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Chapter 3

Small Business Loans

Starting a business can be exhilarating; a leap of faith into the unknown, if you will. Those words also describe what Aaron and Kathy Corr’s customers often experience when they visit TreeUmph!, a fourteen-acre elevated obstacle course in the treetops for adults and kids ages 7 and older. At TreeUmph!, the adventure includes wobbly bridges, tightropes, hanging nets, swinging ropes and, of course, ziplines. It opened in January, 2013 in Bradenton, Florida and the response from the community has been enthusiastic.

But getting the business off the ground proved to be more difficult than the Corrs expected. Like many entrepreneurs, they tapped everything they could to get it started, including personal savings, personal loans, and funds from friends and family. “We’re fortunate to have a good strong team and good capitalization,” says Aaron. In fact, they thought they were good to go, but discovered that there were a lot of state, and municipal, and regulatory requirements that required additional funds.

So they went looking for a small business loan. “We were very confident we could find the money we needed because we knew we had a good idea, a good business plan, and we were well-capitalized,” Aaron says. “But we had a bit of a rude awakening when we started going to banks looking for the additional funding we needed. We literally were refused at the door at the banks that we went to because they would not deal with startup businesses.”

Finally they approached a community bank that was willing to listen to their plans.

Shaun Merriman, president and CEO of Gateway Bank, says that two things set Aaron and his wife Kathy apart: their passion and their planning. “I could tell that this was something that they’d been working on a long time. It was one of the best designed business plans that I have ever seen in 28 years. Their plan was one of the most comprehensive, well-organized, and well thought through.” As a result, Gateway Bank was able to make the loan, and the Corr’s were able to launch a business that’s been garnering rave reviews.

When it comes to borrowing from a bank, who knows better than a banker? For this section, Tom Trafficante, the Executive Vice President and Chief Credit Officer at Heritage Bank of Nevada, provides his thoughts.

Before You Apply for Small Business Loan

You know the saying, “You only get one chance to make a first impression?” That’s true in many aspects of business, including when you apply for a small business loan. Before making a formal application to a bank for a small business loan, be sure to research banks and other lending institutions which are actively making small business loans in your community and arrange a meeting with at least two of these lenders.

There are multiple government and non-profit agencies in most communities to assist small businesses with planning and counseling, including assistance in preparing a business loan application. These include the U.S. Small Business Administration (SBA), Small Business Development Center, SCORE, Chamber of Commerce and Economic Development Agencies. By first contacting one of these agencies, you will be able to determine which banks are more aggressively seeking loans and obtain a referral to meet with them. You should also contact your own accountant, attorney, insurance broker or business associate for a similar reference.

Once your list of banks is narrowed down to two or three, set up a meeting with each bank to discuss your individual situation with them. You should take the opportunity to better understand the bank’s procedures for processing and approving the type and size loan you are looking for.

Factors Used by Banks to Evaluate Business Loans

The application process

The process used by a bank to evaluate small business loans varies considerably for each institution and is based on several factors. The size and complexity of loan request determines the depth and nature of the underwriting process. For smaller business loan requests (typically loan requests less than $100,000), most banks use a more streamlined approval process or automated underwriting process. Some banks utilize automated credit scoring systems for loan requests as high as $250,000.

Credit scoring models are heavily reliant on the strength of the credit reports of both the business and the principal owners of the business who will be required to guarantee the loan. In addition to information obtained from credit reporting agencies, the automated system will use income and asset information from the applicant’s tax returns and from the application to underwrite the loan for sufficient cash flow and liquid assets.

Most banks will require that they be able to review three years of operating history for the business and three years’ financial information from any principal owner with 20% or more ownership interest in order to obtain a commercial loan. Generally, for a business with less than two years of operating history, the business will be considered a “start-up” and generally will not qualify for a conventional loan with a bank. Only in cases where the principal owners have sources of income and strong cash balances to support the loan repayment without the business income, would they be considered by a bank for a start-up business loan. Some banks will consider a loan to a start-up business with an SBA guarantee, but even with the SBA guarantee (discussed in Chapter 4) most banks will not consider a start-up business for financing. If the loan request is declined by the automated system or when the loan request exceeds the threshold amount of $100,000, then the loan is processed with great detail and scrutiny.

