Business Loans are generally used to create working capital, being the amount of funds which are necessary to an organization to continue its ongoing business operations, until the business is reimbursed through payments for the goods or services it has delivered to its customers.
Businesses may rely on borrowed funds (debt capital or credit) as sources of investment to sustain ongoing business operations or to fund future growth. Debt comes in several forms, such as through bank loans, notes payable, or bonds issued to the public. Bonds require the corporations to make regular interest payments (interest expenses) on the borrowed capital until the debt reaches its maturity date, therein the firm must pay back the obligation in full. Debt payments can also be made in the form of sinking fund provisions, whereby the corporation pays annual installments of the borrowed debt above regular interest charges. Corporations that issue callable bonds are entitled to pay back the obligation in full whenever the company feels it is in their best interest to pay off the debt payments. If interest expenses cannot be made by the corporation through cash payments, the firm may also use collateral assets as a form of repaying their debt obligations (or through the process of liquidation).
Most owners of small businesses believe that banks only lend money to companies that don’t need it. This is not true.
However, what is true is that bankers and the banks they represent will not typically make an effort to understand a business when an owner has not made a concerted effort to explain why they need a business loan, in an organized and concise manner:
- The company’s business.
- What it will do with the money it wants to borrow.
- How it intends to repay any borrowed funds.
Business Loan - What Bankers Look For
The first rule of every banker is “Know your customer.” This means that before a bank can make a loan, the bank must have an in-depth understanding of the business, including its history, its future, its products, its customers, its suppliers and its owners. The company’s business plan will normally include these topics.
For smaller business, the bank will rarely distinguish between a company and its owner. This means that the bank will want to understand the personal financial circumstances of the owner, including the details of the owner’s net worth and cash flow, just as the bank needs to understand the finances of the business. The bank will also want to understand the owner’s character. The bank will want to examine the owner’s personal credit history on the premise that the owner will manage the company’s debt similar to the way he manages his personal debt. Also, personal guarantees will always be required. A bank will never consider taking on the risk of lending money to a small business whose owner will not accept the same risk.
Here are some helpful tips to make a loan request package stand above the crowd:
- The package must be well organized.
- The package must be complete. Requesting additional information is time consuming for both the bank and borrower.
- Make it easy for the bank to understand the business.
- Carefully explain how the borrowed funds will be used.
- Carefully explain and document how the funds will be repaid.
- Any required forms should be neatly and completely filled out.
- Be prepared to offer the bank a lien on all of the company’s assets.
To ensure that you help make the bankers life easier, consider including the following supporting documents in your loan request:
- 2-3 years company financial statements. Ensure they tie in to your bank account activity!
- 2-3 years company tax returns.
- Latest accounts receivable aging (if applicable).
- Latest accounts payable aging.
- List of 5-10 largest customers. Indicate each customer’s percent of total sales if over 5%. Not applicable to retail businesses like restaurants or shops.
- Personal financial statement of owner(s).
- 2-3 years personal tax returns of owner(s).
Raising Startup Capital
Business Loan - Business Plan
A business plan is the company’s plan for the future. The bank will want to know if the company intends to grow and how it will achieve its growth objectives. The bank will want to know how the company will compete. The bank will want to know how the company will function in bad times. Who will manage the business in the event of death or illness? Be prepared with the answers to the banker’s most likely questions and you have increased your chances of raising banking financing.
If you're to be successful in getting a bank loan to help finance your small business, you must understand what the loan officer is looking for. Generally, bankers require the most information from a first-time borrower. Unsecured loans usually require more proof of repayment ability than secured loans, and loan packages become more detailed as the size of the loan or its term increases. The following are some examples of what a banker might look for when evaluating a loan applicant.
- Your level of experience. Do you have the education or practical experience necessary to make your business a success?
- Your personal credit history. The bank may insist on a personal security for a first-time borrower. You may have to pledge personal assets such as real estate or other valuables.
