To get bankers to open their pockets, you have to know their language. Here's a primer on the ways banks lend money.
To get bankers to open their pockets, you have to know their language. Here's a primer on the ways banks lend money.
Bankers, even those who are hot on the trail of new clients, play by some pretty conservative rules. They may take you to lunch, tour your offices, peruse your financials enthusiastically, and then turn down a loan request for reasons that seem absurdly technical.
In fact, banks want to lend money. It's the main product they have to sell, and small business is repidly becoming one of banking's most attractive customers (see "Special Report, Banking in the '80s," INC., November). But lending officers aren't standing at the door counting out bills. They still have to cope with both federal and state banking regulations, traditional lending standards, and a persistent desire to keep the funds they lend from straying beyond their control.
The starting point to overcoming these obstacles, most lending officers agree, is to put together a proposal that fits into the conventional categories the banking world uses to describe most loans. There will still be countless variations on these categories, as well as individual terms and conditions to deal with for each borrower. But at least you'll be speaking a language your banker respects -- and that can't hurt.
Here then are the 12 basic loan categories that bankers generally use to classify loans, grouped according to the expected duration of the loan.
Business runs on short-term loans. Technically a "short term" loan means less than a year, but in practice often expands to two or three years. Small companies usually seek short-term loans to finance receivables or inventory, especially in seasonal or perishable lines. But short-term loans can also be turned to many other purposes, from taking advantage of an inventory bargain to taking care of an emergency.
Most short-term loans fall into one of five classes:
* LINE OF CREDIT. A widely used mode of short-term lending, a line of credit consists of a specific sum marked off for a company to draw on, as needed, over a prescribed period. The period may run only 30 days, or may stretch to two years, since repayment is tied to anticipated receipts. Interest is computed only on the amount actually drawn, but a commitment fee of 1/2% to 1% of the total credit line is usually imposed, to pay the bank for reserving funds that may not be tapped. Some banks waive the fee in favor of a compensating balance, a sum that must be kept on deposit throughout the loan period; others work out a combination of compensating balances and commitment fees.
Lines of credit are popular because of their simplicity, but banks have developed several credit line arrangements that fit different borrowing needs. The cheapest, the nonbinding line of credit, may be your best buy if you're willing to risk the line's drying up. With no guarantees, your credit may be curtailed if your company's financial position deteriorates, or even if your industry seems healed for hard times. Moreover, when the economy is tight -- and your need is greatest -- the bank may develop liquidity problems that force a cut-off, although the larger money-center institutions can usually ride out such crises.
The risks of losing the line can be avoided by paying a premium to insert the word "committed" in the loan agreement. The commitment fee will probably double, going as high as 2%, but you're assured that the funds will be there when you need them.
Nonbinding or committed, a short-term line of credit must be "cleaned up" periodically, under most banks' rules. You must be "out of the bank," or fully paid up, for 30 days a year, in the typical agreement.
If cleaning up a line of credit will constrict your cash flow, there's a third form that may be useful -- the revolving line of credit, which requires an annual review and renewal but no cleanup. This is similar to a revolving charge account: As you withdraw funds, your available credit diminishes, and as you repay, it expands by a like amount. Interest is computed only on the funds actually borrowed, and there's usually no additional cost.
Ordinarily, revolving lines are repaid in monthly installments of interest plus principal, but some banks offer other options.At Citibank in New York, for example, you can arrange to restrict some installments to interest, holding off on payments of principal until your cash flow improves.
* INVENTORY LOAN. When a small company with seasonal borrowing needs comes in for a loan of $25,000 to $200,000, some big banks shy away from the formal line of credit, preferring to write what they may call "short-term loans to carry inventory." The bank's collateral is the inventory itself -- sometimes, under an arrangement called "floor planning" that big-ticket retailers use, loans are collateralized by specific inventory items -- so your banker is likely to feel in control of the situation. From the customer's point of view, however, an inventory loan might just as well be a line of credit. Funds are made available to be "taken down," or borrowed, as needed; repayment is made in installments as inventory is sold and receivables satisfied.
