Because most loans and lines of credit are asset-based loans, knowing the lender’s guidelines is very important. The industry and market characteristics, the stage and health of the startup in terms of cash flow, debt coverage, and collateral are critical to the lender’s evaluation process. Naturally, startups have more difficulty borrowing money from banks than established businesses because they don’t have assets, track record of profitability and a positive cash flow. Banks that advance loans to startups usually do so for previously successful entrepreneurs of means or for firms backed by investors with whom banks have had prior relationships and whose judgment they trust. Although, startups managed by entrepreneurs with a track record and with significant equity in the business who can present a sound business plan can borrow more successfully, still with little equity or collateral to pledge, the startup won’t have much success with banks.
How good of a borrowing deal an entrepreneur can strike is also a function of relative bargaining position and the competitiveness among the alternatives. If the startup already has significant debt and has pledged its assets, there may be no room for negotiations. A bank with full collateral in hand for a company having cash flow problems is unlikely to give up such a position to enable the company to attract another lender, even though the collateral is more than enough to meet this guidelines. Further, the availability of bank financing for high-tech startups also depends on where a business is located. Debt and leases as well as equity capital can be more available to startup companies located in clusters of entrepreneurial and technological activity such as Ottawa, Toronto, London, Kitchener and Waterloo than for those that are located in the northern Ontario. In centers of high technology and venture capital the main officers of the major banks will have one or more high-tech lending officers who specialize in making loans to early-stage, high technology ventures. Through much experience, these bankers have come to understand the market and operating idiosyncrasies, problems, and opportunities of such ventures. They generally have close ties to venture capital firms and will refer entrepreneurs to such firms for possible equity financing. The venture capital firms in turn, will refer their portfolio ventures to the bankers for debt financing.
2. Loan Process
The process of obtaining a loan generally consists of the following stapes:
(1) The entrepreneur determines how much money is required, when it is required, and when it can be paid back.
(2) The entrepreneur identifies potential sources for the type of debt he is seeking, the amount, rate and terms and conditions of a loan.
(3) The entrepreneur selects a bank or other lending institution and prepares a written loan request.
(4) The bank evaluates the entrepreneur's loan request. (5) The bank documents the loan. (6) The entrepreneur receives the loan proceeds.
3. Before the Application
Once a startup is formed, the entrepreneur should look for a banker and bank with which he or she can establish a relationship. Choosing a bank and more specifically, a banker is one of the most important decisions an entrepreneur will make. A good lender relationship can sometimes mean the difference between the life and death of a business during difficult times. The choice of a bank and the development of a banking relationship should begin when the entrepreneur does not urgently need the money. When the entrepreneur faces a near-term financial crisis, the venture’s financial statements are at their worst and the banker has a good cause to wonder about entrepreneur’s financial and planning skills – all to the detriment of the entrepreneur’s chance of getting a loan. Because of the importance of a banking relationship, the entrepreneur should shop around before making a choice.
The first step the entrepreneur should take in finding a lender is to ask accountants, lawyers, friends and colleagues who have had dealings with a bank. The advice of entrepreneurs who have dealt with a bank through good and bad times can be especially useful. Once a list of names is compiled, an appointment should be scheduled with each of the prospects for the entrepreneur to get acquainted with them, and for the lenders to get acquainted with the entrepreneur. Second, the entrepreneur should meet with loan officers at several banks and explore their attitudes and approaches to their business borrowers. Who meets with the entrepreneur, for how long and with how many interruptions can be can be useful measures of a bank interest in the entrepreneur’s account. Finally, the entrepreneur shall ask business references from the bank’s list of borrowers and talk to the entrepreneurs of those firms. Through all of these contacts and discussions, the entrepreneur checks out particular loan officers as well as the viability of the bank itself; they are a major determinant of how the bank will deal with the entrepreneur in the future.
