Business loans. A beginner s guide. fundingcircle.com

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1 Business loans A beginner s guide fundingcircle.com support@fundingcircle.com

2 A beginner s guide to business loans Running a business is tough, but financing it shouldn t be. Funding Circle believes in fair and transparent lending, which is why we created this one-stop guide to business loans. Learn about APR, how an application is evaluated, and more so you feel confident making the right choice for your business. 2

3 Included in this guide 5 things to consider before applying for financing 3 key components of a business loan 5 Cs of credit business owners should know Why APR is key to selecting the best loan offer 5 ways to avoid overpaying for a business loan

4 5 things to consider before applying for financing From upgrading machinery and expanding your workforce to launching an innovative marketing campaign, building a successful small business requires hard work, a lot of determination and access to cash to invest in the business growth. As the saying goes, cash flow is the lifeblood of small businesses. But for entrepreneurs growing their businesses money can sometimes be tight, so it s important to understand the financing options available. For small business owners thinking about taking their business to the next level, here are five things to consider before applying for financing: 1. Have a business plan Not all lenders require a formal plan, but it is important to demonstrate knowledge of your industry, articulate that you are passionate about the market opportunity and highlight your competitive advantage. Be prepared to talk about your credit history and how financing will increase your business bottom line, whether it s to help scale faster, plug a short-term financing gap or fund a large asset. If you re unsure how much you need to invest in your company to grow, meet with an advisor before applying for a loan. 2. Compile the right paperwork Besides an overall business plan, lenders will require financial projections and may ask for tax returns, proof of ownership for assets and current bank statements for you and the business. Where possible, it s also useful to have documentation handy that validates the market opportunity and your ability to attract talented employees. 3. Check your credit score This is an important indicator of your creditworthiness. If your score is high (above 700), you have a better chance of being approved for a more attractive interest rate. Request a copy of your personal credit report and check for errors, such as a cable bill you paid on time but that was reported as late. Contact the credit bureau to resolve any issues, and if your score is in the 600s or lower, take steps to improve it before you approach lenders. One important indicator for credit bureaus is the 4

5 percentage of available credit you are using at any one time, so aim to keep your credit card account balance, for example, below 50% of your credit limit. 4. Research different lenders Traditional lenders like banks and credit unions may offer the most competitive rates, but the process can take up to four months and they generally don t lend to businesses that require loans under $500,000. Merchant cash advances provide fast finance to borrowers with lower credit scores, but the trade off can be shady and expensive lending terms. Peer-to-peer and marketplace lenders, like Funding Circle, are nonbank platforms that match businesses looking to borrow with investors who want to lend. Wrapped in a user-friendly online interface, these lenders ask questions relevant to the loan you ve applied for, offer competitive rates and give you a decision typically within days. 5. Compare rates and fees Interest rates and fees fluctuate considerably between lenders and depend on a number of factors from the type of financing and term to your credit score and whether the loan is secured by assets. For example, shorter loans (generally under 12 months) that have repayments based on the cash flow of a business tend to be really expensive, while longer term loans are usually much cheaper. Nav, an online resource for small business financing advice, has built some great calculators to help businesses compare the true cost of borrowing across different types of loans. Copyright 2014 Cleaning Business Today (ISBN ). A version of this article first appeared in the December 2014 edition of Cleaning Business Today. You can read it here. 5

6 3 key components of a business loan It s no secret that at Funding Circle, we employ our fair share of finance junkies. We love to get lost in the jumble of terminology and metrics that permeate our industry. But we know that most businesses looking for financing don t have time to wade into the deep end with us you re busy running and growing your business! To help you make a more informed decision about financing, we ve broken down the three key terms of a small business loan: principal, interest, and fees. 1. Principal Principal is a fancy name for the amount of money you have borrowed and have yet to pay back. If Sam lends Jake $100 on Monday, the principal is $100. If Jake pays Sam back on Tuesday with $20 he finds in his jacket pocket, the remaining principal is $80. Like the principal of a middle school, your loan principal determines how the other parts of your loan function. Interest and fees are often given as a percentage of the principal, so this is the first number to establish and consider when trying to understand the terms of a loan. 2. Interest Interest is the amount of money a borrower pays the lender in exchange for the privilege of using their money. You can think of it as the amount you pay to interest the lender into giving you a loan. Interest can be simple: Sam lends Jake $100 with 10% interest on Monday, so Jake owes Sam $110 when he pays him back at the end of the week. Or interest can be compounding, which means you pay interest on top of the interest you already owe: 6

