Seeking a Bank Loan

Most entrepreneurs have experience with personal loans, and
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

Bank Loans

The profound changes that have occurred in the financial services
industry over the past half century are nowhere more evident
than in banking. Given that banks are typically the first
financial institution growing businesses turn to for capital, we
now consider the structural changes that have occurred in the
banking sector, and what all this means for entrepreneurs who
seek debt finance. Any business owner seeking to access the
capital available from the global banking system should have
at least a basic understanding of these changes and how they
have shaped today’s financial services industry.


The most important reality for traditional banking over
the last generation has been its decline in both size and profitability.
At the core of traditional banking’s problems have
been declines in its cost advantages in acquiring funds (the liability
side of the business), while at the same time losing
some of its income advantages (the asset side). The result has
been an effort by banks to leave, or at least curtail, the traditional
business of deposit taking and conventional lending,
while engaging in a range of new and potentially more profitable
activities. One problem with these activities, however,
is that they are often riskier than more traditional banking
functions, as evidenced by the large number of banks that
have failed in recent years or that had to be taken over by
more profitable rivals.

One important contributing factor to the declining profits
of traditional banking in the United States was the effect of
rules that prohibited banks from paying interest on checking
accounts. These rules worked to the advantage of banks, at
least until the 1960s, because their major source of funds was
checkable deposits. Given that the cost of these funds was
zero, banks had a very low cost of capital. Although savings
accounts did pay interest, the rate was capped at little more
than 5 percent. But the good times for bankers didn’t last.

Rising inflation in the late 1960s and early 1970s led savvy
investors to seek more attractive alternatives. By the late 1970s,
money market mutual funds began to appear. These funds offered
checking accounts but were structured in a way that allowed
them to circumvent the restrictions on paying interest. As
a result, millions of people took their money out of banks and
put it into these higher-yielding investments. Today, checkable
deposits account for less than 20 percent of bank liabilities; as

recently as the 1960s, such deposits accounted for more than 60
percent of the total. The regulatory structure of the banking industry
gradually caught up with these realities with a series of
rules changes, starting in 1980, overturning the interest-rate
ceilings. But by then the damage to the competitiveness of banks
had already been done.

Just as banks were suffering on the cost side, they lost
their advantages on the income side, too. Traditionally, businesses
relied mainly on bank loans for new debt capital, offering
bankers an effective monopoly on the provision of debt
finance, apart from the largest, most creditworthy firms that
could access the bond markets. But within the past 25 years,
the banking industry has been badly hit by a seemingly
nonending stream of financial innovations, including junk
bonds, securitization, and the market for commercial paper.

Perhaps the most important effect of this development is that
traditional commercial banking lost the advantage it once enjoyed
in the commercial lending business (and the higher returns
that came with that advantage), while businesses of all
sizes now have more avenues available to them for raising
debt capital.

These changes have not been limited to the United States.
Similar effects have been observed in Canada, in Europe, and
in some Asian countries. The impact of these changes on the
banking industry is much as one would expect: A growing
number of bank failures and extensive consolidation of the
sector through mergers and acquisitions. But bankers have responded
in other ways, too. For example, some have tried to
maintain their commercial lending businesses by expanding
into new and riskier areas of lending such as commercial real
estate and leveraged buyouts. Another response has been to fo-

cus on off-balance-sheet services and various forms of financial
innovation, including those mentioned earlier, that offer
the prospect of higher margins than are found in traditional
banking. As a result of these changes, banks today bear only a
superficial resemblance to banks of the 1960s.

Off-balance-sheet activities involve the trading of financial
instruments and the generation of income from fees and loan
sales, activities that affect profits but do not appear on bank
balance sheets. As the term loan sale implies, the bank sells all
or part of the cash stream from a specific loan, thereby removing
the loan from the balance sheet. The profit comes from
selling the loans for amounts slightly greater than those of the
original loans. But the interest rates on these loans are still
high enough to be attractive for investors, mainly large institutions
such as pension and mutual funds. Fee income is generated
by providing banker’s acceptances (in which the bank
promises to make debt payments if the party issuing the security
cannot), making foreign exchange trades on behalf of customers,
and a range of other activities.

Financial innovation has been the catalyst behind many of
the changes observed since the 1970s in the financial services
industry. Some of these innovations have become so integral
to the industry, it is hard to imagine a modern financial sector
without them. Innovations take on many forms, but they have
always been driven by the never-ending desire of banks and
other major players in the capital markets to improve their
competitive positions. Changes in the economic environment,
combined with regulatory changes and advances in information
technology, have helped to create these opportunities.

Automatic teller machines and home banking via the Internet
are just two examples among many. So, too, are the futures,

swaps, and options contracts that allow corporate clients
to better manage currency, price, and interest-rate risks.

To banks, one of the key attractions is that these riskmanagement
tools have become important sources of fee income
and commissions, as well as allowing banks to manage
their own business risks.

Another important innovation has been the development
of “securitization,” in which a wide range of assets—such as
mortgages, credit card loans, accounts receivable, automobile
loans, and computer leases—are converted into marketable securities.

The process works like this: A bank combines loans in
pools with similar features, and sells certificates that are secured
by the interest and principal payments on the original
assets. This arrangement offers several advantages to bankers.

First, the activity is profitable, with banks collecting fees from
the securitization process. In addition, as long as the bank sells
the certificates without recourse (which means that they have
no liability on loans in the pool that go bad), they are not required
to allocate loan-loss reserves.

A further advantage of securitization is that it frees up
funds for further loans (and more profits). Just about any type
of loan can be securitized as long as the candidates for the loan
pool are similar regarding size, collateral, pricing, and maturity.

Also, they must show reasonably predictable losses over
time. Commercial loans are one type of loan that normally do
not fit these criteria, because they tend to be negotiated on a
contract-by-contract basis and exhibit substantially different
characteristics. For this reason, commercial loans are not good
candidates for securitization. More specialized lending, such as
car loans and credit card receivables, are more standardized
than commercial loans and have been successfully securitized.

Nevertheless, growing businesses do benefit from securitization
because of its effect on capital requirements.

Capital requirements exist to protect deposit insurance
funds in case a bank fails. If a bank should fail, regulators,
such as the Federal Deposit Insurance Corporation (FDIC) in
the United States, can either pay off depositors or arrange for
another financial institution to buy the failed bank. Minimum
capital requirements provide a cushion that can lower the cost
of either alternative. But these requirements constrain growth
and thus limit the ability of banks to take on risks that might
lead to failure. One effect of off-balance-sheet lending is that
because the loans disappear from the balance sheet, the capital
that would otherwise be required for regulatory purposes is
freed for other uses, including additional loans. This is the major
benefit of securitization to growing businesses that seek
debt capital from banks.
Read More: Bank Loans