In my career as a banker I've had hundreds of conversations with people that want to become small business owners. These conversations often occur when someone is interested in borrowing money to start a new business.
Funding your business can be difficult, and loans are one of the first options most people consider.
It is surprising how many entrepreneurs don't understand how banks make loans and how to fund a start-up business. By understanding the underwriting process you can better prepare for a conversation with your lender.
As a young commercial loan officer I remember one Friday afternoon when a man a restaurant uniform came into the bank to speak with me about a loan to open a new restaurant. He had just finished his shift, was unhappy with the management of the restaurant where he worked, and was certain that if I lent him enough money to open a restaurant, it would be a huge success.
As we discussed his request, I asked some standard questions about his business plan like how much money he had saved for this venture, how much he wanted to borrow, how he would use the funds and when and how the loan would be repaid. He seemed surprised by the savings question and said he had a couple thousand dollars he might be able to invest in his new business.
He was ready for the second question and didn't blink when he told me he wanted to borrow $200,000. He had determined that this would cover leasing a building, leasing or buying (he wasn't sure which yet) equipment, hiring staff, buying inventory, etc.
I asked for specifics and about several expenses not mentioned. He acknowledged he didn't have details and hadn't considered some costs but was confident he could make the $200,000 work.
On when the bank would be repaid, he said he could start repaying the loan after the restaurant started making money which should be about a year after opening. I asked him how the bank would get their depositors' money back if the restaurant didn't make it and he started getting frustrated. He couldn't understand why I just wouldn't open the vault and give him the money!
I think he started realizing he was not prepared for our conversation and his request wasn't as exciting to me as it was to him. Most people recognize this is an unreasonable loan request but may not know why.
Answering some questions might help to prepare you for a loan conversation with your banker.
Where does someone get the money to start a small business?
There are several ways to fund a small business start-up. Most small businesses are funded by personal savings, investment or loans from family or friends and third party investors. In many cases, the entrepreneur uses a combination of personal savings and personal credit to fund their new business.
Generally the only types of bank loan available for small business start-ups are guaranteed loans. The most common guaranteed loans are Small Business Administration (SBA) loans. SBA loans are underwritten by a bank and guaranteed by the government because they can't be made for a specific reason without a guarantee. Reasons may include a lack of established earnings for the business, lack of collateral or loan terms a bank doesn't offer.
Why won't a bank lend money without a guaranteed loan?
As mentioned above, banks lend out depositor's money. They can only do that if they are reasonably certain the funds can be repaid. So the real question is...
How does a bank determine if a loan is reasonably certain to be repaid?
When banks underwrite loans they try to secure more than one way the loan can be repaid, regardless of whether the loan is for personal or business purposes. These are referred to as sources of repayment.
The primary source of repayment for most loans is personal or businesses cash flow. Cash flow is nothing more than the money that is available to the individual or business to repay debt. Income is adjusted by expenses that can't be avoided like taxes and living expenses, or in the case of a business, operating expenses.
After these and other adjustments, the bank compares cash flow with payments for all debts, including the new loan. This is the debt-to-income ratio for individuals or the debt service ratio for businesses.
The bank also reviews the credit history of the borrower to see how they've handled past loans and tries to confirm the stability of the cash flow to ensure it will be available to repay the debt for the term of the loan.
If cash flow is stable, the borrower has a history of prompt debt repayment and the cash flow covers debt payments, cash flow is considered adequate. In the case of our aspiring restaurant owner, the cash flow from his business wasn't reliable or stable since it was based on rough projections and there was no history of earnings. The new business also had no track record of paying obligations.
A secondary source of repayment is another way the borrower can repay the bank if the primary source of repayment (cash flow) fails or falls short.
Collateral is commonly a secondary source of repayment and is something, usually an asset, the bank can liquidate easily to repay the debt. Examples of acceptable collateral are investment accounts, vehicles or equipment and real estate. Banks discount the value of assets used as collateral to ensure liquidation costs are covered and to guard against decreases in collateral value over time.
Our restaurateur didn't consider that he would be spending most of the loan funds on expenses rather than assets that could be used to secure the loan. The few assets he planned to purchase were difficult to convert to cash and would be worth far less used than what he paid for them.
For personal loans, banks are usually comfortable with two sources of repayment. When you buy a car, you sign a promissory note and pledge the car's title as collateral. If you don't pay for the car, the bank takes the vehicle back, sells it and satisfies the debt.
With business loans, banks prefer a third or tertiary source of repayment. Most business loans require the personal guarantee of the owner(s) and this often serves as a tertiary source of repayment. If the business and its cash flows fail and the collateral does not cover the debt, the owner pledges to pay the loan from personal income or assets.
Back to our aspiring restaurant owner. How strong would his guarantee be if he spent all his cash opening the business and if his income was tied to the business and the business failed? Certainly not strong enough to be a valid repayment source.
So if you are interested in starting a small business and decide to talk to your banker about a loan, consider ways you could repay the debt if the business doesn't succeed. Cash flow projections will be questioned so offer other strong sources of repayment and your chances of getting financed will improve faster than used restaurant equipment depreciates!
Photo: Fernando Mengoni on FreeImages.com