The Ins and Outs of Debt Financing
Unlike equity financing, where you sell part of your business to an investor, debt financing simply means receiving money in the form of a loan that you will have to repay. You can turn to many sources for debt financing, including banks, commercial lenders, and even your personal credit cards.
Types of Loans
You don’t need to pinpoint the exact type of loan you need before you approach a lender; they will help you decide what type of financing is best for your needs. However, you should have some general idea of the types of loans available so you will understand what your lender is offering.
A mind-boggling variety of loans are available, which is complicated by the fact that the same type of loan may have different terms at different banks. For instance, a commercial loan at one bank might be written with equal installments of principal and interest, while at another bank, the loan is written with monthly interest payments and a balloon payment of the principal.
Here is a look at how lenders generally structure loans, with common variations.
Line-of-Credit Loans
The most useful type of loan for small businesses is a line-of-credit. In fact, it’s probably the one permanent loan arrangement all business owners should have with their bankers since it protects the business from emergencies and stalled cash flow. Line-of-credit loans are intended for inventory purchases and operating costs covering working capital and business cycle needs. They are not intended for equipment or real estate purchases.
A line-of-credit is a short-term loan that extends the cash available in your business’ checking account to the upper limit of the loan contract. Every bank has its own method of funding, but essentially, an amount is transferred to the business’ checking account to cover checks. The business pays interest on the actual amount advanced, from the time it is advanced until it is paid back.
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Line-of-credit loans usually carry the lowest interest rate a bank offers since they are seen as fairly low-risk. Some banks even include a clause that gives them the right to cancel the loan if they think your business is in jeopardy. Interest payments are made monthly, and the principal is paid off at your convenience. It is wise to make payments on the principal often. Bankers may also call this a revolving line of credit, and they see it as an indication that your business is earning enough income.
Most line-of-credit loans are written for periods of one year and may be renewed almost automatically for an annual fee. Some banks require that your credit line be fully paid off for seven to 30 days each contract year. This period is probably the best time to negotiate.
Even if you don’t need a line-of-credit loan now, talk to your banker about how to get one. To negotiate a credit line, your banker will want to see current financial statements, the latest tax returns, and a projected cash-flow statement.
Installment Loans
These loans are paid back with equal monthly payments covering both principal and interest. Installment loans may be written to meet all types of business needs. You receive the full amount when the contract is signed, and interest is calculated from that date to the final day of the loan. If you repay an installment loan before its final date, there will be no penalty and an appropriate interest adjustment.
Installment loan terms will always be correlated to their use. A business cycle loan may be written as a four-month installment loan from, say, September 1 until December 31 and would carry the low interest rate since the risk to the lender is under one year. Business cycle loans may be written from one to seven years, while real estate and renovation loans may be written for up to 21 years. An installment loan is occasionally written with quarterly, half-yearly, or annual payments when monthly payments are inappropriate.
Balloon Loans
Though these loans are usually written under another name, you can identify them by the fact that the full amount is received when the contract is signed but only the interest is paid off during the life of the loan with a “balloon” payment of the principal due on the final day.
Occasionally, a lender will offer a loan in which both interest and principal are paid with a single balloon payment. Balloon loans are usually reserved for situations when a business has to wait until a specific date before receiving payment from a client for its product or services. In all other ways, they are the same as installment loans.
Interim Loans
When considering interim loans, bankers are concerned with who will be paying off the loan and whether that commitment is reliable. Interim loans are used to make periodic payments to the contractors building new facilities when a mortgage on the building will be used to pay off the interim loan.
Secured and Unsecured Loans
Loans can come in one of two forms: secured or unsecured. When your lender knows you well and is convinced that your business is sound and the loan will be repaid on time, they may be willing to write an unsecured loan. Such a loan, in any of the aforementioned forms, has no collateral pledged as a secondary payment source should you default on the loan. The lender provides you with an unsecured loan because it considers you a low risk. As a new business, you are highly unlikely to qualify for an unsecured loan; it generally requires a track record of profitability and success.
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Almost every loan has covenants. These are promises that borrowers make to lenders about their actions and responsibilities. A typical covenant specifies the amount of debt the borrower is allowed to take on in the future. If you want to see just how restrictive your loan will be, look at the covenants section of the loan agreement.
A secured loan, on the other hand, requires some kind of collateral but generally has a lower interest rate than an unsecured loan. When a loan is written for more than 12 months, is used to purchase equipment, or does not seem risk-free, the lender will ask that the loan be secured by collateral. The collateral used, whether real estate or inventory, is expected to outlast the loan and is usually related to its purpose.
