HOW TO FINANCE THE SMALL BUSINESS
Posted: 8/21/2006 15:36:30

HOW TO FINANCE THE SMALL BUSINESS
William D. Harazin
Law Office of William D. Harazin
Raleigh, North Carolina

Special Thanks to Susan Sandquist
for
Her Valuable Contributions

HOW TO FINANCE THE SMALL BUSINESS

A. HOW TO PROVIDE FOR THE CAPITAL NEEDS OF A BUSINESS.
Regardless of the type of business, at some point or another, the business will require capital. Capital is the money necessary to start, carry on and grow the business. Without capital even the proverbial “better mousetrap” will flounder and never get off the ground. Generally, a business’ first need for capital is during the start-up phase. However, the need will continue throughout the life cycle of a business.
Once the decision to start a business has been made, one of the first major issues is “how to finance the business”. There are generally three methods of financing a business: gift, debt and equity. Unless you are extremely lucky, or you have a wealthy uncle, it is quite unlikely that the business will be financed through a gift. Debt and equity are the more common methods of financing. When the business borrows money to finance its capital needs it is referred to as “debt”. When the business transfers ownership in the business in return for money to finance its capital needs its referred to as “equity”. Financing arrangements can also be a combination of both debt and equity.
In many instances, the first financing will ordinarily come from the owner of the business. That is to say the owner will put in his own money into the venture. This could be either in the form of debt or equity. An owner might want to finance the business by “lending” the business money, thereby gaining some tax advantages. A disadvantage is that a business financed mostly by debt, if not all by debt, does not have favorable a debt to equity ratio in the eyes of potential future investors or lenders.
In assessing an owner’s own individual resources for financing the business, one often looks to the more obvious liquid assets such as cash on hand and savings. Other possibilities exist such as bonuses, dividends, home equity loans, credit cards, retirement funds, sale of stock or stock collateralized loans, each with varying degrees of risk and cost. Nonetheless, one should explore these possibilities.
Regardless of whether the owner himself finances the business through debt or equity, ordinarily more financing will be required for product development, inventory, operating expenses, marketing and other business needs. Many times this additional capital will be generated by additional sales income as the business grows. However, this is not necessarily the most efficient financial strategy for growth especially when short term sales do not provide the income necessary for long term capital investment.
Once an owner’s individual resources are tapped out, other sources must be located for the continued viability and growth of the business, and the issue now becomes “who can provide financing to meet the growing capital needs of the business”. One must understand that “money” is a product just like the product or service of the business seeking financing, and as such, has a cost. Potential lenders and investors market capital to the business owner in the form of various financing arrangements. Two important factors are the risk of the investment and the rate of return on the investment. The higher the risk involved in the financing arrangement, generally the higher rate of return on one’s investment and vice versa.
The risk involved in financing the business may determine who finances the business. Nonetheless, there is a multitude of potential investors and lenders in the financing arena. These include, but are not limited to, the following: family and friends, Commercial Banks, Finance Companies, the Government, Leasing Companies, Customers, Suppliers, Angels (wealthy individuals), Venture Capitalists, and Public Stock Offerings. These may be simple financing arrangements such as a loan or more complicated arrangements such as public stock offerings.
In addition to these methods of financing, the business owner may be able to “find” additional capital in his own business through effective cash management. By controlling the timeliness of accounts receivable collection and account payables, as well as reducing expenses, the business may be able to reduce or eliminate its need for additional capital.

B. UNDERSTANDING THE SMALL BUSINESS LOAN PROCESS AND THE DOCUMENTATION REQUIREMENTS OF COMMERCIAL BANKS.
1. GENERAL
Once an owner is aware of the methods of providing for the capital needs of the business as well as the potential sources of financing, he can then assess the capital needs of the business to determine and target the most suitable, as well as the most likely, source of financing and the appropriate mix of debt and equity. Success in obtaining financing is often dependent as much on preparation, as upon the risk of the investment. As such, an understanding of the small business loan process is essential in putting the business’ best foot forward. Moreover, the underlying documentation required for the standard small business commercial loan is common to most other financing sources. In addition, much of the commercial loan documentation, itself, is required in some form or another regardless of the financing arrangement chosen.
Although substance is a key ingredient in obtaining a loan, credibility is a must. Just as individuals dress for court to instill credibility before a judge and a jury, so should the business take actions to instill credibility in its business, its strategies, its management and its prospects. The lending institutions are not just investing in the concept, they are investing in the owners. They will not trust their money with disorganized owners, who have no idea of the business’ direction, its profitability or its financial needs. Rather, the lending institutions need a comfort level in that they must believe the business owner knows what he’s doing. Lending institutions and investors are looking for a reasonable return on their investment at an acceptable level of risk, whether it be debt or equity. Therefore, the owner must convince them that the risk is reasonable in relation to the return on investment, and he does this through preparation.

2. THE BUSINESS PLAN.
The typical first step in preparing to obtain a small business loan from a commercial bank is preparing a “Business Plan”. The Business Plan is a written document which describes the business concept, its operation, its strategies, its products and services, its market, as well as its competition. It should explain the cash flow including its peaks and valleys, the strengths and abilities of management, and above all, explain why the business is a good credit risk. In addition to an “executive summary”, which is a summation of the Business Plan, it should have attached appropriate financial documentation and analysis. The analysis should be, at the very least, a one year projection and preferably be a three to five year projection.
The Business Plan helps the owner focus on his objectives and carry out his strategies, while giving the lending institutions a clear understanding of the business and its future prospects. Various agencies, such as the Small Business Administration through its Small Business Development Centers offer assistance in preparing Business Plans. There are also several “Business Plan” software programs on the market, which take an owner step by step in developing a Business Plan.

