CHAPTER II
Methods of Financing

Acquiring Financing or Funding

Even the simplest businesses cost money. But it comes in many forms, with many implications for you as an entrepreneur.

THERE ARE MANY DIFFERENT ways to acquire financing, so all the preparation and research you do will pay off well. Before searching for financing, it is a good idea to see what grants and subsidies you might qualify for. They could keep you from incurring debt or losing ownership of your business. However, if you don’t find such funding available, a variety of other sources of financing can help you get your new business off the ground.

When determining what type of financing to procure for your business, there are many avenues to consider. The type of business you have, your future plans, and the product(s) and service(s) you offer all influence your evaluations of options here, and making a good choice is important. There are two main types of financing: debt or equity. Debt financing is the process by which a firm borrows capital (money) from banks and investors, promising to repay the borrowed funds within a certain amount of time with some profit for the lender, usually in the form of interest. The other type is equity financing, when a business relinquishes part of its ownership interest to different sources in exchange for capital. Most well-capitalized, established businesses use a balance of both. This helps mitigate risk and keep the cost of capital to a minimum.

Debt financing is usually done by businesses that have either established positive cash flow (money remaining after collecting revenue and paying operating expenses plus any mortgage payments) or have the necessary collateral (equipment, cash or an individual’s promissory note) to secure the funds from a lender. When businesses choose this method, they are obliged to pay a carrying cost on the funds. This form of financing is common in two types of businesses. One type deals in high-volume inventory purchases that are later liquidated through sales channels. They get in cash relatively quickly, and thus can keep the term of the loan to a minimum. The other type needs to expand by purchasing space or equipment with a liquidation value similar to the debt they take on (for example, real estate, long-term-use equipment, and vehicles).

Equity financing is something else. It can be a great tool when expanding your firm beyond the size and scope of what you could fund with conventional debt financing. In equity financing, you effectively sell an interest in your company in exchange for funding that is provided by a partner or investor. That way, you can raise needed capital, while only being exposed to a few key liabilities like rent or mortgage, equipment expenses, and employee salaries. (For more on equity compared to debt financing, see pages 73-74).

In order to avoid takeovers or buyouts by these parties, you need to consider who holds the controlling interest in an equity deal. Whoever owns more than 50 percent, the majority percentage of the company’s shares, gets to call the shots. Also, depending on the way in which the interest is conveyed, individuals can recoup their investment through multiple channels. This is when contracts detailing cash capital disbursements (debt repayment and/or interest payment) are important.

Here’s an example of a vital cash capital disbursement decision. Imagine you accepted a large start-up loan from an investor to get your business off the ground. What does your cash capital disbursement contract say about your repayment terms? Specifically, when you have to pay it back? Do you have to start repaying the loan immediately, or after three to five years? It makes a pretty big difference.

If you have to start paying back the loan immediately, the principal (original amount) plus interest will put a pretty big dent in your allocated operating budget, from Day 1. Is the loan even worth it, at this point? You can see why your cash capital disbursement terms are extremely important. Make sure the financial terms to which you agree are feasible for your business even under a worst-case scenario for the future.

Lastly, remember that there is a strong correlation between risk and reward in funding. If you have to relinquish a good portion of your ownership interest to other investors in order to get the money you need, you may only be entitled to a small portion of the profits, in the event that the business performs extremely well.

There are many different types of private investors and investment groups. The most common is the accredited investor. These individuals are familiar with the investment world and have probably participated in such ventures previously. They also have certain qualifications to make them attractive financiers. Another type is an angel investor, an individual who has the funds to almost entirely fund the start-up, expansion or growth of a business. Both accredited investors and angel investors are private parties who are not usually affiliated with an investment group.

Investment groups and IPOs

Investment groups, such as venture capitalists (VCs), are another option. Venture capital groups are great for companies that are interested in retaining brain-trust equity and/or a portion of the control, but not all. These groups tend to know exactly what they are looking for in exchange for their involvement. The right to controlling interest and substantial portions of revenue is not uncommon. However, by using such groups, a business’s current owners can nearly eliminate their personal financial risk. Because the VCs have a sizeable vested interest, expect the participation of seasoned business consultants who will take a hands-on approach and work with your firm to achieve success.

Some entrepreneurial businesses have the ability to approach the public through an initial public offering (IPO) of shares of stock. This is the process by which a company works with investment bankers to build a following in a specific trading platform (e.g., a stock exchange), then offers shares representing interest in the company on its behalf, in exchange for a portion of the proceeds. Usually a company has to have a proven track record to launch an IPO, so don’t waste time dreaming about IPOs in your early start-up days unless others with experience confirm it’s worth considering.

