Article provided by Charlie Stewart, Commercial Banker in Charlotte, NC
Maybe you have been thinking about starting a new business. You have identified a market for the product or service, done your research and found the perfect location. Like most growing or start-up businesses, you need capital to support the project.
That means it is time to meet with a bank or a capital source to pitch your idea. And obviously after you have presented your plan, you want a positive response. To improve your chances, your loan package or pitch book should answer this important question: “How are you going to pay the debt back?”
I hope that the information in this article will be helpful as you prepare your presentation. More importantly, I hope that this information will improve your chances of obtaining the type of capital you need on terms that are acceptable to you.
1. Your credit package should tell your story.
A credible financial package should include the following components:
- An overview of the company to include thorough background information on the existing business or on the proposed idea. You should describe the product or service, explaining the market for it and its competitive advantage.
- The overview should provide a thorough background on the sponsors to include their qualifications, education and relevant work experience.
- A convincing argument is you know what you are doing, especially if you are starting a new business, making a significant career change or implementing a major change in business strategy or product offering.
- A detailed explanation of the sources and uses of the proposed capital and debt.
- If this is an existing business, three years of historical financial information on the company (CPA prepared financials with footnotes). Business tax returns will work. Also include company-prepared interim financial information for the current year.
- If this is a new venture or an existing business, two or three years of pro forma statements. The numbers should be based on industry performance or your prior work experience. The pro forma needs to be reasonable and obtainable. It is extremely important that you hit whatever financial benchmarks established in the budget, whether it is top line revenues or bottom line profits. Doing so will earn you credibility going forward.
- Financial information on the owners/guarantors (anyone with ownership >20%). This includes a current personal financial statement, with schedules completed with supporting documents. It also includes two years of personal tax returns with K-1’s for all related entities/projects.
2. Prepare in advance.
Every person and company has a certain amount of borrowing capacity. Prepare in advance for your loan request to put yourself and the company in a position to borrow money! Your prospective lender will take the information that you provided from Item #1 and calculate your borrowing capacity. The lender and his analyst will:
- Input the financial information contained in the corporate financial statements into a financial statement software package. This enables the analyst to compare and contrast the company’s historical financial results in a consistent format.
- Calculate a corporate Debt Service Coverage ratio (DSC). The calculation for the DSC is EBIDA/Annual Debt Service. EBISA stands for “Earnings before Interest, Depreciation and Amortization.” At a minimum, a lender will require a 1.25X’s debt service coverage. The bigger the number, the better.
- Pull the guarantors’ credit report and calculate a Personal DSC ratio. The calculation for personal DSC is similar to a Debit-to-Income ratio for a consumer loan but calculated to fit the commercial underwriting template.
- Calculate a Global Cash Flow by combining DSC and DTI ratios of the borrower and guarantors. Although there is no definitive GCF ratio, it should be higher than 1.25X’s.
- Review and confirm the liquidity of the borrower and guarantors. Liquidity includes cash, marketable securities, corporate accounts, and Cash Value Life Insurance. It does not include IRA’s, 401-K’s, or liquid assets held in joint accounts.
- It is still a fluid process and the analyst may have questions. Don’t take this personally. He is trying to better understand the business and the loan request. He or she is trying to help.
3. “What’s the rate?” is not the right question.
Here is the simple truth. Your capital source wants to be fairly compensated for the risk that they are taking.
- When negotiating with your capital source, remember this: Pricing and rate are important but they shouldn’t be everything.
- Rate is a function of
- The lender’s cost of funds
- The risk of the venture
- The extent of the banking relationship
You cannot control an investor’s or a bank’s cost of funds. However, you can control some of the risk component and the entire relationship component. How?
- Reducing Risk – examples would include putting more equity in the deal; offering adequate or additional assets as collateral; providing full, joint and several, unconditional personal guarantees; requesting shorter loan terms and amortization schedules.
- Relationship – move as much business to the lender as is reasonably possible to include the commercial checking accounts, any related debt, merchant business, credit cards, personal loans and personal checking accounts.
- Banks use a tool called a RAROC model (Risk Adjusted Return on Capital) to help calculate a targeted interest rate. It is too complicated to explain RAROC but you should understand that there is some method to a bank’s pricing process.
- Banks use a tool called a RAROC model (Risk Adjusted Return on Capital) to help calculate a targeted interest rate. It is too complicated to explain RAROC but you should understand that there is a method to a bank’s pricing process.
- Investors use an IRR model (Internal Rate of Return) and will strive to hit target returns based on the estimated risk of the project. You can Google IRR if you want to see the actual calculation.
4. Acquiring capital is difficult
In fact, it could be the hardest part of your business plan. Therefore…
- Expect to be told “no.” Don’t take it personally.
- Cast your “capital” net wide. Different lenders have different appetites for certain types of credit at various times.
- Thank the prospective capital source for their advice and counsel, even if the feedback is a “no.” Ask them if they know of another source that they would refer you too.
- Don’t burn bridges. You may want to come back to them in the future.
5. If you are dealing with a bank, remember these simple facts.
- Your relationship is important. This includes personal accounts, personal loans and personal investments.
- A bank will look at your personal credit report as an indication of your willingness to pay your commercial debt. No matter how unfair it may seem, be sure to pay those contested medical and cell phone bills.
- Bankers like to see liquidity. When they look at your personal financial statement, it is the first item they will look at.
- It is okay to negotiate, but strive to reach a win/win solution.
This seems like a lot of work and it is. Even after you create the perfect loan package, there is no guarantee that your request will be accepted or approved.
However, a thorough, well written loan package will improve your chances of getting a better response. If the initial answer is “no,” a well thought out loan package will allow the bank or credit source to provide you with better feedback on why the request doesn’t fit their credit criteria. With better feedback, you can address the issues or modify the business plan or credit request accordingly.
Wishing you luck as you begin your search for business capital. Please give us a call today to help you prepare your package!