Negotiating Private Lender Credit Terms

Working with commercial banks for loans is essentially a one-way settlement process. The bank offers certain terms as to the interest rate; an assortment of upfront fees; the term, principal and interest repayment formats and due dates; collateralization; and other closing costs associated with screening and obtaining the credit. Entrepreneurs are put in a position where much of the interaction with the banker is not so much negotiations, but the lending institution requesting various types of documentation from the business owner in order to proceed with the deal, with the prospect being that the terms might improve somewhat if certain borrower profile requirements can be met. In the end, the final loan package generally represents the lender's terms more so than the borrower's unique requests regarding the funding structure.

Working with private lenders, however, should definitely be much more of a two-way settlement process. Too often, though, entrepreneurs assume the creditor's offer of terms is as rigid as that of the commercial banker's, and companies can end up with a final loan package that overly favors the lender's requirements, rather than the borrower's unique requests.

There are two basic rules for raising debt-funding from private sources. First, know exactly what terms the firm can handle prior to entering into a dialogue with a lender. And second, negotiate everything associated with establishing the final terms for the proposed loan package.

With regard to the first rule, entrepreneurs should develop their "dream" loan program and put everything down on paper that they would like to see in the final deal. This requires some front-end work, but it is well worth the effort to head into the funding negotiations well-informed of the range of possible terms and very clear on exactly what fits the business and what does not. As a business owner, you should define a clear "uses of funds" schedule on how the loan proceeds will be allocated in the firm. You should also examine various scenarios of how to pay for fees, how much the business can afford to budget each month or quarter for principal reduction and interest, and flexibility on accessing funds when market opportunities surface.

When it comes time to negotiate everything, business owners are in a much better position dealing with a private lender than with a commercial or community bank. Many private creditors ask for significant concessions from the borrowing firm and can present these in a manner that makes them appear to be set in stone. All lenders-whether commercial or private-want to minimize risk exposure, but the entrepreneur should see this as an opportunity to make a presentation that demonstrates the numerous reasons why this loan will not be at great risk. In developing the "dream" set of terms, the entrepreneur can establish solid financial support for the loan, terms that fit easily into the company's periodic cash flow and assessment measures that accurately reflect the growth prospects that the loan can support.

If a private lender proposes allocating funds for the business in three tranches, with only interest due the first two years, but then the total principal accessed rolled into a new fully amortized loan at a higher interest rate in year three, the entrepreneur can counter with funding parameters that have already been closely examined to be a great fit with the firm's cash flow and investment opportunities. When a lender wants collateral, the business owner can counter with a staged collateral schedule or a flexible rolling retirement of assets pledged as principal and interest are paid, and the company hits predetermined performance benchmarks. If business owners take the time to carefully preplan the best credit terms for their firms, and are then comfortable engaging in a dialogue with the private lender, the result should be mutual compromise from the creditor and the borrower on final terms that reflect two parties working together.

David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.