There can be great benefits as well as liabilities associated with making an initial public offering. The most common advantage is that, on average, a firm can collect ten times its value in one offering. In special circumstances, when either the product or service is groundbreaking or there is a large emotional following in the market, an organization can raise exponentially more. This happened frequently during the dot-com era, back in the late Nineties, when technology companies were making IPOs and the stock prices were driven up to staggering multiples above the companies’ book value, simply because of investors’ speculation on the potential for future success.

Local, regional, or even national governments often provide funding for entrepreneurs, as the Small Business Administration (SBA) does in the U.S. Especially for new businesses, the SBA and similar organizations offer competitive loans, grants and subsidies. However, the majority of these funds are only released to businesses or individuals with specific profiles, such as minorities, persons with disabilities, and individuals coming from a disadvantaged socioeconomic background. If you qualify for this avenue for funding, you will encounter numerous waiting periods that can only be expedited by spending more money. Most of the forms necessary for different filings can be filled out digitally and submitted online, or they can be downloaded, printed and then faxed to the designated recipient.

If you are based in a location where special business development incentives are available, be sure to check them out. Has your area suffered from a natural disaster, so that funds are now available to recover and start new businesses? Do your local or higher levels of government, or your industry sector, award grants or subsidies to encourage companies to open new markets, employ certain kinds of workers, or develop products or services in line with governmental planning goals?

With all these sources of money, be careful to not get ahead of yourself. If your regional government offers to pay for companies to attend trade fairs in new markets, for example, don’t travel first and apply for reimbursement later. You will often find these aids need to be applied for and approved before the action they encourage gets started. Still, they are a great boon for start-ups and expanding businesses.

Getting Money from the Government

It’s in a government’s best interest to foster successful businesses. Don’t be shy about checking into the resources available from all levels of government in your search for funding.

GOVERNMENTS AROUND THE WORLD are finding ways to offer assistance to start-ups and businesses that need to grow. Depending on what type of business you’re in, you may be pleasantly surprised by the number of resources that are available to you. Of course, governmental programs vary from place to place, so make sure to research which options exist for you and then decide which are the most appropriate for your business.

For example if you live in the United States, the Small Business Administration (SBA) offers an array of loan programs to suit your organization’s needs. Besides typical start-up loans, the SBA offers additional loan programs such as 7(a) Loans, Microloans, CDC/504 Loans and Disaster Loans. These loans can come with special mandates and restrictions regulating how they are to be used by your business. Let’s look at these as representative types of loans that you may find elsewhere in the world under different names.

Start-up loans

The programs that are called 7(a) Loans in the U.S. are special types of loans that provide financial assistance to business that have unique circumstances. Some of these may include loans for businesses that are located in rural areas, engage in exporting to other countries, and for many other special circumstances.

Microloan programs are often in the news because especially in developing countries, a very small investment can launch a stable, profitable small business, and the loan repayment rate is remarkably high. For instance, a U.S. $300 loan can allow a woman in a remote village in India to buy and run a satellite-fed smart phone. Village residents can pay her cash for the calls or Internet access they make, for example to learn what the current price is for the vegetables they grow. Effectively, this puts the village on the phone grid without any physical lines, and everybody benefits from the entrepreneur’s venture.

Microloans offered by the SBA in the U.S. can similarly deliver small, short-term loans to small businesses and to specific types of nonprofit child-care facilities. These funds are also available to selected intermediary lenders that are not-for-profit organizations with experience in lending funds as well as providing management and technical support. These agents generate loans to qualifying borrowers. The current maximum loan amount is U.S. $50,000; however most microloans are about $13,000.

Here is how you can use the capital from a Microloan:

• Use it as operating capital (for your daily business expenses)

• Buy supplies

• Buy inventory

• Buy fixtures and office furniture

• Buy equipment

• Buy machinery

Note that a U.S. business is generally not able to use the funds obtained from a Microloan to buy real estate or to service existing debts.

The SBA also runs CDC/504 Loans. These loans are offered through Certified Development Companies (hence CDC) and through SBA’s community-based partners. This loan program is available to businesses engaging in economic development. It offers small businesses another avenue for business financing, while promoting business growth and job creation. The 504 loan program offers approved small businesses fixed-rate, long-term financing that can be used to acquire fixed assets for growth or modernization.

Disaster Loans are also available from the SBA, the Federal Emergency Management Agency (FEMA), the Farm Services Agency (FSA) and state governments. These loans carry low interest rates. They are available to renters, homeowners, businesses and nonprofit organizations to replace or fix personal property, machinery and equipment, real estate, inventory and assets of the business in the event of a government-declared disaster.

