidate to get an SBA.
Once you have decided to go down the SBA path you have two options. You can go it alone and put together your own SBA loan package. This will include the application, tax documents and your business plan. Having a business plan will increase your odds of being approved. To get started down this path, check in with your local bank branches to acquire the information needed to apply or go to one of the many fintech lenders and they will sell your information to SBA banks.
You can also work with a third-party company like Guidant Financial, where we can consult with you on the loan process. Our services, for example, include a dedicated representative to help you with your loan application, a strong business plan, and gathering all the appropriate documentation – this is called “loan packaging.”
After your loan application is packaged, we take it to our extensive network of lenders to find you the best loan. Some providers charge for this service, but our loan packaging services are free for loans over $200,000 when you close with us. We ask for an up-front good faith deposit, then refund the deposit when you close your loan with us or include ROBS financing. With loan packaging, you spend much less time lost in the weeds of applying many places for loans – and more time preparing your business. You can give us a call today at 888-472-4455 to guide you through the SBA process.
Secured and Collateralized: Mortgages & Home Equity Lines of Credit (HELOC)
What is a Mortgage or Home Equity Line of Credit (HELOC)?
As an entrepreneur starts to think about the various was to come up with the money to launch their business venture they will quick consider utilizing the equity in their home. For most Americans, their home is part of their long-term savings plan so it’s natural to explore accessing the wealth built up in one’s home.
When prospective business owners use their home’s equity to funds their business there are three different options they use;
Cash out Mortgage Refinancing
If there is equity built into your home you can refinance to access these funds by getting a new mortgage with a high principle on the loan. The rates and closing costs can be higher than a rate and term refinance because you are pulling out money from your home instead of just adjusting the rate and duration of the loan.
If you have built up equity over the years and have favorable terms on your mortgage, taking a second mortgage for the amount you need to fund your business can be an option. These have limitations on total funds and will come with a higher interest rate because they are in second position to your first loan. But it is better to have a higher rate on a smaller amount of money than on the entire principle of your loan
Home Equity Line of Credit (HELOC)
This is a line of credit based on the equity in your home. You can spend the money as you need to and as you pay them back you can spend it again if needed. All the while you know what rate it will cost you anytime you use the money.
Of the different ways to access your home’s equity, a HELOC is probably the best option for entrepreneurs. It’s like getting a credit card, except it comes with a much higher limit and is secured by your house. The other options lock you into a payment schedule that won’t go away even as you pay back the money you borrowed.
When Using a Mortgage or HELOC Makes the Most Sense
Just like with other debt-financing options, your business model is key to whether it is the right fit. The moment you take on debt you are increasing your monthly payments and impacting your cashflows. This is even more important when your debt is secured by your home if you choose to tap into its equity. Make sure you will have strong revenue from day one so you don’t have worry about the added stress of missing mortgage payments.
This is obvious but this option only makes sense if you have enough equity in your home to qualify to use it. The percent you can borrow will vary from lender to lender, but I wouldn’t expect many lenders to go beyond 80-90% of your home’s value. Before you take the money, make sure you will have enough in your home to meet your business needs.
If you have explored all the self-funding, equity funding and non-collateral options and none of those are viable means to fund your business then using the equity in your home makes sense. While starting a business takes a certain acceptance of risk, putting your home on the line should be a last resort. Would you rather use up some of retirement funds or have your house foreclosed on? It’s a dark reality, but truth is not every business is a success. Be smart about what you risk, no matter how great of an idea it is.
How to Get Started with a Mortgage or HELOC & Where to Find Resources
To get started, you will need to get a sense of what your house is worth today. Zillow’s Zestimate tool is a great place to get a ballpark figure for what your home may be worth. From there, they offer some easy to use mortgage calculators to help you get a sense of what your monthly payments would be depending on the amount of money you are looking to take out.
Once you know how much you need and what you can afford to borrow, you need to choose the type of loan and lender. To learn more about the loans available to you, Zillow has a great Mortgage Learning Center. When you go to find the right lender, it is always worth trying to work with your current lender, but it is always good to have different options so check out this best HELOC lenders list from NerdWallet.
Secured and Collateralized: Seller Financing
What is Seller Financing
If you are looking to start a new business or franchise, unfortunately this funding option is not for you. Seller financing is only available to entrepreneurs who are looking to acquire existing businesses. If you are new to the small business world, this option may be completely foreign though 60% to 90% of business for sale included some level of seller financing, so odds are good you will come across it.