The usual inventory loan runs six to nine months, and requires the same 30-day annual cleanup as a line of credit, if you want an extension.
* COMMERCIAL LOAN. Some big banks funnel much of their short-term lending into commercial, or "time," loans which minimize bookkeeping for both lender and borrower. Requiring no installments, a commercial loan is simply repaid in a lump sum at the end of the term, typically three to six months. In practice, commercial loans are often used to finance inventory, but they may be applied to any other purpose that wins bank approval. In making a commercial loan the bank's chief concern, in addition to the company's credit rating, is the source of repayment: How will the company amass the lump sum to meet its obligation?
* ACCOUNTS RECEIVABLE FINANCING. Small companies in almost every industry today find receivables are tying up inordinate amounts of working capital, so they're turning to their banks for loans that will convert unpaid accounts into fast cash.
Which accounts, and how much?Generally, accounts must be less than 60 days past due, and the customers themselves must qualify as creditworthy. For receivables meeting these criteria, banks will advance 65% to 80% of face value, repayable as customers' checks come in. The usual arrangement calls for you to pass the checks on to the bank, which takes its portion and deposits the rest in your account, charging interest only on the amount outstanding.
Although the contract is ordinarily written for one year, many banks are prepared to work out a revolving format. Under such an agreement, which is subject to annual review and renewal, they will continue to advance funds against your incoming receivables. One limitation on receivables financing that doesn't apply to other short-term loans is that most banks set minimums based on the cost of monitoring such loans. At the Southeast First National Bank of Miami, for example, qualified receivables must amount to at least $250,000, which translates into annual sales of at least $2.5 million.
* FACTORING. Perhaps the oldest method of commercial lending, factoring is a variation of accounts receivable financing in which the bank (or a factoring company) buys receivables outright. A couple of decades ago, factoring was largely restricted to the apparel and textiles industries, and was disdained in other quarters. Today, many more industries draw on factoring services. In addition to textiles, major users include the electronics, importing, wood and wood products, plastics, home furnishings, and appliance industries.
Since receivables are purchased without recourse, ordinarily you're no longer involved once the transaction is completed. The bank assumes credit risks and takes on collection responsibilities, receiving payments directly from your customers. But if you don't want your customers. But if you don't want your customers to know you're involved in a factoring arrangement, you have other options. Some banks offer "non-notification" factoring, in which you continue to collect payments on the purchased receivables, and forward them to the new owner.
There are some limits to factoring. The bank subjects receivables to rigid scrutiny before making any purchases, to screen out the poorest risks. Further, your costs, in the form of discounts from face value, may be quite high; often, in fact, they are higher than in most other forms of short-term financing.
Short-term loans tend to be granted by banks without too much concern for collateral since these loans are usually self-liquidating from sales made in the ordinary course of business operations. More likely to require collateral are medium-term loans, of one to five years, which are the usual way to finance machinery and equipment, including furniture and fixtures, plant alteration, and expansion. While you may view the asset you're purchasing as security, don't be surprised if the bank doesn't see it that way and asks for additional collateral, particularly if you're starting a new company. The bank will, however, expect the asset to serve as the source of repayment, in terms of generating increased revenues.
There are two kinds of medium-term loans:
* TERM LOAN. Most term loans providing 80% to 90% of total costs are written either for five years, with a refinancing clause, or for the useful life of the asset. The typical repayment schedule calls for quarterly installments of principal plus interest. Principal payments remain constant, but interest, computed on the amount outstanding, declines over the term of the loan. In consequence, installments are highest at the start, although you can often arrange to tailor the repayment schedule to meet your anticipated cash flow.
* MONTHLY PAYMENT BUSINESS LOAN. Even with this deferral, the quarterly installments may prove initially burdensome. Accordingly, some banks offer a variation permitting you to make approximately equal monthly payments over the entire period. At Union Trust in New Haven, Conn., for example, you can work out a schedule, tailored to your company's needs, that will allow you to repay a much smaller amount in the first year or two than would be demanded by term-loan conditions. Toward the end of the loan period, though, you'll be paying more, under the monthly payment plan. While these payments remain the same, the quarterly term-loan installments decrease, as interest drops along with principal owed.