3. FINANCIAL DOCUMENTATION TO SUPPORT THE LOAN DECISION
The lending institutions, in carrying out their due diligence, will not take the business owner at his word, but rather require substantiation of the Business Plan and the business owner’s statements, as any prudent investor would. In gathering the information to develop the Business Plan, the business owner should have pulled together the substantiating documentation which lending institutions generally require to support the loan decision. Although the focus is on the business, the business owner, especially in start-up companies with little or no track record, will come under scrutiny, and will have to provide substantial personal documentation.
In addition to completing a loan application, the following underlying documentation (1) is usually required from existing businesses:
• the financial projections for three years
• current interim balance sheet and income statement
• cash flow projections
• pro forma balance sheet and income statement (earnings history)
• fiscal year-end financial statements
• tax returns for the past three years
• credit, personal and business references
• current personal financial statement
• individual personal tax returns for past three years

4. CASH FLOW PROJECTIONS.
One of the most important aspects given close scrutiny by the lending institution is the cash flow or pro forma projections, which include estimates of income or sales and estimates of expenses. Cash flow can be divided into three basic categories: incoming funds, outgoing funds and static funds (2). Incoming funds are sales for cash or credit. Since sales are the life blood of the business, cash flow can suffer when money is tied up in past due receivables. Outgoing funds are the basic operating expenses including accounts payable, labor, materials, depreciation, advertising, insurance, utilities, rent, taxes, interest, professional services and miscellaneous costs. Cash expenses should be closely watched so as not to put too much of a drain on available cash. Static funds include the cash and inventory kept on hand. Such funds can be used to enhance the cash position (i.e.. depositing money in a safe interest-bearing account rather than letting it idle.)
The pro forma is the business owner’s forecast or projection of itemized monthly profits and losses, to visualize a current cash flow. It details the amount and timing of income and expenses. Cash flow projections, thereby, help to estimate the amount of money needed and when it will be needed. For the start-up business, the usual rule of thumb is to begin with more than just enough to get started. Financing should cover enough to purchase initial equipment and supplies plus the projected amount needed to cover expenses in the early months in addition to the cost of projected sales. Estimates should not “cut corners” but be based on realistic costs of running the business as it should be run. The pro forma typically should be conservative figures with cost estimates high and income projections low in order to be sufficiently financed to make it through the ups and downs inherent in any beginning business.

5. THE LOAN PROCESS.
Except for small loans, a lending institution’s loan decision process occurs through a loan committee. An owner’s loan proposal consisting of the loan application and the underlying documentation, is generally put together by a loan officer with the assistance of the owner. The loan officer then presents the loan proposal to the committee, who then review the proposal and make their decision. As such the business owner needs to not only select a lending institution, but also a loan officer.
Typically, the business owner’s own bank will be the bank of choice, since the a relationship already exists and the bank knows the business owner best. The selection of the lending institution can be facilitated by networking with other business owners and small business support organizations to gain information and insight into other available banks. There are also banks which specialize in certain types of loans, for example, there are cotton banks, tobacco banks, military banks, etc. Those that have developed a special reputation and expertise in the owner’s industry should also be at the top of the list.
Since the loan officer is going to be the owner’s advocate before the loan committee, it is essential that there is a good rapport between the owner and the loan officer, and that the loan officer has a full understanding of the business and its needs. It is up to the business owner to convince the loan officer that the loan will be a good loan for the lending institution. Though there may not seem to be any choice in the selection of loan officer, the owner should not tolerate a bad loan officer and can ask to be reassigned to another. Also it is good to remember that small loans are generally training areas for loan officers, and the best loan officers in any bank graduate from the small business loan department to deal with the big borrowers. To find a good one, ask other business owners about the loan officers themselves.
Once a lending institution and a loan officer has been selected, the owner should become familiar with the decision making process, the loan officer’s lending authority, the composition of the loan committee, the bank’s policies and services and the existence of any specialize lending departments.

6. THE PROCESS.
Additional independent documentation, such as credit reports and collateral valuation, is gathered to further substantiate the information provided by the business owner and then the financial spreading and credit analysis takes place. The financial information of the business is spread into the lending institution’s standard analytical format to analyze the loan request. Spreading is typically done by entering the financial statements into a computer program which automatically calculates the various financial ratios, and sorts asset, liability and equity items into specific categories. Unclear, ambiguous or unrecognizable items of financial information will be placed in the least favorable or least liquid category. As such the business owner should provide informative footnotes and explanations.
The credit analysis may also involve a credit scoring or grading system, through which the loan application is run. Good scores under such systems typically include ratios better than the industry average, consistent earnings for more than five years, after-tax profits alone equal to 1.3 or more times loan principal repayments, cash flow coverage of term debt equal to 3.0 or better, financial statements prepared by a respected accounting firm, and highly experienced top management (3). The business owner should ask if a rating system is used and prepare accordingly.
In summary, the lending institution is going to be analyzing and answering seven basic questions (4):
• How much money does the applicant want?
• What is he or she going to do with it?
• Why is this loan good for the business?
• Why does the applicant need our depositors’ money to do it?
• When will it be paid back?
• How will it be paid back?
• What happens if the plans don’t work out?
The loan committee will then make its decision based on the loan officers presentation of the loan package, which will include summaries and analyses of the company’s financials, industry trend data, cash flow projections, the formal loan request and summaries of the loan terms, the profit history of the business’s bank accounts and the projected profits on the proposed loan.
In making its decision, the lending institution seeks to satisfy five big C’s: character, capacity, conditions, collateral and capital (5). “Character” delves into the owner’s and business’ reputations for honesty and their credit history. “Capacity” focuses on the management of the business, that is, the skills and expertise of the managers. “Conditions” means the larger economic environment in which the business will operate and includes economic booms and recessions, growing foreign competition, the development of substitute products, etc. “Collateral” is the security which the bank may require for the repayment of the loan. “Capital” assesses the amount the business owner has at risk, and is a measure of the owner’s commitment to the business.

