In the book, Write Your Business Plan, the staff of Entrepreneur Media offer an in-depth understanding of what’s essential to any business plan, what’s appropriate for your venture and what it takes to ensure success. In this edited excerpt, the authors discuss the ABCs of getting a bank loan for your business.
Many of the most successful businesses are financed by banks, which can provide small to moderate amounts of capital at market costs. They don’t want control—at least beyond the control exerted in the covenants of a loan document. And they don’t want ownership. Bankers make loans, not investments, and as a general rule, they don’t want to wind up owning your company.
Bankers primarily provide debt financing. You take out a loan and pay it back, perhaps in installments consisting of principal and interest, perhaps in payments of interest only, followed by a balloon payment of the principal. One of the nice things about debt financing is that the entrepreneur doesn’t have to give up ownership of his company to get it.
Bankers can usually be counted on to want minimal, if any, input into how the business is run. Get behind on the payment schedule, however, and you’re likely to find a host of covenants buried in your loan documentation. Loan covenants may require you to do all sorts of things, from setting a minimum amount of working capital you must maintain to prohibiting you from making certain purchases or signing leases without bank approval. Be sure to have your accountant, financial advisor or attorney review your loan documents and spell out everything for you very carefully before you sign.
A banker’s first concern is getting the bank’s money back plus a reasonable return. To increase their odds, bankers look for certain things, including everything from a solid explanation of why you need the money and what you’re going to use it for to details about other borrowing or leasing deals you’ve entered into.
Bank loan applications can be almost as long and complete as a full-fledged business plan. Plans and loan applications aren’t interchangeable, however. A banker may not be interested in your rosy projections of future growth. In fact, when confronted with the kind of growth projection required to interest a venture capitalist, a banker may be turned off. On the other hand, a banker is likely to be quite interested in seeing a contingency plan that will let you pay back the loan, even in the event of a worst-case scenario.
The five things a banker will look for you to address are:
1. Cash flow. One of the most convincing things you can show a banker is the existence of a strong, well-documented flow of cash that will be more than adequate to repay a loan’s scheduled principal and interest. You’ll need more than a projection of future cash flow, by the way. Most bankers will want to see cash flow statements as well as balance sheets and income statements for the past three or so years. And don’t forget your tax returns for the same period.
2. Collateral. If you’re just starting out in business or dealing with a banker you don’t know well, you’re unlikely to be able to borrow from a bank without collateral. Collateral is just something the bank can seize and sell to get back some or all of the money you’ve borrowed in the event that everything goes wrong and you can’t pay it back with profits from operations. It may consist of machinery, equipment, inventory or, all too often, the equity you own in your home.
Why do bankers seek collateral? They have no desire to own second-hand equipment or your house. Experience has taught them that entrepreneurs who have their own assets at risk are more likely to stick to a business than those who have none of their own assets at risk.
3. Co-signers. They provide an added layer of protection for lenders. If your own capacity for taking on additional debt is shaky, a co-signer (who's essentially lending you their creditworthiness) may make the difference.
4. Marketing plans. More than ever before, bankers are taking a closer look at the marketing plans embedded in business plans. Strong competitors, price wars, me-too products, the fickle habits of the buying public and other market-related risks must be addressed. Your banker (and most other investors) have to know that you recognize these risks and have well-thought-out ways to deal with them. Besides, it’s the cash flow from operations that pays off bank loans.
5. Management. Bankers like to stress the personal aspect of their services. Many state that they're interested in making loans based on a borrower’s character as well as their financial strength. In fact, the borrower’s track record and management ability are concerns for bankers evaluating a loan application. If you can show you’ve run one or more other companies successfully, it will increase your chances of landing a loan to get a startup going.
Bank financing is most appropriate for up-and-running enterprises that can show adequate cash flow and collateral to service and secure the loan. Bankers are less likely to provide startup money to turn a concept into a business, and they're even less likely to put up seed money to prove a concept unless you have a track record of launching previous businesses with successful results.
The old saying about bankers lending only to people who don’t need to borrow is almost true. Bankers prefer to lend to companies that are almost, but not quite, financially robust enough to pursue their objective without the loan. Their natural tendency is to be conservative.
This is important to understand because it affects how and when you will borrow. You should try to foresee times you’ll need to borrow money and arrange a line of credit or other loan before you need it. That will make it easier and, in many cases, cheaper in terms of interest rates than if you wait until you’re a needier and, in bankers’ eyes, less-attractive borrower.