By Dave Costello, TCV Growth Partner -
You own a business. Businesses need money to operate and maybe to grow. You say to yourself, “I know, I’ll get a loan from a bank!”
Easier said than done sometimes.
Banks are in business to make money, not give it away. They expect to be paid back, with interest, whenever they make a loan. The credit check that underwriting banks undertake is generally very robust when deciding to make a loan or not. They are assessing the business’s ability to repay the loan. Among other things, they will look at:
How long the business has been in operation.
How has the business performed over the last few years? In other words, has it made money or lost money? Has it handled its obligations satisfactorily?
Does the business have any hard collateral to pledge, such as a building or equipment?
Does the business have any soft collateral, such as accounts receivable or inventory?
Credit scores of the owners.
Now let’s talk about your business.
How long have you been in business? If it’s less than two years it can be very difficult to get a loan from a bank. Bankers want to see that you have had a period of experience in running the business in the industry you are in and that you are committed to making it a success. If you are highly experienced in the industry but have only had the business a short time, that’s a plus to the banker but it’s not all they will be looking for. The fact that you have significant personal capital invested in the business is also a plus but, again, is only one factor in the decision process.
How has your business performed over the last few years? Are you making money? Are you making enough money to repay any other loans you have? Are you projected to make enough money to repay a new loan from the banker? Even with collateral the bank will want to see a certain minimum level of free cash flow that they can use to get comfortable with making a credit decision. Banks tend to shy away from businesses that are over leveraged, that is, they are carrying too much debt on their balance sheet.
Do you own any buildings that you can pledge to the bank as collateral for the loan? Banks typically want to be in first lien position on collateral such as buildings or equipment.Banks will occasionally take a second lien position on a building or property, but only if it provides sufficient coverage of their loan amount.In other words, the balance of the loan in first position must be fairly low in relation to the value of the property.And even then, its only one factor in the decision process.As a general guide, banks will lend up to 80% of the appraised value of a building or property.If in second lien position, the bank will generally not lend any more than 90% of the combined loans (i.e., loan in first position plus loan in second position) to the value of the building or property.There are a lot of factors that can impact the value of a property over time, so the bank looks to discount the appraised value when making a credit decision. Even if the appraised value is pretty accurate (a relative term), there would be costs to sell a property if the bank had to foreclose because you defaulted on your loan.
You may not own a building in your business but could have accounts receivable or inventory that you could pledge as collateral. If you can demonstrate that your receivables are valid and you historically collect your accounts receivable on a timely basis or that your inventory turns into finished goods or is sold in a short time period, they could be used as collateral for a loan. Banks will typically only advance funds using accounts receivable for accounts that are less than 60 days old, and even then, will only advance up to 70% of the receivable amount. Inventory financing percentages vary depending on the type of item it is. Perishable items are less likely to be eligible collateral for a loan for obvious reasons. The time it remains in inventory is a critical element of the bank’s underwriting review.
What is your credit score? You might wonder why your personal credit score is important in underwriting for a commercial loan. Credit scores show how you manage your personal finances and by extension are indications of how you manage the finances of your business. When thinking about credit, bankers often use the 5 C’s of credit in the underwriting process to convey the credit worthiness of potential borrowers.
1. Character—the applicant's credit history.
2. Capacity—the applicant's debt-to-income ratio.
3. Capital—the amount of money an applicant has or has invested in the business.
4. Collateral—an asset that can back or act as security for the loan.
5. Conditions—the purpose of the loan, the amount involved, and prevailing interest rates.
When you are looking for a loan, make sure you can provide documentation to support your request. This includes:
Accurate financial statements for the last few years.
A business plan describing the purpose of the loan and how loan funds will be used.
A forecast of future performance and cash flow indicating the ability of the business to repay the loan.
Organizational documents of the company identifying the owners.
Tax returns for the last few years.
Finally, I always advise clients to have relationships with more than one bank. Make sure to consider community banks too. You are often closer to decision makers who can be flexible to a degree if appropriate when you work with a community bank. And community banks are very experienced in working with small to medium sized businesses. Large banks can decide to get into or out of a market or industry whereas community banks are committed to doing business in their communities.
If you need help in assessing your situation, approaching a financial institution for a loan, or assembling information for a loan package to submit, TCV Growth Partners can . Email me at firstname.lastname@example.org to start the conversation. We are happy to help!