Credit is the lifeblood of American business, especially for
the smaller firm. It helps the entrepreneur get started, obtain
equipment, build inventory, develop new lines of merchandise,
or expand. In brief, credit makes the business grow.
The financing for small business comes largely from the nation's
14,500 commercial banks. Surveys have found that aside from personal
savings, banks are the major source of capital for starting new
firms. Even more striking, about 85 percent of loans to operating
small businesses come from banks, according to a report by the
National Federation of Independent Business.
In seeking a loan for your company, you are essentially asking
a bank to become your business partner. Before entering the market
for a loan, make sure you have done all of the ground work necessary:
(a) How much do you want and for what?
(b) What terms do you need for your loan?
(c) What kind of a business person are you?
(d) What shape is your business in?
Your preparation must also include doing the groundwork of a
good consumer: Which banks in your area are known for small business
loans? Which ones are the most reliable? Remember, loans are the
products that banks sell. Look for the best combination of price,
quality, and reputation of supplier. In the end, getting a loan
depends upon your credit-worthiness.
1. Planning For A Loan
2. Types Of Loans
3. Selecting A Lender
4. Writing a Business Plan
5. The Review Process
1. Planning For A Loan
Before you step into a bank to borrow, you should ask yourself
some basic questions. Thinking these through and having answers
ready will lead to a more productive credit interview. The answers
to questions such as these are central to the lending decision.
And the information you provide--backed up by your financial statements--will
help the banker make the decision as quickly as possible. Here
are some examples:
- How do you plan to use the money you will borrow?
- How much do you need? (Be prepared to be as specific as
you can about why you need the amount requested.)
- How long will you need these funds?
- How do you plan to generate sufficient cash flow to pay
back the loan?
2. Types Of Loans
As a business person, you know that you may need to borrow to
maintain or expand your business. But loans come in various forms
and some are more appropriate than others for your needs are.
The following are some types of loans available. Try to determine
how your needs match them.
Short term loans
A line of credit allows you to borrow repeatedly up to a certain
amount. You repay and re-borrow as often as you need. At the
end of the year, the line of credit may be renewed. This is
sometimes called a revolving line of credit because of the repeat
borrowing and repayment provisions. These loans, which usually
must be secured by collateral, allow you to maintain an even
cash flow with which to operate your business. They may allow
you to take advantage of special discounts offered by suppliers,
or to gear up for a special sales effort. They can tide you
over until a customer pays a big bill.
One type of line of credit bearing special mention is the seasonal
line of credit. Many businesses have a strong seasonal nature.
There may be a time when you need capital to prepare for a seasonal
product. The period between its production and the income it
produces may be lengthy. Cash flow may be diminished, but you
need to keep operating. When applying for such a seasonal loan,
determine how much you will need and, based on past experience,
when you will be able to repay it. Don't borrow more than you
need. Like most other types of lines of credit, this kind of
loan is expected to be repaid within a year.
Intermediate term loans
These loans may run as long as three years. Consider such a
loan for a business start-up, the purchase of new equipment,
the expansion of a store or plant, or an increase in working
capital. The intermediate term loan is usually repaid in monthly
or quarterly payments from the business's profits. The loan
will usually require collateral.
Long term loans
A long term loan typically runs for more than three years, is
usually secured, and may be granted for business start-ups,
purchasing major equipment, moving a plant or store, or for
other purposes.
The long term loan is commonly repaid on a monthly or quarterly
basis out of cash flow or profits. The loan agreement may contain
provisions which limit your company's other debts, dividends,
or principals' salaries or which require minimum equity or working
capital levels. It may also require that a percentage of the
firm's profits be used expressly to repay the loan. Collateral
for a long term loan may be the assets you are purchasing, supplemented
by your personal guarantee, stocks, bonds, certificates of deposit,
or other business assets.
Commercial mortgages
You may need a commercial mortgage if you plan to buy, build,
or enlarge a building, or to obtain needed land. Generally,
the mortgage is made for 75 to 80 percent of the appraised value
of the property and is amortized over a set period of ten to
twenty years. The bank will probably require an independent
appraisal at the customer's expense.
Should you need cash, property that your company now owns may
be mortgaged. If the property, land or building is already mortgaged,
you may be able to obtain a second mortgage. The interest rate
on the first mortgage should not be affected by the second one.
The interest on the second mortgage would be at prevailing rates--most
likely higher than the rate of the first mortgage.
Letter of credit
Although not an actual loan, a letter of credit is used to facilitate
certain business transactions. Therefore, a request for opening
a letter of credit is similar to an application for a loan and
is treated the same way.
In domestic use, a standby letter of credit substitutes the
bank's credit for the firm's credit by providing the bank's
guarantee of payment to a third party if the borrower fails
to repay the loan. For example, a small firm manufacturing dresses
might need to offer a standby letter of credit to a supplier
of cloth to assure the supplier that the bank will provide payment
for the cloth if the purchaser cannot.
