A Dozen Ways To Borrow 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.
SHORT-TERM LOANS
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.