The entrepreneur should get to know the lending officer at each bank it evaluates for his business checking account. If the account is at a branch office, the lending officer will most likely be the branch manager. The entrepreneur should establish a relationship and get to know its lending officer. This person will generally be the entrepreneur's advocate before the credit committee in the bank making the lending decisions. The more the lending officer likes and has confidence in the entrepreneur, the better the entrepreneur’s chances of receiving financing. The criteria for selecting a bank should be based on more than just loan interest rates. The entrepreneur should also ensure its lending officer is experienced enough to provide it the advice the entrepreneur needs, and to structure financing in the most efficient way possible to meet the entrepreneur's needs. The entrepreneur's lender should be knowledgeable about the unique financing needs of a business in the entrepreneur's industry, give usable advice, and speak the entrepreneur's. Equally important are: (1) Experience – is commercial lending all he does, or does he have enough experience with bank products and services (deposits, letters of credit, lockbox arrangements) so that he is an all-purpose banker? (2) Rapport – does he make the entrepreneur feel comfortable or make the entrepreneur feel worthless? Visit with the lender, chat, find common values and bonds. Find a lender that one can trust their child or checkbook with. (3) Responsiveness – Does he respond to calls and messages in a reasonable time? Find a lender that will generally respond in 24 hours, whether he has the answer or not.
Once relationship is established, it is time to gain the respect of the lender. While relationship can be established quickly, respect comes much more slowly. The lender’s first concern will be whether the entrepreneur can pay back the loan. Accordingly, the lender will want to be convinced that the entrepreneur knows what he or she is doing. To do this, the entrepreneur should be prepared to provide a proven track record of sales and profits and/or a sound business plan projecting the same into the future. A business plan reflects the entrepreneur's commercial expertise and shows the lender that the entrepreneur has the right attitude and direction.
One of the significant changes in today’s lending environment is the centralized lending decision. Since the loan decisions are made increasingly by loan committees on credit scoring, the face-to-face part of the decision process has given way to deeper analysis of the company’s business plan, cash flow drivers and dissipaters, competitive environment, and the cushion for loan recovery given the firm’s game plan and financial structure. Thus, the entrepreneur cannot longer rely on his or her salesmanship and good relationship with loan officer alone to continue to get favorable lending decisions. The entrepreneur needs to be able to prepare the necessary analysis and documentation to convince the lending committee that the loan will be repaid. The entrepreneur also needs to compare the loan request with industry norms and to defend the analysis. Lenders usually like to see three years worth of proven sales and profits before considering a major loan to a startup. In the meantime, the entrepreneur can continue to seek the respect of its lender. The entrepreneur should schedule periodic visitations with the lending officer to review progress on the business plan (to show how right the startup was in its projections). At the same time, the entrepreneur can solicit financial advice from the lender, similar to having a periodic review by the business' own chief financial officer. A lender can be a source of good financial information just from having advised and worked with so many other businesses, some of which are in the entrepreneur's own industry. Further, the entrepreneur’s line of credit will probably be in the lending officer's lending authority. If so, the startup should apply for one and periodically use it, AND PAY IT DOWN. This will establish a history of creditworthiness with the lender.
4. The Application
When applying for a loan, the startup should first obtain a credit report on itself and be able to explain any discrepancies on the report. Further, it should be prepared to answer the following questions:
(1) How much money is needed?
(2) For what purpose?
(3) For how long?
(4) To be repaid how?
(5) To be repaid when?
(6) To be repaid by whom?
These are the basic terms of the loan. It will be the starting point of negotiations.
The entrepreneur should also be prepared to provide the following information:
- Business plan (including start up costs, if applicable);
- Current balance sheet;
- Current income statement;
- Current cash flow statement;
- Balance sheets for the last three years;
- Income statements for the last three years;
- Cash flow statements for the last three years;
- Tax returns for the last three years;
- Projected balance sheet;
- Projected income statement sheet;
- Projected cash flow statement;
- Three business references;
- List of assets and their values that can be provided for collateral; and
- All legal documents related to the business (registration papers, deeds, insurance papers)
The projected balance sheets, income statements, and cash flow statements should be projected out over the loan term, and should show the loan being gradually paid off. The assumptions underlying all figures on the projected financial data and the list of collateral assets should be current, believable, and, if possible, conservative. For added credibility, an accountant should prepare the financial data. Sales figures should be supported by believable marketing data. All information should be legible, neat and organized.
