may believe, naively, that the process is similar to that of commercial
loans. Personal loans—for cars, home mortgages, and
so on—tend to be handled on a routine basis using personal
details such as age and income. Either the loan request meets
certain criteria or it doesn’t. Commercial loans, in contrast, are
far more varied and complex than personal loans, and thus
call for a very different kind of review process.
Few business owners understand the true nature of lending,
and why bankers must be so careful in where they put their
funds. Consider the following example. A bank, which relies on
depositors as its primary source of funds, provides a one-year
loan to an entrepreneur at a net interest margin (the difference
between the interest rate on the loan and the cost of funds for
the bank) of 4 percent. The entrepreneur then defaults, and the
entire principal is lost. To recover the lost principal, the bank
must now earn the full 4 percent margin on 25 new loans of
similar maturity and size. In other words, for every $1,000 it
loses the bank needs $25,000 ($1,000/.04) of good loans just to
break even. And this assumes a margin of 4 percent, which is
higher than what many banks can realistically expect. At lower
margins, the need for good loans to cover the bad ones is even
more acute. This shows why bankers are reluctant to invest in
high-risk ventures, a designation that pertains to most start-up
and high-growth companies, and why they like collateral. Still,
bank loans are available for such businesses.
In making their lending decisions, bankers often rely on
checklists. One popular example is known as the 4 Cs:
- Character of the borrower (reputation and honesty).
- Capacity to repay (based on know-how and experience).
- Conditions (such as industry economics, products, technologies,etc.).
- Collateral (access to assets that can be sold off in the eventof a default).
Many banks use more complex checklists, and for larger
loans, credit scoring models. A typical model converts a set of
financial indicators, such as key financial statement ratios, into
a score that measures the likelihood of a customer defaulting
on the loan. Potential customers who score above a specified
level are considered good risks.
When a bank does take a gamble and the start-up venture
succeeds, the payoff for the bank, in the form of interest on future
loans and fees for a variety of services, can be huge. And
there is plenty of anecdotal evidence to show that successful
entrepreneurs tend to be loyal to the bankers who stuck by
them when they were starting out.
Although practices differ from bank to bank, and from
country to country, most professionals in the sector are in
broad agreement as to what an entrepreneur can do to improve
the odds of getting a loan. Personal impressions are important.
The business owner needs to impress the loan officer
from the first meeting. The aim should be to project an air of
confident professionalism. Dress conversatively, show up on
time, present a comprehensive business plan with credible financial
projections, emphasize any relevant experience and
management skills, and provide whatever documentary evidence
is available to support the case for financing. Some cultures,
particularly in Asia, place enormous emphasis on
face-to-face contacts, but they are important in Western countries, too.
The business owner should be explicit as to how large a
loan is needed, how the funds will be used, why debt is the
right way to finance the firm’s growth, how and when the loan
will be repaid, and why this particular business is a good credit
risk. Bankers like clarity, and the easier it is for the banker to
understand the business, the greater the chances that the lending
decision will be favorable. They value sound business judgment
and evidence that proper financial controls are in place.
Bankers also like to do business with entrepreneurs who have
a strong strategic vision for their companies and a solid grasp
of industry trends.
In addition, the entrepreneur must be prepared to answer
in a forthright fashion when the banker starts questioning key
assumptions behind the numbers in the business plan. This
means that the entrepreneur should be financially literate,
which implies that he or she has at least a basic understanding
of finance and can speak the language of banking. Finally, the
entrepreneur must be flexible and adaptable. Rarely is the financing
proposal accepted right away. The process is likely to
be an iterative one, with the banker suggesting changes, usually
designed to reduce risk to the banker, and the entrepreneur
then coming back with a counterproposal.
One potentially contentious area for negotiation is the
personal guarantee. Although loans can be backed with assets,
the bank is unlikely to be able to recover the full
amount due in case of a corporate bankruptcy. A personal
guarantee, in which the entrepreneur promises to make up
any shortfalls, may be required by a banker before funds will
be lent for a start-up. Naturally, entrepreneurs are reluctant
to do this, because it defeats the purpose behind having a
limited liability company. But bankers will sometimes insist
on it, especially for high-risk ventures. Of course, for more
stable or mature businesses, bankers tend to be more lenient
on this issue.
When loan requests are turned down, it is nearly always
because of one or more of the following reasons: lack of credibility
in the revenue and profit forecasts (often caused by insufficient
documentation), insufficient experience in the
business, cash flow forecasts that raise doubts about the ability
to repay the loan, lack of sufficient collateral, poor communication
skills on the part of the entrepreneur, key
information missing from the loan proposal, and expense
forecasts thought to be unrealistically low. Also, bankers tend
to resent business owners who try to play one banker against
another. If multiple lending sources are sought out, diplomacy
and tact are required.
If a loan is granted, one area for a business owner to pay
special attention to, especially in a small, growing business, is
the management of customer accounts. Bankers resent borrowers
who come back asking for more cash when there is evidence
that the company has become sloppy in the collection
of receivables. Not only is this bad business practice, but it can
be taken by the banker as a sign of poor financial controls that
might extend to other parts of the business.
In the subsections that follow, we explore the most common
loan products available. Understanding the alternatives is
an important first step to securing loans at attractive terms, in
part because of the tendency for bankers to specialize. For example,
some lenders specialize in revolving lines of credit,
while avoiding long-term, fixed-rate real estate loans. Other
banks specialize in term loans, which means that borrowers
seeking lines of credit are well advised to go elsewhere. Once
managers have identified their company’s financing needs, they
can then go about matching those needs with the lending institution
best able to meet them.
Most commercial loans are designed to assist borrowers in
financing working capital needs (i.e., accounts receivable and
inventory), or in making plant and equipment purchases. As
common sense would suggest, this type of loan tends to be
short-term in nature (because the sale of inventory and the collection
of receivables should provide the borrower with the
cash to pay off the loan). Purchases of long-term assets require
longer finance periods (because it may take years for the asset
to generate sufficient cash flows), and therefore tend to be financed
over longer periods.
Read More : Seeking a Bank Loan