Grants can be a great resource for undercapitalized businesses. They are awarded to organizations that qualify under specific criteria. The great thing about grants is that they generally do not need to be paid back. Rather, they are capital contribution incentives that are dedicated to be used by businesses to invest in any number of things, with the most common being to develop products, perform research, work with emerging markets, etc.

The Risks and Rewards of Borrowing from Family and Friends

As long as you’re careful, getting friends and family involved in financing your business can be a rewarding experience for everyone.

“BE ATTENTIVE AND GUARDED.” This advice is like a Golden Rule for working with family or friends if you use their money to start up, run or expand your business.

Asking family and friends for money for any purpose can be a sensitive issue for most people. When the money is not for an emergency situation but rather, for your business, it can trigger a wide range of outcomes. It could lead to a feel-good moment for a family member who agrees to help you in a time of need. Or, sadly, it could create feelings of animosity and controversy. Needless to say, a lot rides on the way you handle things. So, before approaching family or friends for financial assistance, weigh the possible outcomes by considering these pros and cons.

The advantages of turning to family and friends

You may have involved family and friends as you have thought through starting a business, or as you’ve been growing it since then. Or, due to any number of circumstances, they are mostly in the dark about what you are contemplating. Take this into account before you open a conversation about borrowing from them. The good news is that you probably know them very, very well, and you’ll know how to tune your message. But there are other advantages:

A lender with compassion: A family member or a friend may better understand your complete situation, over and above the numbers and information visible on your business plan. They probably feel a sense of pride in your willingness to pursue your dreams, and they are rooting for you to succeed. Unlike a traditional lending source, family and friends know your character, work ethic and commitment to success—things which rarely show up on a loan application.

No bank loan terms and paperwork mean savings: Family and friends might be willing to extend you more favorable terms for the loan than the bank would offer. This could stretch out your repayment schedule, reduce monthly payments, and eliminate other fees that a bank might assess. A formal application process, credit reports, documentation, etc. could also be waived, further cutting your costs. All of this can save you considerable time and money in the hunt for funding. That can be especially important if, for example, you discover a fantastic (but solid!) business opportunity on which you must move fast. Banks are generally not known for their speedy decision-making processes.

Interest rates and other factors: A family member may offer a lower interest rate than a traditional lender, representing long-term savings for you. Additionally, they may not require as much collateral (or any, for that matter) as a stipulation for lending you the money for your new business. A bank is almost certain to require this.

Flexibility re a loan or an investment: Consider, instead of borrowing from your friends or family, giving them the option of becoming investors in your business, if it works with your business model. (See the discussion of debt and equity financing on pages 73-74). This gives your prospect an alternative to just handing over the money. It also gives your prospect a form of ownership security vs. just interest on the money lent. Plus, it is possible that your prospect may have knowledge, skill, network contacts or an extensive background in your new business. These assets, in an investor in your business, could provide a different kind of helping hand in launching your business to its full potential.

The potential downside to family and friends’ involvement

Most negatives related to borrowing from those near you are not so severely bad that you can’t work with them. Again, your familiarity (no pun intended) with these potential backers can help you be much more sensitive to their needs, something you will probably miss if you deal with funders you’re meeting for the first time, hat in hand. Still, there can be some typical scratchy spots.

Family and friends turn into supervisory personnel: Wouldn’t it be great to borrow a huge sum of money from someone very close to you and then have them never bring up the subject again? The only way this may happen is if everything goes exactly according to your plan. So, it’s important ensure constant reporting and follow-up on both sides of the table to keep communication clear and flowing. This will work until you report something doesn’t go as planned…and that will be almost guaranteed to happen. At that point, your backers might not be as understanding as they were during the initial talks. Their concerns may prompt unwelcome meddling in your daily business (or make them feel like they have decision-making powers), which could lead to other issues beyond just the loan component. At a much lower level of drama, your backers may feel that their funding entitles them to drop by, chat, ask you to hire someone they favor or give advice during your business day, which requires diplomatic responses on your part!

Relationships can be tested: Business problems can put a strain on your relationships. Your family and friends might wholeheartedly support your business endeavor (personally and financially). However, they might not truly understand the inner workings, risks or outside factors that your new business has to deal with each day. And if business takes a turn for the worse, whether it’s your fault or not, they may hold you completely responsible for any resulting damage. The same applies to your possible inability to pay off the loan they give you as well.