7. LOAN DOCUMENTS.
Assuming the “5 Cs” are satisfied and the loan is approved, the loan will then be closed much like a residential mortgage loan and its attendant documentation. The following is a non-exhaustive list of documents, which may be required to close the loan:
• A Promissory Note
• Guaranty Agreements
• Security Agreement
• UCC 1 Financing Statements
• Debts and Liens Affidavit
• Corporation’s Certificate of Good Standing or Existence
• Disclaimer of Oral Agreements
• Corporate Resolution of Authority
• Affidavit as to No Material Adverse Change; No Delinquent Taxes; etc.
• Environmental Indemnification Agreement
• Title Opinion
• Title Insurance
• Certificate of Insurance
• Deed of Trust
• Closing Statement

Depending on the lending institution and whether Government Agencies are participating will determine which documents are actually required for closing the loan and disbursing the funds

C. ALTERNATIVE SOURCES OF CAPITAL
Even though the requirements for a conventional loan are rigorous and may at times exclude the vast majority of small business borrowers, the general format and the planning strategies are just as valuable in pursuing alternative financing as they are for the conventional loan from a commercial bank. In addition, most small businesses end up obtaining financing, not from commercial banks, but from alternative sources.

1. SMALL BUSINESS ADMINISTRATION LOANS
Even if the conventional loan is not an option, there may be the possibility of obtaining a government guaranteed loan such as an Small Business Administration (SBA) loan. While the SBA offers a number of financing options for small businesses, it rarely makes a direct loan. Instead it guarantees loans made by banks and other private lenders to small businesses. In addition, preferences may be given for the loan guarantee program if the borrower falls into a certain category such as a minority or woman owned business. The local SBA office is a wealth of assistance and information early on in the financing process.
Even when a business obtains such a guarantee, one still needs to determine the type of lender to pursue. Small Business Administration lenders falls into four main groups. The Commercial Banks previously discussed; a Small Business Lending Company (SBLC); a Microloan Lender; and a Small Business Investment Company (SBIC).

i. Commercial Bank
The business owner’s commercial bank may participate with the SBA in a guaranteed loan and is typically the first avenue pursued since the owner’s bank knows the owner best. This financing arrangement, which is almost identical to the typical commercial loan described above, has the commercial bank still making the loan with a guaranty from the SBA that the loan will be repaid. The SBA guarantee merely reduces the risk to a lender thereby making it is easier for a business to borrow.

ii. Small Business Lending Company
The Small Business Lending Company, also known as an SBLC is a non-bank, licensed private lender that has the authority to make guaranteed loans. These lenders are regulated only by the SBA. While the first step is typically to go to the owner’s commercial bank, for the rapidly growing business whose credit rating is not quite strong enough to qualify for a conventional loan, the non-bank lender can be a good choice if the bank does not grant SBA loans. Approximately ten non-bank lenders exist nationwide (6) and they specialize in SBA loans generally in excess of $50,000.

iii. Microloan Lenders
Microloan lenders are local development agencies that can grant SBA loans for as little as $100 to a maximum of $25,000. Microloan lenders include provisions for technical assistance and other support services for micro businesses, which are defined as having less than five employees, are typically service or retail oriented, have been in business less than five years and require only small amounts of capital ($10,000 or less) (7). Either the local SBA office or the local Chamber of Commerce can provide the location of the nearest Microloan Lender.

iv. Small Business Investment Company
Small Business Investment Companies (SBIC) are another funding possibility. They are privately owned and operated Venture Capital companies that use capital and funds borrowed from the SBA to finance small businesses. SBIC’s are profit motivated businesses that make either straight loans or venture capital/equity investments. There are regular SBIC’s and Specialized SBIC’s (yes, they are called SSBIC’s). SSBICs specifically target the needs of entrepreneurs whose opportunities to own and operate businesses have been limited by social or economic disadvantages (8). While investments give the SBIC actual or potential ownership of a minority of the small business’s stock, SBIC’s are generally prohibited from taking a control position in a small business. An SBIC may use several types of financing with a single small business. Loan interest rates are governed by both applicable state laws and regulations as well as by SBA regulations. Generally, financing must be for at least five years, though a “prepayment without penalty” clause may be included in the financing agreement.
While most SBIC’s want ownership, some will make loans that involve no equity features. Typically, a small business owner and the SBIC negotiate the terms of equity-type investments. Interest rates tend to be lower and collateral requirements, if any, less stringent than straight commercial loans. The amount of equity sought by an SBIC will depend partly on the percentage of the business’s total assets represented by the SBIC financing and the business’ record of stability and growth, among other factors. Three types of equity investments are commonly used by SBIC’s:
• Loans with warrants; which grants the SBIC the right to purchase common stock at a later date for a favorable price.
• Convertible Debentures which allows the SBIC to either accept repayment of the loan or convert it into common stock.
• Common stock purchased from the business.

2. THE EXPORT-IMPORT BANK OF THE UNITED STATES
As a result of the recent publicity of international trade and various international trade agreements such as the North American Free Trade Agreement (NAFTA), many business are looking overseas to sell their products and services. The greatest potential for export growth is in the small business sector of the economy. The Export-Import Bank of The United States, or the "Ex-Im Bank" as it is generally known, creates jobs through exports by providing financial assistance in the form of loans, loan guarantees and credit insurance to exporters and their foreign purchasers. Ex-Im Bank has recently brought its financing services to the small and medium-sized exporting companies through its City/State Partners program. The North Carolina Small Business and Technology Development Center (SBTDC) is a member/partner of this Program and actively works with small exporters to take advantage of the Ex-Im Bank's financing assistance.
A small business involved in exporting should investigate Ex-Im Bank's program's which include:
a. Working Capital Guarantees, which guarantee 90% of commercial loans for buying or producing U.S. goods or services for export;
b. Export Credit Insurance, which protects against the political and commercial risks of a defaulting foreign buyer of the exported goods;
c. Commercial Loan Guarantees to foreign buyers of U.S. goods or services;
d. Direct Loans to the exporters foreign purchasers.
These programs aimed at small and medium-sized businesses reduce the risks to the lenders, thereby making it possible for the small exporters to obtain the financing for which they otherwise would not qualify.
3. MORE GOVERNMENTAL ALTERNATIVES
In addition to the foregoing SBA and Ex-Im Bank programs there are numerous other financing assistance programs sponsored by the SBA and many other Federal Government Agencies, such as the U.S. Department of Commerce (USDOC), U.S. Department of Agriculture (USDOA), and U.S. Department of Energy (USDOE). These governmental programs have a variety of arrangements, which include loans, grants and other assistance to small businesses. These programs typically focus on innovation and economic development within the scope of the particular Agency’s purpose. Moreover, they often target specific groups of business owners, by such factors as race, gender, geography or economic status.
The Federal Government is not the only governmental unit which promotes and sponsors financing assistance programs for small businesses. State and local government also have such programs, as do many non-profit entities formed for the purpose of promoting small businesses through economic development. These programs and agencies have their restrictions, but certainly they should be viewed as potential alternatives to the customary commercial bank financing.

