Originally published in American City Business Journals
By Mark Abell
Imagine starting your new business and going online to take out a loan. You find what you think is an attractive yearly rate of 9 percent. You think you are set until — after you sign — you are shocked to realize it’s 9 percent per month.
These kinds of soul-crushing predatory loans can put you out of business, sometimes before you’ve even started. Millennials, in particular, can be susceptible, as they are most likely to go online to search for a loan.
If you Google “small business loans,” ads for several FinTech lenders pop up even before the U.S. Small Business Administration’s (SBA) site. One lender offers loans from $15,000 up to $2 million, while another seeks customers by promising they can “get funded as fast as 24 hours.”
Some lenders condition their loans on switching to their merchant card-processing service, then add excessive fees to every transaction and subtract their payment from every credit card sale, eroding profits. Others charge interest rates north of 50 percent annually.
Another red flag is the prepayment terms. Often, these loans have a prepayment penalty equal to the sum of the remaining payments. So even if you pay it off early, you pay all of the interest and fees that would have been paid off if you made the scheduled payments.
Anecdotally, as many as 4 percent of applications I see are seeking relief from high-interest loans; and that number is growing every year.
Too good to be true
Of course, not all FinTechs are involved in predatory lending; however, if something sounds too good to be true, it probably is. In fact, financial services tech companies have been praised for keeping America’s offices and factories humming with billions of dollars of loans.
But there’s a dark side to the disruption from this rapidly growing segment of the banking business — extremely high interest rates and arduous terms on some loans that are undermining the long-term sustainability of countless small businesses.
A survey by regional Federal Reserve Banks reveals that the top challenge facing small businesses in 2016 was accessing necessary credit — a problem for 44 percent of businesses. Accessing credit is especially difficult for operations with less than $1 million in revenues — while 72 percent of larger companies were able to secure financing, only 45 percent of smaller firms did.
It’s little wonder then that banner ads promising speedy loan approvals are attractive to entrepreneurs drawn by promises of quick decisions and rapid funding.
How can small business owners spot these lenders? Here are five things to do to avoid getting trapped:
1. Seek a non-profit lender
Regulated lenders such as Accion work with small business owners for financing of up to $250,000, offer crucial business planning advice and ongoing training.
Accion is the type of lender called a CDFI— non-profits across the country that provide affordable small business loans backed by the U.S. Department of the Treasury’s Community Development Financial Institutions Fund. When CDFI lenders turn down a loan request, they counsel entrepreneurs about qualifying on their next application, typically within six months.
2. Plan ahead
Beware of growing too fast. Entrepreneurs should remember that growth does not necessarily equal cash flow, and when it comes to business, cash flow is king.
Business owners should undertake a business analysis before embarking on a period of expansion. Having an accountant model cash flow and financing needs will increase your chance of obtaining a bank loan and help you better understand the impact of new opportunities.
3. Just say no
Sometimes in business, it makes sense to turn down business contracts. When a new contract requires significant investment in machinery, additional labor and inventory but doesn’t produce revenue for a prolonged period, it can make sense to turn down that contract until suitable financing is in place to secure the firm’s financial well-being.
Similarly, large contracts with really big companies can sound really attractive, but if they require you to cut your margins, they may have a significant negative effect on your company’s profitability, especially if that margin erosion spills over to your current clients.
4. Consider an equity partner
Companies that have a rapid and highly-profitable growth opportunity and urgently need funding to take advantage of the moment may find it easier to sell a portion of the business. Understand, unless you are selling to friends and family, most equity partners will demand the same type of detailed analysis that any bank will want, and finding the right equity partner takes time and effort, so plan ahead.
5. Apply for an SBA loan
Some companies go to FinTech lenders before seeking a Small Business Administration-backed loan, fooled that the terms are similar but that the online lender will have a faster and easier process. The truth is that SBA loans offer some of the best financing available for small businesses.
SBA loans offer terms up to 10 years for general working capital and equipment loans, low or no down payment, interest rates similar to conventional bank loans, and they can help a bank overlook a collateral shortfall. If the loan can’t be approved, SBA specialists will often give advice on improving business financials or connect you to resources that can, so that a subsequent application has a greater chance of success.
The good news is that SBA lending is up 25 percent over the past four years, a clear indication that bank credit markets are again healthy. However, companies without sufficient cash flow to cover loan payments may struggle to secure funding from banks since cash flow is the primary requirement for loan approval. Those businesses should nevertheless be wary of online lenders making promises that sound too good to be true.
Entrepreneurs should take precautions so that their rush to get a quick loan doesn’t result in falling prey to predatory lenders that can ultimately ruin their business. Spending more time up front finding the right lender and undertaking the type of financial preparation that will facilitate the right type of loan is always worth the effort.
The right lender can help you understand how banks make loan decisions so that you can gain access to the loan you need today and maintain that access for future needs.
Mark Abell is Senior Vice President and SBA Division Director at NBH Bank.