In the first of a 20 topic question and answer series, John Wroton, Assistant Vice President of Harrington Bank, Chapel Hill, North Carolina, answers key questions which provide insight and a better understanding of the lending process – how risk and your relationship with your banker make a difference. This is the first of two articles on commercial lending.
Recently a panel of bank executives indicated that getting a business loan is about risk and relationships. The degree of risk is assessed on a business based upon a number of factors that are “plugged” into formula. According to the panel if you have a pre-established relationship with your banker, the chances improve in getting your loan. The caveat is that you need to be prepared before you ask – with a robust business plan and concept, cash flow available to make the loan payments, collateral (in most cases) from the business, and a willingness to provide a personal guarantee for the loan.
These elements have different impact and implications for different businesses. For instance, if you are a sole proprietorship, you are legally “the business”. Regardless of what name you use for your business, underlying everything is the fact that there is no difference between you or your company – legally or for taxes. All liability is automatically yours. While you may accumulate assets for the business, those assets count as your personal property, just as your home, your car, and your 401(k). All of these assets are equally subject to forfeiture if someone makes a claim against the “business” or if the “business” gets a loan.
Corporations, on the other hand, are separate legal and tax entities from the owner. This means that the business has an identity of its own, can own assets independent of its owners, and enter into contracts and agreements (through officers and other agents that represent it). A business may have its own credit history, credit risk rating, and obligations to meet. For liabilities, including loans, the corporation may have sole responsibility to meet the obligations associated with those liabilities. The separation between the owner(s) and the liability remains in place unless the owners are asked to guarantee the loan personally.
A personal guarantee is essentially automatic for the sole proprietor. For the corporation, the personal guarantee is another facet of a loan deal that a lender pursues from all but the largest corporations to reduce the degree of risk associated with the loan. Personal guarantees are viewed as risk reducers because not only are the assets and cash flows of the business pledged as security, the personal assets of the guarantor(s) – the owner(s) are there as secondary recourse.
Many lending institutions in the application process do not differentiate between the legal entity status of a business. From the time of application to granting the loan, the owner(s) information, credit history/rating, other sources of income available to meet payments, and assets (homes, cars, investments, and the like) are considered in the equation. They do this because they know at the beginning of the process that a personal guarantee is required on every loan they make to “small” businesses.
If you are thinking about a Small Business Loan from the SBA, please note that all SBA loans require personal guarantees by the owner(s). Like banks and other lending institutions, the SBA wants to be sure that you are “motivated” to use the money wisely to grow your business and generate revenue, profits, and cash flow to meet your obligations.
There are instances of unsecured loans. These loans tend to have higher interest rates than secured loans (loans guaranteed by assets or people), because of the higher degree of risk (no assets to seize directly or secondary means of collection).
What is the first thing a business owner needs to do if he/she expects to seek a loan in the next 6 to 12 months?
If you already have a business, there isn’t a lot you need to do to apply for a loan. The best thing you can do is make sure you have accurate financial information on your business, both income statement and balance sheet. . If you do not have an accountant, this would be a good time to find one who can review your books to make sure you are presenting an accurate picture of what your company is doing. You should also make sure that you pay all of your bills on time (both personal and business). Any recent late payments will reflect poorly when you apply for a loan. If your business is not turning a profit, you should try to do everything you can to turn that around before applying for a loan. Sometimes that isn’t possible, but banks will be much more willing to lend to a business which is profitable than one which is not. If you have a chance to project your income and expenses over the next year based on certain assumptions, it can be helpful to the bank, but not absolutely necessary. Lastly, understand your personal financial situation and, if you don’t have a high net worth (defined as your assets less your liabilities), then you might want to start talking to family and friends about their willingness to assist you as you start applying for a loan.
Are there differences in documentation in the application process from the bank’s and business’ perspective between new (fewer than 3 years old) and established businesses?
Part of this will depend on the bank. Some banks may not even consider a loan if the business has not existed for at least three years. Typically, however, the application process is very similar regardless of the age of the business. Just because a business has been around for 20 years doesn’t necessarily mean it is a good candidate for a loan today. As anyone in business knows, things change – competition, technology advances, and changing social or demographic trends may all impact how a business is performing. Historical performance is important, but the banker will be more focused on what is happening now.
For the loan application, the borrower should be prepared to have two to three years of business tax returns if the business has been operating that long, year-to-date financials printed from the business’ accounting software program, including income statements and balance sheets, and financial projections for the next 6 to 12 months. Two to three years of personal tax returns and a personal financial statement listing all of an individual’s assets and liabilities is also typically required for each person who will be signing or guaranteeing the loan. This will usually give most banks a starting point, but additional information may be required as the loan process continues.
Are personal guarantees “automatic” with some types of loans?