7 Sam lends Jake $100 on Monday with 10% interest, compounding daily. If Jake repays the loan in full on Tuesday, he ll owe $110. However, if he doesn t repay the loan until Wednesday, he ll owe $121: $110 + ($110 x 10%). It s important to remember that the higher the number of compounding periods (eg. daily, weekly, monthly, annually), the higher the compound interest. For example, the amount of compound interest you ll owe on $100 compounded at 10% annually will be lower (cheaper!) than if it compounded at 5% bi-annually. 10%: $100 x 10% = $110 Total amount owed: $110 5%: i: $100 + ($100 x 5%) = $105 ii: $105 + ($105 x 5%) = $ Total amount owed: $ Fees Depending on who you borrow money from, you may be presented with various fees that can substantially increase the cost of your loan. These fees fall into two buckets fees that are charged upfront or at origination, and fees charged over the life of the loan. An origination fee is a simple, one-off fee lenders charge to cover the cost of evaluating and originating your loan. At Funding Circle, your origination fee will range from 0.99% to 6.99% of the total amount you borrowed and is based on the strength of your credit profile. It is deducted from your total loan proceeds, which means you do not pay this fee if you do not receive a loan. Some lenders (but not us!) tack on a slew of additional initial fees for things like submitting an application, processing the loan, preparing the documents or underwriting the loan. If you re borrowing from another lender, you should also be on the lookout for ongoing fees. These fees are incurred during the life of your loan or when you pay it back. Many lenders also charge a prepayment penalty fee to discourage borrowers from paying off their loan early. Using our previous example, it would look something like this: 7

8 Sam lends Jake $100 on Monday with 10% interest, compounding daily and a prepayment penalty of $15. The loan must be repaid by Wednesday. If Jake had $110 on Tuesday, he could pay back Sam early and avoid paying additional interest (saving $11!). However, because he agreed to a loan with a prepayment penalty, he would actually have to pay $125. The prepayment penalty allows Sam to earn more money on interest by encouraging Jake to wait until Wednesday to pay off the loan. If he repays on Tuesday (early): ($100 x 10%) + $15 = $125 Total amount owed: $125 If he repays on Wednesday (due date): i: $100 x 10% = $110 ii: $110 x 10% = $121 Total amount owed: $121 At Funding Circle, we don t think that s fair. We will never penalize you for paying your loan back early. Putting it all together Just looking at the basic components of a loan, you can see how quickly things can get complicated which is why it s so important to work with a lender who has your best interests at heart. At Funding Circle, we believe all business owners deserve the right to transparency. That s why we partnered with other industry leaders to set the first-ever gold standard for responsible business lending in America: The Small Business Borrowers Bill of Rights. We promise to always disclose rates and fees upfront and in plain-english, so you never have to worry about hidden costs. Once you re ready to compare loan offers, it s helpful to have a single number that brings together the key components of each loan you re considering. That number is known as an Annual Percentage Rate (APR), and a good lender will always be willing to help you calculate it. You deserve to work with a lender who empowers you with the knowledge you need to make the best possible financing decisions for your business. Check your eligibility today for a small business loan with Funding Circle. 8

9 The 5 Cs of credit every business owner should know What lenders actually care about Traditionally, many banks have been pretty protective of their credit criteria the list of factors that go into deciding whether to approve or deny your loan application. But for small business owners like you, this black box approach can be the beginning of an endlessly frustrating experience. Imagine applying for a job without seeing the job description first. Or auditioning for American Idol without meeting the judges. At Funding Circle, we believe you should understand exactly what you re getting into from the very beginning. That s why we ve put together this credit criteria guide for all small business owners. In the pages that follow, you ll get an inside look at the five categories of criteria most commercial lenders consider when evaluating a business for a loan. Some lenders might value one or two characteristics more than some of the others, so if you re shopping around between a few different lenders it s a good idea to ask them which ones are most important to them. The Funding Circle difference As you ll discover, Funding Circle takes a holistic view of every loan application which is part of the reason so many businesses choose to work with us instead of a traditional bank when it comes to financing their growth. More than 25,000 small businesses around the world have received over $3 billion in affordable financing through our marketplace. See how we stack up against the competition in terms of rates, fees, and time to funding. 1. Capacity Your business ability to repay a loan When a lender evaluates your business, they re typically trying to answer one big question: Will your business be able to repay the loan plus the additional interest? 9

