— Larry Jones, BCI Lending —
Expanding Your Business
The small business sector of the US economy continues to expand, yet most entrepreneurs lack the financial resources to take their products and services from the idea stage to the marketplace. Most entrepreneurs tend to contact their local bank when they need to borrow for the launch or expansion of a small business. However, banks generally prefer to keep repayment terms short. The reality is that if the financing need is long-term, then traditional banks are not an option since banks do not make long term, fully amortizing loans. Though other financing sources exist in the marketplace, they often require an ownership stake in your company, or they may focus on specific industries, only provide funds for certain needs, or they may focus only on loans or investments larger than most small businesses need.
It is an unfortunate fact that small businesses often face limited financing options. Borrowers CAN come away from a loan interview frustrated and confused because they have a different perspective than the lender. Small business owners often lack understanding of time-tested commercial lending guidelines that frame commercial loan decisions. At the same time, lenders fail to adequately communicate these guidelines in layman’s terms.
Small business owners are sometimes poorly prepared to make business loan requests and lenders often find financing requests incomplete and unstructured. Entrepreneurs may lack clear understanding of the total financing needs of their business or perhaps they may simply be unable to articulate those needs. Small business owners need to provide specific, basic financial information — some historical, some projections — to make the loan application process smooth and successful.
Steps for Immediate Preparation
Identify the financing needs of your business.
Before approaching a lender, carefully analyze your financing needs. Evaluate and quantify the amount that must be borrowed to meet those needs. While the lender will make an assessment of their own in analyzing your loan request, you are responsible for identifying the amount of money needed for specific purposes.Generally, the needs of your business will fall into three broad categories: (a) start-up capital, (b) expansion capital, and (c) working capital. The first two should be considered permanent investments in the business, which means funds will be repaid to the lender over a period of time greater than one year. Working capital can be of a seasonal nature and repayable in less than one year according to the seasonal sales and cash flow patterns of your company. Permanent working capital may be a requirement, especially if your goal is to commit funds to a permanent buildup in working assets (accounts receivable and inventory) in support of sales growth, introduction of new product lines, or territorial expansion.Determination of the loan amount may be a straightforward process, especially when the loan will be used to finance assets which can be readily quantified, such as land, buildings or equipment. On the other hand, if your business needs working capital or funds to build inventory, accurately pinpointing the amount you need to borrow can be greater challenge. In either case, even if your business has a successful performance history, it is important to develop projected financial scenarios (preferably with help of a Certified Public Accountant) to justify the amount you seek to borrow. A good rule of thumb is to prepare balance sheets, income statements (at least 2 years) and cash flow projections (monthly for one year). The lender will want to carefully evaluate your historical performance as well as projections.
Learn the key components of business loan decisions.
In approaching negotiations with a lender, it is important to have an understanding of the rationale employed by lenders when making business loan decisions. A lender’s goal in making any loan is to ensure that its risk is reasonable and that the loan can be repaid according to the proposed terms.
Stability in personal earnings, outstanding debts, and credit history are of importance to the lender even when considering a business loan request. The lender recognizes that, in the case of a small, closely held business, it is hard to separate the earnings and credit-worthiness of the owners from that of the business.Successful lenders do not attempt to avoid risks, but rather to take prudent risks. Lenders cannot assume the same degree of risk that a business owner must assume because lenders are responsible to investors and to federal and state regulators to lend funds safely and soundly. Lenders have ethical and legal obligations to make loans that contribute to the economic well-being of their markets, not “speculative” loans.For a commercial loan request, a lender’s potential return is stated in the contractual agreement (the promissory note) which is executed at closing. As with any decision to invest funds, the issue of risk vs. reward enters heavily into the lender’s decision in how to price the loan. Realize that while you, the business owner, stand to profit greatly from the accumulation of earnings by your business, the lender still only receives the stated contractual interest. That is why a lender will never assume the same level of risk in making a loan that you are willing to assume when investing your own funds as equity into your own business. A clear understanding of this risk vs. reward concept is key to communication with lenders.
Maintain comprehensive, reliable financial records.
