Every business needs capital to start and grow. We all know that. The bigger question for you as an entrepreneur and business owner is what type of capital is right for your company. While the media continues to push the idea that banks are not lending to small businesses – an opinion which his not entirely inaccurate – it still makes sense to start your capital search by speaking with your local banker. A bank loan officer is in fact hired to make loans. And if you don’t at least walk into your bank and apply for a small business loan you will never know if you would have been successful in securing financing.
With that in mind, I wanted to take a few minutes of your time to go over some basics of bank financing. First, don’t forget, that if you are looking for a loan or line of credit over $100,000 or SBA-backed financing, you’ll need a business plan (BizPlanBuilder for Mac or Windows is great for this purpose). OK, on with the show.
Bankers are almost the opposite of investors. They make loans with money that has been deposited with their bank by customers who have been essentially guaranteed to get their funds back at a later date. The money was deposited with the understanding that there is little risk to the customer’s funds, so bankers have to be very careful if, how and to whom they lend money. They must always proceed with great caution.
Bankers use the five Cs: Credit, Character, Cash-flow, Collateral and Capacity—when evaluating a loan. They also look at a company from a deliberately pessimistic point of view to minimize their risk, so you must have good answers to their questions to demonstrate that you understand the issues. When dealing with your bank and banker, it is always helpful to keep the following nuggets of advice in mind:
Zen and Banking
The old saying is that bankers will give you the money when you don’t need it. This echoes the Zen philosophy: When you really want something, you don’t get it. (And you can’t not want something in order to get it either!) When you completely let go of something, it comes to you and you have it. When you don’t need money, bankers seem to want to give you money. That’s the way the world works. Nobody wants anyone who’s desperate. So, the more you try to get bankers to give you money, the more they don’t want to give it to you. To better understand this let’s look behind the scenes.
The Nature of the Banking Business
For example: You ask for a $100,000 loan. The way the banking system works is that they mark up the money they pay depositors by about 2% (the spread). In the backs of their minds, they’re looking at you and considering, “What if you can’t pay this $100,000 loan back?” Remember, in business you have to make up any losses from profits, not sales. So, how much profit is lost if they lose your loan? Two percent at $100,000 is all the profit from five million dollars worth of loans. So if your loan goes bad, that means they lose the equivalent of all the profit they would make on five million dollars worth of loans they’ve made elsewhere.
They Need your First Born
Now you can imagine why they scrutinize every loan. They look at how much business they would throw away if something went wrong with yours. That’s why they’re going to look at everything about you, including your character. Your credit history plays a big part here. They want to be sure you’re the kind of person who’s going to pay back the loan. They don’t want to get left holding a bad loan. That makes it even more imperative that you know what you’re doing in your business. So what do you do? You’ve got to show them a track record. You need to prove that you can pay your loan back no matter what. That’s also why they want collateral-it’s insurance so they won’t have to take it out of their slim profit.
Prerequisites for a Bank Loan
A bank wants to see a track record of profit for the past three years which also means you have to have been in business for at least three years. Banks are looking to finance growth, not cover for inefficiencies. Show them how you’ll use the loan to improve efficiencies in your operation. For example, buying a printing press will save money over buying printing if you spend a fortune on printing. Then the loan would make sense. However, if cash is short because you’re slow to collect receivables, then the loan doesn’t make sense. If you could collect your receivables faster, you wouldn’t need the loan. They prefer a debt-to-equity ratio of less than 3 to 1. This is one of a banker’s measures of risk. Bankers hate risk! The debt-to-equity ratio compares the amount of what you owe to what you own. Banks expect that you will repay your loan out of cash flow-show that you’ll generate enough cash (not just profit on paper) to repay your loan. If you can show that the loan improves cash flow, so much the better.
Your local bank (community or mega-bank) is a great place to start your capital search. The key is making sure that you have your story straight, are prepared to answer the bankers questions in full, and know what you are getting yourself into. If the loan goes great – no problem. If the loan goes sideways – which many loans have done these past few years – just know the bank may come after you!