Since lenders expect to use the collateral to pay off the loan if the borrower defaults, they will value it appropriately. A $20,000 piece of new equipment will probably secure a loan of up to $15,000; receivables are valued for loans up to 75 percent of the amount due; and inventory is usually valued at up to 50 percent of its sale price.
Letter of Credit
Typically used in international trade, this document allows entrepreneurs to guarantee payment to suppliers in other countries. The document substitutes the bank’s credit for the entrepreneur’s up to a set amount for a specified period.
Other Loans
Banks all over the country write loans, especially installment and balloon loans, under a myriad of names. They include:
Term loans, both short- and long-term, according to the number of years they are written for
Second mortgages where real estate is used to secure a loan; usually long-term, they’re also known as equity loans
Inventory loans and equipment loans for the purchase of, and secured by, either equipment or inventory
Accounts receivable loans secured by your outstanding accounts
Personal loans where your signature and personal collateral guarantee the loan, which you, in turn, lend to your business
Guaranteed loans in which a third party—an investor, spouse, or the SBA—guarantees repayment (for more on SBA-guaranteed loans, see Chapter 15)
Commercial loans in which the bank offers its standard loan for small businesses
Once you understand the different types of loans, you are better equipped for the next step: “selling” a lender on your business.
Sources of Financing
When seeking debt financing, where do you begin? Carefully choosing the lenders you target can increase your odds of success. Here is a look at various loan sources and what you should know about each.
Bank On It
Traditionally, the paperwork and processing costs involved in making and servicing loans have made the small loans most entrepreneurs seek too costly for big banks to administer. Put plainly, a loan under $25,000—the type many startups are looking for—may not be worth a big bank’s time.
In recent years, however, the relationship between banks and small businesses has been improving as more and more banks realize the strength and importance of this growing market. With corporations and real estate developers no longer spurring so much of banks’ business, lenders are looking to entrepreneurs to take up the slack.
Many major banks have added special services and programs for small businesses; others are streamlining their loan paperwork and approval process to get loans to entrepreneurs faster. On the plus side, banks are marketing to small businesses like never before. On the downside, the streamlining process often means that, more than ever, loan approval is based solely on numbers and scores on standardized rating systems rather than on an entrepreneur’s character or drive.
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Federal, state, and local governments all offer their own financing programs designed especially for small-business owners. These programs include low-interest loans, venture capital, and economic and scientific development grants. You can find reliable information on how and where to find these programs on the USA.gov website (www.usa.gov/funding-options).
Given the challenges of working with a big bank, many entrepreneurs are taking a different tack. Instead of wooing the big commercial institutions, they are courting community banks where “relationship banking” is the rule, not the exception. It is easier to get a startup loan from community banks, according to the Independent Community Bankers of America. They can be a little more flexible, don’t have a bureaucracy to deal with, and are more apt to make character loans.
Second-String Funding Options
These three lesser-known funding options can provide incremental and critical startup capital:
1. Equipment financing (aka asset-based or capital equipment loans). With the equipment serving as baked-in collateral, equipment financing carries high approval rates for start-ups. One huge benefit: using the equipment to build equity while paying off the loan.
How it works: Similar to a car loan, equipment typically provides 60 to 65 percent of its value as collateral. Interest rates are tied to your credit rating, and most borrowers aren’t required to put up additional capital.
2. Credit card cash advances. Although interest rates can climb into the 20 percent territory, credit cards account for about 7 percent of all startup capital. Those high interest rates make this a strategic option only for companies that can secure a lower-interest bank loan in the near-term to pay them off.
How it works: Say you have multiple credit cards with cash availability totaling $10,000 at 18 percent interest. You would take the maximum cash out and, after six months of credit-building, acquire a bank loan at 10 percent interest to pay them off.
3. Merchant cash advance. If you have a high volume of electronic transactions and are in need of operating capital quickly, consider merchant cash advances. The capital comes at a steep price—as much as 50 percent interest—but it may be worth it if it keeps your doors open.
How it works: Specialized lenders provide cash in exchange for a percentage of all debit and credit card transactions over a defined period or until the loan is paid off. However, borrower beware: The merchant cash advance space is populated with sketchy lenders, making due diligence critical.
You’ll still have to meet credit and collateral requirements just as you would at a larger institution. The difference: Smaller banks tend to give more weight to personal attributes. If the business is located in town, the banker likely already knows the entrepreneur, and the family has lived in the area for years; these things count more in a community bank.