Stress increases: Stress is a fact of life; and owning your own business adds another layer of stress to the ordinary ones. The last thing you need is the addition of family strife! If you borrow from a bank, it takes a big risk. Even if you collateralize the loan, the bank can lose money if you default. On the other hand, when that loan is taken from family or friends, and you default, it can cost them much more than just the principle and interest they were expecting back: a sure recipe for fear, tension, anger and so forth. Lost savings, foreclosure or even bankruptcy could be in store for your backers if they were counting on you for on-time and consistent payments to them. Further, their own situation could drastically change due to illness, unemployment, and other unforeseeable events that could cause them to need their money back, and you might not be able to get replacement funding for some time. All this could be disastrous for everybody, if things don’t go as planned.

Things to do if you approach family and friends for funding

The advice here is simple: Think about this approach to funding and discuss it with others first. Then, investigate the potential pros and cons from every angle to ensure your decision is based on research and facts, not emotion.

If you do decide to reach out to family and friends for funding for your new business, it is vital to prepare and conduct the exploration and execution of this transaction properly, in order to maintain balance and harmony at all times. Use the checklist provided below.

• Be professional and well prepared with your loan request presentation, just like you would for a bank application meeting (in fact, practice on Mom and Dad if you decide to go the bank route!)

• Communicate effectively, honestly and openly with all parties affected

• Give them all copies of necessary documentation so they can review them later

• Put everything in writing… everything

• Present options for lending or investing, if applicable

• Discuss benefits and expected outcomes of the project

• Discuss potential pitfalls and risks involved

• Lay out a comprehensive communication and reporting schedule

• If your backers decide to provide funding, draw up an agreement with an attorney’s help

Statistics show that borrowing from family and friends is second only to using your own money to get a small business off the ground. During tough economic times and when banks are tightening up their lending criteria, this option will continue to be a significant way of powering up new businesses. Given great care in all stages of discussion and execution, it can be a rewarding experience for everyone involved.

Equity vs. Debt Financing

There isn’t a right or wrong way to finance a business, but there definitely are methods that are better or worse for it, depending on your business’s stage of development.

WHEN ACQUIRING FINANCING for your business, you will no doubt come across two of the most common forms of financing: equity and debt financing. These two basic varieties represent the majority of all financing programs used by individuals and businesses alike.

Debt financing consists of a loan (or series of loans) that must be repaid over time, almost always with interest. If qualified, a small business can borrow money with either short-term (less than one year) or long-term (more than one year) arrangements. Banks, finance companies and even some government agencies around the world are the main suppliers of debt financing. In many places there’s a tax advantage attached to debt financing, since the interest you pay on your loan can be tax deductible. Debt financing has another advantage, in that your lender is not obtaining an ownership stake in your business and neither you nor they are obliged to work together further than the current loan’s term, unless both parties want to make a new loan agreement.

However, debt financing also has its disadvantages. The downside to this option is that a small business may at times struggle to make timely loan payments, due to cash flow problems. This must be taken into consideration when selecting this option.

Equity financing is not a loan, but rather a capital infusion obtained from interested investors in exchange for an ownership stake in the small business. This type of financing is provided by angel investors, venture capitalists or private equity firms. Because this option is not a loan, the business does not have to repay the money invested, which can give entrepreneurs peace of mind and free them to focus on growth issues. The burden of stress shifts to delivering on the growth promised, since the investors’ financial goal is to reclaim their capital infusion out of future profits.

The disadvantages of equity financing lie in degree of involvement and percentage of ownership that the investors take in your business. If you surrender more than 50% of your share, you no longer control key votes or strategies. And if your investors are inclined to engage in day-to-day involvement in your company (regardless of their ownership stake), you can end up with exhausting investor relations exercises.

Now that you know how debt and equity financing work, you need to determine which option would work best for your business. If you feel unsure in your judgment, talk with your accounting person, your tax person, and others whose experience you trust. Apart from a lot of work, there’s nothing wrong in applying for both types of funding at the same time to get to a point where you can make real comparisons and come to a choice. But at least in your business’s early stages, your best choice probably will be evident.

Establishing a Line of Credit

When talking about lines of credit for your business, it’s best to start early in order to build up to what you could need later. The secret is to build up over time.

SMALL AND LARGE businesses alike tend to run in cycles. Cyclical ups and downs can be a result of the nature of the business’s goods or services—think of New Years’ decorations. Fluctuations in the economy and consumer buying patterns sometimes are cyclical too. These elements can cause a business to scramble at times to stay afloat financially. Other factors may be more or less constant in a given business. A few that keep business owners up at night are payroll requirements, too many unpaid receivables, and the need for additional inventory or equipment. As a result of all of these factors, business owners commonly encounter difficulties in effectively managing their cash flow.

