Community Economic Development Fund

Finance

All about counting, controlling and making money for your small business.

When business credit scores start to matter

Character and past performance matters a lot in the world of lending as every business owner knows. Lenders can only rely so much on personal interviews and evaluation of self-reported background information to judge character, so a personal credit score becomes a proxy. Most banks have hard cut-off points on personal credit scores for small business applicants. CEDF, since it is not subjected to the same kinds of state and federal regulation as banks are, has more latitude to judge a low personal credit score in light of the totality of the applicant's circumstances.

 

A new business is unlikely to have any kind of business credit score, just like a young person may have an insufficient credit history to generate a favorable personal credit score. CEDF, recognizing this reality in many of our applicants, relies instead on personal credit scores. And in the early years of a business, practically speaking, this may be all that matters in seeking financing.

 

Dun & Bradstreet, historically, was the primary source of business credit scoring. But as the financial technology (fintech) revolution has marched on, D&B has more competition. FICO Small Business Scoring Service now serves numerous banks and the SBA uses this credit reporting product for pre-qualification of 7A loan applicants. (SBA 7A loans are typically originated by banks.) Experian is another D&B competitor with a similar business score product. And the other two credit bureaus, Trans Union and Equifax also offer delinquency prediction models.

 

One might see that as a business grows substantially and its operations begin to dwarf the size and importance of a founder's personal assets, a business credit score becomes more important for suppliers, lenders and insurance companies. Factors such as payment history, age of credit history, debt levels and usage, company size and industry risk factors are included in some calculations but like in the personal credit scoring market, there are lots of different scoring models provided by D&B, FICO and the others. And, not surprisingly, personal credit history of the business owners is also included.

 

But be aware that business credit scores may contain errors, as this Wall Street Journal article explained back in 2013, and because it is harder for businesses to obtain a look a their scores (there's no FTC Free Annual Credit Report for businesses), these corrections may be hard to make. The Fair Credit Reporting Act does not cover businesses. A lender who uses business credit scoring information (as opposed to personal scoring) does not have an obligation to inform you if you are denied based on that score.

 

What do you do? If your business is small and new, chill out and pay more attention to your personal credit score and do your best to improve it. As your enterprise grows, be known a solid corporate citizen that pays its bills on time and controls its use of debt. Develop good relationships with banks and respond to the financial benchmarks they use, which are widely understood. Keep aware of changes in the credit reporting industry and how they impact businesses of your size.

 

Finally, be aware that some fintech companies on the internet that offer a peak at your business credit score are primarily in the business of brokering loans. And their offerings include what CEDF considers the "easy internet lenders" that don't offer traditional amortizing loans. The effective interest rates of these lenders can get very high and devastating for a struggling small business. It's still buyer beware on the internet.

-- Frederick Welk
CEDF Business Advisor

 

Is revenue-based financing right for you?

by Frederick Welk
CEDF Business Advisor

Among the options available to small businesses, revenue-based financing (RBF) seems to be getting more attention recently. It’s structured like a loan and the repayment is tied to a percentage of the company’s monthly revenue. The main attraction for entrepreneurs, accordingly, is that it’s promoted as a way to finance rapid growth without giving up equity and control.

These loan products are marketed through niche lenders. And like much in the internet age, the promise is that the deal can be done quickly and with less documentation.  But as we shall see, they are much more expensive than conventional financing through a bank or a nonprofit lender, such as CEDF.

I love creative financing concepts.  I bought my first business using an arrangement somewhat related to RBF (but on much more reasonable terms).  But, these costs reminds me a bit too much of the “easy internet lenders” that we warn about at CEDF.

Looking at some of the funders’ websites showed some variety in the terms. The minimum monthly revenue of the business might range from $15K to $30K. Maximum funding was listed as 1/3 of annual revenue in once case and six times monthly recurring revenue in another. To qualify, businesses have to have gross margins better than 50%.  This is because if one has to budget 3% to 10% of monthly revenue (debited out of your bank account) to repay the financing, there had better be enough profit left over to run operations.

The term repayment cap is used to describe the total cost of capital. This can range from 1.3 times to 3 times the amount borrowed. On the low side that would mean repaying $65K on a $50K loan or even $150K on the same $50K financing.  A three-year $50K SBA Microloan at 7.5% would have a total repayment of $55,991, which equates to only 1.12X the financed amount. The terms are said to be three to five years, which is comparable to an SBA Microloan. So one can see there is an enormous cost associated with the corner-cutting that an RBF might provide when it comes to the application and qualification process.  

Of course, it might be comforting to think that as revenue fluctuates the repayment commitment will flex too.  But the lenders have baked this into their own qualifications. That’s why they are offering to fund businesses with subscription-based or other stable revenue sources.

Bottom line is that old-fashioned loans from banks or alternatives from community lenders are still the least expensive way to borrow, unless of course, your Uncle Bob is simply willing to forgive your debt.

This will be an unforgettable opportunity

For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it?
Luke 14:28 KJV

This Bible verse is not about Jesus giving real estate development or small business financial advice but for the sake of some entrepreneurs I wish He would have. Sadly, it is not an infrequent occurrence that CEDF’s lending department receives applications related to stalled projects. The owner thought they had enough money but they ran out because of unforeseen responsibilities imposed by government regulations, increases in the price of equipment or materials, delays in construction, etc.

Sometimes these situations are obviously foreseeable, some are pure bad luck. But the common factor in three examples that I have heard about lately, and the element that makes these head-slappingly tragic is that a lease was signed before a carefully considered set of cost estimates was totaled.

Of course, you might say, you have to sign a lease and get possession of the space in order to start building, and only then do you discover the overruns.

But the scenarios I’ve seen aren’t the bad luck kind, they’re the reckless, hope for the best, “I’m sure we can finish for cheap” sort of problems. And they come up frequently.

Something in the impatient psyche of an entrepreneur makes them believe that the location they have chosen is the last one on earth suitable for their project. And naturally the landlord or leasing agent has revealed that several other serious parties are ready to commit and snatch the opportunity away. Indeed, they will never forget this one.

-- Frederick Welk
CEDF Business Advisor

Take Warren Buffet's advice

As usual, Warren Buffet's 2019 shareholder letter has drawn attention for what some may consider to be a surprising risk to his insurance portfolio -- a cyber security disaster comparable to a catastrophic earthquake. He's talking about an event or string of events that disrupts society and shuts down businesses with a significant impact on the economy.

This article's author describes three approaches to adopt as a reaction to this threat. And they make sense for businesses of all sizes.

First, the author argues complacency is affecting CEOs. There are so many reported breaches and attacks, that it's beginning to be viewed as just a routine part of running a business. But others – probably small business owners -- negligently ignore the threats, feeling resigned to their inability to effectively deal with events that seems common but unpredictable like a tornado or other extreme weather disaster.

The second piece of advice is to accept the reality that the enemy has any individual company out-matched and that outsourcing to specialists is the only sensible place to begin (once your head is out of the sand). Here's where small businesses with limited resources, again, face special risk because they give up the fight. It’s like saying you aren’t going to sweep the sawdust and crumpled paper off of your shop floor just because you don't have an elaborate sprinkler system.

Finally, the author points out that the government may be warning business owners, but it's not going to help. Don't expect the FBI to roll back a ransomware attack or remediate your data breach. In fact, the regulatory arms of the government will hold you accountable for negligence (which includes inaction) as a lesson to others.

 

 

 

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