4. FINANCE COMPANIES.
Although Finance Companies are similar to commercial banks in that they make loans to businesses, they generally assume higher risk and use different criteria to evaluate borrowers and loans. Since the Finance Companies assume higher risk, they will charge a correspondingly higher rate of interest. Asset-based financing is being provided more and more by Finance Companies, who will collateralize the loan with the assets of the business. The assets generally used as collateral are inventory and equipment. Some Finance Companies specialize in specific industries or types of collateral.

5. FACTORING.
Factoring is a financing arrangement which provides capital in return for a business’ accounts receivables. This can be done either by lending money to the small business using the business’ accounts receivables as collateral, or by actually acquiring title and ownership of the business’ accounts receivables. In the second method, the Factor assumes the risk of collection of the business’ accounts receivables. In either event, because there is more risk involved, the cost to the small business is higher than conventional financing.

6. ANGELS, VENTURE CAPITAL COMPANIES AND INITIAL PUBLIC STOCK OFFERINGS.
Though the more complicated means of obtaining capital through Angels, Venture Capital Companies and Public Stock Offerings is beyond the scope of this manuscript, they are worth mentioning. A wealthy individual investor is referred to as an “Angel”. The Angel may be a family member or a friend, but more than likely will be an unrelated wealthy individual investor. Individual investors in North Carolina may qualify for a tax credit for investments in qualified North Carolina Business Ventures.
The Venture Capital Companies, as well as the public stock offerings are methods of raising larger amounts of capital by selling a substantial amount of ownership in the business. These methods carry with them higher costs, increased complexity and substantial federal and state regulation. Nonetheless, under certain circumstances they may be the right financing method.

C. LEASE FINANCING
Lease Financing is a method of obtaining items that are essential to the growth of the business by leasing the items rather than purchasing them. Office space, vehicles, equipment, machinery, furniture, phones, art work, plants and nearly everything else can be leased. There are two basic types of lease entities: “captive” lessors and “third-party” lessors. A captive lessor is generally a company, which leases its own product directly to the lessee, such as a postage meter or a copy machine manufacturer. A third-party lessor is a company, which leases products, but does not manufacture or represent a such products.
Ordinarily, purchasing will require either a substantial cash payment, or a loan, whereas leasing allows for a minimum initial cash outlay. The main advantage of leasing is that small businesses can use leasing to expand working capital. It preserves cash and credit for other cash flow needs while providing the business with close to 100% financing on essential business purchases.
Assume a $10,000.00 computer is needed. If the owner buys the computer, he will either pay $10,000.00 in cash, or obtain a bank loan for 75-80% of the total purchase price and pay the balance in cash. On the other hand, leasing the computer will probably cost the equivalent of two monthly payments or approximately $400 up front. By leasing, the net cash flow savings is $9,600 (9). In addition, there are certain tax advantages of leasing depending upon the lease arrangement. However, the overall cost of leasing generally will exceed the purchase price, as well as the cost of a loan. The cost of insurance and a maintenance contract are generally required and must be factored into the overall lease cost, thereby increasing the monthly payments. Finally, due to the residual value, the leased item will not necessarily belong to the business at the end of the lease term.
Most Leasing Companies require underlying qualifying documentation similar to that which a bank requires for a loan. These include a lease application, trade and bank references, a financial statement, an interim balance sheet and income statement, if applicable, the history of the business and indication of management experience. If the business is new, a personal financial statement and personal credit references will also be needed. Leasing Companies generally require small business owners to personally guarantee the lease.
In considering leasing as a financial alternative, it is important to consult an accountant to determine the impact leasing will have on both the cash flow and tax situation, and an attorney should review the lease documents.

E. COLLECTION AND CREDIT: SUPPLIERS AND CUSTOMERS.
A business owner should not overlook the possibility of obtaining financing from its suppliers and customers, either through loans, equity or other assistance. The suppliers can provide financing either directly through a loan or other strategic partnering arrangement, or indirectly through its own accounts receivables policies. The supplier, like the small business, is dependent upon its customers for survival. As such a strong supplier, not wishing to lose a customer, may be willing to make a loan to the small business, or perhaps invest in the business creating a mutually beneficial partnering arrangement. On the other hand, most suppliers extend credit to their customers by not demanding immediate cash payment. Rather, they carry the sale as an accounts receivable to be paid by the small business within some period of time such as 30, 60, 90 days. This in effect allows the small business to obtain supplies and inventory on credit, and potentially selling the same during the credit period, thereby possibly avoiding the need for conventional financing.
Much like the suppliers, a business may also be able to obtain financing from its customers. Again, this can be done through a loan or other strategic partnering arrangement. Though not considered financing, the small business can make its existing finances work harder through effective cash management. Effective cash management would provide for the timely collection of its accounts receivables. This collection policy is the flip-side of the above-mentioned supplier financing through credit sales. Allowing its customers to drag out payment over a long period of time is in effect providing financing to the customer. If this is to be done, it should be as a conscious decision, as opposed to poor cash management policies. The loosening of credit by suppliers and the tightening of collection policies for its customers allows the small business to more effectively manage its cash flow and possibly avoid conventional financing.

