Working Capital

What to Do if A Bank Rejects Your Loan Application

Loan application for small businesses

If a bank rejects your business loan application, you’ll likely experience a mix of emotions. The feeling after a loan rejection could range from frustration to questioning the future of your small business.

It’s essential to take a step back and understand how often banks reject business loans.

Roughly 80% of small business loans face rejections from large banks each year. 

Loan application rejections aren’t personal. They’re a business decision tied to an extensive and complicated underwriting process and heavy competition for limited capital. 

Start by accepting this event as a learning experience. Understanding why the bank rejected the loan can help you improve future loan requests. 

Also, you can explore several convenient, alternative options to fund your business. We will explore both goals in this article.

 

Analyze Why the Bank Rejected the Loan Application

Think about the bank’s perspective. If a bank rejects your loan application, ask why they made this decision.

This information is critical to your next steps.

Banks typically reject loan applications for one of three broad reasons.

 

1) Extensive Documentation Requirements

Document requirements to secure a loan vary depending on the lender and your business history.

Still, the applicant must provide more than a simple balance sheet and a practiced pitch to secure funding.

Unfortunately, many business owners lack experience applying for loans. They may not know the extensive requirements around due diligence or how to secure the required documentation.

Lenders are thorough with their selection methods. To start, they likely require a written business plan, tax and cash flow analysis. They also request your business credit history, personal financial information, and references. But there could be more preparation required. 

Business owners in specialized industries may require other supporting documents. For example, lenders may request educational transcripts to confirm your academic background.  

They might also ask for your resume to prove expertise in fields such as law, engineering, or accounting. Loans for property development or infrastructure projects might require blueprints and government permits.

If you learn that you require additional information, be prompt to respond. Seek out the licenses, specialized documents, or other certifications necessary. These will help you find success in future loan applications.

 

2) Business Specific Conditions

Second, rejections may center around the company’s balance sheet and credit.

These conditions include:

A low credit score: The credit scores of both the business owner(s) and the business are critical to an application. Businesses benefit from a score of 160 or higher on the Small Business Scoring Service.

If your score is too low, fix your credit history promptly. Contact credit agencies to determine ways to boost your scores. You should pay off existing debt, and avoid new inquiries or forms of credit. You should also work to remove any marks from collection agencies.

 

Weak Cash Flow: Poor cash flow (or profitability) is the most common reason why banks reject applications, according to Pepperdine University.

Banks are critical of firms that fail to generate the consistent income needed to pay fixed and variable expenses. The application process places a strong emphasis on consistent revenue generation. 

Business owners can also boost cash flow by improving invoice practices. For example, they might send invoices earlier or use invoice factoring to secure working capital. They can also consider slashing costs and building an emergency cash fund. 

Lack of Collateral: Another crucial factor centers on loan collateral in the event of default. Many rejections typically result from the owners’ lack of collateral.

Remember, banks accept both personal and business assets as collateral, so compile as extensive of a list as possible. Standard collateral may include real estate, equipment, or existing inventory. But keep in mind, banks prefer more liquid assets that can be sold quickly if a default occurs.

Time in Business: Traditional banks seek consistent revenue and market success for at least two years when considering applications. Startup companies will face more scrutiny in this process. However, lenders may give entrepreneurs leeway if the applicant has managerial experience or a strong academic background. 

If you lack such experience, consider boosting your education or work with mentors to expand your business knowledge. You could also explore funding solutions tailored for startups

 

3) Factors Outside of Your Control

Sometimes, outside events can reduce activity in the broader lending market. External factors that could limit lending may include macroeconomic headwinds. 

This means the bank may reduce borrowing due to concerns about the broader economy. Back in 2008, for example, banks faced a severe liquidity crisis that created a global credit crunch. Lending standards tightened, and banks lent less capital to businesses and consumers.

Also, the bank may face lending restrictions from their regulator that will not allow them to provide specific financing terms or expand their available book of loans. Interest rates set by the Federal Reserve and loan-to-deposit ratios can also impact a lender’s decision.

Many situations exist outside of your control. Consider addressing them in future loan applications. Explain how your company mitigates broader economic risks in your business plan. Doing so will make you a more attractive applicant to lending institutions.

Part Two: Explore Alternative Financing Options

Once you have assessed the reason for rejecting your loan application, consider your options. In addition to improving your pitch, explore alternative funding methods outside of traditional loans.

You may find these options better fit your needs and the current stage of the company growth cycle. Here are a few categories and the pros and cons of these funding options.

 

Explore Small Business Administration (SBA) Loans

Small business lenders (typically approved banks) fund SBA loans with the backing of the Federal government. Government backing improves approval odds for business owners (approval rates hover near 50%). Loans also range between $500 to more than $5 million.

That said, SBA loans are highly competitive. Underwriters typically reserve these loans for applicants with strong collateral, a solid credit history, and a longer period in operation.

Pros

The government backs both short- and long-term loans. This structure provides flexibility for borrowers. Applicants also benefit from interest rates that are more competitive than those found at big banks and alternative funding options.

Cons

While small banks have higher approval ratings, they depend on SBA. The process is notoriously long and requires a lot of box-checking. The funding wait-time may also take several months after the lengthy application process. Meanwhile, investors cannot obtain financing from other lenders when using SBA loans.

 

Venture Capital

Venture capital firms pool investment capital from many groups, including institutional investors and high-net-worth individuals. They then deploy this capital to fund and launch new businesses.

Pros

Venture capital funding does not incorporate loans. Business owners, therefore, do not need to repay the capital deployed into their company. Venture capital firms may also take a proactive interest in your business’ success, given their investment. Managers can provide expertise and strategy insight to help build your business.

Cons

Venture capital firms commonly require you to give up a stake in your company for their investment. They will also press for more favorable terms (i.e., higher equity) based on your current revenue and growth projections. The funding process can be extensive and will require pitch decks, meetings, and presentations.

 

Invoice Factoring

If you’re seeking a faster influx of cash, consider invoice factoring or invoice financing. This is a practice where a business sells its outstanding invoices to a third-party company like FundThrough for a fee.

The factoring company pays a large amount of the invoice to you. It will work with the customer to secure payment at a later date. Companies with a large number of outstanding receivables are the top candidates to use this form of funding.

Pros

Companies can receive payment for an invoice by the following business day. This eliminates the 30, 60, or 90-day wait for customer payment. The influx of capital immediately boosts cash flow.

Cons

Companies do not receive 100% of their outstanding invoice as they pay a fee to get immediate funding.

 

Specialty Loans

Specialty loans exist to provide funding to specific groups or causes. Organizations will provide financing to individuals based on unique qualifying criteria, including age, gender, disability, or ethnicity.

Other institutions will provide loans to specific industries like agriculture, energy, medicine, technology, or non-profit organizations. These funds exist to provide economic opportunities to specific demographics or industries. For example, Silicon Valley Bank provides credit lines and specialty loans to firms in the consumer and enterprise sectors.

Pros

If you meet specific demographics or industries, you will face less competition in the loan application process.

Cons

Most businesses do not qualify for specialty loans due to their industry or qualifying criteria. Also, the approval process can take much longer and require additional documentation and evidence to support your demographic or industry claims. Due to the restrictive nature of these loans, you must apply that capital specifically to its intended purpose.