10 The most obvious way to answer this question is to look at your business cash flow and see how your typical monthly revenue compares to your typical monthly debts. At Funding Circle, we break your cash flow evaluation into two parts: The recurring nature of your cash flow. It s always a good sign when your net cash flow is positive, month over month. We look for fairly consistent sales, a steady flow of contracts, and regular reinvestment of cash to keep growing your business. Your future cash flow projections. We don t just care how your business has performed in the past we also want to know how it s going to perform in the future. Are you landing a big contract soon? Is your busy season just around the corner? To get a simple, objective view of your business capacity, a lender will often calculate your Debt Service Coverage Ratio (DSCR). Lenders vary in what metrics they include in this calculation, but Funding Circle uses a Global DSCR, which takes into account your personal assets and debt obligations. Ask your accountant for help calculating and interpreting your own DSCR, or use the formula below to calculate it yourself. DSCR = (Personal Cash Flow + Business Cash Flow) (Personal Debt + Business Debt + New Debt) A large DSCR (greater than 1.5) tells a lender you have a greater capacity to repay your outstanding debts, while a low DSCR (lower than 0.75) might indicate difficulty making regular repayments. 2. Capital How much skin in the game do you have? The second thing a lender may consider when evaluating your business is how committed you are to the success of your business. This sounds like a fairly subjective question, but it is often measured by how much capital you have personally invested in your business to date. When a business owner invests their own money in their company and continues to reinvest profits in its continued success, it is a strong signal that they will use a new loan to keep the business on the right path. At Funding Circle, we don t have a minimum capital require for eligible businesses, 10

11 but we do take this characteristic in context with other measurements to develop an understanding of your business potential. 3. Conditions The overall environment in which your business operates No business is an island, and your lender will likely consider at least a couple external factors when evaluating your business. A good lender will already know about recent trends in your industry, and will focus on the things that you re doing to react to these changes. Here are three areas to think about when applying for financing acknowledging them during the application process can help you position yourself as a worthy applicant. The competitive landscape. Who is your competition, and how do you differentiate yourself? How could more capital help you improve your business weak points so you can get an edge. Customer relationships. Do any of your customers represent more than 10% of your revenue? If so, how do you protect those relationships? Could additional capital be used to help you diversify your revenue base? Industry-specific risks. Are there any macroeconomic or political factors that could affect your business? Will any of the capital be used to address these trends or more abrupt changes? Tip from an underwriter: Whenever you apply for capital, it s always helpful to show you know exactly how you plan to spend your funds. Will you be purchasing new equipment? Hiring a new salesperson? Covering an accounts receivables gap? Let us know, and don t be afraid to be specific. 4. Collateral Any property or asset that a lender might ask of you to secure a loan Generally, loans with sizable collateral like a mortgage or a car loan are easier to qualify for and come at lower rates. If you miss too many payments on your loan, the lender can seize the collateral to make up for its lost investment. In contrast, unsecured working capital and other business loans often come with higher rates because the lender has little recourse if the borrower defaults. 11

12 At Funding Circle, our term loans are secured by a lien on your business assets and with a personal guarantee from the owner(s) of the business. A personal guarantee is a document that states you will be liable if your business is unable to meet its debt obligation. The fact that we use a personal guarantee on our commercial loans means even asset-light businesses that may be rejected by traditional banks due to their limited collateral may qualify for a Funding Circle loan. 5. Character An overall assessment of your trustworthiness and credibility The final category most lenders judge applicants on is their character and credibility. Most lenders quantify this seemingly subjective concept by looking at your credit score. The general principle is that a borrower s previous actions are indicative of their future actions if you were late or defaulted on previous loans, they re going to think it s more likely you ll have trouble paying back their loan. For this reason, it s critical that you understand and track both your personal credit score and your business credit score. But a good lender should understand that your business is more than just a series of financial statements. When Funding Circle evaluates your character, we also consider how long you ve been in business and how much experience you have in your industry. We might look at your reputation with your customers and your community even taking into account your business social media footprint. 12

