In the old world (you know, pre-2007), bad credit was typically an insurmountable barrier to getting a small business loan. It wasn’t always that way. Looking even farther back, neighborhood banks were willing to make unsecured business loans and bad credit business loans to local small business owners. Your credit rating was just one criterion. One that could be offset by other factors: Your business’s overall history, current cash flow, the quality of your character.
But then the angel got his wings and flew away. Banks grew larger and more rigid in their lending criteria. The credit crisis hit in 2007 and banks couldn’t lend to anyone. As our economic system moved out of the immediate financial crisis, new laws and business priorities made writing small business loans even less attractive for big banks.
Enter the alternative finance market. The underwriting criteria used by alternative lenders make small business loans available to owners with bad credit. Alternative lenders make capital available to business owners by giving them “credit” based on a wider variety of factors beyond credit rating.
The Big Bank Method
This is a bit of a misnomer. It’s not just big banks. Small neighborhood banks are having difficulty lending to small business owners with bad credit as well. Jamie Dimon, CEO and Chairman of JP Morgan Chase, noted that “smaller banks are having a hard time making loans because the examiners are all over them.” A bank wants to show that it’s managing its risk by not lending too much to people with bad credit.
Banks can look at both business and personal credit rating when assessing the risk a loan presents. A small business owner most likely needs a personal credit rating of at least 680 to qualify for a small business loan. That’s “qualify” for the business loan. Not necessarily approved. If the bank also looks at your business’s credit rating, they’re looking for a score of at least 75. These are both good credit ratings, blocking out those with bad credit.
While a credit score isn’t the only data point banks are looking at, it is usually a threshold criterion. Banks will also spend weeks reviewing your business’s financial statements, tax returns, and business plans. They may even look at your personal background and resume, and those of other key personnel at your small business.
Carl Faulds explains: “In some cases, banks will take a flexible approach when a business has a marginal or poor credit score. In this situation, their decision will be based on the credibility of the business plan and of the principals.”
At first glance, it may seem this harkens back to an earlier time. Yet, taking on the increased risk of making business loans to those with bad credit creates financial and legal compliance risks for all kinds of banks. The banks are also considering their business loan processing and servicing costs. Automating the process requires having stringent criteria that bump people out who don’t meet those criteria.
The systemization of business loans also means that the costs for making a $10,000 loan aren’t appreciably lower than for a $1 million loan. Yet the returns for the bank on the $10,000 loan are obviously significantly lower. It’s no wonder that banks are now directing most of their loans to larger businesses.
Underwriting in the World of Alternative Business Funding
Lenders in the alternative funding market take a very different view of bad credit. Since this market began growing exactly because bad credit business loans weren’t available at banks, alternative funders aren’t put off by a bad credit score. Instead, they’re more focused on current and projected business performance.
They’ll still look at past financial statements during their underwriting process to get a sense of past performance. But they’re looking for a lot more than just the numbers. They’ll look at accounting records to assess cash flow, monthly and annual revenue. Recent NSFs (non-sufficient funds) on a checking account may be taken as an indication that repayment could be difficult.
They’re also analyzing the numbers to learn about the operational details of the business – purchasing history, sales and delivery schedules, and fluctuations in labor needs.
The longer a company has been in business the better, because there’s more data. A longer business history means that the lender can make a more accurate prediction of your capability to pay back a small business loan, and over what period of time. Many small business loans originated by alternative funders are short term, so their ability to forecast the immediate short term performance of the small business is a key underwriting consideration. This is why United Capital Source (UCS) doesn’t lend to start ups; we need to see a business history.
Having a business history also means having business relationships – with vendors and with other sources of credit. Showing stable, long term business relationships with important vendors is a good reflection of your own reliability and suitability as a business partner. Having positive tradelines showing a regularly paid off credit line or credit card also represent a reliable business performance history.
Underwriting the 21st Century Way
In our new social media world, alternative funders also have other means to assess small businesses. It’s not at all unusual to check out your social media presence. They may look at your social media following, level of engagement and traffic. They’ll also look at comments and reviews about your business on sites like Facebook, Yelp, and Google My Business.
Online reviews have been shown to have an impact on a small business’s bottom line. In fact, one Harvard Business School professor found that Yelp reviews had a greater impact on the bottom line of small, independent restaurants than the big chains. So the quality of your business’s online reputation isn’t simply a “soft” credit criterion. Online activity translates into real dollars, or not.
Social media’s ability to impact a business’s revenue will only grow. Review sites continue to get more sophisticated in their ability to weigh quality reviews and ignore the trolls. The divide between those small businesses that use social media effectively and those that don’t will widen. All this online activity around your small business means that it will only grow as an underwriting factor.
