Introduction
Most businesses will not qualify for equity based financing during the early and growth stages of their development. In fact less than 6% of all businesses are financed by equity investments such as angel investment or venture capital. Most small businesses are financed from business and personal loans.
The Small Business Administration found that owner investment and bank credit are the two most widely used kinds of financing. More to the point, these small growing firms rely heavily on external debt, receiving about three-quarters of their funds from banks in the form of loans, credit cards, and lines of credit. Capital requirements for businesses vary widely depending on rate of growth, industry sector, working capital needs and many other factors, but it should be noted that a significant number of businesses use no outside financing.
Below we outline more on debt based financing and how it is secured from third parties, but first a quick disclaimer: We are not lawyers, financial advisors, bankers or accountants. If anything sounds like legal, accounting, banking or financial advice, it’s not. We are entrepreneurs and are providing our knowledge as well as commonly available information in a form to give you an overview of the types of debt and the process we have used in our businesses to support debt based business growth.
Types of Debt Financing
Credit Cards are issued by financial institutions and allow the user to borrow pre-approved funds at a point of sale or to complete a purchase. Some cards offer the ability to get cash advances. Business owners use the cash or the credit to purchase items for their business or fund operations. An annual percentage rate is assessed on the balanced carried on the card depending on the credit score of the borrower as well as the type of card issued.
Lines of Credit are a special form of a loan. A maximum loan amount is set which the business can use as needed for operational needs. The business (aka borrower) can access funds from the line of credit at any time, as long they do not exceed the maximum amount set in the agreement. Borrowers will usually have to pay at least the interest monthly to maintain the loan and that rate is usually lower than credit cards but higher than bank loans.
Bank Loans are the most common form of capital for a business and provide medium or long-term financing. The loan is over a fixed period of time usually 3-10 years and interest is charged on an annualized basis (usually lower than lines of credit and credit cards). Timing and amount of repayments are prescribed in the loan documents and except in rare cases some security (aka collateral or personal guarantees) is provided by the business owner. It is generally easier to finance fixed assets (such as land, buildings, and machinery).
SBA Backed Loans are a special form of bank loan where the Small Business Administration (SBA) guarantees as much as 80 percent of the loan principal for the lender, usually a bank. There are vary loan programs depending on a borrower’s needs and not all banks do SBA lending. Those that do often require that a third party SBA loan consultant be used to prepare and qualify the borrower for the loan. Even when the SBA backs the loan, collateral or personal guarantees or both are still usually required.
SBIC Loans are made by a privately owned company that is licensed and regulated by the Small Business Administration (SBA). This financing company is called a Small Business Investment Company (SBIC). SBICs invest in small businesses in the form of debt and/or equity but typically target mature, profitable businesses with sufficient cash flow to pay interest at a rate that is generally higher than a bank loan or SBA loan.
Factoring or Receivables Financing is a debt method in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. Factoring allows a business to obtain immediate capital based on the future income attributed to a particular amount due from a customer. The discount is the fee charged by the factor for the up front capital and is usually higher than a bank loan interest rate.
How do Lenders Decide to Loan You or Your Business Money?
The capacity of you and/or your business to take on debt is determined by lenders using a variety of metrics and measures. Some of these measures include the level of EBITDA, debt to equity ratio, and total debt to EBITDA ratio. Other measures include the stability of earnings historically, cyclical factors such as seasonality, cash to interest coverage ratio and others.
The most practical measure that any business owner can use to assess their ability to service a loan is by using common sense metric of affordability. At a macro level both you and the bank want to make sure the debt you take on is affordable. As a business owner you want a loan that you consider to be affordable in that you are not paying too high an interest rate, too high of a principal payment usually determined by the term (length of the loan), and also the ability to pay back the loan early without penalties. A $1MM loan with 20% interest that you have to pay back in 12 months is probably not only ill advised but also mostly unaffordable by you as the business owner when you need the cash to grow revenue. Affordability can be measured most directly by your debt service coverage ratio which is measuring the ability of cash flow to pay principal and interest back by month or the debt to revenue ratio which is the total recurring monthly debt divided by gross monthly income.
How to Approach a Lender
To make the process of applying for debt and credit easier it is best to assemble a package of materials so that a bank officer can quickly determine whether or not they will consider you for financing. Getting everything together will rapidly advance your application with limited back and forth needed between you and the lender. Further, as we discuss later this also helps you “shop your deal” to multiple lenders with the hope that they will compete for your business and you can get the best deal (e.g. lowest interest rate) for your financing. Here we outline what to assemble in advance of going to a bank.
The Package
The Business Plan: With few exceptions most all banks and lenders will require a business plan though nowadays they can be shortened. The business plan at a minimum will contain a summary of the company, its product offering, market, the team, and financial projections. For an outline and example of a business plan go here.