F. CONCLUSION
An understanding of capital needs and sources will greatly enhance a business’’ ability to obtain the appropriate financing. The process and the documentation required is generally the same among the various types of financing arrangements. Therefore, identifying the appropriate source of financing is the key to the successful financing of a small business. The foregoing sources are but a few of the numerous sources of financing in the government, private and non-profit sectors. Additional assistance in identifying financing sources can be had from the local Small Business Administration Office and the Chamber of Commerce.






















HOW TO FINANCE THE SMALL BUSINESS

A. HOW TO PROVIDE FOR THE CAPITAL NEEDS OF A BUSINESS.

B. UNDERSTANDING THE SMALL BUSINESS LOAN PROCESS AND THE DOCUMENTATION REQUIREMENTS OF COMMERCIAL BANKS.
1. GENERAL
2. THE BUSINESS PLAN.
3. FINANCIAL DOCUMENTATION TO SUPPORT THE LOAN DECISION 4. CASH FLOW PROJECTIONS.
5. THE LOAN PROCESS.
6. THE PROCESS.
7. LOAN DOCUMENTS.
C. ALTERNATIVE SOURCES OF CAPITAL
1. SMALL BUSINESS ADMINISTRATION LOANS
i. COMMERCIAL BANK
ii. SMALL BUSINESS LENDING COMPANY
iii. MICROLOAN LENDERS
iv. SMALL BUSINESS INVESTMENT COMPANY
2. THE EXPORT-IMPORT BANK OF THE UNITED STATES
3. MORE GOVERNMENTAL ALTERNATIVES
4. FINANCE COMPANIES.
5. FACTORING.

6. ANGELS, VENTURE CAPITAL COMPANIES AND INITIAL PUBLIC STOCK OFFERINGS.
D. LEASE FINANCING
E. COLLECTION AND CREDIT: SUPPLIERS AND CUSTOMERS.
F. CONCLUSION


BIBLIOGRAPHY

Dawson, George M. Borrowing For Your Business. Winning the Battle for The Banker’s “Yes”. New Hampshire: Upstart Publishing Co., 1991.

Fallek, Max. Finding Money For Your Small Business. U.S.: Dearborn, 1994.

Heath, Gibson. Getting the Money You Need: Practical Solutions for Financing Your Small Business. Chicago: Irwin, 1995.

Koeler, Dan M. The insider’s Guide to Small Business Loans. Oregon: The Oasis Press, 1996.

Wood, Debra S. Capital Opportunities for Small Businesses, 10th Ed., Small Business Technology Development Center


















ENDNOTES

1. Heath, Gibson. Getting the Money You Need: Practical Solutions for Financing Your Small Business. Chicago: Irwin, 1995., P.16.

2. Fallek, Max. Finding Money For Your Small Business. U.S.: Dearborn, 1994., P. 40.

3. Dawson, George M. Borrowing For Your Business. Winning the Battle for The Banker’s “Yes”. New Hampshire: Upstart Publishing Co., 1991., P.42.

4. Dawson, George M. Borrowing For Your Business. Winning the Battle for The Banker’s “Yes”. New Hampshire: Upstart Publishing Co., 1991., P. 49.

5. Dawson, George M. Borrowing For Your Business. Winning the Battle for The Banker’s “Yes”. New Hampshire: Upstart Publishing Co., 1991., P. 59.

6. Koeler, Dan M. The insider’s Guide to Small Business Loans. Oregon: The Oasis Press, 1996., P. 14-16.

7. Koeler, Dan M. The insider’s Guide to Small Business Loans. Oregon: The Oasis Press, 1996., P. 16-17

8. Koeler, Dan M. The insider’s Guide to Small Business Loans. Oregon: The Oasis Press, 1996., P.17.

9. Heath, Gibson. Getting the Money You Need: Practical Solutions for Financing Your Small Business. Chicago: Irwin, 1995., P. 32.




