5. Credit Evaluation and Loan Approval
When a bank makes a loan it wants some reasonable assurance that it will be repaid. Accordingly, it gives great attention to those factors which, experience teaches it, provide some indication as to the entrepreneur's ability to do so. It will look first and foremost to the entrepreneur's capacity to repay. It will examine the startup's cash flow, the timing and probable success of repayment, payment history and alternate repayment sources. The lender will also look closely at how much of the entrepreneur's own equity he or she has put at risk in the business venture. As that risk increases, so does the likelihood that the entrepreneur will do everything possible to make sure that the venture succeeds and all its obligations, including the bank's loan, is paid in full. The bank will also examine and evaluate any collateral that may be available as security for, and an alternate source of repayment of, the loan. The collateral may be the assets of the business (or perhaps a related entity) or even the assets of one or more of the owners. In that connection, the bank may also consider and require personal guarantees of payment and performance from one or more of the owners and others. The bank will also want to consider the purpose of the loan and the purposes for which the entrepreneur intends to use the proceeds. Finally, the lender will evaluate the character of the entrepreneur. Can he or she be trusted to repay the loan as promised? Does the entrepreneur have a good reputation in its business among its competitors and customers? Does the entrepreneur have sufficient educational and/or business experience to effectively carry out the business plan? These factors provide the framework for understanding the lending process, at least from the viewpoint of the banker.
So how do these factors get into action as part of the loan application process?
Ability to Repay
Banks want assurances the loan can be repaid in a timely manner. Generally, they will look to at least two sources of repayment – the startup's cash flow and the collateral for the loan (including any guarantees). The analysis of the adequacy of cash flow focuses upon the business’ financial statements. These will prove particularly helpful in the instances where the company has a relatively healthy financial track record. Startups and marginally profitable ventures will need to prepare a loan package which addresses the questions the lender is likely to have about the ability to repay.
The lender takes into account the credibility and credit worthiness of startup and its management. Accordingly, the entrepreneur shall obtain personal and business credit reports. The report should be checked for accuracy of all information and, in particular, whether any errors may exist in the credit history (such as late payments, non-payments, loan delinquencies, etc.). The burden for reporting and obtaining corrections to any credit reports will fall on the entrepreneur. The elements of a credit report that could lead to difficulty in obtaining a loan include repeated late payments of credit, a credit or loan that was never paid, a judgment or bankruptcy within the last seven (7) years.
Banks want to see that the entrepreneur has assumed some of the risk in the success or failure of the business. Hence, they want to see an "equity cushion" (the amount of the "cushion" can vary but the loan applicant can expect to see a request of 20% to 40% of the principal loan amount). Equity generally comes in two forms: retained earnings and the cash from the owners and/or outside investors. The latter will often take the form of either outright equity (stock in the corporate entity, membership interests in the limited liability company, etc.), convertible debt (i.e. debt which may at some designated time or event be converted to equity) or subordinated debt.
Collateral is the second, and by far the least preferred, method of loan repayment. It is important to remember that for lending purposes, the value of the collateral is based not on fair or full market value but rather at a discounted value, taking into account the value that would bee lost if the item of collateral had to be liquidated to effect a loan repayment. The amount of the discount will vary widely depending upon the nature of the asset. Cash or cash-like assets (e.g. certificate of deposit) will be valued at or near 100% of its face value while items such as personal automobiles or perishable inventory will have little or no collateral value. Keeping the above factors in mind, the following document will be the most likely required from the entrepreneur:
Personal Financial Information
- Personal Financial Statements (generally on bank forms);
- Copies of Personal Tax Returns (including all schedules for 3 years);
- Source/Amount of Owner's Equity;
- Credit Report for and principals (with all exceptions explained);
- Resumes of Principals
- Business Plan;
- Description/History of the Borrower;
- Benefits from the loan;
- Organizational Documents (certificate of incorporation, by-laws, articles of organization, operating agreement, partnership agreement etc.);
- Credit Report for the Borrower (with all exceptions explained.);
- Three Year Cash Flow Projections;
- Three Year Projections of Profit and Loss;
- Balance Sheet and Profit & Loss Statement (last three fiscal years and most recent completed fiscal quarter);
- Copies of Business Income Tax Returns (for 3 years);
- Copies of any Existing Leases;
- Schedule of All Business Term Debt (Notes, Contract & Leases Payable);
- Aged Account Receivable/Accounts Payable.
