Virtually all businesses will, at some time, need to obtain outside financing. For the small business owner, this generally means obtaining some type of bank loan. And for many, this turns out to be a frustrating and difficult experience. It doesn’t have to be that way, however. Whether you are looking for financing to purchase a new business or are in the need of seasonal financing, proper planning will increase your chances of obtaining the needed financing. A side benefit may be that, during the process, you will learn more about your business.
There are several methods of obtaining outside financing, such as venture capital organizations or even bringing in another investor. However, the most common method is some type of traditional bank loan.
The Loan Process
Before approaching your banker for a loan, you should first get an understanding of what your banker is interested in and anticipate the questions that will arise during the loan process. Having substantial collateral is not the only factor in which the bank will be interested. Banks are in the banking business and have no interest in running your business, should you default on the loan. This means that your banker will be interested in how you will repay the loan, as well as the collateral that you have available.
Determine why you need the loan.
Although it may seem obvious, your first step should be to determine why you need the loan. If this is a start-up business, will the loan proceeds be used to purchase equipment and inventory, provide working capital, or maybe even finance product research and development? Or, as an established business, are you experiencing cash flow problems because the business is under capitalized or are you simply in a seasonally slow period? The four most common reasons for obtaining financing are: acquiring or starting a new business; working capital; seasonal peaks; and equipment acquisition. Although the basic framework is the same, your loan package should be customized to address the reasons financing is needed.
Cut expenses, reduce debt
Prior to applying for the loan, you should put your business in the best possible financial order. Pay close attention to expenditures. By reducing expenses as much as possible, you increase both your cash flow and profits. Work hard to collect any receivables owed to you. You may consider restructuring existing debt to improve your working capital ratios. Liquidating unused and superfluous assets will improve working capital as well as increase cash balances. You may even need to reduce your own salary.
The above comments hold true even if you are starting a new business. In most cases, you will be required by the bank to personally guarantee the loan. For this reason, your personal financial condition will play an important role in securing the financing.
Preparation of Your Loan Package
The next step is to actually begin preparation of your loan package. The components of the package are discussed below. Just remember to customize each to your specific needs.
In addition to prior years’ financial statements (three to five years), projections for future cash flow and profits should be included. Other financial data may include prior tax returns (personal and business), financial ratios, information on historic growth rates, etc. Include any information that will convince the banker of the fiscal soundness of your business. If prior financial information is poor, emphasize positive factors such as increases in gross margins or improvements in cash flow or key financial ratios. When the purpose of the loan is to start or acquire a new business, prior financial data may not exist. In these situations, projections and budgets take on additional importance. They should be supported by sufficient factual information to prove that the goals are credible and not just “pie in the sky” wishes.
By demonstrating knowledge of pertinent financial ratios and industry statistics, you will further convince your banker as to your credibility. Be sure and point out areas where you exceed the “norm”. The best source for this information is trade associations, but other sources are available. A lot of good information is available on the Internet.
Ownership Information & Resumes
This material is especially important when acquiring or starting a new business. Information on your background, education, experience and capabilities is vital.
In narrative format, you should identify the reasons for the financing request and the amount and repayment terms of the request. Clearly indicate how the loan proceeds will be used. This portion of your loan package should tie all the other sections together into a concise financing plan.
The purpose of the loan request will dictate what other information may be needed in your loan package. When requesting funding for a new business, you should include information on marketing, management plans, industry background and predictions, and pro forma financial information (that is, financial information prepared as if the loan has been funded).
For working capital loans or an annual line of credit, provide information on how much funding will be needed during seasonally slow periods and how it will be repaid during the peaks.
An important rule in preparing your loan package is not to hide unfavorable information. Such information should be presented with the details of how you plan to overcome the problem. Full disclosure will add to your professionalism while discovery of undisclosed negative information will destroy your credibility.
Secure a Second Opinion
After completing a draft of your loan package, visit with your certified public accountant (CPA). If you are a start-up business, this is a good time to begin building a relationship with a CPA. A CPA will be able to identify strengths of both your business and your financing plan and offer suggestions on how to emphasize them. The CPA may also be able to provide guidance on how to put a positive note to what otherwise might appear as negative information. For instance, a drop in cash balances may be a result of paying off previous debt. Through experience, your CPA may also know which banks in your area are most likely to provide the type of financing you need.
Finally, as mentioned earlier, it is a common practice in today’s lending environment for banks to require a personal guarantee from small business owners. So no matter how convincing your financial information is, do not be surprised if the banks request such a guarantee. Give this request careful consideration, as a default by the business on such a loan may affect your personal assets, as well as those of the business.
Before you apply for your loan, do your homework – know your business, know your industry and know the answers to questions before they are asked. This information will not only make the loan process easier, but, more importantly, increase the probability that you will be successful in obtaining your loan.
by Danny R. Snow, CPA