In an international transaction, a commercial or import letter
of credit refers to a specific transaction. It helps insure
the buyer and seller, who may be separated by thousands of miles
and operate under different legal, political and business practices,
that they will both receive protection regarding the receipt
of goods and payment for them. For example, a small U.S. tea
manufacturer may wish to purchase tea leaves from a supplier
in the Orient. The letter of credit would contain provisions
guaranteeing that the seller would receive payment by a specified
date if the buyer received the merchandise by a certain time
and if the merchandise met pre-determined standards of quantity
and quality.
Equity Financing
Previously, several types of debt financing have been described.
However, another way you can obtain financing for your business
is to share its ownership with others. Through this equity financing,
additional individuals or firms provide capital for the company
but may or may not take part in its operation.
General partners are those who normally contribute both capital
and management time. They share in business responsibilities
and liabilities. Limited partners are individuals who contribute
capital to the business but who normally have neither management
responsibilities nor liabilities. A sole proprietorship is a
business where there is only one owner, and this person is responsible
for all the company's debts.
If you establish a corporation, you can accommodate numerous
equity investors in the business. Each investor is a stockholder
and owns a part of the company. A privately held corporation
may consist of an unlimited number of stockholders. Often they
are friends, relatives, or employees. A publicly held corporation
is one which seeks to offer ownership to the general public.
Shares are sold by an investment banking or stock brokerage
firm.
Since the objective is to raise money, the corporation can
obtain equity financing through the issuance of a number of
instruments:
- common stock is issued to friends, relatives, and investors.
- preferred stock represents ownership in the business, but
requires that its holders be repaid first if the business
should go bankrupt.
- convertible debentures are bonds which may be converted
into common stock before being repaid to holders.
- debt warrants allow holders to buy a company's stock even
after the debt has been repaid.
A business that is a corporation may enjoy certain advantages
in obtaining funds. But bear in mind that corporations are more
highly regulated than most other legal entities.
A Note on loan collateral: Banks will usually require
the value of the collateral to be somewhat greater than the
amount of the loan. One factor to be considered is the liquidity
of the collateral. Another consideration is the expected economic
life of the collateral. For example, items that rapidly lose
value, such as seasonal inventory, are not normally acceptable
as collateral for intermediate or long-term debt. When making
loans to businesses with multiple owners, such as partnerships
or corporations, banks may require a pledge of personal assets
or a personal guarantee.
A Note on equity financing: Although some companies
select equity financing, debt financing historically has been
and currently is preferred by most small firms. The existing
tax structure is one special reason for this. Interest paid
for a loan is deductible as a valid business expense. It reduces
the tax burden. Furthermore, the money obtained through borrowing
is controlled by the owner of the business-control over the
company is not diminished. Thus, where credit can be obtained
at a favorable rate, debt financing is usually the better course
for the small firm than equity financing,
3. Selecting A Lender
Choosing the bank for your loan should be a careful decision and
not based on relatively superficial grounds, such as convenience
of location. Money from one bank is every bit as good as money
from another bank, so it pays to shop around.
Interest rate Obviously the cost of financing should
be a factor in selecting a bank. Different financial institutions
may offer different rates because of variations in their cost
and availability of funds. Also, ask whether agreeing to maintain
a minimum balance in the bank will result in a lower rate. At
some financial institutions it will. Many banks may offer only
variable rate financing or both variable and fixed rate loans.
With variable rate loans, the interest rate will be tied to
some economic index, and the rate on the loan will change to
correspond with increases or decreases in the index.
Quality of Service Do additional research besides studying
interest rates before selecting your bank. However, the number
and quality of other small business services and the bank's
commitment to long-term relationships are important, too. See
if the bank is one that makes a specialty of lending to small
business. If there is one with small business people on its
board of directors, this may suggest a willingness to deal with
small firms. Also, you may want to know whether the bank participates
in programs of the U.S. Small Business Administration. Check
with other small business owners in your industry or your region.
They may know of banks which have a history of serving your
kind of business and are therefore worth considering. If your
colleagues have had good service from a bank, a fair rate, and
good financial guidance, they should be quick to pass this on.
Ask your accountant or lawyer for suggestions as well.
4. Writing the Business
Plan
5. The Review Process
Every lender tries to understand the condition of the borrower's
business as well as its prospects. That is the reason for asking
you to submit several types of financial statements. They give
the banker a chance to see how critical aspects of your business
relate to each other.
The "seven C's" of credit are used as a framework to analyze
a credit request. Each of the following is looked at in relation
to the borrower, the business, and the market area. Identified
risks need to be mitigated and strengths should be enhanced.
Loan Considerations
7 C's of Lending
1. Credit
2. Character
3. Capacity
4. Capital
5. Condition
6. Capability
7. Collateral