6. Loan Documentation
Once the loan is approved, the entrepreneur should expect to be asked to sign a number of different documents. The language of such documents can be quite tedious. If the stakes are high, the startup should have a lawyer review such documents. The most common documents in a loan transaction are:
Provides the terms, conditions and promises governing the loan, as well as representations and warranties regarding the loan, collateral, the startup, and anything related to the loan, collateral and the startup. This document may be many pages, and may even be several volumes.
Evidences the actual debt under the loan.
Governs the granting of real estate to secure the loan, as well as conditions and promises governing the loan and mortgage, as well as representations and warranties regarding the loan, the mortgage, the real property described in the mortgage, the startup, and anything related to the loan, mortgage, the real property, and the startup.
Governs the granting to the lender of a security interest in personal property to secure the loan. It also describes conditions and promises governing the loan and security agreement, representations and warranties regarding the loan, the personal property assets, the startup, and anything related to the loan.
Personal Property Security Act (PPSA)
Is a financing statement that being properly documented and recorded with the appropriate agency where the debtor is located, provides creditors priority over other creditors in foreclosing on the personal property put up for security.
7. Building a Relationship with Banker
Further After obtaining a loan, the entrepreneur should cultivate a close working relationship with his or her banker. The entrepreneur should keep the banker informed about the business, thereby improving the chances of obtaining larger loans for expansion and cooperation from the bank in difficult times. In addition to monthly and annual financial statements, bankers should be sent product updates releases and any newspaper and magazine articles about the business. The entrepreneur should invite the banker to the business facility, review product and services development plans and the prospects for the business and establish a personal relationship with the banker. The entrepreneur should never surprise the banker with bad news and always make sure that the banker sees them coming as soon as the entrepreneur does. Unpleasant surprises are a sign that an entrepreneur is not being candid with the banker or does not have the business under proper control.
If the future loan payments cannot be met, the entrepreneur should not panic and avoid his or her banker. On the contrary, he or she should visit the banker and explain why the loan payments cannot be made and say when it will be made. If this is done before the payment due date and the entrepreneur-banker relationship is good, the banker may go along. What else can the banker do? If the entrepreneur can convince the banker of the viability and future growth of a business, the banker really does not want to call a loan and lose a customer to a competitor or due to a bankruptcy. The key to communicating with a banker is candidly to inform but not to scare. In other words, the entrepreneur must indicate that he is aware of adverse events and have a plan for dealing with them. To build credibility with the banker further, the entrepreneur should borrow before he needs to and then repay the loan. This will establish the track record of borrowing and reliable repayment. The entrepreneur should also make every effort to meet the financial targets he set for himself and have discussed with the banker. If this cannot be done, the credibility of the entrepreneur will erode, even if the business is growing.
8. Final Notes
(1) Borrow when you do not need it.
(2) Avoid personal guarantees. Put caps and time limits on the amounts based on performance milestones, such as achieving certain cash flow, working capital, and equity levels. Also, don’t be afraid to offer your guarantee and then negotiate ways to get back in whole or in part.
(3) The devil is in details. Read each loan covenant and requirement carefully to appreciate their consequences.
(4) Try to avoid or modify so-called hair-trigger covenants, such as – if there is any change or event of any kind that can have any material adverse effect on the future of the company, the loan shall become due and payable.
(5) Be conservative and prudent