8 Key Reasons Small Businesses Are Denied Loans
There’s no doubt about it: growing a small business is no small challenge. No matter how amazing your idea or product, you’re bound to encounter some serious mountains.
According to a TD bank 2017 Business Survey, some of the key challenges that small US-based businesses face today are rising interest rates and rising healthcare costs, both of which can be at least partly attributed to uncertainty surrounding the state of political leadership.
And these days, more and more small businesses like startups are turning to credit cards and other forms of financing over bank loans than ever before. This is partly because some one in four businesses applying for credit were denied, and the ones who received financing did not get as much as they needed.
According to the Federal Reserve Bank of New York:
“… although many employer small businesses were profitable and optimistic, a significant majority faced financial challenges, experienced funding gaps and relied on personal finances. These issues were even more pronounced for the smallest firms, which were less likely to receive necessary funding and more likely to rely on personal finances to operate.”
Despite the fact that the vast majority of businesses in the United States are classified as small businesses - that is, they have employee bases of 500 or less - approximately half of all businesses fail in the first 5 years.
Many of these fail due to lack of funds and a lack of finances.
On top of that, even the businesses that succeed don’t even break even for 2 or 3 years, making financing at the outset crucial. The tricky part is that securing financing is also the most difficult part, which is why so many small businesses are denied financing. And owners are understandably frustrated.
Here are a few key reasons why small businesses are often denied funding.
An Uncertain Economic Climate
Uncertainty behind the local and regional economy is a basic stressor and reason behind the struggle many small businesses encounter. This very uncertainty is why so many businesses are likely to seek financing.
Unfortunately, this problem is also a reason why banks are less likely to give loans. When times are tight, lending is too. Banks aren’t inclined to lend when it’s possible the economy will take a dive, tanking many small businesses.
Because of this, many people are turning to personal savings, lines of credit, and even loans from family and friends.
Lack of Collateral
Collateral is some type of asset which secures the loan. This collateral can be some type of equipment, real estate, or anything else a bank could repossess and sell if the business fails to repay the loan.
It’s crucial for small businesses to list collateral on loan applications for the obvious reason of showing that they can pay it back in the case of default. The problem is that most startups don’t have much collateral like vehicles or business equipment. The result is the small business is denied a loan.
Gender and/or Ethnic Bias
Unfortunately, there appears to still be a major gap here, even though lenders are not supposed to be biased in this way. In fact, loan approval rates are much higher for white males than they are for women and minorities.
According to gudcapital.com:
“… small businesses that were more than 50 percent owned by a woman only received 15 percent of all SBA 7(a) loan approvals; American Indian owned businesses received 1 percent; Asian owned businesses received 24 percent; African American owned businesses received 2 percent; Hispanic owned businesses received 6 percent; White owned businesses received 53 percent; and male owned businesses received 70 percent of all SBA 7(a) loan approvals.”
The sexism can be so bad that some female founder resort to extreme measures, like creating an imaginary male founder to dispel the bias.
Bad Credit History
If a business owner has a terrible credit score, there’s a really good chance they’ll be denied funding. No surprise here.
This is why it’s so important that business owners get to know their credit score before they apply for a loan. Additionally, they should focus on building a solid credit score from the get go, even if they think they won’t need a big loan.
Understanding your business credit score makes you more likely to be approved for a loan and more prepared to grow your business.
What many don’t realize is that if you’re a small business owner, you need to have both a strong personal and business credit score to secure a significant amount of financing from major banks. There’s no way around this.
According to nav.com, the ideal credit score is 680 to 720. It also helps if a business owner understands how to demonstrate a solid history of responsible money management.
If you your credit score is low, you’ll need to spend time improving it before applying for a loan.
High Operating Expenses and Slow Growth
If a business can’t adequately demonstrate growth and growth projections, they may have trouble securing adequate financing for further growth---another catch-22 situation.
According to a Small Business American Dream Gap Report, 3 of 10 small businesses face challenges covering operating expenses. This trend is often due to the challenges of incorporating new employees as well as expanding or building inventory. Unfortunately, if they can’t cover their expenses, they’ll have difficulty securing funding
According to Entrepreneur.com, some 26 % of business owners don’t hire or expand because they don’t have the funds to do so. In turn, they resort to personal savings or loans from friends and family, despite the significant risks and high interest rates involved in these actions.
Lack of Cash Flow
In the past year or so, about 45% of businesses sought out financing, namely to cover operating expenses and expansion. This need for funding indicates a severe need for extra cash flow, which can be a huge red flag to banks.
Cash flow is not only one of the main reasons that existing businesses fail, it’s also a top reason why financing applications get denied. The reason behind this is simple: expenses come first before loans. This makes sense if you think about it on a personal financing level as well: you’re going to pay your rent and bills before you pay your loan payments. It’s simply a matter of priority.
Type of Business
According to nav.com, business owners are more likely to be denied financing if they are sole proprietors, brand new businesses, or state-approved businesses. In addition, businesses are liable to be rejected based on the type of industry they’re in.
In this game, size matters, and unfortunately the very nature of most small businesses makes them a bigger risk, especially if they are new. According to the Federal Reserve Website, smaller firms are “notably less successful at obtaining financing at large banks (45% success) than larger firms … (72% success).”
Part of the way a bank assesses a loan application is by assessing the customer base. If they’re looking at an application from a business in an industry that has a stable customer base, they are more likely to approve the application. Showing diversity in your client base is a key way to show secure projections.
Unclear Understanding of the Financing Process or Options
According to nav.com, there are at least 44 of different options for small business financing in the U.S. Depending on your area and/or industry, there may even be specialized grant options that are not widely advertised. Entrepreneur.com reports that some 20% of businesses applying for loans in the past 5 years had experienced multiple rejections and a quarter of these did not have a clear reason for the denial.
Researching and applying for these can be extremely time-consuming, which is why it’s recommended that small businesses ask the local business association for tips pertaining to their specific situation and/or industry.
All this points to a serious lack of understanding and transparency around what makes a business credit worthy. If people simply aren’t aware from the get go, or they’re asking questions but not getting clear answers, there’s obviously a problem.
To better prepare for loan applications, small business entrepreneurs need to have a clear picture of their current status, both in terms of financing and in terms of future projections.
They need to understand the context of securing funding to build accurate projections, and they can then send these projections with the loan applications to hopefully create a positive feedback loop.
But beyond that, small business owners need to thoroughly demonstrate their financial responsibility in order to have the best chance of securing crucial funding.
When you have business self-awareness, you are much more likely to succeed and to get the financing you so desperately need.
An alternative way to fund your small business instead of a loan is to save the money yourself. Check out this savings plan.