A. Understanding the Small Business Loan Process and Documentation Requirements of Commercial Bankers
1. The business plan
Most start-up small businesses are self-funded and work on a pay-as-you-go basis to augment financing. As these companies grow, income from sales helps them up one notch at a time. Their rapid dollar turnover creates quick cash flow but is not necessarily efficient or accepted as a professional business practice. At some point in the first 18-36 months, growing companies need more money for product development, inventory, operating expenses, marketing and to establish and extend credit terms. Money is a product, available as a loan or as an investment. Banks, lenders and investors market capital to the business owner through various financing plans just as the owner markets a product. Whether a client comes to you for advice on how to finance a business that is still only in the planning stages or regarding one already in existence, there are many common issues to consider.
Commercial banks will make money only if they are virtually certain they will be repaid for any loans dispersed. Since 50% of all small businesses terminate within roughly the first four years, commercial banks will rarely lend to any business without at least three years of financial statements which indicate it will succeed well beyond the four year mark unless some kind of government guarantee is available. In addition, it is important to point out that commercial banks are only one of a wide array of funding options. Nevertheless, a basic understanding of the commercial bank loan process is crucial since their standard loan paperwork requirements are commonplace throughout all other lending programs.
Regardless of which funding option proves best for an individual business, existing or start-up, the first step is to put together a proper prospectus. Also called a business plan, a prospectus is a map for a business to follow. It should describe the business concept and how it works, define that business’s market and competition, explain cash flow peaks and valleys, explain the strengths and abilities of the management and, overall, show why the company is a good credit risk.
Standard elements include an executive summary of about 2-3 pages which is a summation of the entire plan, presented at the beginning of the plan that should capture the reader’s interest. The business description gives any history of the company, explains what it does and its projected direction. A management section should be included to explain or illustrate organizational structure as well as the expertise of the managers and an explanation of the roles they will play. The plan must describe the product or service to be sold and should discuss such details as quality controls, securing of raw materials, production process, time tables, and list all intellectual property owned.
A section on competition and market share provides information on the business’s competitive status. It should tell how many other firms do the same or similar thing and how their price structures compare. It should list the business’s market share and any anticipated increase in the market share that may come from, for example, product improvement, and opportunities for expansion or secondary products. A marketing plan must also be included to outline current or anticipated marketing strategy.
The prospectus should include a section on growth projections, either what would happen if the business were launched or the projected growth compared to the last few years’ growth patterns for an existing company. It should anticipate requirements such as money for research and development and requirements for more labor and other increased costs if growth occurs. The prospectus should also include a contingency plan anticipating risks and outlining back up actions that can be taken if difficulties arise. It should describe what happens to cash flow if, for example, the sales targets can’t be obtained, if key staff leave, or if the cost of labor or goods rises substantially.
The financials section of the plan contains all appropriate financial information including pro forma and cash flow analyses showing expected figures by month for the first year and quarterly for the next two to three years. The specific financial documentation required by the commercial bank will be discussed shortly. The business plan should also include an appendix with supporting documentation such as resumes indicating the experience of managers, field-test results of a product, long-term contracts or lease agreements that impact the business, etc.
The business prospectus or plan helps the entrepreneur stay on target and gives funding sources a good idea of company strategies and plans. It should extend out to at least one year, however funding sources prefer a three to five year outlook. Various agencies, such as the Small Business Association sponsored Small Business Development Centers, offer help in preparing business plans. Remember that the business plan may be presented not only to banks but to any potential investor and thus it should state precisely what is offered in return for the use of the investor’s money, whether that is the percentage of interest the owner is willing to pay, a percentage of profits, a percentage of the business, a seat on the board of directors or other ownership interests.
2. Finance documentation
Since start-up companies will not have a company credit history, the loan applicant will have to provide documentation instead on his or her personal credit background and current credit character in addition to presenting the business concept and the anticipated income figures with a summary for each year over at least a three-year period. As the business grows, lenders will require additional information for future loans. The following documents are usually required from existing businesses:
? the financial projections for three years
? current interim balance sheet and income statement
? cash flow projections
? pro forma balance sheet and income statement (earnings history)
? fiscal year-end financial statements
? tax returns for the past three years
? credit, personal and business references
? current personal financial statement and personal tax returns for past three years (of the owners)
In addition, it is advisable to review all business records before applying for the loan to assess where the applicant currently stands and to assess future borrowing needs. Any pertinent tax records, employment records, inventory, furniture, fixtures and equipment, current loan records, current contracts list, receivables list, payable list, and building lease or mortgage should be carefully examined to determine the company’s true position and the requirements for this loan request. The information should be organized in a logical fashion and a final run-through should be done to ensure that all the financial data cross-checks and balances.
The financials section must outline the amount of money needed, what terms are preferred, repayment preference, collateral available, and the source of funds to be invested in the business in addition to the proposed loan. It must describe the specific use of funds and should include literature, quotations and other documentation supporting how the funds will be used and the projected income statement for the business for a recommended three year minimum.
One of the most important sections of the loan proposal and one which will be given close scrutiny by the credit department of the bank is the section covering the cash flow projections so it is important to understand what these involve. Cash flow projections include considerations regarding credit when estimating income or sales, which will be discussed later, as well as preparing a list of expense items and their estimated costs. If a net loss is predicted, the figures and possibly the business idea itself will have to be re-examined. Cash flow needs can be divided into three basic categories: incoming funds, outgoing funds and static funds. Incoming funds are sales for cash or credit. Since this is the life blood of the business, profits can suffer when money is tied up in past due receivables. Outgoing funds are the basic operating expenses including accounts payable, all items needed to conduct the business such as the cost of labor, materials, depreciation, advertising, insurance, utilities, rent, taxes, interest on loans, professional services such as accountants, engineers, etc., and miscellaneous costs. Cash expenses should not put too much of a drain on available cash. Static funds include the cash and inventory kept on hand and can be used to enhance the cash position (for example, depositing money in a safe interest-bearing account rather than letting it idle.)
A cash flow projection or pro forma projects what the owner thinks he or she will sell and spend, all monthly profits and losses, to visualize a current cash flow. It shows when and how much income will be received. Cash flow projections help to estimate how much money will be needed. For the start-up business, the usual rule of thumb is to begin with more than just enough to get started. Financing should cover enough to purchase initial equipment and supplies plus the amount the projection shows is needed to cover expenses in the early months in addition to the projected sales. Estimates should not “cut corners” but be based on how much it realistically costs to run the business as it should be run. It is suggested that multiplying the lowest point in the cash flow by 150% or even 200% will be very near the actual amount spent. It is typically advantageous to base the cost estimates high and the income projections on minimal returns in order to make it through the extreme ups and downs inherent in any beginning business.