What is required to apply for a small business loan

Typically, a small business loan request will require the following information:

• The business tax returns for the most recent three year period

• The personal tax returns of the all principal owners for the most recent three year period

• The fiscal year end business financial statements for the most recent three year period

• Interim financial statement (since the most recent fiscal year end)

• Personal financial statement of the principal owners

• Liquid asset verification and debt schedules for both the business and the principal owner

• Other pertinent information about the company and its principal owners

• A current year budget or projection may be requested

Once this information is received by the bank, a credit analyst will create a financial spreadsheet which displays the historical financial information in various formats, calculates numerous ratios and trends, and then compares the information to other companies of similar size in the same industry. You should request a copy of these spreadsheets whether your loan is approved or not, as there is often valuable information for your own consideration.

The financial spreadsheets are then sent to a loan officer for review and underwriting. If the loan officer determines that the request is eligible for consideration, the officer will compile a credit memorandum which summarizes the loan request, the financial condition of the applicant, variances from lending policy and risks associated with the request. The credit memorandum could be a few pages or longer than 100 pages, depending upon the size, nature and complexity of the loan.

Loan officers may have some direct authority to make a loan, but generally loan approval will require the signature of a credit administrator. If the credit request is larger, typically over $1 million or more, the loan request will need to be approved by a loan committee. In most cases, a loan which is approved by the loan officer and the credit administrator will rarely be declined by a loan committee.

Obtaining Loan Approval

The commercial loan underwriting process can be very complex and is beyond the scope of this book to fully describe. However, there are some basic financial data and ratios that are the key to obtain loan approval. The first is the amount and stability of historical and projected cash flow of the business. The second is the amount of debt and equity and available collateral for the loan. And lastly is the liquidity and financial strength of the principal owners of the business who guarantee the loan.

Loans are expected to be repaid from future excess cash flow, and thus the biggest issue for a loan officer to consider is if the cash flow is adequate to repay the loan. It is important to distinguish between net income and cash flow. A simplified approach, called Traditional Cash Flow method, will average the company’s prior three years of net earnings (net income), plus interest, plus other non-cash expenses like depreciation and amortization (this number is referred to as EBITDA). Using the EBITDA, the loan officer will calculate the current principal and interest payments of the existing debt, plus the principal and interest on the requested debt (this number is referred to as Debt Service). The loan officer calculates a debt service coverage ratio (DSCR) by taking EBITDA divided by Debt Service. This ratio should exceed 1.20. In other words, the company should show historically that it has 20% extra cash flow above the proposed loan’s payments.

Aside from the traditional historical cash flow, the loan officer will consider the trend of the sales and expenses and look for improving or declining cash flow. He will also review the balance sheet for other sources and uses of cash. Other uses of cash include such items as capital expenditures, and growth of accounts receivable and inventory relative to trade payables and other financing.

The second significant loan underwriting concern is the amount of debt and equity. The loan officer will calculate a debt to equity ratio by looking at the company’s total debt divided by the amount of equity. The total debt should be less than 4 times the equity. In other words, the company should have at least 20% equity. Equity provides a cushion above the debt which allows the company to be sold or liquidated and still be able to repay the loan.

The company’s assets are usually pledged as collateral for the loan. Collateral is a specific asset (or assets) which is pledged to the bank to secure repayment of the debt. For financially strong companies and guarantors, banks will make unsecured loans. However, most small business loans are secured by the company’s assets, such as its inventory, receivables and other fixed assets. In the event of default, the bank will have the right to repossess and sell the assets or collect the receivables to repay the loan.

The final consideration is the principal owner’s financial strength. In almost all cases, small business loans made by financial institutions will require the personal guarantee of any principal owner with 20% or more ownership of the company. If the business defaults on the loan, the bank will have the right to pursue the owner of the company. Loan approval considers the liquid assets, personal cash flow and overall net worth of the principal owner, especially if the primary cash flow and collateral offered by the business are not sufficient. The bank may ask that the principal owner pledge additional collateral to support the loan if the company’s assets are not adequate collateral for the loan

What If The Loan Is Declined?

