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Before the Loan Decision


Choosing a bank and, more specifically, a banker is one of the more important decisions a new or young business will make. (See Exhibit 73.) A good lender relationship can sometimes mean the difference between the life and death of a business during difficult times. There have been cases where, other things being equal, one bank has called its loans to a struggling business, causing it to go under, and another bank has stayed with its loans and helped a business to survive and prosper. (Although we refer specifically to banks and banking relationships, much of the following discussion of lending practices and decisions applies as well to commercial finance company lenders.) However, it should be recognized that many large banks, when considering relatively small loans (under $2 million), rely mostly on credit scoring to decide whether credit can be granted.


Those banks that will not make such loans generally eke the lack of operating track record as the primary reason for their refusal. Growth, based on a history of operating success, is one of the favored reasons for lending. Lenders pay particular attention to firms with seasoned management teams who are backed by investors with whom they have had prior relationships and whose judgment they trust.


Exhibit 7.4 offers guidelines for the entrepreneur and his or her man­agement team as to the preliminary steps they should take in asking for a loan. Because of the importance of a banking relationship, an entre­preneur should shop around before choosing a banker or other lender. The criteria for selecting a bank should be based on more than just loan interest rates. Equally important, entrepreneurs should not wait until they have a dire need for funds to try to establish a banking relation­ship. The choice of a bank and the development of a banking relation­ship should begin when you do not urgently need the money. When an entrepreneur faces a near-term financial crisis, the venture's financial statements are at their worst and the banker has good cause to wonder about management's financial and planning skills—all to the detriment of the entrepreneur's chance of getting a loan.


Exhibit 7.3 What to Look for in a Bank


Banking knowledge: Few bankers will intentionally lead you astray. But Dan Lang, co-owner of Nature's Warehouse, a $6 million baked-goods business in Sacramento, discovered that some bankers have a tighter grip than others on what's possible in a given situation. Lang and his partner met with lending officers at several banks to try to get $ I million in financing to help buy Nature's Warehouse. But only one, the lending officer at Sacramento Commercial Bank, "said right away he could do it as a ten-year SBA loan. Without hesitating, he knew what he could and couldn't do."


Sense of urgency: "Banker's hours" may be a fading notion, but a CEO's and a banker's ideas of a "quick turnaround" are often days, even weeks, apart. Tom Kinder, co-owner of Pure Patience, a bedding-products mail-order business in Sharon, Vermont, found that his bankers at Vermont National Bank were able—and extremely willing—to meet his compressed timetable for a $ 100,000 loan. Kinder says he even got evening calls at home, updating him on the progress. One of the reasons for the time-perception difference is that the bank starts timing when all the data they need is in their hands, while the entrepreneur starts counting as soon as the first call is made!


Teaching talent: Many bankers can't—or don't want to—articulate what they expect from customers and how the bank makes its decisions. But Dwight Mulch, president of Preferred Products Corp., a building-materials distributor in Burlington, Iowa, says he gets both types of information from his lending officer at First Star Bank and has benefited greatly. "He practically led me around by the nose. He showed me what to put in the plan, and he still tells me how the system works," says Mulch.


Industry knowledge: Whatever industry you're in, it helps to have a banker who has had some exposure to your type of business, says Dave Sanger, president of Resource Solution Group, a computer-consulting business in Southfield, Michigan. Sanger's lending officer at Manufacturer's Bank in Detroit "knows we don't have the same kind of assets as a retailer or a manufacturer," Sanger says, "and she knows the terminology."


Financial stability: Given a choice, Kevin Whalen, chief financial advisor of Twin Modal, Inc., a Minneapolis transportation-broker age firm, didn't pick the bank that was offering the most aggressive deal. And it's a good thing too, he says: "that bank has had real problems with regulators and has pulled way back." Before selecting Marquette Bank, Whalen, a former banker himself, did spreadsheet comparisons of several banks, comparing returns on assets, capital-to-asset ratios, and so on. "I felt that in the long run, we'd be better off with the most conservative bank around."


Manager with backbone: Banks have policies, notes Mike Walker, president of Walker Communications Inc., a public relations firm in Scottsdale, Arizona, "but you want to have a manager with the courage to override them if it makes sense to do so." Walker's branch manager at First Interstate Bank of Arizona, for instance, allows him to draw on checks immediately after they're deposited and often acts as a


troubles hooter for him within the bank. "I don't know what the manual says," offers Walker, "but I think you need somebody who can take a stand." (This is true when the request is reasonable.)


G. B. Baty and J. M. Standll describe some of the factors that are especially important to an entrepreneur in selecting a bank.7 The bank selected should be big enough to service a venture's foreseeable loans but not so large as to be relatively indifferent to your business. Banks vary greatly in their desire and capacity to work with small firms. Some banks have special small business loan officers. Other banks see such new venture loans as merely bad risks. Does the bank tend to call or reduce its loans to small businesses that have problems? When they have less capital to lend, will they cut back on small business loans and favor their older, more solid customers? Are they imaginative, creative, and Exhibit 7.4 Key Steps in Obtaining a Loan


Before choosing and approaching a banker or other lender, the entrepreneur and his/her management team should go through the following steps in preparing to ask for a loan.


• Decide how much growth they want, and how fast they want to grow, observing the dictum that financing follows strategy.


