Am I seeking the right kind of capital
to start or grow?

Understanding the differences in the kinds of capital for starting or growing a small business, and how they relate to the type of operation you are contemplating is important. Let’s look at the three major categories: Grants, Equity and Loans

Grant funding

Think of money from family or close friends, provided as a gift, as a grant. That might be the most likely grant source for many. Commonly, entrepreneurs seek grants through programs funded by government or corporate support programs. Unfortunately, these programs are not consistently available, and many are the result of special initiatives related to the COVID pandemic or efforts to ameliorate social injustices. They tend to be small in comparison to the amounts needed to start or grow a business and they are often competitive awards or require matching funds. It is very rare to find a grant to provide your first dollar of capital to start a business. Most grant programs are for operating businesses.

Equity

The money an owner contributes to the business entity is called equity and the most common source of business funding is the savings of the founder(s). Adding a business partner is a very common way of multiplying the initial capital stake to start or grow. Equity capital is often called “patient capital” because owners may be willing to tolerate operating losses during periods when there is insufficient revenue or profit relying only on the vision of better times ahead. Tech companies are common examples of startup ventures that can’t produce immediate profits, and are often considered risky and thus need patient equity backing. While larger capital stakes can be raised through equity, there are disadvantages to a founder. You’ve got one or more business partners now with a say in the way the firm is managed. And you’ll be sharing your profits – forever. So equity is potentially much more expensive than debt in the long run.

Business loans

Many entrepreneurs are not comfortable sharing the steering wheel with others and prefer to retain controlling interest in their company. If the business concept is of the type that can quickly earn revenue and profits, they will find that debt capital, usually through business loans, comes with certainty over the cost of funding and potentially lower cost when wise choices are made. But there are some disadvantages to debt. For one, there are limits to how much debt a company can comfortably take on, and therefore how much debt a lender is willing to offer. And, unlike patient equity capital, you have to make payments on the agreed schedule. You should also be sure you are seeking debt from an affordable source. The internet is a "Wild West" of offerings requiring minimum documentation but crazy costs of capital. Be careful if you aren't working with a bank or community lender.

Can I pay the loan back comfortably?

 

Knowing if you can pay back a business loan comfortably requires that you have good information about your company’s financial condition. This requires much more than your faith and confidence in your operation. You need standardized, current bookkeeping, which will also provide the ability to share detailed, credible reports with a prospective lender.

Where do the dollars come from
to repay a loan?

Businesses need liquidity to be able to pay the bills. A lender takes a quick measure of this ability from the balance sheet by comparing current assets against current liabilities. In other words, does the business have the money at hand to pay what’s coming due soon? Business assets include cash, money others might owe the business and inventory if it sells physical goods. Other assets like equipment, vehicles, furniture and the paint on the walls isn’t of much use to pay bills. The business needs to keep those to run the operation. Even the inventory can take a long time to sell in some cases, and collections of debts can too. That leaves cash. And in normal operations, the only way you get more of it is by selling goods or services faster than you spend. That’s essentially a definition of profit. While a business can rely on cash flows or cash reserves to pay back a loan, that can’t work forever. Eventually, the cash has to be replenished with profits.

What is Debt Service Coverage?

If you look up the definition of “Free Cash Flow” in an accounting textbook you get this formula: Free Cash Flow = Net Operating Profit After Taxes − Net Investment in Operating Capital. To simplify this, it means the profit left over after paying (or setting aside money to pay) income taxes minus all of the stuff you plan to buy to invest in the business is what’s “free” for other purposes – like the cost of borrowing.

Lenders want you to have free cash flow left over after taking care of all those other business needs, like paying income taxes and making necessary investments in the business. To be sure you can pay back a loan, here’s the concept that really matters: Debt Service Coverage Ratio (DSCR) = Annual Net Operating Income / Annual Debt Service

Annual Net Operating Income means your gross revenue minus your operating expenses.

A lender computes your Annual Debt Service by adding up the payments you have to make for all of your debts, including principal and interest, including the loan you are requesting.

For small business owners, where commonly their own personal income comes from the business, a lender will also look at your “global” debt service. That means adding in your personal obligations such as mortgages, car payments, credit cards, etc.

Is there a Plan B
if the business stumbles?

Lenders have obligations to protect their loan capital. Too many bad loans could endanger bank depositors or the continuance of a community lender’s program. So, there’s always emphasis on what alternatives are available in case the business encounters unanticipated challenges. Understanding these expectations will help you prepare a more viable loan request.

What are secondary sources
of repayment?

Evaluating the likelihood that a borrower can repay the loan involves making a judgment based not only on current financial conditions but on the uncertain future. An important aspect that adds confidence to a lender is the availability of secondary sources of repayment. This can take the form of substantial assets or income outside of the business. For instance, the owner may have an outside full-time job with a salary that could cover the business loan payment if needed. Or, a spouse or other owner or guarantor may have those means. Or, the business owner may have sufficient investment income, etc.