- Your company's liquid assets. What is your business' ability to meet short-term debt from working capital?
- Your profitability. The bank will want to evaluate past and current operating statements and balance sheets. Also, projections of long-term profit and loss and a cash flow analysis will probably be required.
Getting a bank loan is not always easy. Here are some steps to take in order to be prepared and to increase your chance of success:
- Establish a sound personal credit record. Use credit to deal with local sources. Have and use a credit card and make monthly payments promptly.
- Establish and maintain a relationship with your banker. Keep your banker informed about the state of your business. Show him or her occasional operating statements, balance sheets, or sales records.
Keep your business records current and in good shape. You will always be prepared to make a loan request as soon as you need it.
Hopefully, you are already at the stage where you are looking for funds to start or expand your business. In this article, we will explain some of the different ways to find financing. Due to the high cost of setting up a business, determining how you will finance your business is crucial.
Loans are a time-tested way of raising capital for your business. We would love to tell you that it is as easy as going to the bank and asking for money, but as you probably know by now it is quite the opposite. We wrote the following steps to help you raise the right amount of capital to get your business going.
Decide how much money you need.
This is an obvious but often misunderstood statement. Entrepreneurs, particularly start-ups, when budgeting for their business often focus on what they will need to get their business going, or to finance a particular project without accounting for working capital or cash for contingencies. This is dangerous because lack of working capital can mean the death knell for the business.
On the other hand, some entrepreneurs, again start-ups, drastically overestimate their costs. This will make lenders not only to question the entrepreneurs’ assumptions, but also question whether they know what they are doing.
Now focus on the lender.
If you are a start-up: Loan amounts below $25,000 are considered smaller, micro-loans. Not all banks will be interested in doing a SBA guaranteed loan for small amounts (more below). Micro-lenders and Alternative-lenders are better equipped to handle this type of loans. These lenders usually make smaller loans and have a community focus. Look to credit unions, local development corporations and other non-profit lenders.
A Small Business Administration (SBA) guaranteed loan is a guarantee to the lender. If the borrower defaults, the lender is guaranteed repayment of a portion of the loan by the SBA. You are still liable for the loan, so your obligation does not go away. From our experience, an amount of $50,000 and above is the usual range for SBA loans. The higher the amount requested the more the lender would look for collateral to secure the loans. Start-ups and existing businesses can apply for SBA guaranteed loans.
If you are an existing business: If you own a company that has documented sales (you will need to show previous years’ tax statements) then you can apply for conventional bank loans. These loans are usually easier to apply, and may have lower interest rates. Normally for a conventional bank loan, you will need to be in operations for at least 2 years.
Set your expectations.
The bank does not want to own your business. It is highly unlikely that you will get a loan for a 100% percent of the project cost. You will need to put down a co-payment. Although the minimum co-payment varies by industry and lender, expect to put down at least 20%-30% or more of the cost of the project.
Find out your credit score.
You should check your credit score and look over your credit report to make sure there are no problems. A credit score of above 650-680 is considered “Good”, but it does not mean you will get a loan. A credit score in the 700-800’s is very good and increases your chance of getting approved.
You can request your credit report from one of the reporting agencies, or use one of the many online services available to check your score.
Start researching your options.
Start weighing all your options. Think of ways to strengthen your loan application. Can you find a co-signer? Bring in a partner with good credit or experience? Invest more cash into the business? If you think that you are not a strong candidate for a business loan, you can present the lender with options to increase your chances.
Start writing the business plan and create the financial projections.
The business plan is more than a plan—it is a tool that helps you evaluate your business concept, your product or service, and discusses how to implement your ideas. A business plan is also a tool to obtain investors, lenders, and strategic partners. You can find many resources and opinions on the Internet as well as your local bookstore on how to build an effective business plan. A lender will usually require a comprehensive business plan as well as a projected 1-year cash flow projection (month-by-month), 3 years income statements, a balance sheet, a statement of sources and uses of funds, and a loan amortization schedule. One mistake that we usually see is that the figures on the Business Plan do not match the figures on the financial projection. Double-check your work before sending it to the bank.
