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Write Your Business Plan

How to Fund Your Business Using Banks and Credit Unions Here's everything you need to know about securing a loan with favorable terms for your business.

By Eric Butow

Key Takeaways

  • Bankers provide debt financing, which means an entrepreneur does not need to give up ownership.
  • Loan covenants must be reviewed carefully before accepting a loan.
  • Bankers will ask for information regarding your cash flow, collateral, cosigners, marketing plans and management team.
  • Your personal credit must be in order before you can secure a business loan.
  • Credit unions are not-for-profit financial institutions that may provide lower interest rates and fewer fees than banks.

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This is part 3 / 10 of Write Your Business Plan: Section 2: Putting Your Business Plan to Work series.

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. The cost is clearly stated.

Related: Finance Your Money Right

Bankers can usually be counted on to want minimal, if any, input into how the business is run. Most often, as long as you remain current on payments, you can do as you like. Get behind on the payment schedule, and you're likely to find a host of covenants buried in your loan documentation.

Loan covenants, however, 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 approval from the bank. In fact, most bank loans contain so many covenants that it's difficult for a borrower to avoid being technically in default on one or more of them at a given time. For this reason, you want your accountant, financial advisor, or attorney to review your loan documents and spell out everything for you very carefully.

Related: 3 Strategies For Getting Into Lending Shape

Your loan officer is likely to ignore many covenant violations unless you stop, or seem likely to stop, making timely payments. Even then you'll probably get a chance to work out the problem. But if you remain in violation, you may find yourself declared in default in short order, and the bank may demand all of its money immediately, perhaps seizing your collateral and even forcing you to protect yourself by declaring bankruptcy.

What Bankers Want

A banker's first concern is getting the bank's money back plus a reasonable return. To increase the odds of this, bankers look for certain things in the businesses they lend to. Those include everything from a solid explanation of why you need the money and what you're going to use it for to details about any other borrowing or leasing deals you've entered into.

Bank loan applications can be voluminous, 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 things a banker will look for you to address are:

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. Basically, you're going to have to show where you're going to get the money to pay back what you're borrowing.

Related: Choosing A Lender? Watch Out FOr These Costly Traps.

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.

Collateral. If you're just starting out in business or if you're dealing with a banker who you don't know well, you're unlikely to be able to borrow from a bank without collateral. (That's doubly true if, as is the case with many entrepreneurs, both descriptions apply to you.) Collateral is just something the banker 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. It's advisable NOT to put your home up for collateral—it's simply too big a risk.

But it's a good idea to take the initiative here and propose something that will be used if you suspect a banker will require it. Often the collateral will consist of whatever you're borrowing money to buy—production equipment, computers, a building, and so on.

Related: 4 Ways To Finance Your Business.

Why do bankers seek collateral? They have no desire to own secondhand 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.

Quick tip: It seems sensible to plan to put up as collateral the exact item you're borrowing money to buy. But bankers often demand more because it may be impossible to sell the item that you're buying for what you'll owe on it. So, plan to use purchased equipment for part of your collateral but be ready to offer more.

Cosigners. They provide an added layer of protection for lenders. If your own capacity for taking on additional debt is shaky, a cosigner (who is essentially lending you his or her creditworthiness) may make the difference.

Related: Choosing A Business Loan Type

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. There are also very web-savvy marketers out there, and it helps if you are tapped into online marketing, such as social media.

Your banker (and most other investors) has 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.

Management. Bankers like to stress the personal aspect of their services. Many state that they are interested in making loans based on a borrower's character as well as her 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.

Related: Despite Access to Credit, Many Business Owners Are Reluctant to Take on Debt

Getting Your House in Order

As an entrepreneur seeking a bank loan, or any funding for that matter, you'll want to make sure you have everything in place, including all of your financial documentation as well as your credit history. And if you need to improve your credit history and rating, you should do so in advance. Even if you have previous business experience, you'll need to get your personal credit information in order. Start by contacting one of the three major credit bureaus:

Equifax: 1-800-685-1111, www.equifax.com

Experian: 1-888-397-3742, www.experian.com

TransUnion: 1-800-916-8800, www.transunion.com

Do this once because loan officers will also inquire, and the more your credit ratings are checked, the more suspicious it may appear to lenders. Also, read your credit reports carefully, especially if your rating is not as good as you expected. Credit bureaus make more mistakes than you would ever imagine. Make sure there are no errors on your credit reports. If there are errors, call the credit bureau to have them corrected.

Related: 6 Tips For Navigating Online Lending Options

Lenders Look at the Four Cs of Credit

  1. Character. What's your reputation and record?
  2. Capacity or cash flow. Do you have sufficient cash flow to repay principal and interest?
  3. Capital. Does your business have enough capital to keep going if you can't pay the debt from earnings?
  4. Collateral. Do you own something valuable the banker can take if you can't pay the loan back?

Don't Take No for an Answer

One, two, three strikes, you're out. Most small business owners give up after trying three banks. You should be more persistent. Those entrepreneurs that have persisted have found that the fifth, tenth, or even twentieth banker has been impressed enough to give them a loan. Of course, tweaking the business plan based on the criticism you receive can, and often does, help improve your odds as you continue going from bank to bank. Listen and learn from feedback and criticism, make changes if you feel the comments are relevant, and keep on going. Be persistent.

Related: Fund Your Business With Bonds And Indirect Funding Sources

When Bank Financing Is Appropriate

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 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. Even then, each concept will stand on its own merits.

Bankers are sensitive to the term or length of a loan. Most bank loans are short to intermediate term, meaning they are due in anywhere from less than a year to five years. A short-term loan may be for ninety days and used to finance receivables so you can get a big order out the door. A longer-term loan, up to twenty years, may be used to purchase a piece of long-lasting capital equipment.

Borrowing When You Really Need It

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. Bankers are lenders, not investors. Unlike a venture capitalist who takes an equity position, bankers don't get a higher return on their loan if you happen to be more successful than expected. Their natural tendency is to be conservative.

Related: The Current State Of Business Lending

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.

Credit Unions

Another option when seeking funding is to join a credit union. According to the National Credit Union Administration, there are more than 4,900 credit unions in the country with 131 million members as of March 31, 2022. Because credit unions are not-for-profit financial institutions, their focus is serving the financial needs of their members and not on making a profit. As a result, once you have applied and joined a credit union, it may be easier to get a lower interest rate with fewer fees than can be found at a bank when procuring a loan. However, like a bank, you will still need to prove your creditworthiness and that you can repay the loan or have someone cosign for it.

Because banks have gotten a lot of bad press in recent years for attaching fees to all sorts of activities, many people have switched over to credit unions. One reason is that credit unions typically offer more personalized service, which can include helping you get your house in order before applying for a loan. Credit unions may also offer a sense of camaraderie because they are typically sponsored by a business, a community, or some group of people of which you are one. This can be advantageous because you may find other people interested in your business ideas.

Related: Choosing A Bank For Your Start-Up? Here Are Some Things To Know.

While credit unions are not protected like banks by the FDIC, they are covered by the National Credit Union Share Insurance Fund (NCUSIF). This fund provides federal and most state-chartered credit union members with up to $250,000 of insurance per individual depositor, per federally insured credit union.

Term to Know: Balloon Payment

A balloon payment is a single, usually final, payment on a loan much greater than the preceding payments. Some business loans, for example, require interest-only payments the first year or two, followed by a single large payment that repays all the principal.

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