Finding the Right Financing a Big Part of Starting a Business
Apr 30, 2018 04:57PM ● Published by Vanessa Orr
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Many people get a great idea and want to start a business. And while that entrepreneurial spirit is admirable, there are a lot of things that need to go into a start-up to ensure that it will be a success. One of the first and most important considerations is how that business will be financed—and what lenders need to know before they’ll consider providing any funds.
According to Dollar Bank’s Vice President and Manager of Business Banking David Weber, most financial institutions define start-ups as businesses that are less than two years old. While some banks take a hard line and won’t fund such ventures, others will work to find conventional funding sources, such as federal, state and local programs, that can help these companies get the financing they need.
“One of the primary vehicles we use is the Small Business Administration (SBA), which is a great organization that can be used to help support start-up businesses or businesses with a lack of collateral,” Weber explained. “It’s a bit of a misnomer when people say that they’ll go through the SBA instead of a bank; it doesn’t technically work like that. Approximately 95 percent of SBA lending is actually done through traditional banks.”
In the past, most businesses that applied for financing had some type of collateral, such as inventory or accounts receivable, which helped banks decide if those businesses were a worthy risk.
“In Pittsburgh, we’re seeing a change in industry type—long gone are the days when manufacturing companies created a product like steel,” Weber said. “Now we are a city of innovation driven by health care, technology and service companies. These types of companies don’t have widgets or inventory or accounts receivable for a bank to hold as collateral; intellectual property is their biggest asset.”
To help support this gap in collateral, financing institutions such as Dollar Bank work with the SBA when they’re not comfortable providing a conventional loan. The SBA reduces risk to lenders by guaranteeing that they will make at least a portion of their money back. “When a bank loans money to a company, under an SBA-guaranteed loan, that company pays a one-time insurance premium at the time of closing to the SBA,” explained Weber. “That way, if the loan goes into default, the bank can purchase the guarantee from the SBA, and depending on the program, receive up to 75 percent of the loan amount back.”
While there are other conventional financing options, such as local and state programs, Weber noted that these are few and far between. “State and local organizations allocate set amounts of money at the beginning of the year, but once it’s gone, it’s gone,” he said. “There’s a finite amount available for small businesses, which is why the majority of start-ups go through the SBA.”
One example of this is the Pittsburgh Urban Development Authority’s traditional business loan program, which typically lends businesses $50,000 to $60,000 and more, and its brand new Micro-Enterprise Loan program which will provide loans of $5,000 to $20,000 to start-up businesses. It is estimated that in its first year, the micro-enterprise loan program will provide funds for 20 to 30 businesses.
While the conventional approach works for many start-ups, others may look for more nonconventional sources of funds, including “angel” investors, who provide funds in return for a stake in the business, or crowdfunding, which raises small amounts of money from a large number of people, most often via the Internet.
What do lenders need?
No matter where a start-up looks for financing, there are a number of things that they need to provide to prospective investors. According to the Independent Community Bankers of America (ICBA), financial institutions follow the “Six Cs” before issuing a loan, considering the character of the business owner; credit history; capital; cash flow; collateral; and the capacity to repay the loan.
While each financial institution has its own set of rules, there are some general things that businesses can do to help their applications move through the process.
“I’d say the number one thing that small businesses should do, especially start-ups, is show that they have a business team assembled,” said Weber. “It’s important to know that the company already has an accountant, CPA, attorney, business coach/consultant in addition to a business plan.
“Lenders need to understand what the business is, where it’s located, and what is unique about it,” he added. “Have you looked at your competition? If we get a plan for a dry cleaner in Fox Chapel and there are three other dry cleaners within a half mile, we need to understand how this particular dry cleaner will be better than the competition.”
Banks also look at industry averages to see if a start-up’s projections match what’s going on in similar markets with similar offerings, and they also strive to understand an owner’s background. “If a physicist wants to open a construction company, we may question why,” said Weber. “It might work, but most start-ups have a better chance of success in an area in which they are familiar.”
Weber suggests that before approaching a financial institution, entrepreneurs do an abundance of research, taking ample time to understand the industry, and talk to professionals like bankers, attorneys and CPAs, as well as other business owners in the same industry.
“A lot of people have great ideas and want to act immediately, but I advise them to take a step back and get as much information as they can first,” said Weber. “No one wants to get blindsided and find that they can’t make payroll. Think through every possible scenario, and when you’re sure that you’re 100 percent comfortable, then move forward.”