Start-ups and young businesses can be particularly vulnerable to these powerful forces. Cash may be scarce for them, some or all of the time. One solution to help minimize this threat is establishing a business line of credit.

Lines of credit explained

Not just for rainy days or times of trouble, a small business’s line of credit loan can actually help a small business grow and thrive. Designed to finance short-term working capital needs, i.e., to pay current bills when you know the cash you need to do so is coming in soon, a small business line of credit is administered by banks and other financial institutions to qualified businesses meeting certain minimum lending requirements.

There are two sorts of credit lines. Banks will usually extend a secured line of credit to most start-up ventures. This means that a personal guarantee and/or collateral of some sort will be required to gain approval of the credit line and its maximum amount. On the other hand, the lender may extend an unsecured line if your small business can demonstrate the credit line will involve minimum risk for the bank, through a record of consistent earnings and a positive cash flow over time.

Based on your business’s credit worthiness, just like with a personal credit card, small businesses are approved for a credit line with a pre-determined maximum withdrawal amount. Once established, your business can use a revolving borrowing-and-repayment process during the term of the loan. That’s why this type of financing is also known as a revolving line of credit.

Understanding the terms of the line

As a business owner you have to consider several factors before signing up for a line of credit.

• Term. Many lines of credit are for a term of one year; however, there are exceptions to this rule.

• Interest rates.

• Repayment requirements.

• Annual fees.

• Documentation needed to get the line established.

After your line has been established, it is always advisable to maintain an open flow of communication with your banker. This step affords you the opportunity to learn about transitioning out of secured to unsecured lines. Your communication also keeps you informed about the bank’s other lending products that may be available to you as a result of your payment history with your current line of credit.

And speaking of payment history, there is a plus in all of this, in addition to having access to cash when you need it. A solid history of timely payments made over a period of time also improves your credit worthiness and borrowing power with the lending institution. This is an important asset, because when the time does come when your business needs more substantial financing than a credit line offers, such as a full-scale business loan or second round of financing to allow your business to expand, you’ll be a more attractive candidate for that loan too. The same is true with corporate credit cards and the accompanying payment history that goes with them.

Of course, you take on a large responsibility whenever you use OPM—other people’s money. What if you are slow or inconsistent in your repayment of the line of credit? Well, your lender may then require you to pay down your line, that is, reduce the amount you owe so the lender’s risk is similarly reduced. The rule of thumb is that when you have not followed the agreed-upon payment schedule, even though the total sum borrowed may not be due for several more months, you may be asked to ramp up payments or even pay it all off as a result of violating the terms of your loan.

The path of least resistance

Many small business owners, especially in the early stages of their business’s life, feel leveraged and collateralized to death. This becomes a normal feeling for more experienced entrepreneurs. The key is transitioning out of this stage by patiently building up your business’s track record and then letting it speak for itself. And always remember: bankers don’t like surprises. Apply for any sort of financing as far as possible before you need the funds!

Even before you start seriously thinking about seeking a line of credit for your business for the first time, there are several things you can do to help make the application process (or any application process for that matter) lead to success. One way to accomplish this is to build credit early on. Even if it may not affect your credit report or score, establishing accounts or relationships with outside entities in your business’s name is vital.

• Put everyday financial services such as business banking accounts, a safe deposit box, debit cards and even a small-balance credit in your company’s legal name.

• Other components could be mobile phones, subscriptions and monthly data plans, utilities and insurance coverage.

• Create an invoicing system for receivables.

• Finally, develop a history of open incoming receipts from vendors.

All these things simply add credibility to your application. They provide excellent supporting documentation when you decide to apply for a credit line.

Your goal here is to start and develop an expanding chronological file of your business dealings: externally (with vendors, etc.) and internally (with your banker and other lenders). With each transaction, and subsequently with each passing month of successful payments, your credit worthiness with the bank will take shape and expand with sustaining credentials. This clean, well-documented file will pave the way for success with other banking and financing initiatives you may be planning. Your line of credit may become a cornerstone for those plans.

In short, although a revolving line of credit can seem a major step in solving cash flow issues that may be either present or looming in a young business, you should view this stage as establishing and strengthening a bond with your banker and lending institution. A credit line is important and plays a crucial role in the early days, but it also leads positively to other support if you manage it well. Your line may stay in place indefinitely. The way in which you manage it, however, will have a major impact on your future dealings with lenders.

Using Collateral to Your Advantage

Understand this concept will help you use it wisely and avoid getting stuck with an undesirable deal.

