Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
Definition or Explanation: Term loans are the basic vanilla commercial loan. They typically carry fixed interest rates, and monthly or quarterly repayment schedules and include a set maturity date. Bankers tend to classify term loans into two categories:
- Intermediate-term loans: Usually running less than three years, these loans are generally repaid in monthly installments (sometimes with balloon payments) from a business's cash flow. According to the American Bankers Association, repayment is often tied directly to the useful life of the asset being financed.
- Long-term loans: These loans are commonly set for more than three years. Most are between three and 10 years, and some run for as long as 20 years. Long-term loans are collateralized by a business's assets and typically require quarterly or monthly payments derived from profits or cash flow. These loans usually carry wording that limits the amount of additional financial commitments the business may take on (including other debts but also dividends or principals' salaries), and they sometimes require that a certain amount of profit be set-aside to repay the loan.
Appropriate For: Established small businesses that can leverage sound financial statements and substantial down payments to minimize monthly payments and total loan costs. Repayment is typically linked in some way to the item financed. Term loans require collateral and a relatively rigorous approval process but can help reduce risk by minimizing costs. Before deciding to finance equipment, borrowers should be sure they can they make full use of ownership-related benefits, such as depreciation, and should compare the cost with that leasing.
Supply: Abundant but highly differentiated. The degree of financial strength required to receive loan approval can vary tremendously from bank to bank, depending on the level of risk the bank is willing to take on.
Best Use: Construction; major capital improvements; large capital investments, such as machinery; working capital; purchases of existing businesses.
Cost: Inexpensive if the borrower can pass the financial litmus tests. Rates vary, making it worthwhile to shop, but generally run around 2.5 points over prime for loans of less than seven years and 3.0 points over prime for longer loans. Fees totaling up to 1 percent are common (though this varies greatly, too), with higher fees on construction loans.
Ease of Acquisition: Challenging but sometimes a moderate challenge when smaller amounts are involved. However, for loans more than $100,000 (sometimes up to $200,000), you need a complete set of financial statements and must undergo a complete financial analysis by the lending institution.
Range of Funds Typically Available: $25,000 and greater.
What do banks look for when making decisions about term loans? Well, the "five C's" continue to be of utmost importance.
- Character: How have you managed other loans (business and personal)? What is your business experience? "If a corporate executive wants to open a restaurant, then he'd better have restaurant experience," says Rob Fazzini, senior vice president at Busey Bank in Illinois.
- Credit capacity: The bank will conduct a full credit analysis, including a detailed review of financial statements and personal finances to assess your ability to repay.
- Collateral: This is the primary source of repayment. Expect the bank to want this source to be larger than the amount you're borrowing.
- Capital: What assets do you own that can be quickly turned into cash if necessary? The bank wants to know what you own outside of the business-bonds, stocks, apartment buildings-that might be an alternate repayment source. If there is a loss, your assets are tapped first, not the bank's. Or, as one astute businessman puts it, "Banks like to lend to people who already have money." You will most likely have to add a personal guarantee to all of that, too.
- Comfort/confidence with the business plan: How accurate are the revenue and expense projections? Expect the bank to make a detailed judgment. What is the condition of the economy and the industry: "Are you selling buggy whips or computers?" Fazzini asks.
Use the following guidelines when selecting a business bank:
- Ask friends where they bank and if they are satisfied.
- Forge a relationship with a bank long before you will need a loan. You'll find out how they treat you. Get to know some folks at the bank on a first-name basis. Start building a relationship. Believe it or not, banks want to talk to you even if they cannot lend you money.
- Scan your newspaper for evidence of who is making the kinds of loans you are seeking. Not all banks can be the best at everything. Some are better at business loans; some are better with consumer deals.
- Visit two to four banks to find your fit. Be upfront; tell them you are considering a loan and that you are talking with other banks. Then listen to their pitch.
- Think about working through the SBA or other economic-development groups to secure better terms. They are not only for businesses that cannot get funding any other way.
Excerpted from Financing Your Small Business.