3. Establishing credit with banks and the bank’s agenda in loan processing
The bank’s decision making process happens through a loan committee. Borrowers need to know how to present themselves to their best advantage since the lending process is a game they play infrequently compared to the bankers. The borrowers often take what they can get and don’t get what they need from banks. Borrowers should know how to protect themselves against indifferent loan officers to prevent wasted time, too much money being lent, mismatching of need and repayment schedules or the panicky snuffing out of a business by collateral foreclosure. One key is to prepare the business plan or loan request in a way that will help the applicant stand out from the crowd as professional and prepared. The request is not just a mechanical fill-in-the-blanks process but a sales pitch in itself. Successful borrowers know the bank’s needs, motivation and limits. They understand the underlying questions the bank is looking to have answered, its basic concerns, and how to lower the level of risk presented to the bank. They also know how to select the right bank and the right loan officer.
Remember that loans for small amounts and SBA loans are considered troublesome and that banks do not utilize their most talented loan officers to process small loans. When helping your client in the bank selection process, do not believe bank advertising. Enough probing should be done to determine that the bank is profitable and growing in capital base and loan totals. The local newspaper’s business section is a good resource for tips on the strength and safety ratings of local banks and there are information services that sell bank ratings. Networking with other business owners and small business support organizations will also help the potential borrower to choose the right bank for his or her particular enterprise.
The client can ask for a financial disclosure statement which the bank must provide and can also ask if the bank is under “direct regulatory operating supervision”. A yes answer to the last question means the bank is in serious trouble. The client should also stay away from banks that have a reputation of being an easy touch; they may be trying to build up loan totals by taking on risky deals. Your client should also know that there are banks which specialize in certain types of loans, for example, there are cotton banks, tobacco banks, military banks, etc. Those that have developed a special reputation and expertise in the borrower’s industry should be at the top of the list.
In addition, bank ownership is on record with the state’s Department of Banking for state banks and the Comptroller of Currency in Washington D.C. for national banks. It is not impossible that the owners might be shady dealers in deep debt. Entering a long, expensive relationship with such a bank could be a dangerous investment of time and money for your client. In addition to asking other business owners, the potential borrower can ask key suppliers and customers which banks they use and why.
In addition, keep in mind that the best loan officers in any bank graduate from the small business loan department to deal with the big borrowers. Ask other business people about the loan officers themselves; they should not be overly pessimistic or push-overs. The borrower can also ask the officer about his or her own career; frequent moves can be a danger signal that the officer is attempting to stay one jump ahead of a poor lending record and may skip out on the borrower leaving him or her in a messy position with the bank. Ask also about the officer’s lending authority, who sits on the loan committee, about the bank’s policies and services and whether there are any specialized lending departments. Even though the situation may prove difficult and awkward, your client should not tolerate a bad loan officer and can ask to be reassigned to another. The loan officer will present the request to the loan committee and the credit reputation and presentation skills of the officer are important in getting the loan approved. The loan officer should understand your client’s industry. Remember that borrowing is not a favor or a friendship, it is an adversarial business relationship.
Potential borrowers also need to recognize the basic pressures put on banks and give themselves plenty of lead time when making requests. Also remember that the banker operates from a basic fear that the borrower will actually repay the loan, forcing the banker to find another to replace it. The banker is looking for the perfect loan, one which the borrower theoretically could repay by slowing company growth but doesn’t. This “evergreen credit” is a fully collateralized loan secured by accounts receivable and inventory. The perfect borrower is one whose business is growing at a steady, controlled pace. Principal and interest payments are made on time but the credit needs keep growing. At some point, the debt will be replaced with new equity or long-term non-bank financing and the cycle can start again.
Banks do not like uncontrolled, rapid growth so businesses in this position need to use cash flow projections to show the bank they understand that a growing company uses cash more rapidly than it creates the cash it needs. The potential borrower needs to show the plans, the benchmarks, the controls and answer the lender’s endless questions.
Another thing for potential borrowers to remember is that nothing will put the chill on ability to borrow like tax trouble. A loan to pay delinquent taxes is one of the toughest to get approved and it will brand such borrowers as high risk regardless of how well they are able to resolve the situation. Banks will want to see both company tax returns and company financials and any differences must be explainable because of standard accounting practices. Risk, the four letter word for bankers, comes in various forms and it will largely determine whether some alternative form of funding will have to be used. Types of risk include country risk, industry risk and company or credit risk.
Once a loan officer takes the materials the client has prepared, they are sent to the credit department for “spreading” and for credit “analysis” by trainees fresh out of college or business school. The principal lessons they learn are saying “NO”, number-crunching and cash flows. Files are passed around like library books and are known to get lost, paralyzing the progress of a loan request. The files contain commercial credit bureau reports, loan officer memos and call reports, bank and borrower correspondence, deposit and loan balance histories, identification of other banking services used by the borrower and its principal officers, inquiries received about the customer from other lenders and creditors, the results of inquiries made by the bank on the borrower, data about the borrower’s industry, the business’s financial statements, annual reports, publicity releases, newspaper stories and anything else the bank thinks is relevant.
The trainee “spreads” the financials into the standard analytical format used by the bank, orders credit reports, checks out collateral values and does an analysis of the loan request. Spreading is typically done by entering the financial statements into a computer program which automatically calculates the various financial ratios. If the bank uses a commercially available program as opposed to an in-house one, it may be possible for the client to run the numbers through beforehand. In spreading, asset, liability and equity items are sorted into specific categories. Any items on the financials that are not crystal clear and easily recognized will go first into the least favorable or least liquid category. If the “commissions receivable” is in current assets but it does not specify when they will be paid, they will be reclassified as long-term assets. “Notes payable” without maturity dates will be listed as current liabilities due within one year even if they are not. The company may look like it can’t pay its bills much less a bank loan. The client should provide good footnotes and explanations.
After spreading, the credit department will analyze the cash flow projection. It may also run the loan application through a credit scoring or grading system. The client can ask if the bank uses such a system for commercial loans. Good scores under such systems typically include ratios better than the industry average, consistent earnings for more than five years, after-tax profits alone equal to 1.3 or more times loan principal repayments, cash flow coverage of term debt equal to 3.0 or better, financial statements prepared by a respected accounting firm, trade suppliers reporting payments discounted to prompt and highly experienced top management. Good management schemes for a business looking to develop its borrowing strength include hiring a respected local accounting firm for systems reviews and good tax advice, setting up financial policies that create a positive picture and solid management and industry reputation.