WE’VE ALL BEEN THERE BEFORE. All of us have needed support to work through a financial issue. Earlier, it was our parents who were first in line for our requests for advice, a bail-out, or comfort and encouragement. But after a certain point in our lives, it becomes time to seek financial assistance elsewhere. Enter: the local bank.

Today, the bank is still, for the most part, able to offer us two types of credit or loan options. These enduring options are known as secured and unsecured financing. Let’s examine both.

Unsecured and secured financing

Let’s start by defining an unsecured loan or credit extension first. An unsecured loan is a loan obtained without the use of collateral—some real thing, like a house or bank account balance that can be seized by the creditor in the event that the borrower fails to pay back properly. An individual acquiring an unsecured loan simply agrees to pay back the loan within a certain period of time, or term, based on her credit worthiness, employment history, and other factors. She will sign documents confirming these claims as part of the application process. This type of transaction is also known as a signature loan. Most credit card accounts are opened under this scenario.

But then what is a secured loan? It’s a loan in which you pledge an asset you own that the lender would be permitted to take ownership of, in the event that you default on repayment. This allows you to obtain financing that you need but can reasonably be expected to repay, while the lender is assured his risk is minimized. Secured loans are therefore also called collateral loans.

So how does a secured loan really work? Say you need to borrow a sum of money to buy the materials you need to produce 1,000 gadgets for a new customer. You can offer your bank your delivery truck as collateral (usually the collateral is higher in value than the loan’s value) and promise the bank it can sell your truck to repay your loan in case you can’t make the agreed payments on time. Both you and the bank know that the truck is essential to your ability to do business, so it’s a good prod to repay your loan correctly—which makes your banker sleep better at night.

Collateral therefore has enormous importance in your business’s survival and success. Let’s look further into how you can use collateral to secure a loan for your small business.

How a collateral loan works

As we saw above, in a collateral loan, your loan paperwork describes an asset which you promise to relinquish to the lender if you are unable to repay the loan as agreed. With that promised, the lender faces less risk and your loan request gets easier to approve. There are obviously pros and cons to this approach. Let’s look at both.

Pros: Collateral of any kind secures a loan, meaning the lender can be absolutely certain that the money lent will come back—either through your repayments or through seizing and selling your collateral to repay the loan in the event you default. The stronger and more stable your collateral (which the lender will interpret to mean that it holds value that can easily be tapped), the better your chances of getting the loan approved. For example, the truck in the scenario above is easier to sell off than a truckload of tomatoes that are going bad or 100,000 pairs of shoelaces in weird colors. Additionally, strong collateral usually dictates better terms and interest rates. Usually, a well-collateralized loan can be walked through the loan process fairly quickly and with less red tape as well.

Cons: Remember, when entering into a collateral loan, you are essentially authorizing the bank to take your pledged asset from you if you are unable to repay it. Ask yourself, “Can my business afford to do without X, if for any reason we can’t repay the loan?”

Also, be aware that if you are attempting to use your small business’s own assets as collateral, even if it was incorporated to limit your personal liability, this particular safeguard may not totally shield you from financial exposure. Especially for start-ups and smaller businesses, a personal guarantee of personal assets still may be additionally required by the lender as a stipulation to the loan application process. So here we are back to that collateral thing again.

Types of collateral

Collateral pieces are divided into two separate categories: a) assets that you own 100 percent, outright, and b) assets that you owe on (or still carry a balance against). If you still carry a balance on the proposed collateral (such as equipment or a mortgage for a home or property) the credit grantor will examine the amount of equity (or value) the collateral encompasses to make an educated decision on how much weight the asset actually holds against the loan in question. This investigation will roughly determine the amount the bank will be able to recover if the loan goes into default mode. Here are the major forms of collateral an individual or small business might use in the secured loan process:

• Real estate (homes, land, buildings)

• Business inventory

• Accounts receivable

• Cash savings

• Deposit accounts (certificates of deposit, investment products)

• Equipment and machinery

• Vehicles (cars, trucks, tractors, boats, recreational vehicles)

• Appraised valuables (jewelry, paintings, collectibles)

But wait a minute!

You may be suddenly struck with the thought, “Hey, if I have all these assets, even cash in my piggy bank, why am I pledging them to the bank?” That’s the kind of math only you can do. If you feel very confident that you can repay your secured loan and not put your collateral at risk, it’s working for you. If you are uncertain or there are recognizable risks in the picture, think long and hard about whether you can pledge adequate collateral to get the money you need and make the payments responsibly. It’s not always rosy in business, neither for you nor the bank, so be prepared to do a lot of creative problem solving every time you need to apply for a loan or credit.

