Funding Your Small Business, Part 1: What a bank is (and what it isn’t)
This is the first in a two-part series about securing startup funding for a small business.
Part 2 discusses options that don’t involve going to a traditional bank.
It can feel like the worst chicken-and-egg scenario of all time: You have an idea for a small business that will generate money, but you need to generate money to start your small business.
What’s an entrepreneur to do? The first place your mind might go is to the bank, and that’s the focus of this article — traditional funding options from a traditional financial institution. But first, there’s something you need to understand.
A bank isn’t what you think it is.
The No. 1 search on Google that involves the phrase “small business” also includes some variation of “funding.” It’s also the No. 1 FAQ for small-business mentors, whether their student is wanting to start a new business or grow an existing one.
Translated, it means that every small-business owner needs money, but most of them don’t know how to get it.
Businesses that make up to $10 million a year in sales have several options for securing funding. (Above that, the options change and get more complex, but less than 1% of all businesses are in that group.) And for most of them, the first stop is a bank.
All About Banks
Most business owners exist in a world where they believe that banks are there to support their dreams or help them grow their struggling small businesses. This is not true.
If you only take one thing away from this article, let it be this: Banks are for-profit companies. Their tolerance for risk is low, because they only make a little bit of money when they pick correctly and back a successful venture. If they’re wrong, they lose … a LOT.
Think of it from the bank’s perspective: If they loan you $10,000 at 5%, they get back $500 per year. Then they spend about $400 of that on their branch rent, employee salaries and insurance, so at the end of the year they net out about $100 from you.
And that’s only if you’re successful and able to make your loan payments. If they bet wrong and you default, they lose the whole $10,000. To break even on that mistake, they have to bet correctly on 100 $10,000 loans. Just to make up for being wrong once.
That’s a really scary thing for a bank, especially when 30% of new businesses don’t survive their first year in operation. Still, most entrepreneurs think a bank should give them money — and balk when they don’t. Here are two of the most common misconceptions:
1. My business doesn’t make any money, but I will be profitable once I get bigger! I just need to scale up, and then I will have profit.
Banks know that this isn’t true. Very few businesses get more profitable when they get larger. In fact, most businesses get less profitable when they grow. If you’re not already operating a profitable business, growth rarely helps — and often hurts. Banks know this. And because they’re risk-averse, they won’t lend based on a hope for the future.
2. I’m a startup, and I have a great business plan! It’s Uber-for-XXX! Of course I don’t have any profit yet, I am just opening! Aren’t banks there to help companies get off the ground?
Nope. Banks only give money to businesses that have proven that they can be profitable and successful. Banks do not give loans to startup companies because the vast majority of them fail.
Here’s the hard truth: A bank is only going to loan you money if it’s a sure thing you’ll be able to pay it back. That usually equals two conditions:
- You’ve been in business for at least two years.
- Your business is making a healthy EBITA profit of 5% to 20%, depending on your industry. (Learn more about EBITA here. It’s a critical concept throughout your business!)
If this is the first time you’ve ever heard that acronym, it doesn’t mean all hope is lost. Here’s what you need to know.
Getting a Small-Business Loan
Every bank, large and small, uses the same basic process when determining whether they’ll give you a loan. They all gather nearly identical information, including these documents:
- Your business and personal federal tax returns for the last three years. No bank will trust your Quickbooks printout to tell them how much money you made.
- A “personal financial statement,” or PFS, which is a long, exhaustive list of everything you own and every debt you have.
- A “business debt schedule” that digs into the details of your debt, such as credit cards and other loans, and the terms of those agreements.
Most banks will also employ two people in the process of your getting a loan:
- The Banker. The banker’s job is to give you false hope that the bank will give you money. (Ha?) Actually, their job is to be the nice person who explains to you why the bank won’t give you money. (Not quite.) All kidding aside, the banker is the actual human with whom you’ll have a relationship at the bank. They’ll try to help you get a loan, and/or gently explain to you why you can’t have one.