Could you provide a loan guarantor?

What’s commonly referred to in the world of consumer lending as a co-signer on a loan, is called an additional guarantor in business lending. This can make the difference in approval of a loan request when there are deficiencies in the circumstances of the principal guarantor, the business owner with controlling interest in the company. It’s important that the financial means of this additional guarantor is free from its own complications and the guarantor must have some reasonable connection to the borrower if he or she is not an owner of the business.

Might you need to provide collateral?

When loan requests grow to a particular size, collateral becomes much more important. The experience of lenders teaches that business owners willing to pledge collateral, whether it be equity in a personal residence or other property that can be liquidated easily, are much more determined to see through the hardships and unforeseeable eventualities of business.

Do I have enough invested?

 

Closely related to the concept of collateral, is the question of whether a business owner has made a meaningful investment in the business that signals a commitment to overcome inevitable adversities. No lender wants to take on 100% of the risk in a credit transaction. Having some “skin in the game” for business loans can take the form of an acceptable percentage of cash injected into a new venture or the value of assets in an already established business. In commercial and residential mortgages, this is thought of as the down payment on the property purchase.

Does the lender believe
my business plan?

 

Loan officers often gain great familiarity with numerous industries without being experts in any one. But expertise is generally not required to spot business plans with wildly optimistic financial projections. Revenue forecasts that rely on geometric increases in sales are not credible and signal naïve ambitions of the owner.

Did I include the necessary elements?

 

Lenders don’t expect business plans to be works of literature. But they should be functional for explaining the story of a business or industry with which the reader has no prior familiarity. The magic is not in the length, visual format or arrangement of topics but in its comprehensiveness. The outline in the illustration is as good as any.

What’s going on in the economy,
my industry and my business?

 

While a business owner’s personal efforts are crucial to its success, forces on the outside and inside beyond his or her control can have enormous importance too. A written business plan and the personal meetings with a loan officer provide good opportunities to provide perspective and interpretation. Is the general economy’s condition improving or hurting business prospects? There might be counterintuitive circumstances that an outsider wouldn’t understand without your explanation. Is the industry prospering or slumping because of changes in consumer tastes? Changes in technology? Regulatory issues? Is your business operation facing staffing challenges? New competition? Great success with new product introductions? Telling your story in a believable and memorable way is important.

Does the lender believe I can succeed?

In the venture capital world, where tech startup businesses are born and buried with surprising frequency, it is said that shrewd investors bet on the jockeys not the horses. This is because it is inevitable that challenges to any startup will occur, no matter how carefully or cleverly the business concept is designed. But, talented entrepreneurs will seek a successful way to pivot and move past the obstacles. While the financial stakes are different for a lender supporting a Main Street small business, the idea remains that confidence in the owner is a most important ingredient.

Personal and business credit scores
are a proxy for character

 

An experienced lender knows that it is impossible to judge a prospective borrower’s commitment to repay a loan based only on the agreeableness of a business owner’s personality. So, examination of one’s track record in paying bills is an indispensable. This leads banks, being under tight government regulation, to develop credit policies that fix minimum credit scores for business lending. Community lenders, with more flexibility, can consider related circumstances with more discretion. For most small businesses, developing a business credit score independent of the founder’s personal score is difficult, especially if buying on credit is not customary for their industry. Therefore, personal credit score often carried the complete burden of proving your good character.

Do I show sufficient business knowledge and interest in learning?

Especially for community lenders with strong business advisory programs, whether a loan prospect is coachable can be a very significant trait. A minority of business owners become owners after having had management experience in that same operation or industry. So, it’s common that learning to become an owner is a novel experience and sometimes a crash course. The willingness to accept advice from more experienced sources of support is highly predictive of success.

Do I have industry
and management experience?

Entrepreneurial ambition frequently exceeds practical experience, especially when it comes to startups seeking funding. In fact, it is a frequent reason for loan application denials. There simply are too many things to learn quickly, particularly in high-failure-rate industries such as restaurants. Lenders consider related management and industry experience to be a way to mitigate risk and often insist on it.

Can I demonstrate my ability to assemble a team?

The ability to successfully grow a business means the owner must start working “on the business” not just “in the business.” This is a challenging assignment for time-impoverished owners with limited financial resources who are forced to wear too many hats, even those that don’t fit so well. Showing that you aren’t just relying on your own wits begins with assembling a required team of professionals – a CPA, a business attorney, an insurance agent and, even if you are not yet a loan customer, your banker. Back inside the business, are you the only revenue producer? How would this work if you are ever to grow? If you have other staff responsible for sales and or production, do you have adequate front line supervision? Are you developing policies, procedures and practices for effective human resource management? These are all indications a lender is on the watch for as they are indicative of business stability and potential.