Almost every individual or small business will have to investigate the possibility of a secured loan for their specific needs at some point. However, the expert business advice is quite simple here: Be organized, educated and prepared for the process. Knowing your options and uncovering the pros and cons of each option will assist you in making the right decisions regarding what to offer as collateral, how much collateral is adequate, how much risk is involved, and if a collateralized loan is the best solution for you at a given time.

What’s the Lender Looking for?

Your introduction to the Three Cs of Credit. Measure up well with them and you’ll be on your way to successful funding.

APPLYING FOR AND GETTING your first small business loan can be an exciting event. It can also be a nightmare if you’re not prepared for the loan process. Much like qualifying for a home loan, to qualify for a commercial or small business loan or for a line of credit, you’ll have to go through a six-step process. The steps required are usually the same, regardless of the type of loan (or the amount) you may be seeking. They include these critical phases:

• Loan application

• Pre-approval

• Processing

• Underwriting

• Approval (hopefully!)

• Closing

You must clear each hurdle of the process in order to take a seat at the closing table. But what exactly do lenders look for, anyway? In previous sections we’ve described the particular documents they may be seeking. And as we noted, it is important to be able to produce all documents in a timely, professional manner. These documents must be up to date and accurate in every way to support your case for receiving the financing you seek.

The Three Cs of credit

The best way to illustrate the overall prerequisites the lender may set forth is to explain the three credit measuring sticks that can make or break a loan request. They are known as the Three Cs. Let’s take a look at them.

• Character: You are popular, successful and a pillar in the community. Everybody thinks you are highly trustworthy and your spouse thinks you’re simply the greatest. That’s wonderful; however, this isn’t the variety of character rating that creditors are seeking. The character the lender thinks about is how you as a potential borrower have handled your past debt obligations. In essence, the lender wonders, “Are you likely to pay back the money if we lend it to you?” Lenders often look for another “C” within this category as well. It’s Consistency. They wonder, “What does your job history look like?” or “How long have you lived in the area?” Longevity in employment and residency indicate stability. Lenders will also seek out your private credit history and personal background.

• Capacity: One quick way to define capacity is your present and future ability to meet financial obligations. Another way to look at it might be your income and other resources minus other debt payments. Either way, the lender wants to assess your overall capability of paying back the loan or extension of credit being considered. One crucial element of this category is the debt-to-income ratio (or DTI). Some lenders also simply refer to it as a debt ratio. This ratio is calculated by totaling your consumer debt (credit cards and installment loans) and adding to that number your housing debt (mortgage payment, property taxes and insurances). This number is then divided by your income. It looks like this:

[ (Consumer Debt) + (Housing Debt) ] / Income

• The acceptable debt-to-income ratio is many times dependent upon the other two Cs of Credit; and many lenders look for different ratios for different loan programs. The interest rates can also be greatly affected by your overall capacity.

• Collateral: As we have seen, the credit grantor may seek to use property, financial assets, or other valuables that could be employed as security to guarantee the repayment of a loan. Nearly every lender wants to be sure that you have something of value that could be sold and/or leveraged in case you default on the agreed-upon terms. A house, land, a savings or money market account, or anything with a legitimate appraised value, for example, could be used to collateralize a loan or extension of credit. Just be aware that collateral can be seized and sold if you default!

Down the road

At some point, your small business may grow and expand to the level where your personal information, collateral and/or credit rating may not be needed by the bank or other lending organizations. Your small business may decide to transition to a certain type of corporation or entity, add investors, institute a board of directors, add locations, or carry out numerous other long-range plans that will change the scope and future of your business dealings. In that case, transactions at your bank may also take on different variations as well.

However, if your business follows the same guidelines as you did as an individual when you first sought financing, the transition should be seamless. Keeping excellent records, maintaining up-to-date files, and being able to provide all the documentation the lender requests will continue to be mandatory for loan approval. But because your business now has a track record of success, it will be able to stand on its own merit in most cases.

Once your business establishes this track record, creditors and other entities will be able to access those records through outside organizations to assist them in making sound decisions on your small business. One such company is Dun & Bradstreet (http://www.dnb.com/). Often referred to as D&B, this public company, based in the United States, licenses all types of information on businesses and corporations for assistance in making credit decisions. These reports are also used in business-to-business marketing and supply chain management decisions as well. D&B maintains information on over 200 million companies worldwide. Others include Equifax, Experian, UK Credit Info and Duport.

The golden rule in practical terms

The task is easy to describe: You (and ultimately your small business) must be determined, regardless of the size, scope or nature of your business, to establish, maintain and archive impeccable records and documentation. This practice should never waver for any reason. Whether you’ll be seeking to grow, gain financing, or even to sell your business, your records and documentation are what lenders, creditors and potential buyers will be examining in making their decisions.