Whether the bank you target is big or small, perhaps what matters most is developing relationships. If you have done your personal banking at the same place for 20 years and know the people with authority there, it makes sense to target that bank as a potential lender. If you do not have that kind of relationship at your bank, get to know bankers now. Visit chamber of commerce meetings, go to networking events, and take part in community functions that local bankers or other movers and shakers are part of.
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A 2014 Harvard Business School study revealed that 48 percent of small business owners fund their companies via commercial bank loans. About 34 percent do so via regional or community bank loans.
Boost your chances of getting a loan by finding a lender whose experience matches your needs. Talk to friends, lawyers or accountants, and other entrepreneurs in the same industry for leads on banks that have helped people in your business. Pound the pavement and talk to banks about the type and size of loans they specialize in. Put in the work to find the right lender, and you’ll find it is more likely to pay off.
Commercial Finance Companies
Banks aren’t your only option when seeking a loan. Nonbank commercial lenders, or commercial finance companies, have expanded their focus on small business in recent years as more and more small banks, which traditionally made loans to entrepreneurs, have been swallowed up in mergers. The advantage of approaching commercial finance companies is that, like community banks, they may be more willing to look beyond numbers and assets. Commercial finance companies give opportunities to startups and a lot of other businesses banks will not lend to. Here are two commercial finance companies to get you started:
Franchise Focus
Financing is any startup entrepreneur’s biggest challenge—and it’s no different for franchisees. The good news is, franchisors may offer a little extra help in getting the capital you need.
Some franchisors offer direct financing to help franchisees with all or part of the costs of startup. This may take the form of equipment, real estate, or inventory financing. The goal is to free up money so franchisees have more working capital.
Many franchisors are not directly involved in lending but have established relationships with banks and commercial finance companies. Because these lenders have processed loans for other franchisees, they are more familiar with new franchisees’ needs.
The franchisor you’re interested in can tell you about any direct financing or preferred lender programs available. The Franchise Disclosure Document should also include this information.
If your franchisor doesn’t have a preferred lender, you can often find financing by approaching banks that have made loans to other franchisees in the system. Talk to franchisees and see how they financed their businesses.
Once you’ve found a lender to target, you’ll need to provide the same information and follow the same steps as you would with any type of business loan.
Privately held Commercial Finance Group (www.cfgroup.net) specializes in providing finance solutions to small and midsized companies in a wide range of industries that are unable to qualify for bank financing.
At Business Lenders (www.businesslenders.com), loan evaluators look beyond traditional lending criteria to consider management ability and character. “Somebody who has bad credit could still be a good credit risk,” says founder Penn Ritter. “It depends on why they had the credit problem.”
Commercial lenders require a business plan, personal financial statements, and cash-flow projections and will usually expect you to come up with 20 to 25 percent of the needed capital yourself. For more information about commercial finance companies, call the Commercial Finance Association at (212) 792-9390, or visit http://community.cfa.com.
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Looking for financing? Consider an unexpected source—your vendors. Vendors may be willing to give you the capital you need, either through a delayed financing agreement or a leasing program. Vendors have a vested interest in your success and a belief in your stability, or they wouldn’t be doing business with you. Before entering any agreement, however, compare long-term leasing costs with short-term loan costs; leasing could be more costly.
Give Yourself Credit
One potentially risky way to finance your business is to use your personal credit cards. The obvious drawback is the high interest rates; if you use the cards for cash advances rather than to buy equipment, the rates are even higher.
Some entrepreneurs take advantage of low-interest credit card offers they receive in the mail, transferring balances from one card to another as soon as interest rates rise (typically after six months). If you use this strategy, keep a close eye on when the rate will increase. Sometimes, you can get the bank to extend the low introductory rate over the phone.
Experts advise using credit card financing as a last resort because interest rates are higher than any other type of financing. However, if you are good at juggling payments, your startup needs are low, and you are confident you’ll be able to pay the money back fairly quickly, this could be the route to take.
Applying for a Loan
The next step is applying for the loan. It’s important to know what you’ll need to provide and what lenders are looking for.
The Loan Application
Think of your loan application as a sales tool, just like your brochures or ads. When you put together the right combination of facts and figures, your application will sell your lender on the short- and long-term profit potential of lending money to your business. To do that, the application must convince your lender that you will pay back the loan as promised and that your managerial ability (and future loans) will result in a profit-making partnership.
