Navigating the Business Loan

Guidelines for Financiers, Small-Business Owners, and Entrepreneurs

Morton Glantz

• Publisher: Academic Press
• Year: 2014
• ISBN:
  9780128018064
• Topic: Business
• Subtopic: Finanza d'impresa
• Index: Business

The need for "back to basics" information about credit risk has not disappeared; in fact, it has grown among lenders and investors who have no easy ways to learn about their clients. This short and readable book guides readers through core risk/performance issues. Readers learn the ways and means of running more efficient businesses, review bank and investor requirements as they evaluate funding requests, gain knowledge selling themselves, confidence in business plans, and their ability to make good on loans. They can download powerful tools such as banker's cash flow models and forecast equations programmable into a cell or tablet. Readers can punch keys to ascertain financial needs, calculate sales growth rates calling for external financing, profits required to internally finance their firms, and ways to position revenue growth rates in equilibrium with their firm's capital structure – a rock-solid selling point among smart lenders and investors.

The book's "how-to, " practical and systematical guide to credit and risk analysis draws upon case studies and online tools, such as videos, spreadsheets, and slides in providing a concise risk/return methodology.

• Introduces ways to define and manage risk
• Uses case studies and online tools to extend and apply credit analysis and business management tools
• Surveys "hard" and "soft" data and ways they help lenders, other financiers, small-business owners, and entrepreneurs spot potential problems, write optimal business plans, and deliver effective loan or /investor geared presentations

Chapter 1

Business Structures and Funding Sources^*

Abstract

While traditionally small firms have established relationships with commercial banks, the era of easy credit is over. With many large banks now partially owned by the government, and with toxic loans still on the books, you may discover that banks are not as friendly to small business as they once were. So what do you do if you need capital for your business right now? The good news is that there are still options out there; banks are not the only shops in town. You may need to look in new places and be creative to find low-cost money to start or expand your business. Just one caveat – to get the most bang for the buck, you must be exceptionally prepared as you talk over financing requirements. This book should help you open a few doors.

Keywords

business structures financing sources

community banks, SBA documentations

Outline

SHORT REVIEW OF BUSINESS STRUCTURES 2

SELECTING A FINANCING SOURCE 8

WHAT TO CONSIDER BEFORE YOU APPLY 14

Review Credit Reports 14

Prepare a SWOT Matrix 15

Check for Red Flags 16

DOCUMENTATION GENERALLY REQUIRED FOR A SMALL BUSINESS LOAN APPLICATION 18

While traditionally small firms have established relationships with commercial banks, the era of easy credit is over. With many large banks now partially owned by the government, and with toxic loans still on the books, you may discover that banks are not as friendly to small business as they once were. So what do you do if you need capital for your business right now? The good news is that there are still options out there; banks are not the only shops in town. You may need to look in new places and be creative to find low-cost money to start or expand your business. Just one caveat – to get the most bang for the buck, you must be exceptionally prepared as you talk over financing requirements. This book should help you open a few doors.

While it is true that the era of easy credit for small businesses is past, viable businesses that qualify for credit can take advantage of historically low interest rates and an increasingly robust lending environment. If you are prepared to argue your business’s merits with confidence, if you understand the inner workings of lenders’ operations, if you are hands-on in meeting lenders’ requirements, and if you can perform the due diligence processes offered in this book, bank and other cheap credit sources can be yours.

So how can you take advantage of emerging ease of access to credit, which will allow you not only to finance your business with cheap funds but also to build a sustainable relationship with your lender? First, you will need to understand the inner workings of credit risk due diligence as it applies to your business, which is clarified in this book. Follow up by initiating communications. Your attorneys and accountants can help facilitate this, perhaps during a business lunch. If you are not yet a customer, convince potential lenders to set up a solicitation folder that will hold records of on-site calls, business discussions, and financial figures.

Remember, bankers have high loan approval criteria; their standards fall within the institution’s credit policy and procedure guidelines. Today, the name of the game is adequate client information, sophisticated analytic tools, banker-styled cash flows, business and equity valuations, computer risk modeling, simulation analytics, stochastic optimization, and interactive credit risk ratings. Why now and not before? Because the debt crisis showed lenders insisting on “know thy customer” that due diligence spelled the difference between successful, survivable banking and chaotic, lax infrastructures that contributed to the demise of many once-proud financial institutions. Narrowly focused and ill-informed banking primed to attract loan volume at the expense of quality is a thing of the past.

In this chapter, we will review common small-business structures and lending sources, go over the steps you should take before arranging a loan interview, and list the documentation required to apply for a small-business loan.

Short review of business structures

Here are some questions lenders ask when they evaluate a small business’s prospects for success. Keep these questions in mind as we review common small-business types and their associated risks.

• Are opportunities sought in the marketplace viable for future growth?

• Is the company’s structure feasible, given the direction and resources available?

• Does the company operate with a well-defined, feasible business plan?

• Can the company eventually compete in global markets?

• How good are the leadership qualities of people running the operation?

• What phase of the business cycle is the company in?

• Which loan product would be optimal?

Family-owned, small, and entrepreneurial businesses in general: Family-controlled businesses typically represent a market segment in which financial service needs are great. Small- to middle-market businesses provide bankers with opportunities to offer advice on expansion, estate planning, financial asset management, and consulting. These opportunities can result not only in maintaining operating accounts for the business, but also in opening personal accounts for family members. This arrangement improves the bank’s operating balances for the current period, as well as the present value of all future balances.