Find a lender
Finding the right lender is not easy; each lender has its own criteria for lending. However you can use the list below to get an idea of what type of institution is a better fit for your loan needs.
Banks are one of the largest small business lenders but their approach to lending varies. Commercial Banks decisions are based on your strength as a borrower (a good credit score, personal financial statements, experience and collateral) the banks goals for the period and their lending philosophy. Banks may be looking to expand their small business loan consumer base; others may focus on larger loans or a specific industry.
You will need a high credit score if you are applying for a bank loan (with or without the SBA guarantee). Although, this is not an absolute rule for all banks, we found that a credit score over 700 is a better predictor on the success of a loan application. The bank may look for collateral (home equity, saving, etc) if you are applying for amounts over $50,000.
The borrower’s personal financial situation is key for the application. The bank’s underwriter will analyze the person’s net worth; as well as look at her previous earnings, length of credit history, among other factors.
For lower amounts the bank may not require a business plan. However, if there is a particular weakness in the loan application, the loan officer may ask the borrower to submit a business plan and financial projections.
These institutions do not conduct consumer banking but offer business services and business loans. Lenders’ requirements vary depending on the institution, and some prefer lending to specific industries. The Non-bank lender may take longer to process your loan application than a regular bank, but they can approve loans that banks find too risky.
Non-Bank lenders usually require a business plan and ample documentation with the loan application. Compared to banks these lenders have more flexibility working with lower credit scores as long as the borrower has the necessary experience and collateral.
Region Specific Lenders
There are neighborhood specific for-profit/non-profit lenders that have more flexible lending terms. For example: Credit Unions and Community Development Organizations may lend to specific neighborhoods. The nature of your business and the reason why you are requesting the loan should fit with the organizations’ goals.
Micro and Alternative lenders Micro and Alternative Lenders lend to riskier borrowers. These borrowers usually have low credit scores or they are just building credit, also they don’t have a strong financial history and have little or no collateral. These institutions lend lower amounts and charge higher interest rates.
Preparing the Loan Application Package
A “Loan Package” is the paperwork you submit to the bank in order to apply for a loan. The Loan Package includes the following:
- Business Plan
- Business Financial Projections
- Personal Financial Information
- Personal Tax Statements
- Information about business, location, sales contracts, etc.
- Business Owners’ Resumes
Loan applications are approved or declined much quicker than people think. A lender can approve an SBA express loan within 36 hours. Regular commercial loans have similar processing times. You should expect to get an answer within 2 weeks, and hopefully close the loan (get access to the money) within another 2 weeks. However, if the institution needs more documentation, or if the loan is for a larger amount, then it might take longer to process the loan, especially SBA loans.
When applying for a loan, you must prepare a written loan proposal. Make your best presentation in the initial loan proposal and application; you may not get a second opportunity.
Always begin your proposal with a cover letter or executive summary. Clearly and briefly explain who you are, your business background, the nature of your business, the amount and purpose of your loan request, your requested terms of repayment, how the funds will benefit your business, and how you will repay the loan. Keep this cover page simple and direct.
Many different loan proposal formats are possible. You may want to contact your commercial lender to determine which format is best for you. When writing your proposal, don't assume the reader is familiar with your industry or your individual business. Always include industry-specific details so your reader can understand how your particular business is run and what industry trends affect it.
Provide a written description of your business, including the following information:
- Type of organization
- Date of information
- Product or service
- Brief history
- Proposed Future Operation
You should also refer to
- Management Experience: Resumes of each owner and key management members.
- Personal Financial Statements: SBA requires financial statements for all principal owners (20% or more) and guarantors. Financial statements should not be older than 90 days. Make certain that you attach a copy of last year's federal income tax return to the financial statement.