Seller financing is when the seller acts like a bank, they would provide you a loan to cover part of the overall purchase price. Typically, they will cover between 5%-60% of the purchase price. Obviously, the amount they are willing to finance varies considerably from deal to deal. You will be hard pressed to get an owner to finance 100% of the transaction, so you need to be prepared to come to the table with a down payment.
Since the seller is acting like the bank, you need to be prepared to go through credit checks, background checks, resume reviews and requests for collateral to secure the loan. The seller will be relying on you to effectively run the business to make monthly payments. It is only fair they do their due diligence to make sure you are a capable business owner.
At this point you might be wondering why would a business owner be willing to finance a business they are trying to sell? Offering seller financing helps the seller entice more buyers because most prospective buyers don’t have enough cash on hand to buy a business outright, so they let them buy it from them over time. There are entrepreneurs who won’t even consider buying a business unless seller financing is offered. They feel that if the seller isn’t willing to leave some skin in the game, the business might not be worth what they are asking.
The terms will change from deal to deal but here is some of what you can expect. Most sellers will cap out at financing more than 60% of their asking price. The terms of the loan will be similar to what you would get through a bank and likely be at 6-8% over a 5-7-year time frame. You should also expect there to be terms that the business gets turned back over to the seller if you don’t make payments in one to two months, as well an offer of collateral outside the business.
Let’s talk down payment. It is great that the seller will loan you some of the money to buy their business, but you still need to come up with at least 40%. Personal cash or money pulled together from friends and family would be ideal, but there are other means. Rollover for Business Start-ups for example can be used in combination with Seller Financing, allowing you to keep your monthly payment to just the seller. Another option is to get an SBA loan to cover the down payment. Going the route of the SBA loan as a down payment results in some requirements from the lender.
While the SBA lender likes that seller financing is part of the deal because that indicates to them that the seller is confidant in the business viability to make revenue in the future, the lender will have requirements that reduce their exposure in the deal.
Seller will be in full or partial standby
Being in standby impacts the seller’s rights to receive payment from the loan. Full standby results in the seller not receiving any payment on the loan, while partial standby allows the seller to receive interest-only payments. The SBA requires sellers to be in a standby position for 2 years and most other bank loans follow suit.
Seller will be subordinate to the SBA loan
Being subordinate to the SBA loans means the bank is in first position. If the business defaults on the loan the get first rights to the proceeds any assets sold. business.
Its obvious sellers aren’t crazy about these requirements, but this helps the SBA mitigate their risk when multiple types of financing are needed to acquire a business. If the seller has confidence in your ability to run the business and knows it has healthy cashflows, then they should be less concerned about the requirements debt-financing from a bank puts them in.
When it comes to seller financing you are going to find most sellers won’t be proactively advertising it due to the risk they would be taking on. Seller financing has benefits to both parties involved so if you are highly interested in a business, see if it is an option available. As you are considering if the deal is right for you, ask yourself if the terms result in a payment that the business can cover and still allow you to make a living wage?
When Seller Financing Makes the Most Sense
Seller financing is frequently the bridge to business ownership for people who don’t have large amounts of cash at their disposal. It also works great with other self-funding and equity financing options like Rollover for Business Start-ups and an Angel Investor. While it fills the gap for people who don’t have the means to self-finance, it can also be hugely beneficial for those who aren’t able to obtain a standard bank loan to due to poor credit or a lack of overall credit in the market. If you need seller financing because of poor credit, expect to have a higher interest rate and come to the table with more money to put down.
If you are new to business ownership, having guidance as you get your feet wet can be worth its weight in gold. When seller financing is used, there will typically be a transition period built into the agreement where the seller agrees to help you as you take on the new business. This is great for you because you get to learn the ins and outs from someone who was in your position and it is great for the seller because they can make sure you have everything needed to run the business so you can make your payments.
If you feel the seller’s price on the business is a bit too high, trying to negotiate seller financing into the deal can help you get a better price or overall deal. By including seller financing as part of the deal you are forcing their hand, because if the business can’t sustain the percent you are asking them to finance they won’t want to include it. If they refuse to keep some skin in the game, then that can give you some room to push the price lower.