Many companies find the reduced early payments advantageous, but whichever method of repayment suits you better, you should be aware that medium-term loans, in contrast to short-term loans, may impose operating restrictions on your company. The bank may insist on your maintaining a certain level of working capital or current ratio (current assets/current liabilities); or limits may be enforced on the distribution of dividends or on other debt. If you don't like the conditions laid down by one bank, however, try another; you're sure to find differences.
Loans of five or more years, least often sought and probably the hardest to get, will be linked to specific business purposes. The most common include purchase of real property, major expansion, acquisitions, and start-ups.
* COMMERCIAL AND INDUSTRIAL MORTGAGES. Banks ask sharp questions about potential real estate purchases because, as a Bank of America lending officer cautions, "Pride of ownership can mean business failure." Nevertheless, if you get the chance to buy the building you're now renting, most banks will consider a mortgage loan of up to 75% of appraised value. Commercial and industrial mortgages may be written in a variety of ways, depending on the value of the building, your company's long-range profit projections, and the bank's lending policies. Under the best circumstances, you might get a 25-year mortgage, to be paid off in regular monthly installments. More likely, though, you'll have to settle for a mortgage of 5 to 10 years, but your monthly payments probably won't reflect this short period. Rather, they'll be geared to a 15- or 20-year amortization period.When the mortgage comes due, you'll be faced with a "balloon" payment of the entire amount still owed. Many companies manage to refinance at this point, but a new loan won't be guaranteed.
* REAL ESTATE LOAN. Many companies face just the opposite problem: They already own real estate, and want to borrow against its value to finance an acquisition or other form of expansion. You can tap this equity, without giving up a low-interest first mortgage, by adding a second mortgage -- if you have sufficient equity and good financial standing. If you're in a less solid position, a "wrap-around" mortgage could be an alternative. This differs from a second mortgage in one detail: The bank tightens its control by receiving all your mortgage payments, and then passing on the amount due to the holder of the first mortgage.
If your mortgaged property has appreciated substantially, you might consider refinancing. You can probably get a new mortgage based on current value, but you'll have to give up your old interest rate and take on today's higher rate. Your banker may try to discourage you from refinancing -- unless you're certain you can turn the cash you get into long-term profits.
* PERSONAL LOAN. Most bankers believe an owner's personal assets should provide much of the financing for major expansion and acquisition, so you may have to think about including a secured personal loan in your long-term financing plans. Any property in your own name can be used as collateral, along with marketable securities, savings passbooks, and certificates of deposit. Such collateral is readily acceptable, and a personal loan may be easier to negotiate than a business loan.
To help you put the proceeds to most productive use, the bank may recommend a sophisticated leveraging technique. For example, you may be advised to turn the funds over to your company as a "subordinated loan," repayable to you only after other company debt is discharged. While this kind of loan doesn't create real equity, it will appear on your balance sheet as "surplus capital," a source of leveraging further loans up to three times the amount of the surplus.
* ASSET-BASED LOAN. Long used by big corporations, but new to the repertory of small companies, is the leveraged buy-out, in which the target company's own assets are used to finance the takeover. Virtually every asset can be used -- receivables, raw materials, inventory, machinery, and equipment. Under the most favorable conditions, a combination of these assets may generate as much as 70% of the acquisition cost. But you'll be charged the prime, or "base rate," as some banks are starting to call this benchmark figure, plus 2% or 3%. Moreover, the bank is likely to insist on various operating restrictions as well as keep close tabs on the assets. But once again, not all banks make the same demands, so you can shop around for the best deal.
* START-UP LOAN. Starting up parallels expansion and acquisition, in the banks' view, which means that you'll have to pour much of your own money into the project. In addition to funds raised by personal loans and partners' investments, you may be able to get a term loan from the bank's venture capital specialists, though a Small Business Administration guarantee, which protects 90% of the total, is frequently a condition. This procedure can involve a fair amount of paperwork and delay, unless your bank participates in the SBA's Certification Program; about 500 of the nation's approximately 14,100 commercial banks participate.