The end of last week Charles Green published a piece about a recent study conducted by the San Francisco Federal Reserve. “Business loans may be more available, but they are not offered at terms that are considered cheap,” said Simon Kwan, vice president of the San Francisco Fed’s economic research department.

If you’re a small business owner and have been in search of a small business loan, this isn’t really news to you—particularly if you’re one of the smaller small businesses. Despite the fact Green so ably points out that the Prime Rate fell 5.25 percent in 2007-2008, “…the spread of the commercial loan interest rates over the target federal funds rate remains above its long-run average,” says Kwan. He concludes, “…business loans are not yet cheap relative to banks’ funding costs.”

In other words, despite the fact the Prime Rate hasn’t changed since it dropped 5.25 percent about seven years ago, the spread (interest rate) bankers charge isn’t passing that savings on to their small business borrowers. What’s more, since the lion’s share (some estimate only 10 percent of small business borrowers are successful at the bank) of borrowers don’t wind up with the financing they need from the bank and end up with non-bank, alternative financing, capital for small business owners is very, very expensive.

What does this mean? Small business owners need to become much more savvy about how they finance growth. Unless your business is wildly profitable, you have great collateral, and your credit score is above reproach, it’s unlikely you’ll have much luck at the bank and you’ll need to approach what my friend Mr. Green calls “Innovative Lenders” from a different paradigm.

Expensive doesn’t necessarily mean bad. It does mean you need to know what you’re doing and what you’re getting into.

1. What do you need the money for? Having been a small business owner myself, I understand that small businesses always seem to need money. Most of the capital available through innovative lenders, at least in my opinion, is designed to address short-term needs for capital and shouldn’t be considered a long-term solution for financing growth. For example, some time ago I spoke with a small business owner who had just won a fairly substantial contract from the federal government. In order to fulfill the contract he needed to ramp up personnel and equipment, but needed some short-term capital to make it happen. Because of the government’s payment cycle, he wouldn’t be paid in time to absorb the expansion expense with cash flow—he needed a loan. Turned down by his bank, he turned to an alternative lender for a short-term (60-day loan) which he paid off once he received his first payment from the contract. As might be expected, he paid a higher interest rate than he might have if the bank had been willing to work with him, but he was able to access the capital quickly and ramp up to fulfill the contract making the extra expense a profitable business decision.
2. What impact will the influx of borrowed capital have on the business? My father had a philosophy for when he borrowed and when he didn’t borrow for his small business. If the borrowed capital wasn’t for something critical to impact the bottom line of the business, he waited until he could make the purchase with savings. He understood that the burden of unnecessary debt on his business sapped profits. That’s why he never borrowed money for things he felt like the business could do without. That’s not to say he didn’t borrow money, he did. He simply made sure every time he borrowed, it was going to provide a critical value add. This philosophy is even more important as the cost of borrowed capital increases. I’m surprised at how many people we talk to, when asked how much financing they are looking for, reply with, “How much can I get.” In my opinion, this is the wrong response. Before looking for a loan, the small business owner should know exactly what he or she is looking for and what they intend to do with it. In fact, with the cost of borrowed capital what it is today, small business owners who are considering a small business loan should be thinking about the minimum amount of borrowed capital it will take to meet the objective.
3. Know the numbers. I’ve said this before. It’s critical to know what your financial reports are telling you about the health of your business. Most people don’t get into small business thinking they want to dive into spreadsheets and financial analysis—that’s what bookkeepers and accountants are for, right. It’s true, there are many day-to-day tasks you can hire someone to take care of, but in the end, the business owner needs to be able to read a financial statement, understand the implications of what’s on their profit & loss statement, and be able to explain it. If the lender knows more about your business by looking at your financial reports than you do, you’re unlikely to get a loan. Take the time to learn about the financial reporting you need to run a business. Your accountant or bookkeeper should be able to explain it to you and should be required to make sure you completely understand before you’re done. If not, you probably have the wrong bookkeeper or accountant.

The implications of the San Francisco Fed’s report are significant, as Mr. Green describes in his piece. Nevertheless, I’m convinced the biggest take-away is that small business owners need to spend time educating themselves so that when they’re sitting across the desk or on the other end of a phone call with a lender, they know exactly what they want, they know exactly what they need, and they know what the financial status of their business is so they can make the best deal possible for their business. Otherwise, more and more businesses will likely be borrowing their way out of business as the cost of capital rises.