The Burden of Borrowing

Like many growing companies, Safe Handling Inc., a transportation and warehouse services business in Auburn, Maine, has relied on a range of credit during its 12-year history: funding for equipment purchases, working capital loans and term debt, often from multiple lenders. While meeting each creditor's reporting obligations is time-consuming, the bigger concern is how these collateral issues could jeopardize future funding for the $5 million-plus company. It has even paid off loan balances rather than allow a lender's requirements to stifle growth. "We are mindful of the alternative of paying off a lender to maintain simplicity for growth," says CFO Bill Howell. "We need to be positioned for future borrowings to fund growth, and we can't do that with onerous collateralization requirements."

Often, the indirect costs of borrowing, such as burdensome collateral conditions, have more impact on a growing business than the loan itself. A bank may require the borrower to keep a certain percentage of the outstanding loan balance in an account, for example, or charge a penalty if any of the loan principal is prepaid. Even firms with straightforward financing needs should bear in mind that a variety of factors determine the cost of a loan, not just interest rates and fees a lender charges for reviewing and preparing documents.

While bank competition has given entrepreneurs increased bargaining power over interest rates, many indirect loan costs are non-negotiable, including the expense of updating a business plan, paying an accountant or lawyer to meet pre-closing requirements, and providing a lender with ongoing financial reports.

Choosing the wrong creditor is also costly, particularly a lender that pulls credit during problem periods. And while a company may have a loan amortized over a longer period of time for lower monthly payments, the bank may renegotiate interest rates and terms based on the company's performance and other conditions.

Taking Off the Blinders
For those reasons, experts advise entrepreneurs to not only read the fine print of a loan agreement, but also consider how it will affect your company's growth. "It's really the peripheral costs in terms of what that loan takes out of you and how you're able to manage it that are important," says Suzanne Caplan, a business consultant with PGM Group LLC. "I would not go to three different banks and blithely choose the one that gave me a quarter point less. I would look at all services and whether they're going to grow with me."

Companies such as Safe Handling, Caplan notes, are wise to assess the long-term consequences of a collateral decision, which can come back to haunt a business in need of further financing. "If you've secured a loan with receivables, and your receivables grow from $300,000 to $500,000, you're prevented from using that as collateral anymore because it's secured," explains the Pittsburgh advisor. "It's a matter of 'What does this mean to me now, what does this mean to me three years from now, and am I going to need this collateral back?'"

Meanwhile, focusing too heavily on the direct costs of a loan, such as interest rates, may also lead entrepreneurs to ignore the legal and accounting burdens of obtaining credit. Along with hiring an accountant to prepare documents, you may also need an attorney to assist with real estate deals, Caplan says.

The lender's scrutiny won't end with credit approval. It will monitor performance, with some creditors going so far as requiring borrowers to maintain financial ratios related to debt coverage and working capital. Larger banks, not community-based creditors, most often use those formulas. "We're going to look at the financial ratios," says William Gossett, president and CEO of Islands Community Bank N.A. in Beaufort, South Carolina, "but it's not formalized on the smaller loans in which you have a borrowing agreement that has [required ratios] in it."

In some cases, a loan is reviewed out of state, making it less likely the lender will waive conditions and be as patient as a local lender. "If your portfolio is reviewed in another state, and they see that [the financial ratios] are off, they may call the loan," explains Caplan. "Sometimes, it may have little to do with what is happening in your business, but whether your folder is complete or financials come in late."

In such situations, the best defense is a good offense: Companies should advise a lender early about any anticipated capital needs and deliver bad news swiftly, along with a viable action plan, says Safe Handling CFO Bill Howell. "The more proactive you are, the more forgiving [lenders will] be if you hit an occasional short-term critical need."

Increasing Costs
No matter the nature of the loan, the cost of credit is rising. Collateral requirements are greater in response to tightened underwriting standards, says Keith Leggett, senior economist for the American Bankers Association, "and there probably has been movement toward lower limits, [such as] loan-to-value limits, which does imply a cost because borrowers are having to put up more of their own equity."

Adding to the cost is the requirement that companies obtain business interruption insurance as a condition of financing. "9/11 changed the landscape," Leggett says. "Businesses that were not actually by the World Trade Center, but were down below Canal Street, you couldn't get to them, and you had that interruption. Without insurance, it's going to make credit much more expensive."

The cost also depends on how badly a bank wants to do business. Deposit levels and whether the company will use other products, such as investment services, contribute to loan pricing. "Most banks have formulas where they try to factor in what the relationship is going to mean to the bank," says Edwin Clift, president and CEO of Merrill Merchants Bank in Bangor, Maine. "You try to factor that into your pricing formula." In terms of direct costs, most banks charge an origination fee, often 1 to 2 percent of the loan amount.

Borrowers also fund legal services obtained during underwriting. For a loan secured by inventory receivables, for instance, the bank hires an attorney to ensure it has a valid security interest in the collateral, which typically costs a few hundred dollars, he says. "Getting into real estate transactions, it may run more than that," Clift adds. "If it's a straight real estate transaction on the building that is going to secure the loan, you are probably looking at legal and documentation fees, depending on the loan amount, of a couple thousand dollars. And you'll have an appraisal fee of $1,000 to $1,500, depending on the part of the country you're in."

Ultimately, a company should use its financial stability as leverage for negotiating other things, such as collateral requirements, prepayment penalties, interest rates and ratio covenants, says Howell. "The more profitable and financially strong a company," he says, "the more there is the ability to negotiate."

Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.