Banks are in the money-lending business. To lend money, they need evidence of security and stability. It’s that simple.
How can you provide this evidence when your business hasn’t even gotten off the ground? Begin by making sure your loan application is both realistic and optimistic. If you predict an increase in sales of between 8 and 12 percent, base your income projections on an increase of 10 percent and then specify what you intend to do to ensure the additional sales.
Also make sure your application is complete. When a piece of an application is missing, bankers instantly suspect that either something is being hidden or the applicant doesn’t know his or her business well enough to pull the information together. Underwriting rules aren’t as flexible as they used to be, either.
There are 12 separate items that should be included in every loan application. The importance of each one varies with the size of your business, your industry, and the amount you are requesting.
1. Cover sheet
2. Cover letter
3. Table of contents
4. Amount and use of the loan
5. History and description of your business
6. Functions and background of your management team
7. Market information on your product or service
8. Financial history and current status
9. Financial projections to demonstrate that the loan will be repaid
10. A list of possible collateral
11. Personal financial statements
12. Additional documents to support the projections
“You fail if you don’t try. If you try and you fail, yes, you’ll have a few articles saying you’ve failed at something. But if you look at the history of American entrepreneurs, one thing I do know about them: An awful lot of them have tried and failed in the past and gone on to great things.”
—RICHARD BRANSON, FOUNDER OF THE VIRGIN GROUP
Many of these items are part of your business plan; a few of them will have to be added. Here’s a closer look at each section:
1. Cover sheet. This is the title page to your “book.” All it needs to say is “Loan application submitted by John Smith, Sunday’s Ice Cream Parlor, to Big Bucks Bank, Main Street, Anytown.” It should also include the date and your business telephone number.
2. Cover letter. The cover letter is a personal business letter to your banker requesting consideration of your application for a line of credit or an installment loan. The second paragraph should describe your business: “Our company is a [sole proprietorship, partnership, or corporation] in manufacturing, distributing, and retailing X type of goods.” The third paragraph is best kept to just one or two sentences that “sell” your application by indicating what your plans are for your business.
3. Table of contents. This page makes it easy for your banker to see that all the documents are included.
4. Amount and use of the loan. This page documents how much you want to borrow and how you will use the loan. If you are buying a new piece of equipment, for instance, it should show the contract price, add the cost of freight and installation, deduct the amount you will be contributing, and show the balance to be borrowed.
5. History and description of your business. This is often the most difficult to write. The key is to stay with the facts and assume the reader knows nothing about your business. Describe, more fully than in the cover letter, the legal form of your business and its location. Tell why you believe the business is going to succeed. Conclude with a paragraph on your future plans.
6. Management team. Bankers know that it’s people who make things happen. Your management team might consist of every employee if they oversee an important part of your operation, or it might be just you and one key person. It also includes any outside consultants you plan to use regularly, such as your accountant or banker. In one or two pages, list each person’s name and responsibilities. Where appropriate, describe the background that makes this person the right choice for that job.
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Loan officers at your bank may be a valuable resource in identifying state, local, and agency assistance. They may have gone through the steps with other new business owners in your area. Even if they don’t offer you a loan or a loan on terms you can accept, you should make time to chat and get their insights on other assistance.
7. Market information. You should begin these pages with a complete description of your product line or service and the market it is directed toward. Next, describe how you have targeted your market niche and how successful you have been. Finally, detail your future plans to add new products or services.
8. Financial history. Most bankers want to see balance sheets and income (profit and loss) statements. As a startup, you will need to use projections. Bankers will compare these to norms in your industry.
aha!
If you are a woman or a member of a minority group looking to purchase a franchise, you may be eligible for special financial incentives or assistance from the franchisor. Ask franchisors you are considering whether they have such programs and what the requirements are.
9. Financial projections. This set of three documents—a projected income statement, balance sheet, and cash-flow statement—should show how the business, with the use of the loan, will generate sufficient profits to pay off the loan. Your accountant can help you prepare these documents.
10. Collateral. Listing your available collateral—cash reserves, stocks and bonds, equipment, home equity, inventory, and receivables—demonstrates your understanding that your banker will normally look for a backup repayment source. Each piece of collateral listed should be described with its cost and current fair market value. You might need to provide documentation of value—so be prepared to get appraisals or get your paperwork in order.
11. Personal financial statements. As a startup, you will need to add your personal guarantee to any loan the bank makes. The banker will want to see your tax returns for several years and balance sheets showing personal net worth. Most banks have preprinted forms that make pulling these figures together relatively easy.