Put all together, the bad credit business loan bottom line for alternative funders is understanding a small business’s actual business performance and being able to use that to accurately predict future performance – and thus ability to repay a small business loan. Detailed business plans, as banks often require, don’t matter because lenders like UCS fill in the business performance forecast from looking at these past experience details. Bad credit scores, either personal or business, don’t factor in.
Business Operational Quirks Impact Underwriting
One of the reasons alternate lenders examine a business’s operations so closely is to identify the operational quirks that impact our assessment of how, when and whether it can repay a business loan.
A quick review of four different small businesses will bear this out:
- medical practices
- auto repair shops
For example, restaurants work with a high number of vendors and usually have a correspondingly high number of revolving invoices to pay. Their cash comes primarily as credit card payments, with some cash. So their cash flow in and out is extremely fluid. It’s also not uncommon for restaurants to have well-defined high and low periods.
When you consider a sub-contractor for construction work, they also have clear busy and slow periods. However, their cash flow is completely different. They typically have only a few invoices a month, both payable and receivable. They may only get paid at a few milestone points during the course of a construction contract, yet they continue to have to pay their employees on a regular basis. Employees like that.
In addition to cash flow differences, restaurants are usually juggling more vendor relationships than a sub-contractor, who more often have a few number of regular general contractors with whom they work. In either case, alternate funders like to see long, stable vendor relationships.
There are also many business types that have to work with payers who are often separate from their customers. Think of medical practices and auto repair shops. In many cases, they’re working with insurers – and all of the related administrative headaches and paperwork – to get paid. The result is scarce cash flow.
While medical practices and auto repair shops share this operational quirk, they also have their own unique challenges in addition. For medical practices, they’re also dealing with government payers, Medicare and Medicaid. This means more than sludgy cash flow. It means the medical practice can’t set its own prices; the government payer is, and can change it essentially at will. A slow cash flow is one thing, if it’s still predictable. Planning for the risk of having to bill less on future invoices is another.
For auto repair shops – they have to operate almost like a retail store in terms of planning for inventory on hand. They have to lay-out cash for parts before someone else pays for them. So an alternate lender is going to look at how well the repair shop manages it inventory expenses. Does it have a good, predictive system that ensures it’s not wasting money on unnecessary inventory? Or does it waste its cash flow on ad hoc, unorganized buying?
Matching the Underwriting Risks to the Right Lending Package
The operational details that help alternative lenders assess a small business’s ability to repay its bad credit business loan dictate which types of lending packages make sense for any given business.
Let’s go back to the four small businesses we’ve already explored.
A business with regular credit card receipts, like the restaurant, is a good candidate for a merchant cash advance (MCA). With an MCA package, the lender automatically receives a daily percentage of the restaurants daily credit card receipts.
This benefits the restaurant by linking its repayment to its cash flow, so the merchant cash advance doesn’t become a drag on its cash flow. For the lender, having automated payment set up ensures some repayment is made each day, and continues until the advance is fully repaid.
Sub-contractors who have only a few monthly invoices may be more open to a three month, unsecured business loan that lets them continue to pay their workers while waiting for a slow-paying contractor to pay their invoice.
Or, perhaps, they don’t want to wait for the contractor to pay. Having a low number of high dollar receivables makes them a good candidate for a factoring deal. In a factoring deal, the sub-contractor gets a percentage of their outstanding receivables upfront, while the lender takes responsibility for collecting on them. The sub-contractor gets the rest of the amount owed, less the repayment to the lender, when an invoice is actually paid.
Factoring deals also make sense for medical practices, but for slightly different reasons. A medical practice will have a high number of receivables within a broad range of values; from a $50 office visit to thousands of dollars for a procedure. Factoring works well for the medical practice because it shifts the burden of collecting on their receivables. It works well for the lender because it’s basing repayment on invoices already issued – not relying on future invoices, some of which may be lower than currently projected.
Looking at the auto repair shop that has to manage its inventory expenses, perhaps a business line of credit or credit card makes the most sense. That way it’s only borrowing what it’s actually spending on it’s projected need for parts. But the shop also has the flexibility to make unexpected purchases in case their projections weren’t entirely accurate.
Using Alternate Credit to Improve Credit Scores
Alternative business lenders look at a business’s other points of “credit” with the focus on business performance as an indicator of ability to repay the loan, not the credit score. It’s why many of the terms to alternative lending packages give the lender more control over repayment. A credit score can predict the likelihood that a business will make loan repayments, based on past history of doing so. In the world of alternative finance, lenders need more control over repayment to mitigate their risk.
The good news is that this different paradigm of business credit means a bad credit score isn’t an insurmountable barrier to accessing a small business loan, but it does make it more expensive. The even better news is that alternative lending packages that more closely manage repayment can help a small business improve its credit score, making future small business loans less expensive.