When you apply for a small business loan, your lender will expect you to substantiate your loan request. What does that mean? In simple terms, it means justifying the amount and purpose of your request for small business funding.
Taking the time to substantiate your request ensures that you’re requesting the right loan amount to meet your goals. In this article, we’ll go over how to substantiate your loan request and the five areas lenders are looking for you to cover.
Why do lenders require a substantiation for a business loan request?
Most lenders require you to justify your loan application in some manner to show that the amount you’re requesting is reasonable based on what you’re trying to accomplish. When it comes to government-guaranteed and supported loan programs, you’ll need to be more detailed in your justification given that these programs are fueled by public funds.
The paperwork you’ll need to complete for a loan request is fairly easy and can be completed in just a few hours in order for lenders to have a quick look at your business. Gathering all of the supporting evidence you’ll need to complete these forms and submit an application for full loan approval will normally take a few days.
There are five areas that a lender may ask you to substantiate. Let’s take a look at each:
1. Equity contribution
Equity is the cash that you and investors are putting into the project to go along with the loan funds. For a lender to verify your equity contributions, the money will need to be in your business’s bank account or you’ll need to show that your investors have that amount of money in their accounts.
To help lenders verify that funds are from legitimate sources, they’ll want to see that they’ve been in an account for at least 60 days. For example, if you’re working on a project that needs $100,000 in equity from a single investor, here’s what a lender may need to see:
- Three monthly bank statements from your business showing that the funds were deposited in the bank account at least 60 days ago, and a copy of the cancelled check or wire transfer receipt for the deposit from the investor.
- If the funds haven’t been deposited in your business bank account yet or were deposited less than 60 days ago, then the investor will need to provide three monthly bank statements. This will show that the funds were deposited and available in their account for at least 60 days. If the funds have not been in that account for 60 days, then the investor will need to show three months of bank statements from the source account of those funds. They need to be able to show at least 60 days of the equity funds being available in a single account.
2. Construction costs and professional fees
Construction costs and professional fees, which are often the most expensive use of funds for a business loan, need to be supported by an official quotation from your construction contractor, architect, engineer, or lawyer. These documents need to be on letterhead that lists the name of the company, provide ample details about the work to be done, and be signed or substituted by an online quote.
Particularly for construction costs, you’ll want to make sure that the quote you receive is as close to actual cost as possible, so after your loan closes, you don’t need to modify it if costs increase. The lender will use the contracts that come from these quotations to disburse your funds.
3. Furniture, fixtures, and equipment
All furniture, fixtures, and equipment costs must be specified during the loan request. All items that cost more than $1,000 must be accompanied by a quote or copy of their pricing from an online store.
4. Lease deposit
In general, it’s a good idea to not commit to a lease agreement until you have all of the funds lined up — including those from your business loan. Many people are not fortunate to have this opportunity (they will lose their desired space if they don’t sign the lease immediately). If you do, you can justify the lease agreement at first with a term sheet from a prospective landlord explaining the proposed monthly rent, deposit, address, term of the lease, and any extensions. A document like this will be satisfactory to allow you to proceed towards a loan approval, and then, a full lease agreement would be required to close on a loan.
5. Working capital
Working capital needs can’t be measured by adding up paperwork like in the previous two categories. Instead, your need for working capital is justified by your financial projections. Writing an assumptions document can help to explain how you came up with all your revenues and expenses and their validity. Each of the following items are considered in your projections and will need to have information to support their validity:
- Expenses: You can justify your expenses using a comparison (how much or what percent of sales “utilities” cost for a similar type of business, for example), by getting a quote for that monthly expense, or by creating an effective business budget that is reasonable (for example, setting a monthly budget for travel expenses).
- Revenues: All revenue projections are ultimately estimates. You can support the validity of your revenue projections by comparing your projected revenue to your square footage (showing your sales per square foot) or breaking down your revenues into an average spend per customer and a projection of customers per month.
Once you’ve compiled your revenues and expenses, you can justify the working capital portion of your loan request with the following:
- Pre-opening working capital: how much you plan to spend on rent, insurance, utilities, and training-period wages before you open.
- Post-opening working capital: how much cash you need to cover the losses you project your business to have in its first months of operation.
- Permanent working capital: how much cash your business will need to hold onto, after it becomes profitable and into the long term.
Ready to submit your application? Pursuit can help
When you substantiate your business loan request, you’ll gain a better understanding of your business start-up costs, which will pay off in the long run. Another advantage? You and your lenders will learn more about what your business really needs in order to get up and running.