Unless you are a corporation with multiple shareholders, it is likely that the bank will want you to guarantee a loan personally. From the bank’s perspective, it causes concern when someone is not willing to stand behind his or her business. what are they lending options if a business was established using the personal assets of the owners and is now close to generating cash flow, they have a signed deal with a customer but need working capital?. They have no additional collateral remaining outside of the business.
This will really vary on a case-by-case basis. With one customer and no other assets in or out of the business available to secure a line, it is going to be very difficult for a bank to provide a line of credit. Usually the best option is to try to negotiate with that customer on favorable payment terms. Maybe the customer could provide a payment up front, or at least agree to provide payment within 3 to 5 days of receiving an invoice. Friends and/or family could also be used to supply additional collateral and/or cash to help support the business.
Does business experience factor into the risk equation?
Business experience is an intangible that can help if a bank is undecided on a credit decision. But, if the other pieces of the lending puzzle aren’t there (i.e. no cash flow, no collateral, and poor credit of the guarantor(s)), then experience really isn’t going to matter.
How big a role does the “relationship” play in convincing a bank to take a greater risk with a business than dealing with a new customer?
Having an existing relationship with a customer does help in the credit process. A person or company which maintains account balances (i.e. no overdrafts), pays loans on time, and has a history of being responsible will be viewed more favorably than someone who might have the same factors, but has not been a customer of that bank. On the other hand, an existing customer who has not maintained their accounts or loans will be viewed less favorably. On the whole, any time the bank has experience with someone, the more likely they will try to make a loan for that person.
Are there third parties other than the SBA which can be brought in to serve as a guarantor of a loan – not associated with the borrower or his/her business prior to the loan?
Absolutely. Anyone that the borrower would like to serve as guarantor can be added to the loan. Family, friends, other employees of the business, etc. can all serve as guarantors. The bank cannot say they want a specific person to serve as guarantor, but the bank can say that without additional guarantor support, they cannot approve the loan request.
Another alternative besides personal guarantees is for someone to provide additional collateral for the loan. Someone could agree to keep a certificate of deposit (CD) at the bank and pledge that CD to support the loan. This way, that person is not a direct guarantor on the loan.
Are officers of a company who are not owners ever asked to serve as guarantors?
The only requirement a bank might have is that all owners, members, or shareholders of a company have to serve as guarantors on a loan. If there are just one or two primary or majority shareholders, then the bank might require these individuals serve as guarantors. However, the bank might say that in order for the loan to be approved the Borrower will need to bring in additional guarantor support. It is then up to the Borrower to decide who else could be brought in to guarantee a loan.
If a business has five partners sharing equally in ownership (20% each), do they all have to act as personal guarantors if personal guarantees are needed? How much do they each guarantee – the whole loan or 20% per owner?
A bank will typically want personal guarantees from all the shareholders in this scenario. Additionally, these are usually unlimited guarantees, meaning each guarantor is responsible for the total of all debts owed to the bank. There is also a limited guarantee, which sets a dollar limit on a particular person’s guarantee. Even with limited guarantees, the bank will usually want greater than 100% coverage of the loan amount to help ensure that it is protected. In the example above, the bank might agree to each owner guaranteeing 25% of the loan amount, so that the bank has a total of 125% guarantee. The structure of the limited guarantee will, in part, be determined by the individual financial strength of each of the guarantors as well as their ownership percentage of the business.
Do lenders ever require a business to bring in an experienced business person – as an owner, director, officer, or consultant – to ensure that the business has the management capability and a better chance of succeeding?
The bank does not want to get involved in the day-to-day operations of the business. It would be very unusual for the bank to require the hiring or firing of anyone in a customer’s business. The bank might bring attention to the fact that a certain skill set might be needed or that a certain individual was potentially not the best fit for a certain position.
An investor or shareholder in the business would be more likely to require this type of action.
If a new business is started by individuals who have no assets, poor credit, and no business experience, what options if any do they have to get a loan?
Their options are going to be very limited. Their best bet would be to approach friends and family for a loan. Friends and family will typically be willing to give much more lenient credit terms than a bank. Utilizing credit cards would be another option to get started. They could also look into various loan programs such as loans backed by the Small Business Administration (SBA) or other special loan programs a bank might be offering (i.e. loans given to business owners who complete a specialized course or courses). They could also research any grant programs which provided funds in the industry in which they were trying to start the business.
What are some of the risk factors that anyone seeking a loan can reduce prior to making the loan application?
A new business is typically seen as a greater risk than an established business. A business which has increasing revenue and profitability is typically seen as a better risk than one which has decreasing revenue and/or profitability. Someone with lots of credit (high credit card balances, a home mortgage and a home equity line, car loans, student loans, etc) is a higher risk than someone with little or no debt.
If at all possible, always pay all of your bills on time, don’t open too many credit cards or carry high balances on your credit cards, and don’t apply for a lot of credit all at once.
Is it wise to deal with banks one at a time or is a shotgun approach better if you don’t have an established relationship with a bank?