- Loan Repayment: Provide a brief written statement indicating how the loan will be repaid, including repayment sources and time requirements. Cash-flow schedules, budgets, and other appropriate information should support this statement.
- Existing Business: Provide financial statements for at least the last three years, plus a current dated statement (no older than 90 days) including balance sheets, profit & loss statements, and a reconciliation of net worth. Aging of accounts payable and accounts receivables should be included, as well as a schedule of term debt. Other balance sheet items of significant value contained in the most recent statement should be explained.
- Proposed Business: Provide a pro-forma balance sheet reflecting sources and uses of both equity and borrowed funds.
- Projections: Provide a projection of future operations for at least one year or until positive cash flow can be shown. Include earnings, expenses, and reasoning for these estimates. The projections should be in profit & loss format. Explain assumptions used if different from trend or industry standards and support your projected figures with clear, documentable explanations.
Other Items As They Apply:
- Lease (copies of proposal)
- Franchise Agreement
- Purchase Agreement
- Articles of Incorporation
- Plans, Specifications
- Copies of Licenses
- Letters of Reference
- Letters of Intent
- Partnership Agreement
Secured Business Loan
Collateral: List real property and other assets to be held as collateral. Few financial institutions will provide non-collateral based loans. All loans should have at least two identifiable sources of repayment. The first source is ordinarily cash flow generated from profitable operations of the business. The second source is usually collateral pledged to secure the loan.
Your bank is in business to make money. Consequently, when a bank lends money it wants to ensure that it will be paid back. The bank must consider the 5 "C's" of Credit each time it makes a loan.
Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships - personal and commercial - is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.
Capital is the money you personally have invested in the business and is an indication of how much you will lose should the business fail. Prospective lenders and investors will expect you to contribute your own assets and to undertake personal financial risk to establish the business before asking them to commit any funding. If you have a significant personal investment in the business you are more likely to do everything in your power to make the business successful.
Collateral or guarantees are additional forms of security you can provide the lender. If the business cannot repay its loan, the bank wants to know there is a second source of repayment. Assets such as equipment, buildings, accounts receivable, and in some cases, inventory, are considered possible sources of repayment if they are sold by the bank for cash. Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that - someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.
Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
Character is the personal impression you make on the potential lender or investor. The lender decide subjectively whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience of your employees will also be considered.
Business Loan - Investment Finance
Investment finance (also known as equity finance) involves selling part
of your business (‘shares’) to an investor. The investor will take a share of any profits or losses that the company makes.
Advantages of investment finance include:
- investors can bring new skills and opportunities to the business, eg marketing or exporting overseas
- you won’t have to pay any interest, or repay a loan
- you share the risks of the business with your investors
Disadvantages are that:
- it can be a demanding, expensive and time-consuming process
- you’ll own a smaller share of your business (although your share could eventually be worth more money if your business succeeds)
- you may have to consult your investors before making certain management decisions
- only limited companies can sell shares, so you can’t raise money in this way if you’re a sole trader or in a partnership
Sound financial management is one of the best ways for your business to remain profitable and solvent. How well you manage the finances of your business is the cornerstone of every successful business venture. Each year thousands of potentially successful businesses fail because of poor financial management. As a business owner, you will need to identify and implement policies that will lead to and ensure that you will meet your financial obligations.
To effectively manage your finances, plan a sound, realistic budget by determining the actual amount of money needed to open your business (start-up costs) and the amount needed to keep it open (operating costs). The first step to building a sound financial plan is to devise a start-up budget. Your start-up budget will usually include such one-time-only costs as major equipment, utility deposits, down payments, etc.
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).
The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms “corporate finance” and “corporate financier” may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.
Your plan should include an explanation of all projections. Unless you are thoroughly familiar with financial statements, get help in preparing your cash flow and income statements and your balance sheet. Your aim is not to become a financial wizard, but to understand the financial tools well enough to gain their benefits. Your accountant or financial advisor can help you accomplish this goal.
