Congratulations, your business has grown to the point that you’re in the market for your first commercial loan. Where do you start? How do you get approved? Should you form a limited liability company or corporation to borrow the money?
The application process can be both confusing and overwhelming. This post will give you a basic overview of the steps you’ll need to take to apply for a commercial loan.
Step 1. Pick a lender. The first step is getting in contact with a commercial lender. Commercial lenders will often tell you they’re in a relationship business. They want to see themselves as a partner in your future success. Therefore, pick someone who seems interested in being your partner and who you think you can work well with going forward.
Step 2. Be wary of rate-shopping. Because your lender will basically be a partner in your business, be wary of choosing your bank based solely on rates. Jordan Space, a Vice President of Integrity Bank, says "like any other product or service, you get what you pay for. A cheaper rate can carry with it a lower level of customer service." Rate shopping makes sense when you’re looking to refinance your home because you’ll likely never talk to the originating bank again after your loan closes. Commercial loans are entirely different, and as you’ll see, this is a person who you will send financial statements to every year and who will likely make site visits to your office, especially with an asset-based loan or construction loan. When referring to this relationship, Space says "a lot of times we’re talking about 10, 20-year terms, and therefore, 20-year relationships. Your lender is like a business partner, choose your partner carefully and base it on the best relationship fit, not just on interest rate." Having a good partner is more important than twenty-five basis points.
Step 3. Put together financial statements. The first thing your commercial lender will ask for is personal financial statements and tax returns of the owners of your business and the same of your company (if it is a separate entity). If your business is incorporated, the bank will require the owners to personally guarantee the loan. This does not vary from bank to bank. Virtually every bank will require this from the owners of a small business. Also, check your credit score. The bank will check the credit of the individual owners and take this into account when approving the loan.
Step 4. Do your own cash flow analysis and put yourself in the bank’s shoes. Based on the statements you give the bank, the bank will do a cash flow analysis. What that means it the bank will determine how much extra money you’ll have after paying all of your bills and the loan. This is called a debt service coverage ratio or debt coverage ratio. For example, if your business’s net income is $500,000, and you have $375,000 in debt, your debt coverage ratio is 1.33 to 1.00. You should basically be doing the same sort of micro-analysis of your finances when you apply. Also keep in mind you’ll need some money on hand to pay closing costs like an origination fee and appraisal fee.
Step 5. Think about forming an entity. If you are looking to get a loan to buy real estate, you should consider forming an entity to own the real estate and get the loan. You and the other owners will still need to guarantee the loan, but it is beneficial to form another entity for a number of reasons. First, the loan agreement you sign will likely state that the borrower is not permitted to incur additional indebtedness without the bank’s consent. This can be a problem with your operating entity but less of a problem for an entity formed just to own the real estate. Second, forming a new entity will separate the liability associated with real estate ownership from the liability associated with running your business. Finally, there may be tax benefits involved in your operating entity leasing the real estate from your new real estate entity. Consulting with an attorney and accountant will be beneficial.
Applying for a commercial loan can be an overwhelming experience the first time small business owners go through it. It is lengthy and invasive because the bank will be reviewing a great deal of personal information. Take it one step at a time and consult with professionals who can assist you with the process, such as your attorney, accountant and financial advisor.
Derek Dissinger is an attorney at Russell, Krafft & Gruber, LLP in Lancaster, Pennsylvania. He received his law degree from Duquesne University and practices in a variety of areas.