Financial Details of Your Business: This is an exhaustive accounting of your business’s financial setup. It includes all current and past loans or debts. It includes your bank account(s) details such as bank name, account number, purpose, and balance. It also includes tax ID numbers, addresses for the business and owners, and complete contact information for all of the above. Other items to include are investment accounts, credit card accounts, and the like.
Complete Financials Statements: One of the most important things to furnish for a loan is a complete financial picture of your business. This starts with the balance sheet as it stands today. Then if possible at least three years of profit and loss statements. These financial statements would ideally be audited or at least reviewed by a CPA firm for accuracy.
Detailed Reports on Accounts Receivable and Accounts Payable: An aging accounts receivable report including sales and payment history for debtors. For accounts payable the same including your history of payment and contact information for those that can vouch for your behavior and credit.
Personal Financial Details: As you might expect banks will want the business owners to personally guarantee loans to make sure the owners are sharing the risk with the bank for the business loan. To do so the banks will require a personal statement of net worth (your personal balance sheet). You can find an example of that here. Further you will need to supply social security numbers, details on assets and liabilities including investment accounts, credit card accounts, auto loans, mortgages, etc. All owners with a significant interest in the business (usually 5% and greater) will need to supply this information.
“Key Man” Insurance: Small businesses depend on the key owners working in the business in order for them to work and grow. In the event of their death the business would likely fail and that would introduce risk to repayment of the loan. As a result either in advance of or during the lending process an insurance policy will need to be put in place that names the bank as the beneficiary to insure repayment of the loan in the event of death of the key man.
Collateral Listing and Details: Except in the case of some SBA loans you will likely need to assemble a list of collateral or hard assets that can be pledged to back up a business loan. In the event of default these are the assets the bank will lay claim to for recovery of their lent money. Types of collateral include inventory (though only a fraction can count and it must not be old or obsolete), owned equipment, accounts receivable (verified by the bank and only a portion of it will count), and other items such as land and buildings. The need for collateral in young, growing firms usually means that most small business owners will have to pledge personal assets usually house equity to get a loan for their business. Make a list of collateral with details including serial numbers and models of equipment, inventory breakdown, building and land addresses and descriptions, etc. and include supporting materials such as prior appraisals.
The Packaging of the Package
Unless you have a pre-existing relationship with a bank already lending to your business, it is advisable to prepare multiple packets for multiple banks so that you can shop your financing request around and find the most favorable terms. A binder with tabs for each of the sections above works best. Place a cover letter and table of contents ahead of the materials. Feel free to include company brochures and marketing materials as appropriate.
Sending the Package
It is best to email or call the bank to find the appropriate person to receive your package. Hand drop of your package to the bank and hopefully that bank officer. You can request in the event they opt not to fund your loan that they return the materials to you so you can 1) recover your sensitive information and 2) signal to the bank that you are shopping around and 3) can reuse the materials. When sending the package you can indicate that you are sending the materials to multiple banks looking for the best partner for your business.
Now that You Have the Financing What Can You Expect
Once a lender has made a decision to lend to you, documents will be signed — and usually quite a lot. However, that is just the beginning. Here are some things that maybe expected of you now that you are working with a lender — especially a bank.
Setting Up a Post Office Box for Your Receivables that Your Lender Controls: To make sure that a lender gets paid in good times and in bad they may request that you have all of your accounts receivable sent to a post office box for which they have a key. They will then handle your deposits for you and in the event things go south can keep your receivables to start getting paid back first.
Monthly Financial Reporting to Your Lender: Your lender will want to make sure that the assumptions on which they made the loans are still true and in many cases if the business metrics start to falter the lender can call the loan/credit facility and/or change the terms. As a result your monthly Profit and Loss Statement and Balance Sheet will need to be sent to your lender in a timely manner.
Sending Annual Business and Personal Tax Returns To Your Lender: Similar to the monthly financial reporting above, the lender will want to validate that you are keeping your regulatory filings up to date and maintaining the fiscal health of your household and business.
Sending an Updated Personal Net Worth Statement to Your Lender: To monitor for changes in personal income, spending, savings, debt, and assets, your lender will likely request an updated personal net worth statement on an annualized basis.
In the Case of Banking Lending, Move All Your Accounts to That Bank: A bank, to further their own interests and provide the bank security, may strongly encourage or require that a significant amount (if not all) of your business banking by done with that bank (and maybe even your personal banking). For lines of credit it is a practical necessity. When you do so there is a benefit in that your aggregate financial power is concentrated and in full view of the bank and in many cases that can help you negotiate favorable and future financing with greater easy. Plus it establishes a history and loyalty that can give stability to you and your business. In subsequent financings you can package up all your banking and shop it as a large opportunity to other banks.
Conclusion
Lenders are friendly people and will help guide you through the process of securing financing for your business. We encourage you to start building these relationship throughout the life of your business. A good bank and lender can save you a lot of time and headache when you are growing fast.