Major Challenges To Securing A Business Acquisition Loan
Qualifying for a small business acquisition loan can be quite an ordeal to say the least.
If the business being sold is very profitable, the selling price will likely reflect a significant amount of goodwill which can be very difficult to finance.
If the business being sold is not making money, lenders can be difficult to find even if the underlying assets being acquired are worth substantially more than the purchase price.
Business acquisition loans, or change of control financing situations, can be extremely varied from case to case.
That being said, here are the major challenges you'll typically have to overcome to secure a small business acquisition loan.
The definition of goodwill is the sale price minus the resale or liquidation value of business assets after any debts owing on the assets are paid off. It represents the future profit the business is expected to generate beyond the current value of the assets.
Most lenders have no interest in financing goodwill.
This effectively increases the amount of the down payment required to complete the sale and/or the acquisition of some financing from the vendor in the form of a vendor loan.
Vendor support and Vendor loans are a very common elements in the sale of a small business.
If they are not initially present in the conditions of sale, you may want to ask the vendor if they would consider providing support and financing.
There are some excellent reasons why asking the question could be well worth your time.
In order to receive the maximum possible sale price, which likely involves some amount of goodwill, the vendor will agree to finance part of the sale by allowing the buyer to pay a portion of the sale price over a defined period of time within a structured payment schedule.
The vendor may also offer transition assistance for a period of time to make sure the transition period is seamless.
The combination of support and financing by the vendor creates a positive vested interest whereby it is in the vendor's best interest to help the buyer successfully transition all aspects of ownership and operations.
Failure to do so could result in the vendor not getting all the proceeds of sale in the future in the event the business were to suffer or fail under new ownership.
This is usually a very appealing aspect to potential lenders as the risk of loss due to transition is greatly reduced.
This speaks directly to the next financing challenge.
Business Transition Risk
Will the new owner be able to run the business as well as the previous owner? Will the customers still do business with the new owner? Did the previous owner possess a specific skill set that will be difficult to replicate or replace? Will the key employees remain with the company after the sale?
A lender must be confident that the business can successfully continue at no worse than the current level of performance. There usually needs to be a buffer built into the financial projections for changeover lags that can occur.
At the same time, many buyers will purchase a business because they believe there is substantial growth available which they think they can take advantage of.
The key is convincing the lender of the growth potential and your ability to achieve superior results.
Asset Sale Versus Share Sale
For tax purposes, many sellers want to sell the shares of their business.
However, by doing so, any outstanding and potential future liability related to the going concern business will fall at the feet of the buyer unless othewise indicated in the purchase and sale agreement.
Because potential business liability is a difficult thing to evaluate, there can be a higher perceived risk when considering a small business acquisition loan application related to a share purchase.
Is the business in a growing, mature, or declining market segment? How does the business fit into the competitive dynamics of the market and will a change in control strengthen or weaken its competitive position?
A lender needs to be confident that the business can be successful for at least the period the business acquisition loan will be outstanding.
This is important for two reasons. First, a sustained cash flow will obviously allow a smoother process of repayment. Second, a strong going concern business has a higher probability of resale.
If an unforeseen event causes the owner to no longer be able to carry on the business, the lender will have confidence that the business can still generate enough profit from resale to retire the outstanding debt.
Localized markets are much easier for a lender or investor to assess than a business selling to a broader geographic reach. Area based lenders may also have some working knowledge of the particular business and how prominent it is in the local market.
Personal Net Worth
Most business acquisition loans require the buyer to be able to invest at least a third of the total purchase price in cash with a remaining tangible net worth at least equal to the remaining value of the loan.
Statistics show that over leveraged companies are more prone to suffer financial duress and default on their business acquisition loan commitments.
The larger the amount of the business acquisition loan required, the more likely the probability of default.
A strong Business Plan may not guarantee success; but it could certainly prevent failure!
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