12. Additional documents. In this section, you can include whatever documents you feel will enhance your loan package. This might include a copy of the sales contract on a new piece of equipment, a lease and photograph of a new location, blueprints, or legal documents. If you are introducing a new product or service, include a product brochure and additional market research information.
This section can help a new business overcome the lack of a track record. While glowing letters won’t make a banker overlook weak finances, an assurance from your largest customer that your services are valued can help your banker see your full potential.
What Lenders Look For
Your application is complete, with every “i” dotted and every “t” crossed. But is it enough to get you the cold, hard cash? What are lenders really looking for when they pore over your application? Lenders typically base their decisions on four criteria, often called the “Four C’s of Credit”:
1. Credit. The lender will examine your personal credit history to see how well you’ve managed your past obligations. If you have some black marks on your credit, the banker will want to hear the details and see proof that you repaid what you owed. A couple of late payments are not a big deal, but two or more consecutive missed payments are. Get a copy of your credit history before you turn in your application. This way, you can find out about any problems and explain them before your banker brings them up.
2. Character. Character is hard to measure, but lenders will use your credit history to assess this as well. They take lawsuits, bankruptcies, and tax liens particularly seriously in evaluating your character. They will also do a background check and evaluate your previous work experience. They might ask for personal references.
3. Capacity. What happens if your business slumps? Do you have the capacity to convert other assets to cash, either by selling or borrowing against them? Your secondary repayment sources may include real estate, stocks, and other savings. The lender will look at your business balance sheet and financial statement to determine your capacity.
Read the Fine Print
Hallelujah and yippee! You can almost hear the choirs of angels singing as your banker smiles and hands you the loan documents. You got the loan!
Not so fast. Before you sign that piece of paper, take a good look at what you’re getting into. Many entrepreneurs are so excited about having their loans approved, they fail to read the fine print on their loan agreements. That can lead to trouble later on.
It’s a good idea to get the loan documents ahead of time so you have a chance to review them for a couple of days before you sign, according to the American Bankers Association. Bankers won’t have a problem sending advance copies of the documents but will generally do so only if they’re specifically asked.
Most bankers will be happy to help you understand the fine print, but it’s also a good idea to have your accountant and lawyer review the documents, too. Let us repeat: READ every word. And for any passages or terms you don’t completely understand, get clarification from an accountant, lawyer, or trusted mentor who has experience understanding loan terms.
Although it varies slightly from bank to bank, a small-business loan package usually consists of several documents, typically including a loan agreement, a promissory note, and some form of guarantee and surety agreement.
Loan agreement. This specifies, in essence, the promises you are making to the bank and asks you to affirm that you are authorized to bind your business to the terms of the loan. Most banks require you to verify that all the information on your loan application is still true before they disburse the loan.
Promissory note. This details the principal and interest owed and when payments are due. It outlines the events that would allow the bank to declare your loan in default. Knowing these events ahead of time can help you protect your credit record. Look for “cure” language in the default section. A cure provision allows you a certain amount of time (usually ten days) to remedy the default after you’ve been notified by the bank. If such a provision isn’t included, ask if it can be added to prevent you from defaulting accidentally (in case a payment is lost in the mail, for example). Also make sure you understand what the bank can and can’t do after declaring default.
Guarantee and surety agreement. Because startups generally have insufficient operating history or assets on which to base a loan, banks usually require the loan to be guaranteed with your personal assets. The bank may ask you to secure the loan with the equity in your home, for example.
4. Collateral. As a startup, you will most likely be seeking a secured loan. This means you must put up collateral—either personal assets, such as stocks or certificates of deposit or business assets like inventory, equipment, or real estate.
A Loan at Last
A good relationship with your banker is just as important after you get that loan as it is in getting one in the first place. The key word is “communication.” The bank wants to be told all the good—and bad—news about your business as soon as it occurs. Most business owners fear telling bankers bad news, but keeping problems hidden is a mistake. Like any relationship, the one with your banker is built on trust. Keep him or her apprised of your business’ progress. Invite your banker to visit your business and see how the proceeds of the loan are being put to good use.
Once you’ve established a relationship with a banker, it is simple to expand your circle of friends at the bank. Every time you visit, spend some time meeting and talking to people, especially those further up the ladder. Often, the bankers will be the ones to initiate contact. Take advantage of this opportunity. The more people you know at the bank, the easier it will be to get the next round of financing.