• Determine how much money they require, when they need to have it, and when they can pay it back To this end, they must:


—develop a schedule of operating and asset needs


—prepare a real-time cash-flow projection


—decide how much capital they need


—specify how they will use the funds they borrow


• Revise and update the "corporate profile" in their business plan. This should consist of


—the core ingredients of the plan in the form of an executive summary —a history of the firm


—summaries of the financial results of the past three years —succinct descriptions of their markets and products —a description of their operations —statements of cash flow and financial requirements —descriptions of the key managers, owners, and directors


—a rundown of the key strategies, facts, and logic that guide them in growing the corporation


• Identify potential sources for the type of debt they seek, and the amount, rate, terms, and conditions they seek.


• Select a bank or other lending institution, solicit interest, and prepare a presentation.


• Prepare a written loan request


• Present their case, negotiate, and then close the deal.


• After the loan is granted, it is important that the borrowers maintain an effective relationship with the lending officer.


Source: Jeffry A. Tirnrnons, Financing and Planning the New Venture (Acton, MA: Brick House Publishing, I 990), pp. 82-83.


helpful when a venture has a problem? To quote Baty, "Do they just look at your balance sheet and faint or do they try to suggest construc­tive financial alternatives?"


Finally, ask for small business references from their list of borrow­ers and talk to the entrepreneurs of those firms. Throughout all of these contacts and discussions, check out particular loan officers as well as the viability of the bank itself—after all, the officers are a major determi­nant of how the bank will deal with you and your venture.


What the Banker Wants to Know8


You first need to describe the business and its industry. Exhibit 7.5 sug­gests how a banker "sees a company" from what the entrepreneur might say. What are you going to do with the money? Does the use of the loan make business sense? Should some or all of the money required be equity capital rather than debt? For most businesses, lenders do not like to see total debt-to-equity ratios greater than one. The answers to these questions will also determine the type of loan (e.g., line of credit or term).


1. How much do you need? You must be prepared to justify the amount requested and describe how the debt fits into an overall plan for financing and developing the business. Further, the amount of the loan should have enough of a cushion to allow for unexpected developments.


2. When and how will you pay it back? This is an important question. Short-term loans for seasonal inventory buildups or for financing receivables are easier to obtain than long-term loans, especially for early-stage businesses. How the loan will be repaid is the bottom-line question. Presumably you are borrowing money to finance activity that will throw off enough cash to repay the loan. What is your contingency plan if things go wrong? Can you describe such risks and indicate how you will deal with them?


3. What is the secondary source of repayment? Are there assets or a guarantor of means?


4. When do you need the money? If you need the money tomorrow, forget it. You are a poor planner and manager. On the other hand, if you need the money next month or the month after, you have demonstrated an ability to plan ahead, and you have given the banker time to investigate and process a loan application. Typically, it is difficult to get a lending decision in less than three weeks (some smaller banks still have once-a-month credit meetings).


One of the best ways for all entrepreneurs to answer these questions is from a well-prepared business plan. This plan should contain projec­tions of cash flow, profit and loss, and balance sheets that will demon­strate the need for a loan and how it can be repaid. Particular attention will be given by the lender to the value of the assets and the cash flow of the business, and to such financial ratios as current assets to current liabilities, gross margins, net worth to debt, accounts receivable and payable periods, inventory turns, and net profit to sales. The ratios for the borrower's venture will be compared to averages for competing firms to see how the potential borrower measures up to them.


Exhibit 7.5 Bankerese: How Your Banker Interprets the Income Statement


Sales


• Cost of Goods


Gross Margin


• Selling


• G&A


•R&D Operating Margins


• Interest Expense


• Profit Before Taxes


• Taxes


• Profit After Taxes


• Dividends/Withdrawals


What do you sell? Whom do you sell to? How do you buy? What do you buy? Whom do you buy from?


Are you a supermarket or a boutique?


How do you sell and distribute the product?


How much overhead and support is needed to


operate?


How much is reinvested in the product?


How many dollars are available before financing


costs?


How big is this fixed nut?


Do you make money?


Corporation, Sub S, LLC, or LLP?


How much and to whom?


How much money is left in the company?


For an existing business, the lender will want to review prior years' financial statements prepared or audited by a CPA, a list of aged receiv­ables and payables, the turnover of inventory, and lists of key custom­ers and creditors. The lender will also want to know that all tax payments are current. Finally, he or she will need to know details of fixed assets and any liens on receivables, inventory, or fixed assets.


You should regard your contacts with the bank as a sales mission and provide required data promptly and in a form that can be readily under­stood. The better the material you can supply to demonstrate your busi­ness credibility, the easier and faster it will be to obtain a positive lending decision. You should also ask, early on, to meet with the banker's boss. This can go a long way to help obtain financing. Remember you need to build a relationship with a bank, not just a banker.


The Lending Decision


One of the significant changes in today's lending environment is the centralized lending decision. Traditionally, loan officers have had as much as several million dollars of lending authority and could make loans to small companies. Besides the company's creditworthiness as determined by analysis of its past results via the balance sheet, income statement, cash flow, and collateral, the lender's assessment of the char­acter and reputation of the entrepreneur was central to the decision. As loan decisions are made increasingly by loan committees or credit scor­ing, this face-to-face part of the decision process has given way to deeper analysis of the company's business plan, cash-flow drivers and dissipaters, competitive environment, and cushion for loan recovery given the firm's game plan and financial structure.


The implication for entrepreneurs is a demanding one: you can no longer rely solely on your salesmanship and a good relationship with your loan officer for favorable lending decisions. You, or the key team member, must prepare the necessary analysis and documentation to con­vince people (whom you may never meet) that the loan will be repaid. You also need to know the financial ratios and criteria used to compare your loan request with industry norms and to defend the analysis. Such a presentation can facilitate and quicken approval of a loan, because it gives your relationship manager the ammunition to defend your loan request.