As a small business owner, your capacity for growth is limited by your available capital. You can’t spend money you don’t have. Even if doing so would mean a better deal on inventory, a much-needed equipment upgrade, or an expansion to meet rising demand.
For the vast majority of businesses, there is no lifeboat in the form of venture capital funding. That’s why 43% of firms applied for new capital in 2018, mainly in the form of a business loan, line of credit, or credit card. According to the Federal Reserve, most of those who did were looking to expand their business, pursue an opportunity, or acquire new assets.
Business financing, even when it comes in the form of “debt,” can be an excellent tool for springboarding to greater success. But because of the stringent requirements most banks and traditional lenders have regarding small business loans, many businesses seek funding with alternative lenders or through merchant cash advances.
Online or non-bank lenders aren’t always a bad thing. Some, however, will take advantage of businesses that need emergency funding, or cash fast, and offer a loan product that locks the business into a spiral of debt that makes long-term success difficult, if not impossible.
If you’re applying for small business financing, due diligence is a must, especially with your livelihood on the line. Let’s review the six red flags to look for when seeking financing.
An Upfront “Advance Fee” Just to Apply
When taking out a loan, you’ll likely have to pay various fees, such as a guarantee fee or underwriting fee. But you should never pay money upfront to start the application process.
An advance fee—also sometimes called an application fee, a finder’s fee, or a fee to get started—is one of the most common business scams out there today, according to the Better Business Bureau. Fraudulent lenders may try to swindle money out of you up front in exchange for a shot at a “low-cost” loan. Don’t fall for it.
Note: For some loans, you may have to pay what’s known as an origination fee. Good lenders won’t charge you this fee until you enter into the loan agreement, however. This is very different from a fee for virtually nothing in return.
A Lender that Tries to Compare Interest Rate and APR
One of the most common “apples-to-oranges” comparisons in the world of small business lending is when a lender insists on telling you the interest rate on a loan, rather than the APR.
Interest rate is the percentage of principal charged by the lender to use the lender’s money. The APR stands for “annual percentage rate,” and is the total cost of a loan, expressed as a percentage, in a given year—which means it includes extra fees and charges such as origination fees.
For an accurate comparison of two loan products, you’ll need to compare their APRs. Interest rate only tells part of the story. If a lender refuses to express your loan in terms of APR, or otherwise complicates the comparison with jargon, you know you have a problem.
A Loan Offer that Comes Via a Cold Call
Business lenders are busy organizations—they don’t have the time or sources to cold call business owners just to see if they are interested in a loan.
If you receive a cold call from a lender offering you low-cost financing, and the caller uses hard-sell tactics to try to get you to accept the loan, it’s a good bet that their offer is actually predatory.
This kind of cold call often happens immediately after a business owner takes out a loan. The lender will typically file a UCC lien against your business assets—just to stake their priority claim, in the event you default. This lien is public information and can be used by predatory lenders to contact you with additional funding offers.
Instead of letting another lender follow-up with you to try and plug your funding gaps, look into a loan renewal with your primary lender instead.
A Promise of Guaranteed Approval
Guaranteed approval of any sort of financing, whether personal or business, is a huge red flag. A lender that claims to offer loans regardless of your personal credit score, business credit score, time in business, industry, availability of collateral, or any other important factor, should be approached with skepticism. These are factors legitimate lenders consider to offset their “risk” by extending you a loan with an enormous interest rate. You can most likely do better.
Here’s another red flag that seems obvious: If something seems too good to be true, it probably is.
But if you’re new to the world of business financing, you may not know what that looks like. So keep this in mind: One of the best loan products a small business owner can hope to obtain is an SBA loan, which is a loan partially guaranteed by the federal government’s Small Business Administration. Interest rates for the most popular SBA loan product start at around 8%.
If you have a long-standing relationship with a local bank, have excellent credit scores, a long-established business, and proof of outstanding profitability, you may qualify for a bank loan with an interest rate below what the SBA offers. These cases are few and far between.
If a lender offers you rates that beat these numbers, you’ll know the deal is probably too good to be true.
A Poor Financial Fit
Different lenders can offer different maximum loan amounts. Different loan products give you access to chunks of cash or pools of credit for varying amounts of money. What you need from your lender very often depends on your current financial situation and business needs.
For example, a term loan is an excellent loan product if you have a significant expansion project in the works and will need a large capital infusion to cover costs. On the other hand, if you often find yourself struggling to cover cash flow and make payroll due to late payments from clients, a line of credit or invoice financing option is a better bet.
Lenders that try to push a term loan on you to cover variable cash flow aren’t looking out for your best interests. If the financing on offer doesn’t match your needs, pass.
Wrapping it Up
Taking on debt, even in the service of pursuing a promising business opportunity, is always a risk, and you should never take that risk lightly. Don’t rush into a loan product, even in an emergency—instead, keep your eye out for red flags like the ones above, and only take on financing that makes sense for you in the short and long term.