Despite the increase in transparency in recent years, the application and underwriting process behind small-business lending can still be confusing for many applicants. So we sat down with Daniel Feiman, managing director at Build it Backwards, to get some inside details about how different lenders go through the application process.
Small-business lending is crucial in giving business owners the working capital they need to kick-start or expand their business. Underwriters like Daniel have years' experience of sitting on the other side of the desk and evaluating potential borrowers. Daniel was able to share his perspective and advice on the small-business lending process and how borrowers can best go through the process.
This interview has been condensed and edited for clarity. If you're a small-business owner interested in sharing your funding story, tweet us at @ValuePenguin.
Daniel, can you explain what experience you have with small-business debt underwriting?
Sure. I was a commercial lender for about 18 years. Half of that was in traditional and the other half of it was in nontraditional lending. A significant part of my responsibilities included not only finding clients or prospects, but also understanding what they wanted versus what we offered, and then gathering up all the appropriate information, underwriting the application and then making a preliminary decision whether it met our criteria or not. If it did, I would write up a formal proposal, present it to the loan committee and try to get it approved.
When you say traditional and nontraditional, are you talking about a bank or a credit union versus an online lender?
No, this was prior to online lending being significant. The traditional banks I worked for were traditional commercial banks; the nontraditional really were alternative lenders. I'll give you a quick example: I ran a portfolio for a lender for three years, and we only did very unusual real estate-based transactions. We were truly a niche lender, and as a portfolio lender we could do things that others couldn't.
What're the top mistakes that you've seen in the application process?
I would say that the most common mistake is borrowers not knowing what they want. Many times, it is literally as if they're coming to the bank hoping the bank will give them all the answers without the prep work being done. I've seen it so many times. It was frustrating, sitting across the desk from sophisticated and successful businesspeople who didn't take the time to look at their circumstances, to do projections, know how much they wanted, and how much they could qualify for. I really had to educate them to come in and tell me what they wanted; not ask me to give them a number.
Isn't it common for small businesses to apply for a loan to see what offer can be made first?
Actually, it's not ideal because it gives the lender the idea that the borrower doesn't know enough about their business to know how much they need. You come in, you sit across the desk from me, you say, "OK, Daniel, how much can I borrow?" That's actually the wrong question. I'm going to look at your financials, your projections, and try to figure out what you need. Frequently, a lender will get you only partially down the road.
Take the opposite end of the spectrum where you've committed in your operating process to larger orders for customers, but now you don't have enough working capital and you can't fulfill it. You do your homework in figuring out what you need. Then you come in and say, "Daniel, I need $200,000. This is what I'm going to use it for, and this is how I'm going to pay you back." Then it's up to me to try to determine if I can meet that. That is how the process should ideally work.
It sounds like the vetting process is pretty intensive, but a lot of online lenders claim applications are examined within minutes. How does that work?
If you're getting an answer in minutes from an online lender, everything is objective; it's on a score basis. If you tick enough of the right boxes, you'll get a yes. That's fine if you qualify for a million (dollars) and you want $50,000. But many small businesses want and need an amount that is typically right at the edge of what they could qualify for. More often than not, a scoring system online is going to miss one of the most critical parts of underwriting, which is the character of the borrower. When I sit across from you and we're having a conversation, I am gauging my gut reaction to whether I think you're honest or not. Whether I think, "If things don't work out the way they're supposed to, are you going to find a way to make your payments anyway, or are you going to take my money and disappear?"
What's another big mistake?
Under communicating is a big one. It's easy when you're hitting your numbers and making all your payments. We'll probably have lunch twice a year and until your needs change, it's very simple. The hard part comes when things don't go according to plan.
I'd say things don't go to plan about 75% of the time. Revenues may be off, or you might get hit with unexpected expenses. I was just with a client this morning and their revenues are right on target, but they've had a couple of unexpected expenses, so their margins are down by a third. That's making it somewhat difficult to meet all of their cash-flow obligations. So, the question is, are they going to pay the bank first or somebody else first? During the term of a loan, not communicating with your bank when there's a problem magnifies the problem. It's best to let your lender know about things like this as early as possible because it gives us the opportunity to work with you. If we're notified last minute, we usually don't have much flexibility.
What are some ways lenders can help in those situations?