- The Underwriter. The underwriter is the human version of an Excel spreadsheet who takes all your information and puts it into a beep-boop machine that spits out either “yes, we will loan you this money” or “no, we will not loan you this money.” You will almost never talk to this person. And when the banker tells you that you can’t have a loan, they’ll blame the underwriter so that you don’t yell at them.
The Different Types of Banks
Now that we have the basics, we can talk about the different types of banks. They fall into one of five categories:
1. Banks you’ve heard of. Chase, Bank of America, Wells Fargo, for example. These banks are big. As in, Chase has more than 250,000 employees and more than $3 trillion in assets.
Big banks usually offer a wide variety of loan products in many flavors, so you’re likely to find something that suits your needs. Their branches are ubiquitous and often global, and their websites are intuitive and robust.
On the other hand, you won’t just feel like a number at a big bank; you’ll likely only be a number. If you’re lucky, you’ll get a banker who cares about you but might feel constantly stymied by the system. If you’re unlucky, your banker might only refer to you by your account number.
Customer service at big banks tends to be terrible, too. It’s often offshored/outsourced, you may find yourself shouting “Operator!” at the phone, and their decisions, rules and fine print can be incomprehensible.
Finally, decisions can take a long time, and the process may be extremely opaque.
2. Regional banks. These are growing scarce as they get absorbed by big banks, but many regional banks still exist — Umpqua Bank in the Pacific Northwest, for example. It has $30 billion in assets (which sounds like a lot), but remember, Chase has over $3 trillion. The pros and cons list tends to be the middle ground between big banks and …
3. Little banks and credit unions. Usually they’re just in your city, and you may have never heard of them. The pros and cons list tends to be flipped from the big banks.
At a little bank, you can be a person! Your banker may get to know you, and even care about you and your business. Smaller institutions also tend to be able to make decisions more quickly and transparently, and customer service is frequently top-notch.
On the downside, little banks might have limited product menus. Their websites tend to be quite basic, and if you someday want to expand to a new market, they may not cover that area.
Bonus note: Credit unions are just little banks. There’s nothing a bank can do that a credit union can’t, and vice versa. The only significant difference is that credit unions are, by charter, required to be for a specific group or geographic area. Little banks aren’t bound by those restrictions; they’re just banks that haven’t expanded (or don’t want to).
4. Online lenders. Lately, there’s been a proliferation of “online only” lenders, sometimes referred to as “fintech” (financial technology) banks. What separates fintech organizations from traditional banks is the lack of human interaction. Everything is decided by computers. This means you can often get decisions quickly, but it also means you may not be able to dispute bad information or question a denial. Getting help can also be more difficult, because these banks run on lower margins, often relying on algorithms to help them stay lean and efficient.
Most times, online lenders aren’t full-service outfits with checking and savings accounts. They focus strictly on lending.
5. Non-banks. Those money companies online with generic names like “Business Financing Pros” and “SmallBiz.net Lending” (not real names). These are “second-tier” lenders, or perhaps more accurately, vulture lenders. They are the lenders you might find after being turned down by every traditional bank.
Their deals tend to have very high interest rates because vulture lenders are making different calculations from banks. Like their traditional counterparts, they understand that most businesses will fail. But instead of just saying no, they anticipate the loss by charging you a ton of money to get a loan.
Funding Your Small Business, Part 2: How to get startup money for your small business
PS: Want to get the most out of your banking relationship? Do this:
Form a relationship with your banker. They’re the one who will go to bat for you if underwriting turns you down at first, or will go the extra mile to make sure you know about every available program that might help you. If you’re rude or dismissive to your banker, they will not try as hard for you. They are not simply “gatekeepers” or “paperwork pushers” – they’re an integral part of your success at that financial institution.
Bad at making friends? Here are some ideas: Learn when their birthday is and send a card. Tell a joke, send a funny picture, or do whatever else it is that will make their day. When they have 50 emails to answer and they see your name, give them a reason to go to yours first. Too many people treat their bankers like order takers at McDonald’s, and then complain that they can’t get any help. Cause and effect are hard for some folks, but this one is easy: Be nice to your banker and they will be nicer to you.