If you don’t have an established relationship with a bank, it is probably smart to talk to loan officers at 3 or 4 banks to get a feel for differences, if any, between them. Talking to family, friends, and business associates about where and with whom they bank is a good way to get started. The size of the bank is another criterion to consider – a small bank usually has more personal service and more flexibility while a larger bank may have more options and products available. Once you complete this process, it is probably best to narrow it down to one or two banks which seem to fit with your needs and where you feel most comfortable. The advantage of this approach is that you can spend time working with the loan officer, giving you the best shot of getting a loan approved. The downside is that, should the bank not approve a loan, you have lost time by not working with other banks. Additionally, if you are able to get a loan approved at a couple of banks, you can leverage that to try to negotiate the best loan terms. So, you may not want to put all of your eggs in one basket, but you also don’t want to take such a shotgun approach that you can’t respond quickly or effectively to the bank’s questions.
How do credit cards – even those without a balance – impact a loan application?
Multiple credit cards are not necessarily viewed as a negative. High credit balances, credit cards whose balances are all at their limit, and total credit card debt does factor negatively on a loan application. Having multiple open credit cards can also negatively impact your credit score, regardless of whether those cards carry a balance or not. It is always a good idea to write your credit card company to close any card you are not using. By using only one or two cards, paying them on time, and not maxing them out, you will be a much better credit risk to a bank.
If a person has previously filed bankruptcy, does it prevent them from getting a loan or increase the risk and consequently the interest rate?
If the bankruptcy has not been discharged, getting a loan will be very difficult at best. Even once the bankruptcy has been discharged, banks will be hesitant to lend money to you or your business unless you have an additional guarantor or have excellent collateral for a loan (i.e. cash, equity in your primary residence, non-retirement investment account). Lenders who might work with you if you don’t have any of these items will charge you a very high interest rate and fees.
If a business owner decides to apply with many different banks for loans, is there an adverse impact on their credit rating just from applying for the loans?
Each time someone pulls your credit, it does have an impact on your score. However, there are many factors that go into your credit rating and unless you continue to apply for credit many times over many months, these credit pulls are unlikely to have a significant impact on your overall score.
What services are available – directly from lenders or from other businesses – which improve the chance of getting a loan or the terms of the loan?
Lenders typically don’t offer any specific services to improve the chances of getting a loan. However, the loan officer at the bank should be willing to talk to you about what you will need in order to get a loan with that bank and may be able to refer you to people that he or she knows who could assist you.
There are various classes available which can help an entrepreneur understand the basics of business and what banks look for. Local community colleges are a good resource to start with. There are also individuals who do consulting for a fee who can help prepare a business plan and work with you to help you get a loan. The phone book, the internet, or a loan officer at a bank are good ways to find these business consultants. Federal, state, and local governments usually offer programs as well and keep lists of various business resources. Local chambers of commerce and other networking groups can be an excellent place to get referrals to people who might be able to assist you.
If an applicant is turned down for a loan, how can he/she regroup and come back to try again – how long should he/she wait and what actions do they need to take to improve the application?
If you are turned down for a loan, the bank has to give you a reason. Typically, talking to the loan officer will help to clarify what you need to do to become eligible. How quickly you can reapply depends on the reason for the credit denial. If the primary reason is bad personal credit, then it might take six months to a year to repair your credit.
Credit history of the business and/or the owner(s) plays a heavy role in assessing risk, how do lenders use the score? Is collateral the only “offset” to a low or poor credit history?
Every lender will use the score differently and place a different weight on its value in the overall credit decision. Each lender might also have its own threshold for the credit scores (i.e. they just don’t lend to anyone with a credit score below 620). Some lenders will just look at the credit score number. Others might dig deeper into the credit report to try to understand the reasons behind a low score. Someone who has good overall financial strength (i.e. a large net worth) but poor credit might be viewed more favorably than someone who has a low or negative net worth and poor credit. It really does depend on the unique circumstances for that individual.
Cash collateral which can be placed in the bank and used to secure a loan is the easiest way to obtain a loan. Equity in a house or other real estate might also be a valid option.
If someone is considering starting a business, what foundation is needed – relationships and credit standing – before they start the business?
There is no right answer to this question. People have started successful businesses from their garage with no more cash than for the sale price of their car in order to buy their initial inventory. On the other hand, businesses started with millions of dollars in cash have failed. However, making sure that you are in a strong position financially (i.e. little to no credit card debt, all other debts paid off as much as possible, good credit score, at least six months cash savings) will help to ensure that if your business does not take off as fast as you thought it would (or if it takes off faster than you thought!) you will have the personal flexibility to make it work.
Harrington Bank is a locally owned and operated community bank with two locations in Chapel Hill to serve all of your personal and business banking needs. Contact: John Wroton, Assistant Vice President, www.bankatharrington.com, (919) 945-7818, [email protected]
Copyright ©2005 F.O.C.U.S. Resource, Inc.