For many start-ups and small businesses, gaining access to capital can be a real challenge. A 2019 Goldman Sachs report involving 10,000 small business participants revealed that one out of three respondents was not able to secure the full amount, or any, of the capital they initially requested.
Traditional lenders like banks are reluctant to lend small business loans to new entrepreneurs in particular. But why?
Small businesses comprise 99.9% of the total enterprises in the U.S., so it’s safe to assume they are crucial to ensuring that America’s economic health is in tiptop condition.
Here are five common reasons why traditional lenders are reluctant to release loans to small businesses:
5 Reasons Why Entrepreneurs Struggle to Secure a Small Business Loan
1. Tighter bank requirements and regulations
After the global recession in 2008, banks had to tighten their belts and implement new standards that were more conducive to their long-term security. Banks have become more cautious about the potential risks they will take on when releasing small business loans, especially when the company is still in its infancy stage.
2. Poor credit history
Before releasing small business loans, traditional banks analyze the applicant’s credit history to evaluate whether he or she is credit-worthy. Credit is a strong indicator of risk. The lower a business’ or business owner’s credit score, the riskier it is to provide them a loan.
Entrepreneurs with poor credit or small businesses that have not operated long enough to build a good credit history will find themselves at a disadvantage with banks.
3. No solid business plan
Let’s say a business owner does have poor credit or they are a new entrepreneur. A strong business plan will go a long way in a loan application. Despite the importance of this document, many companies fail to produce it.
Why is it so important? A good business plan provides financial projections that are key to wooing bank decision-makers. The business plan should demonstrate the company’s growth by including a years’ worth of revenue and profit, as well as the sales forecast for the next few years. Banks will use this to evaluate the business’ capability to pay off the loan.
If the business is unable to convince traditional lenders about the company’s ability to pay debts, the chances of walking away with a business loan are slim to none.
4. Less Profit in Small Business
When a business owner asks for a loan, he or she needs to be able to pay it back. It makes sense that small businesses typically ask for much smaller loans in comparison to their larger counterparts. Small businesses don’t need as much capital to operate as larger businesses do, and they also don’t accrue as much profit.
For the banks, it costs just as much money to underwrite a $1 million loan as it does anything less than that, say a $50,000 loan, but they’ll make more money from interest paid on the larger loan. Simply put, banks prefer to lend to bigger businesses over smaller ones because they stand to make more money processing larger loans.
5. Poor cash flow forecast
Cash flow – the money coming in and going out – is the lifeblood of any company. Poor cash flow means that incoming cash flow is no longer enough to support business operations (the outgoing cash).
When the cash inflow and outflow are not balanced, the business becomes insolvent. It won’t be able to pay off debts, operational expenses, and employee salaries. A business with poor cash flow will most likely scare off traditional lenders.
Are There Alternative Options?
Yes! Other lending options are available to help growing enterprises get the funds they need to prevent closing their doors for good.
Alternative lenders can fund borrowers with unsecure small business loans. These lenders don’t impose the rigorous application requirements that traditional banks do. It’s not only easier to apply, but easier (and quicker) to receive approval for these types of loans.
Lenders, in this case, are going to assume most of the risk, which is why unsecure small business loans tend to have higher interest rates. That said, they typically do not require collateral from the borrower. Small business owners only need to make sure their credit score is in good shape and that they have a comprehensive business plan in place to support the application.