If your loan request is declined, you are entitled to be told specifically why you have been declined. The best strategy is to meet face-to-face with the loan officer and discuss the specific reasons for the decline. You should inquire about what changes or benchmark ratios need to be improved to obtain a loan.

If the loan officer is not an SBA loan specialist or the bank is not an active SBA lender, you should meet with the SBA officer or locate the most active SBA lender in the community. The SBA guarantees a significant portion of the loan principal (up to 90%) and many banks and other non-bank financial institutions will make loans declined by banks. You should also go back to some of the resources mentioned in this book and begin searching for alternative lending sources. There are many sources of financing available and strategies to become “bankable” if you search for them.

Thank you, Tom, for your valuable insights.

We will discuss SBA loans in the next chapter. But first, it is appropriate to provide several more tips for dealing with banks, or any lender for that matter.

Where Do I Stand?

If the numbers and formulas we’ve been describing in this chapter make your head spin or your eyes cross, you may check out a couple of simple tools that can help you (and lenders) handle your businesses’ overall financial health.

Sageworks is an internet company that develops products that can be used by small businesses, accountants and other financial advisors, as well as lenders, to evaluate the financial health of a business. According to Sageworks, there are five main financial statement ratios that creditors frequently use to evaluate the financial performance of a private company. They are:

• Cash to Assets

• EBITDA to Assets

• Debt Service Coverage Ratio

• Liabilities to Assets

• Net Income to Sales

With the Sagework platform, eight to ten pieces of information can be entered to produce a report that will help evaluate the businesses’ financial statements and analyze what they are doing well, as well as what areas may need improvement.

“Some businesses will run these reports to see where they stand before they talk to a banker. It’s a quick proxy for what will I hear from my bank?,” says analyst Libby Bierman. But a business owner can also use it, “for leverage or to negotiate for better payment terms,” she says, if the financial health of the business is strong. For more information, including free whitepapers on business credit topics, visit our Resource Section.

Dress for Success

It should almost go without saying that when you meet with a banker or other lender you should dress appropriately. We’ve added the word ‘almost’ to that last sentence in recognition of how informally people conduct themselves now. Most of you know how to dress. But clearly—the evidence is all around us—some people don’t. So while we don’t want to come across as a nag or a scold, if your idea of formal is a T-shirt without holes in it, we have some work to do. The point of this book is to get your business financed. You’ve got to use every strategy and tactic to get it done. Show the lender some respect by dressing appropriately. (For an entertaining and interesting perspective on this topic, read Crazy Egg founder Neil Patel’s post, “How Spending $162,301.42 on Clothes Made Me $692,500” on his website, Quicksprout.com.)

Avoid High Salaries and Entertainment Expenses

Lenders want their money to be applied to the business. They don’t want that money going to your salary and your enjoyment. They want you committed to the business by taking a low salary at the start and foregoing the perks of larger businesses.

A Winning Business Plan

There is considerable debate about whether a business plan is a necessity. Some entrepreneurs say they either never created a business plan, or if they did, never used it. And it’s true that in certain circles (especially those trying to raise money in Silicon Valley) a “pitch deck” is considered more appropriate than a formal business plan. (We will discuss the pitch deck in more detail in Chapter 14.)

But banks and other financial institutions tend to be traditionalists, and they often want to see a well thought out and well drafted business plan. (In certain countries, such as Germany and Peru, a business plan is an absolute necessity.) Not only does a business plan serve as a road map for where you are headed but for lenders it is the starting point of the journey. It also forces you to ask hard questions about your business and where you see it headed. Those are the same questions that a bank or other lender will ask. The proper drafting of a business plan is a book unto itself. Please consider reading Garrett Sutton’s Writing Winning Business Plans.

Even the SBA says a business plan is “an essential roadmap for business success.” SBA loans are up next…