The importance of accurate financial records cannot be overstated. Records are critical to the successful management of your company’s growth. The quality of financial records is put to the ultimate test when applying for financing. If the loan is for a new venture, it will be necessary to prepare reasonable financial projections showing capacity for profitable operations. Detailed business plans show the lender your professionalism in preparing for growth and expansion and better equips the lender to respond to your request in a timely manner.
Utilize an independent accountant.
An outside accountant provides independent advice on the merits of financial decisions. The accountant can be a sounding-board to help prevent financial mistakes. Periodic preparation (and possibly audit) of your company’s financial records will serve to raise the confidence of lenders that these statements accurately depict your company’s financial condition.
Principles of Business Lending
There is a broad spectrum of financial needs presented by entrepreneurs, so small business loan decisions can be hard to quantify. However, there are five principles that form a common thread running through all business loans. The lender will pose these five questions in order to assess the risk level of lending to your business.
Am I dealing with an honest loan applicant who can repay the loan even if the business falters?
A lender will want to be satisfied as to your character and your willingness and capacity to repay debt obligations. Provide the lender a personal resume and outside character and business references. These often prove invaluable, even though personal and business credit reports will be obtained later by the lender to verify your credit standing.Demonstrate a commitment to repay the loan no matter what is required. How do you do this? Offer forthrightly to do whatever is necessary to stand behind the loan. Show an unqualified willingness to guarantee it personally, and realize that it may be necessary to pledge personal assets as collateral. Hesitation to make this type of personal commitment could be interpreted by the lender as a sign that you lack complete confidence in the venture thus making the lender skeptical about the risk of a loan to your business.
How much of an investment will you have at stake in the business?
Commercial lenders do not assume equity risks when making loans. A willingness by the business owners to invest their own funds as equity in the venture sends a positive signal to the lender that you are clearly committed to its success. The level of personal investment sought by a commercial lender will vary with each loan and is often weighed in proportion to other supporting credit factors.
Can you show clear evidence that the loan can be repaid in a timely manner?
The lender will look for a reasonable repayment plan and source(s) of repayment. It is critical that you present financial statements (preferably prepared by an independent CPA) as to past and future business profits and cash flow. Profits are important, and the lender will want to see profitable operations. However, it is cash flow that will ultimately repay the loan. Be aware of the difference between profits and cash flow and include projections for both in your loan request. If the request is for a start-up business, projections will be of paramount importance to the lender in judging ability to repay the loan. Assumptions for any projections must also be included in the loan application.
How does the lender collect its loan if the business cannot generate sufficient cash flow to repay the loan?
Does the lender have an acceptable “secondary source” of repayment? This is where collateral or guarantor support enters the picture. A lender will seek to lessen its risk by shifting it to the owner(s) of the collateral or to individuals who guarantee the loan. However, lenders generally refrain from making commercial loans solely on the basis of collateral. The lender must first be comfortable that a viable primary repayment source exists such as profitable business operations and positive cash flow. Collateral liquidation is always a last resort for loan repayment.
What external conditions may impact the ability of the business to repay the loan?
At issue here are things such as current economic conditions in your market, competition, location, and a host of other variables, tangible and intangible, over which a business owner has little, or no control, but which could detract from the ability to repay a loan.
Business Loan Request Checklist
These are topics a loan applicant must be prepared to address when applying for a business loan.
- What is the name of your business? What is its legal structure—proprietorship, partnership, corporation, or limited liability company (LLC)?
- Provide a brief background and history of your business or a complete business plan.
- If operating an existing business, present the lender financial statements for the last three years. How about a personal financial statement? If you do not have a company financial statement, present business tax returns from the last three years.
- Submit pro forma balance sheets, income statements, and cash flow projections.
- Present the latest in-house monthly balance sheet and profit and loss statement.
- Who are the principals involved (percentage ownership of each)? Provide current personal financial statements and three years of personal tax returns on all principals in the business. Ensure that principal owners of the business are prepared to guarantee the loan.
- What is the purpose of the money to be borrowed? What are the amount and terms requested?
- What dollar amount, if any, are you injecting into the transaction?
- What collateral is available, either business assets, personal assets, or both?
- Are assets insured? If so, provide evidence to the lender.
- What are the primary and secondary sources of repayment? Is there other income outside the business to support repayment of the loan?
- Present names and contact information for your accountant and attorney.