Temporary refinancing or deferral of payment come to mind. If you've established a payment record with the bank and you think you'll be late, maybe the bank will just defer that payment until the end of the term. Option two is to defer the payment for three or six months, or until the end of the loan. Or we could restructure the loan; maybe you make interest only payments, or interest plus a certain percentage of principle. If you communicate, there's a lot of flexibility that a lender has.
Is there anything a small-business owner should keep an eye out for when shopping around for a loan?
What can you find out about a lender that they may or may not be broadcasting, whether it's good or bad? I always tell borrowers, you want to talk to your peers. Who are they banking with, and why? And if they've made a change in the last couple of years from lender A to lender B, why? Because part of it is understanding not all lenders—online, credit union, traditional banks, whatever—have the same program. Some are more real estate oriented, or home loan oriented. Some lenders don't make loans under a certain amount, and others won't loan over a certain amount. Find out what the lender specializes in, find out who you know that finances with them, and why. Make sure to go online and look at what the lender is promoting; what they're promoting is what they're currently interested in. During my career, a couple of the banks I was working for would de-emphasize certain products, and in some cases get out of the market, and then focus on other things. Most of it had to do with what the bank chooses to focus on, their underwriting guidelines, or in some cases, what the regulators require them to.
It seems like word of mouth is still big here.
I would definitely say that's a significant part. If you've got a car, you want to go to a good mechanic who's going to do the work, who's going to be trustworthy and charge you a fair price. You can go to Angie's List or the Yellow Pages or any other resource. Or you can talk to one of your neighbors, and they say, "You know, you've got to go to this gal over here; she's just a whiz, she's honest, she cares."
It's surprising given how much of the industry has moved online.
I know exactly what you mean. And yet, my experience has been very different. The vast majority of my clients have been small businesses. Even the ones that use online banking are talking to colleagues or peers, and they're doing their research through them. What information can I get from an individual anecdotally? What information can I get from a prospective lender online, and what are some third-party resources? These are all pieces of the puzzle that you put together to say: We will look hard at lenders A, B and C, and not at a couple of the others because of such and such reason(s).
What can small businesses do to be able to compare different loans side by side if some online lenders don't clearly list out their rates?
Ask more questions. And what I mean by that is: Ask the online lender—and I know you must go to whatever chat room they have going, or whatever vehicle—ask them to convert their rate into an APR. Ask them to follow the traditional definition of an APR and convert it. And if they can't or won't, that tells you that maybe they're trying to hide something, so go to the next option.
Is there a way to work around all that?
The reality is if you have little to no cash reserve and you're a new startup, you're probably going to be a marginal business with marginal credit. You likely won't be able to walk into Bank of America and act like a gold-plated borrower, which is why you turn to online lenders with easier requirements.
My first recommendation would be to walk away from any lender if they're being dishonest with you. But for that sector of the business population that really has little options, you have to say: "What can I do to use this lender for the least amount of time, to get into a position where I'll be able to qualify for a better lender—whether that's three months, six months or a year?" Set yourself a goal to improve your profile as a borrower and use the online lender as a stepping stone.
That makes sense, especially given the gap between rates that some online lenders charge versus what traditional lenders typically charge.
It really is. I know that years ago, one of the lenders I worked with was a factoring company: they'd buy your receivables. Their rates were obscene. And even they would tell their customers, "Look, you're probably going to only want to stay with us for 12 to 18 months, because legally, we're charging you 36 percent a year plus points, when you could go to the bank and borrow at 12. So, we're going to be your short-term solution until you get into a position to move on”. If the lender is telling you that, you know there has to be a better choice in the near future. Unless you've got a business that can't improve its credit or its cash flow, or it's in one of those shadier marginal businesses, you're just going to have to pay that freight, and that's the cost of doing business for now.
A lot of the application process depends on a solid business plan. Where can I go as a business owner to get help around putting one together if I don't have much experience with that?
There are a lot of choices. If you have a CPA—and you absolutely should have a CPA—they'll help you a lot. If you go to a traditional bank, walk in and say, "I really would like to do business with you, I think it's a fit. I need some help preparing for a loan request," you usually should be able to get some junior lender there to help you; that would be option two. Option three is to use a nearby Small Business Development Center (SBDC) or a community college that usually has something similar. They have either free or very low-cost consulting to help small businesses put these pieces of the puzzle together. And don’t forget about a good management consultant with an expertise in strategic planning.