Unsecured Business Loans

Business loans are designed to help businesses grow or meet immediate needs. The idea is to get a large sum of capital now by leveraging future cash flow.

Overview:

Let's say a business needs $100,000 in working capital now to fulfill a project for one of its customers. The business makes $20,000 a month in profits.

Thus, the business could wait 5 months, save its profits and have the $100,000 needed for the project. But, the customer is asking for the project to be completed in two weeks.

Or, the business could leverage both its monthly profits of $20,000 and its profits from this job and secure a small business loan for the $100,000.

The business could make monthly payments on the loan - using its $20,000 monthly profits until the project is completed. Once the project is completed, it could pay off the loan; plus fees and finance charges, and then realize the remaining balance from the project as profits if it so chooses. Or, it can just continue to pay the terms of the loan and plow back all of the revenue from the job into the next profitable project.

Not a bad scenario given the choice between accepting the project and its profits or rejecting the project due to limited cash flow.

Business loans can also be taken out for inventory purchases, equipment and machinery, commercial real estate, to bridge a funding gap, for working capital, or for any realistic business matter.

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Structure of Business Loans:

Business loans are usually term facilities; meaning that the original balance is paid down on a fixed schedule of both principle reduction and interest charges.

Most terms are set by need. If your business is only needing those funds for a short period, say under a year, the term can be set for that period. Typically, business loan terms range from three to five years.

With unsecured business loans, since there is no collateral (or secondary form of repayment), the lender will set the shortest term possible in an attempt to reduce its long-term risk - the longer the terms, the more chances that your business may hit a slow period and default on the loan.

Terms for loans can be set up as interest only payments, quarterly payments, or balloon payments.

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What Makes A Business Loan Unsecured?

Unsecured Business Loans are usually monetary loans that are not secured by any business or personal asset. Here, the lender is counting on your business to be able to generate future income to make the monthly payments on the loan.

As a side note, the most common type of unsecured business loans are business credit cards.

Secured Business Loans, on the other hand, are loans in which the borrower pledges some business asset acceptable to the lender as collateral for the loan. Collateral for business loans come in all forms and shapes from stocks, bonds, and other financial assets to inventory, property and plant and equipment and machinery. However, for the most part, loans are secured by the assets purchased by the capital from the loan.

The lender (bank, financial institution, or non-bank entity) is given security - a lien on the asset - until the loan is paid off in full. If the business defaults on the loan, the financial institution would have the legal right to repossess the asset(s) and sell it to recover any outstanding loan balance and other charges.

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Unsecured Business Loans Are Hard To Get!

Why are unsecured business loans so hard to get? Because there is so much risk to the lender that loan will never be repaid in full to include the interest (how the lender or bank makes its revenue).

When business loans are unsecured, the lender has nothing to fall back on to recoup losses should your business close or not be able to meet its payments.

Thus, while unsecured business loans are extremely hard to get, they also come with higher costs in the form of higher interest rates, higher fees and more monitoring by the lender - not to mention shorter terms which makes loan payments extremely high.

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Interest and Fees:

When financial institutions lend money, they take risks in doing so. Further, lenders put out a lot of effort in providing loans; from underwriting, auditing, and servicing of the facility to securing the capital from investors or depositors. For these efforts and its risk, banks and other financial institutions will charge both fees and interest when making business loans.

Fees MAY come in the form of:

• Application fee
• Origination fee
• Monitoring fee
• Audit fee
• Appraisal fee (unless loan is unsecured)
• Monthly service fee
• Annual fee

In any case, the financial institution is attempting to ensure that it covers its cost in providing these loans as well as make a tidy profit for its shareholders, owners, or investors - similar to what your business does when it sets its prices.

Interest can either be fixed or variable; but, are mostly variable. Interest rates are typically tied to some monetary measure like the LIBOR or Prime Rate (stated in percentages) - these are measures that financial institutions use to determine what their costs of funds are (i.e. their costs in getting the capital to loan to your business).

Financial institutions usually add additional percentages points to the base measure. This additional increase in rate is usually tied to the riskiness of the borrower. Example: Prime + 2%. If the Prime Rate is 4% - the total interest rate is 6% (4% + 2%).

Expect variable rates to be lower at origination but have the possibility to increase substantially if market conditions warrant. Fixed rates, as the name suggests, are fixed over the life of the loan and usually start out much higher than variable rates but do not carry the same market risks. Example: Prime + 4% - fixed as opposed to Prime + 2% - variable.

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Purpose:

Most financial institutions, especially banks, are very picky about the use of funds of their loans. Lenders want to protect themselves, their depositors and/or investors. To do so, they may restrict how the proceeds of a business loan are used.

Obliviously, lenders do not want to lend to businesses that conduct illegal operations. Should the business get caught doing something illegal, the financial institution stands a very good chance of never seeing its money again.

In conjunction, lenders do not like to lend to borrowers who have shown in the past that they are not willing to repay borrowed funds. This is usually determined by examining a borrower's credit history.

Moreover, banks, during their underwriting, will determine, in their minds, if you or your business has the wherewithal to make the minimum monthly payments. If you or your business does not have the cash flow to make monthly payments, how can the bank or lender be assured that they will get their money back?

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Repayment:

Lenders typically like to see three (3) sources of repayment. The first and most important is cash flow - the profits your business generates in operation of the business. However, if the loan is tied to a financial assets like inventory or accounts receivables, the lender wants to see those assets converted to actual cash (cash flow into the business) as soon as possible.

Second, is usually based on the collateral securing the loan. Lenders look for assets that have resell values that meet or exceed the amount of the loan. Should the loan not have specific collateral (like an equipment loan would) or is under collateralized, the lender will require a blanket liens against all the business' assets.

As unsecured business loans don't have collateral as a second form of repayment, banks and other lenders will compensate for this with higher interest rates and fees.

As a third source, lenders typically turn to personal guarantees. This shows the lender that the business owner(s) is willing to risk their own personal assets to grow the business. So, be willing to provide your potential lender with at least three sources of repayment - including a personal guarantee.

In regards to cash flow, it is not sufficient to have just enough cash flow to cover the payments of a business loan - both principal and interest - but to have a little bit more (as much as half more) - just in case your business has a slow period, it can still meet the minimum payment.

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Example:

To determine if your business could service a $100,000 business loan, begin with your net income. To this amount, add back depreciation (this is a non-cash accounting anomaly) and any and all interest payments that you already make. This should be the net amount that your business has to cover your total debt service - we will call this amount your modified net income.

At 8% for 36 monthly payments, a $100,000 loan would require a monthly service of $3,134 or $37,608 per year. Assuming that your business does not have any other debt, you would have to, at the least, earn this amount over and above all other business costs (over total operating expenses). However, most banks want to see a debt service ratio of 1.5 X - meaning that you need to earn the payment amount plus 50% or $4,701 per month - to cover the loan payments.

The reason is to assure the lender that, should your business hit a small bump or down turn, your company would still be able to service the facility for the entire 36 months.

Small Business Loans and Business Lines of Credit are great sources of working capital for new or growing businesses. These business loan types can be used for nearly any business purpose including (as stated) working capital, inventory, overheads and operating expenses. Unsecured loans are harder to obtain as they add additional risk to the lender. However, keep in mind that it takes money to make money and all businesses need capital from time to time!

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