13 Why APR is key to selecting the best loan offer As you begin the process of shopping for a small business loan, it s easy to become overwhelmed by fast-talking salesmen, endless strings of acronyms and deals that seem too good to be true. How do you cut through the chaos and make sense of it all? The key is to calculate the Annual Percentage Rate, or APR, of a deal before you sign the dotted line. At Funding Circle, we believe that transparency builds trust, so we ve put together a quick tutorial on one of the most familiar and least understood terms in finance: APR. What is APR? APR, or annual percentage rate, is a figure that tells you the true cost per year of borrowing money. It s the true cost because unlike the interest rate, APR also takes into account additional fees and charges that are too often hidden in the fine print. As a result, the APR is generally higher than the advertised interest rate, so it s important to ask about the APR when comparing competing loan offers, or even better: learn how to calculate it yourself. How do I calculate APR? The Truth in Lending Act requires most credit lenders to disclose the APR and terms of the loan prior to signing, but it s also possible to calculate the APR on your own if your lender is transparent about details of the loan. (Side note: If your lender isn t upfront about the way their APR is calculated, it s probably a good indication of a bad deal.) To calculate your APR, you ll need: 1. The amount of the loan 2. The interest rate (ask whether it compounds daily, monthly or annually) 3. A list of all additional fees* 13

14 Math wizards can try to work it all out by hand, but if you don t want to worry about carrying the two, you can save yourself from unnecessary flashbacks to high school math exams by using a specialized APR calculator. *The only additional fee that Funding Circle charges at the time of signing is a 0.99%-6.99% origination fee. If you borrow from another lender, possible additional costs include fees for underwriting, loan processing, document presentation, loan application, early repayment penalties, etc This calculator, designed by Nav, helps you calculate the APR of a standard term loan. To calculate the APR for other products (MCAs, Invoice financing, mortgages, etc.), try Nav s other business calculators. Why is APR important? It s tempting to simply look at the interest rate when comparing potential loan offers, but it doesn t give you the full picture. For example, one loan may have an attractively low interest rate, but if it is compounded daily or associated with a whole bunch of additional fees it may wind up being much more expensive than you originally thought. Given the amount and term of your loan, APR takes into account all of the costs associated with financing the loan and is the best metric to help you compare apples-to-apples. How do I lower my APR? Lowering your APR is pretty intuitive. A low APR generally indicates lower interest rates and fewer associated fees. But you can also lower your APR by extending the term of your loan. Keep in mind, however, that longer loans are often associated with higher interest rates. Is a lower APR always better? While APR is a critical number to consider when comparing competing loan offers, it s also important to look at the APR in the context of the full terms of the loan. For example, APR alone isn t a direct indication of how much interest you ll wind up paying over the life of a loan. In the scenario below, increasing the length of the loan allows you to pay less per month and therefore per year thus lowering your APR. But because there are more payments, you ll wind up paying an additional $48 in interest. Selecting a lower APR may also not be optimal if you are quoted a variable APR. With a variable rate, the lender reserves the right to change the interest rate during the life of the loan depending on conditions totally under their control. A variable loan that started with a low APR could wind up costing you much more after the promotional period expires. 14

15 Loan Amount: $1,000 Monthly Compounding Interest Rate: 10% Origination Fee: 2% Term: APR: Monthly Payment: Total Cost: 24 months 12.03% $46 $1, months 11.39% $32 $1,152 You might prefer to take the option with lower APR because the additional cost is spread over the course of three years. But if your priority is to save money, you should pick the loan with the higher APR. Whichever one you choose, you need to calculate the APR and understand the details of the loan in order to make an informed decision. On the other hand, Funding Circle always offers a fixed annual interest rate throughout the life of your loan, so there are no unexpected surprises down the road. So what does this all mean? Before you sign any papers, you should understand all of the terms and conditions associated with your loan. Calculating your APR is an essential step in evaluating a loan offer, but it s not the only metric you should consider. Honesty and transparency are part of Funding Circle s core values, so we provide small business owners all of the information required to calculate the true cost of a loan. We offer fixed interest rates as low as 4.99 percent and only ask for a one-time origination fee of 0.99 percent to 6.99 percent. It s free to apply, with no monthly servicing fees, early repayment penalties or other hidden costs. You ll also be assigned a personal account manager to answer any questions you have about your loan before you sign. You can easily request an amortization schedule, so you know exactly how much is due each month. Your account manager can even help you calculate your APR, which of course you now know how to confidently calculate on your own! You deserve to work with a lender who empowers you with the knowledge you need to make the best possible financing decisions for your business. Check your eligibility today for a small business loan with Funding Circle. 15