While seller financing is an option to finance the purchase of a business, it is a funding option that is all about negotiation. If you aren’t comfortable negotiating, make sure you are working with someone who is or plan on exploring other funding options. The terms will change from deal to deal and it is critical you have your basis covered.
How to Get Started with Seller Financing & Where to Find Resources
Seller financing is an option that has plenty of nuances and will change from deal to deal, so take the time to read The Dos and Dont’s of Seller Financing. This article will provide more detail around essential elements of a seller financed deal, as well as what seller financing looks like from the seller’s side.
If you know seller financing is an option you will need to or want to include, you will want to focus your business search. Business listing sites such as BizBuySell.com have a checkbox under more search options that will allow you to filter your business search to only show business where seller financing is offered.
Once you have a business you are interested purchasing, make sure to consult your business attorney and CPA as you negotiate the terms of the deals. If you are just getting started, sites like RocketLawyer, LegalZoom and Avvo can be great resources as you work through some of the basic documents like the letter of interest, deal contract, promissory note and bill of sale.
Secured and Collateralized: Portfolio Loans (Securities Backed Line of Credit)
What is a Portfolio Loan (Securities Backed Line of Credit)?
Have you been diligent about saving for your future by building a strong investment portfolio? When looking for a way to fund your business you may look at the money in your investment portfolio but might be hesitant to sell them because of the capital gains tax you would have to pay in order access these funds. If only there were a way to create liquidity out of your investment portfolio without having to sell it off…I think you know where this is going.
Portfolio Loans, formally known as Securities Backed Lines of Credit (SBLOCs), offer you an inexpensive way to access the cash in your portfolio without having to liquidate your securities. A line of credit is setup where the securities held in your portfolio act as the collateral, like how your homes equity is the collateral in a home equity line of credit. You can typically borrow 50-90% of the value of the assets held in your investment account. The amount a lender offers will depend on the value of your overall portfolio and the types of assets in your account.
The most attractive part about portfolio loans is their incredibly low interest rates. While it varies between lenders it can range from 2-5%, which are rates you won’t find on any standard bank loan. As you borrow the money, you only need to make interest payments. There is no defined payback schedule, you can pay back some or all the principle at any time.
The low interest rate brokerage firms charge for portfolio loans is due to the risk you are taking on with this loan option. If you borrowed 80% of your portfolio value and the market tumbles by 20% you will be given a maintenance call, where you are required to offer up additional collateral to secure the loan. If it tumbles below the value of the portfolio, they can require you to start liquidating assets to pay back the loan. While the benefit of these funds can be great, it is important to understand you are taking on the risk if your portfolio drops in value, not the brokerage firm.
When a Portfolio Loans Make the Most Sense
If you have at least $85,000 in securities in your portfolio that trade $5 per share or higher, then a portfolio loan may be the right option for you assuming you are looking to fund your business with a secured/collateral backed option. You won’t find lower rates on funding that is secured through collateral. If your stock portfolio is the only place you have the money needed to start your business, using a portfolio loan to avoid having to pay capital gains is the cheapest way to access that money.
They are also perfect for someone with less than perfect credit, because the brokerage firm typically is only evaluating the amount of money you can borrow based on the value and mix of your portfolio, although bankruptcies can be a roadblock.
The funds come with no strings attached, meaning there is no requirement for what the funds can be spent on. Unlike an SBA loan, with a portfolio loan you could start a business that is legal in your state, but illegal at the federal level. This would be a risk you would be taking on by doing so, but there aren’t any restrictions for how you spend the funds from your portfolio loan because the brokerage firm has leverage to ensure they get their principle back.
How to Get Started with a Portfolio Loan & Where to Find Resources
The best source information on portfolio loans, securities backed lines of credit (SBLOC’s) comes from articles on FINRA and the SEC. These articles do great job of getting into the details of SBLOCs and the risks that come with them. While these articles lean heavy on the risk, which makes sense given the sources, we believe it is important to understand the risk and be armed to ask the right questions if you decide to explore portfolio loans as a lending option.
To assess whether you can use a portfolio loan you will need to evaluate your portfolio ensuring you have the $85,000 minimum value required from most SBLOCs. From there you can see if your brokerage offers Portfolio loan programs. If not, you can give us a call today at 888-472-4455 to help you find the right portfolio loan program to fund your business.