Why Did I Get Turned Down for a Commercial Loan?
It’s probably because the lender was not comfortable with one or more of your “Five C’s” of credit. (Don’t be confused – diamonds have 4 Cs – commercial loans, somewhat confusingly, have 5) The “Five C’s” are the basic components of credit underwriting and are used by lenders to gauge the creditworthiness of a potential borrower. Regardless from where you are seeking funding – a bank, a local development corporation, or a relative – a prospective lender will determine your creditworthiness (i.e. what’s the probability that you will pay back the money you borrowed?). This process is sometimes more art than science. The “Five C’s” of credit, in the order of importance (from the lender’s perspective), are character, collateral, cash flow, capacity, and conditions.
Character is the general impression you make on the prospective lender. Lenders look at a borrower’s past credit reports, credit score, personal financial statement, business income statements, balance sheets, forecasts, etc. along with the purpose of the loan. The lender will form a subjective opinion as to whether or not you are sufficiently qualified to repay the loan. Your educational background, experience running a business, and your industry knowledge will be considered. The quality of your references and the experience levels of your employees will also be reviewed. Payment history on existing credit relationships – personal or commercial – is considered an indicator of future payment performance. No matter how much collateral or cash flow you have for a loan, if your background check/screening doesn’t comes back squeaky clean, you may not qualify for the loan you requested.
Collateral can help a borrower secure a loan. Giving a lender collateral means that you pledge an asset that you own. It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess the collateral and sell it to recoup the dollars that were lent. Some lenders may require a personal guarantee in addition to the collateral pledged as security for a loan. A personal guarantee is another layer of protection for a lender. It’s a document promising to be personally responsible for the company’s loan if the collateral pledged doesn’t completely satisfy the amount you borrowed. Secured guarantees are additional forms of security you can provide the lender, such as pledging your home to the lender with the agreement that it will be the ultimate repayment source in case you default on the loan.
Cash should always be the primary source of debt repayment. The prospective lender will want to know exactly how you intend to repay the loan and how much cash is available to service the debt. The lender will consider the cash flow from the business, the timing of the payments, and the probability of successful repayment. Potential lenders may also want to know about other possible sources of repayment, such as your personal (and liquid) cash reserves. In addition to examining income, lenders tend to look at the length of time an applicant has been running, as well as the stability of the company. This is where the history and the trends of the business become very important when presenting to the prospective lending source.
Capacity is the borrower’s ability to repay the debt or the amount of leverage that is put on the business. The more debt that is put on the company (or a ratio of debt relative to equity), the higher the risk profile of the business. Lenders also like to consider the amount of equity capital a borrower puts toward a potential project or investment. A large equity contribution by the borrower decreases the chances of default.
Paid in Capital is the amount of money that is personally invested in the business and is an indication of how much an owner has at risk should the business fail. Interested lenders and investors will expect you to have contributed from your own asset pool first and to have undertaken personal financial risk to establish the business before asking them to commit any funding. Typically for every $1 you put in the business, the lender will put in $3 to $4.
The conditions of the loan, such as its interest rate and amount of principal influence the lender’s desire to finance the borrower. Conditions describe the intended purpose of the loan. Will the money be used for working capital, additional equipment, inventory, real estate, etc.? The lender will also consider micro and macro economic conditions and the overall business climate, both within your industry and in other industries that could affect your business. Interest rate hikes could threaten the payment of a loan if the loan does not have a fixed rate or is not on a fixed payment schedule.
Securing a commercial loan can be an intimidating event and making sure your lender matches your business needs is incredibly important. A professional advisor can work with business owners to make sure that they are structuring their debt transaction appropriately and can take a lot of the guess work out of applying for a loan. At TKO Miller, we help business owners navigate the world of commercial loans with our Debt Placement Group practice.