Often, family businesses are passed down from one generation to the next. In the past, leadership roles automatically devolved to the eldest son. Now, management control tends to be more widely distributed and business owners generally are willing to seek help in making these choices. Still, sometimes family businesses lack definitive direction due to ill-prepared succession management and difficulties resulting from family members working together. These situations may lead family-run businesses to be unaware of the early stages of financial difficulties, or to ignore financial distress signals. Often management is unable to cope with a crisis because ownership is not separate from management; there might be no perceived fiduciary duty if management is not separated from ownership. In some cases, owner-managers inherit the wealth, but not the skills and talents of prior management. Sometimes management fails to properly train the heir-apparent. For example, the CEO may have far too many expectations of his or her successor, yet resist training the successor or bringing in competent management from outside the company.

Typical small-to-middle-market, family-run businesses are also more prone to financial crises than other types of firms, particularly during transitional phases between generations. Small businesses may have neither the assets nor the infrastructure to withstand recessions and other unforeseen economic disruptions. Without the manpower and expertise of larger companies, they are more susceptible to failure. Here are some warning signals that indicate that all is not well in a small business:

• A decline in operating margins and/or a loss of working capital. These problems, if not addressed, could turn a short-term cash shortfall into a severe liquidity crisis.

• Overly optimistic sales forecasts. Small businesses may attempt to project good results in an effort to hide financial distress signals.

• Failure to keep pace with changing trends, including customer preferences, new technologies, government regulations, and stiffer competition as the industry matures.

• Inability to submit financial statements in a timely manner. Typically the accountant’s opinion letter should not be dated more than 90 days past the fiscal year-end.

• Process slowdowns attributable to failing equipment as management elects to forego costs involved with maintaining existing equipment and/or replacing obsolete equipment. Most severe financial problems in family-run businesses occur within a year of starting operations.

• As the burden on cash flow is increased, the company may try to increase sales through any means possible. These attempts might include price-cutting and deal-making. Sales may be made to customers with poor credit ratings, which will result in collecting problems. As assets become tied up in outstanding receivables, additional strain is placed on cash flow. As a result, the firm might not be able to meet its short-term needs, so trade debt will build up while the company can still get credit.

While small-business owners are risk-takers, they are nevertheless also innovative and creative visionaries attempting to build long-term value, to identify opportunities, and to capitalize on change. Truly exceptional accomplishments in business are the product of small ideas molded by entrepreneurial perspective. Small businesses should not be viewed as short-term propositions, but as serious long-term prospects. Successful pioneers such as Sam Walton, Steven Jobs, and Ray Kroc were all entrepreneurs who harnessed small ideas and converted them into large, profitable corporations.

Sole proprietorship: Sole proprietorships are the simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and the owner. As the owner, you are entitled to all profits and are responsible for all your business’s debts, losses, and liabilities. You do not have to take any formal action to form a sole proprietorship. As long as you are the only owner, this status automatically comes from your business activities. In fact, you may already own one without knowing it. If you are a freelance writer, for example, you are a sole proprietor. But like all businesses, you need to obtain the necessary licenses and permits. Because you and your business are one and the same, the business itself is not taxed separately. Keep in mind the downsides of sole proprietorship (your lender will!):

1. Unlimited personal liability: Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions.

2. Difficulty raising money: Because you can’t sell stock in the business, there is little opportunity for investment. Banks are also hesitant to lend to a sole proprietorship because of a perceived lack of repayment options if the business fails.

3. Pressure: The flip side of complete control is the heavy burden and pressure it can impose. You alone are ultimately responsible for the successes and failures of your business.

Partnership: A partnership is a single business in which two or more people share ownership. Each partner contributes to all aspects of the business, including money, property, labor, or skill. In return, each partner shares the profits and losses of the business. Because partnerships entail more than one person in the decision-making process, your lender will want to review the partnership agreement. The agreement should document how future business decisions will be made, including how the partners will divide profits, resolve disputes, change ownership (bring in new partners or buy out current partners), and dissolve the partnership.

There are three general types of partnership arrangements. General partnerships assume that profits, liability, and management duties are divided equally among partners. If you opt for an unequal distribution, the percentages assigned to each partner must be documented in the partnership agreement. Limited partnerships give partners limited liability as well as limited input with regard to management decisions. These limits depend on the extent of each partner’s investment percentage. Limited partnerships are attractive to investors in short-term projects. Joint ventures act like general partnerships, but exist for only a limited time period or for a single project. Partners in a joint venture can be recognized to be in an ongoing partnership if they continue the venture, but they must file as such.

Be wary of partnership’s possible pitfalls. Like sole proprietorships, partnerships retain full, shared liability among the owners. Partners are not only liable for their own actions but also for the business debts and decisions made by other partners. In addition, the personal assets of all partners can be used to satisfy the partnership’s debt. With multiple partners, disagreements are bound to happen. Partners should consult each other on all decisions, make compromises, and resolve disputes as amicably as possible. Unequal contributions of time, effort, or resources can cause discord among partners.

Sub S corporations: Probably the most notable difference between an S corporation and a regular C corporation is that the S corporation is generally not subject to federal income tax. Its net taxable income is reported by the stockholders of the S corporation on a pro rata basis, and added to their other income or losses on their personal federal income tax returns. Some of the disadvantages of S corporations are that they cannot deduct expenses unless or until actually paid to stockholders, and they are limited in their ability to deduct certain fringe benefits of shareholde...