A loan presentation package will be prepared by the loan officer and the credit department including summaries and analyses of the company’s financials, industry trend data and cash flow projections. The formal loan request and summary of the loan’s purpose, structure, terms and collateral are included as well as the profit history of the business’s deposit and loan accounts at the bank and the projected profits on the proposed loan. Most banks have profit goals for each loan and the setting of the loan interest rate is a function of both degree of risk assigned by the bank and the bank’s profitability targets. Risk rating and deposit balances at the bank directly impact the loan pricing formula. Customers who always keep a bare minimum balance in their account will pay more loan interest. Other factors are determined by forces external to the bank or by the bank’s internal cost accounting and shareholder relation’s policies. The bank will exactly describe the impact on the loan interest rate of money left in the client's account at the bank. If 10% of the loan amount is left on deposit with the bank, the interest rate will be higher than if 20% is left. The client should ask his or her accountant to help calculate whether it is a good deal for the business or not.
In summary, the credit department is going to be analyzing and answering seven basic questions:
1. How much money does the applicant want?
2. What is he or she going to do with it?
3. Why is this loan good for the business?
4. Why does the applicant need our depositors’ money to do it?
5. When will it be paid back?
6. How will it be paid back?
7. What happens if the plans don’t work out?
The loan officer, in preparing and presenting the loan presentation package to the loan committee is seeking to satisfy five big C’s: character, capacity, conditions, collateral and capital. As to character, the loan officer checks out the reputation for honesty and good credit history of the applicant. Capacity focuses on the management of the business, that is, the skills and expertise of the managers. Conditions means the larger economic environment in which the business will operate and include economic booms and recession, growing foreign competition, the development of substitute products, etc. Collateral is meat for bankers and they will want it even when none is needed, demand excessive amounts relative to the risk involved and insist on personal assets to collateralize a business loan. Not many small businesses borrow unsecured unless they are well established with steady earnings streams and substantial amounts of unpledged and depreciating assets. They have the ability to raise additional money from non-bank sources. They typically borrow for short-term need and repay in less than twelve months.
However, the secured borrower should remember to maximize the value of the collateral. Financial assets such as government securities and publicly traded stocks and bonds are good whereas specialized, customized machinery is not. The borrower should verify the values listed by supplying the lender with, for example, used and new equipment prices. The value of the assets to the business is nearly always considerably more than the loan value placed on them by the lender.
The assessment of capital refers to how much the business owner has at risk. It is a measure of the owner’s commitment to the business. If the lender ends up loosing on the loan, the borrower better hurt too. A borrower with little to lose may be tempted to walk out on the loan when times get hard. A loan decline because of insufficient equity or capital in the company is almost impossible to overcome. The borrower might change the amount requested and retry at another lender but more likely than not, a non-bank lender such as a commercial finance company will be required.
Even though the requirements for a conventional loan are stiff and exclude the vast majority of small business borrowers, the planning strategies are as valuable in attracting any type of investor as they are for the commercial bank. Even if the possibility of the conventional loan is out, there may be the possibility of obtaining a government guaranteed loan such as an SBA loan. While the SBA offers a number of financing options for small businesses, it rarely makes a direct loan. Instead it guarantees loans made by banks and other private lenders to small business clients. The guarantee merely reduces the probability of loss to a lender so it is easier for the client to borrow. In addition, there may be preferences for obtaining such a guarantee if the borrower falls into a category such as a minority or woman owned business. Your client should consult the local SBA office for assistance and information early on in the financing process.
B. Alternative Sources of Capital
Even when the client obtains such a guarantee, he or she still needs to determine what type of investor to pursue. Small business lenders come from four main areas. The commercial bank we have been discussing would be the client’s bank of record- where he or she has been doing business. As mentioned, pursuing the conventional loan will be nearly impossible for all but well-established businesses. However, the client’s bank of record may participate with the SBA in a guaranteed loan and is typically the first avenue pursued since the bank of record knows the client best.
In addition to the bank, a non-bank lender, also known as an SBLC or Small Business Lending Company, is a licensed private lender that has the authority to make guaranteed loans. These lenders are regulated only by the SBA. Approximately ten non-bank lenders exist nationwide and they specialize in SBA loans. They prefer to handle loans in excess of $50,000.
Microloan lenders are local development agencies that can grant SBA loans for as little as $100 to a maximum of $25,000. Again, the local SBA office can give your client the location of the nearest microloan lender or consult the local Chamber of Commerce. Venture capital companies are another funding possibility. They are also known as SBIC’s, Small Business Investment Companies. They are privately owned and operated firms that use their capital and funds borrowed from the SBA to finance small businesses.
While the first step is typically to go to the owner’s bank of record, for the rapidly growing business whose credit rating is not quite strong enough to qualify for a conventional loan, the non-bank lender can be a good choice if the bank of record does not grant SBA loans. Microloan lenders include provisions for technical assistance and other support services for microbusinesses which are defined as having less than five employees, are typically service or retail oriented, have been in business less than five years and require only small amounts of capital ($10,000 or less).
SBIC’s are profit motivated businesses that make either straight loans or venture capital/equity investments. There are both regular SBIC’s and Specialized SBIC’s (yes, they are called SSBIC’s). SSBIC’s are specifically oriented toward the needs of entrepreneurs whose opportunities to own and operate businesses have been limited by social or economic disadvantages. While investments give the SBIC actual or potential ownership of a minority of the small business’s stock, SBIC’s are generally prohibited from taking a control position in a small business. An SBIC may use several types of financing with a single small business. Loan interest rates are governed by both applicable state laws and regulations as well as by SBA regulations. Generally, financing must be for at least five years, except a borrower may elect to have a prepayment clause included in the financing agreement.
Typically, a small business loan applicant and an SBIC negotiate the terms of equity-type investments. Interest rates tend to be lower and collateral requirements less stringent that the rates of straight loans and it may be that no collateral at all is required. The amount of equity sought by an SBIC will depend partly on the percentage of the business’s total assets represented by the SBIC financing and the business’s record of stability and growth, among other factors. Three types of equity investments are commonly used by SBIC’s:
1. Loans with warrants; this means the SBIC can purchase common stock for a favorable price during a specific time.
2. Convertible debentures for which the SBIC can either accept repayment of the loan or can convert into common stock.
3. Common stock purchased from the business.
While most SBIC’s want ownership, some will make loans that involve no equity features. SBIC’s are not required to use SBA loan forms.
Naturally, SBIC’s are not the only source available for equity type funding. Friends and family may invest in the business as stock owners or as non-participating partners. Various business forms such as the Sub-S enterprise or the Limited Liability Company may also be feasible (I think these would have been discussed in the first portion of the seminar.) Up to $300,000 worth of stock can be issued and sold before going through the Federal Trade Commission. This type of equity financing is sometimes called a small company offering registration, or SCOR. Since the laws governing private sales of securities are somewhat restrictive, SCOR’s provide a means of selling common stock to the public. Companies can trade their common stock over the counter rather than deal with the difficulties that initial public offerings face.
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