16 5 ways to avoid overpaying for a business loan by Sam Hodges Coy about costs. Brushing over the fine print. Pressuring you into something bigger or more expensive than what you need. If you re an entrepreneur, chances are you ve had at least one uncomfortable encounter with a lender who just didn t seem to have your best interests at heart. Earlier in my career, my partners and I built up a network of successful fitness businesses. The business grew quickly, and we started shopping for a loan to help us expand our profitable model to new markets. It was during this time that I got my first glimpse into the opaque underbelly of the traditional lending industry. We were shocked at how many lenders literally could not produce an amortization and repayment schedule. And when we asked them to share their fee structure and APRs? Crickets. There are 28 million small businesses in the U.S. These entrepreneurs create two out of every three net new jobs and employ half of the private sector workforce (about 120 million people!). They deserve better. They deserve an efficient and transparent way to fulfill their growing capital needs, and they deserve to understand the true cost of their loans. The good news is that there are some simple tricks you can use to weed out the bad apples and ensure you get a fair deal on your financing. If you re looking for an injection of cash to jump-start your business, here five ways to avoid overpaying for a loan: 1. If they can t tell you the APR, walk away. Application fees, annual costs, service charges, origination fees you have the right to know the total cost of any loan you are offered so you can easily compare it to other offers and make the right decision for your business. Unfortunately, financing has traditionally been sold with pricing that can be confusing or misleading and the true cost of a loan is often not disclosed. Instead, some lenders quote rates that are calculated a little differently from a true interest rate, so their products appear cheaper. 16

17 One of the best ways to do an apples-to-apples comparison on loan products is to calculate the APR (annual percentage rate), a figure that tells you all the costs for one year in a single equivalent interest rate. It s the true cost of your loan because, unlike an interest rate, an APR also takes into account additional fees and charges often hidden in the fine print, and also normalizes for how frequently you ll need to make payments. Many merchant cash advance lenders claim they can t calculate an APR or that an APR is irrelevant because they re not offering term loans. That s fundamentally wrong. They may not like it, but they can definitely do it. There are some products with high APRs that make sense for certain businesses in some circumstances, but a lender should be able to make that case transparently and equip a borrower with the right information to make the right decision for his or her business. A good lender will always be willing to help you calculate an APR, so that you can accurately compare your options. 2. Don t accept prepayment penalties as par for the course. Some credit products charge a fixed repayment amount, making it impossible for you to save money by paying early. This is not always transparently disclosed, so if in doubt ask the lender to explain how much you d owe if you repaid early on a specific date. If it s greater than the principal outstanding, then there s a prepayment penalty. End of story. 3. Watch out for double dipping. If you take out a new loan before repaying an existing one with a lender, ensure you are not unfairly double charged for the outstanding portion of your loans. The new fixed charges should only be calculated based on the additional capital you have received. For example, a business owner who still owes $10,000 on a loan may take out a second loan for $25,000. The $10,000 could be rolled into the new loan so he or she only receives $15,000 of new capital. However, if this individual is charged fees on the full $25,000 amount, he or she would have effectively been double charged on the outstanding $10,000 amount. 17

18 4. Don t stand for stacking. Stacking occurs when a lender convinces you to add a loan or cash advance product on top of another credit product you already have from a different lender. In this situation, you could end up with multiple cash advances stacked on top of each other, each diverting a percentage of sales from reaching the business. This can quickly become a boa constrictor around your business s cash flow. Whether you re in a tight spot or want to jump on an unexpected business opportunity, it s important to remember that just because you need another injection of capital, doesn t necessarily mean you need a whole new credit product. Instead, consider if refinancing your existing debt can potentially lower your overall costs compared with the temporary boost you would get from taking out a new loan or cash advance. There are two ways you can do this: One option is to take your current term and stretch it out a little longer to lower your monthly principal and interest payments. This is likely to increase your rate, but could be a completely reasonable strategy for the long run. The second, trickier option is to find a credit product with a lower interest rate and refinance as long as the origination fee and any other charges on the new loan are less than the lifetime difference between the old and new interest rate payments. 5. Resist peer pressure. Before you start shopping around for a loan, work with your accountant or financial advisor to figure out how much money you actually need to accomplish the goals you have for your business. Avoid lenders who attempt to upsell you on a much bigger loan than you need or who try to pressure you into accepting offers too quickly. Sometimes the lure of additional working capital can be tempting, but remember it s about finding the right sized financing for you. To learn more about your rights to fair and transparent financing, check out the Small Business Borrowers Bill of Rights. Written by Sam Hodges, Co-founder and Managing Director of Funding Circle USA. Copyright 2016 by Entrepreneur Media, Inc. All rights reserved. 18