How to Behave When Applying for a Loan

This personal aspect of entrepreneurship is important for the success of your business.

THE PROCESS OF APPLYING for a loan is more serious and complex than simply completing a loan application and submitting it to your local bank. Too many potential borrowers, and especially new business founders, fail to properly prepare their records and information before pursuing a bank loan. If you are not able to answer some key questions your banker puts to you, you can make a very poor impression, one that will be hard to reverse.

This news might seem a bit scary, particularly if you are feeling stressed because you really need the loan. It’s time to take a deep breath, shrug off the pressure, and set yourself up to produce a really successful dog and pony act. By calling it that, we don’t mean to make fun of the process or the seriousness of both your and your banker’s needs to make good financial choices and decisions. We mean your image needs to be professional, polished and confident. That comes from knowing your business well and learning to think like your banker so you can deliver precisely what she needs—hopefully to approve your loan. Let’s walk through the process.

Preparation

Applying for a loan obviously begins with your preparations. You need to organize certain key information for the loan application and interview. Your lender will be evaluating all the information you prepare. She’s going to try to determine a number of things:

• The amount you want to borrow and how long you estimate you’ll need the funds

• The risk of the loan—what chance you have of defaulting or paying late

• Your justification for the loan; what you plan to do with the money if it’s approved

• Your business’s ability to pay back the loan

• The collateral your lender feels is needed to secure the loan, given all the factors above

• Your individual credit strength (i.e., your private finances) as a guarantor and manager of the loan

You must consider these elements when preparing your business’s financial records, business plan documents, spreadsheet forecasts for revenue and expenses, plus your personal financial statement and other relevant information. The information you prepare in your support kit must be accurate, straightforward, thorough, easy to read, and professionally laid out.

Do your best, but don’t feel you have to do this solo. Your accountant, or a trusted friend who’s got more experience (and a good track record!) at borrowing funds, can be very valuable as a reviewer and sounding board for polishing up your kit.

Particularly if your business is rather “young,” you might want to apply to more than one lender (and here, your accountant or a friend might be helpful in making an introduction or supplying you with useful information about various lenders). In our experience, you can get a surprising array of interest rates, payment terms and other details from two or three lenders even if they are given the very same kit.

Once you have prepared all the necessary information to support your loan application, you will be set to complete the loan application document preferred by the lender(s) where you will be applying. Sometimes a question on the application can show you that you need to include, or re-position, information in your support kit.

After completing this second package of information, prepare a cover letter for the lender. Think of this letter as the written form of the verbal presentation you will give to the lender. The writing itself gives you an opportunity to organize your thoughts and compelling points about why the lender should approve your application. It will help you focus and polish your message and important key points so that when you speak with the lender, you will be very well prepared to answer all questions. As you see, preparation is key to the loan application process.

Getting set for show time

Now that you have completed a well-organized set of documents and written a well-thought-out cover letter, you can prepare for your actual loan interview. The lender may meet with you to receive all the documentation and discuss the loan request, or simply ask you to send the documents in advance of an interview. Regardless of the sequence of events, preparing for the loan interview is an important piece of the process.

Creating a good impression starts with your appearance. The first impression the lender forms of you may come from the face-to-face meeting or a telephone discussion that she conducts as a loan interview. Since most loan interviews are in person, give careful attention to your dress and appearance. Formal business attire is not always necessary, but when it doubt, dress up rather than down. In many situations, “smart casual” can work, but if you are unsure and it’s possible, drop by the lender’s office and take a look at what the bankers are wearing, and then match that style (or go a step more formal). The key is to dress in a manner to match the business image you wish to present to the lender. When in doubt, choose for tasteful, conservative, unobjectionable fashion in impeccable condition.

This is all about strategy. You need to consciously think about how you will behave during the loan interview. Your body language, manners, and etiquette all impact the impression you make with the lender. Small things add up to a meaningful impact, so here are some commonplace but time-honored tips for opening the conversation and then handling the presentation for best impact. As you begin the meeting,

• Maintain good posture when standing or sitting.

• Offer a friendly and sincere greeting when you meet.

• Extend your hand for a handshake if it is the appropriate custom in your area. Some cultures may prefer bowing or other gestures. (As a general tip, if you are new to the local culture, make sure you know the key do’s and don’ts that apply.)

• Maintain eye contact and keep a friendly facial expression.

• Smile if the culture views a friendly smile positively.

• Expect to spend a short time establishing a connection with your contact. You might comment on some unusual feature of the lender’s office, a neutral topic like the weather, or (if you know the person already) some reference to a past conversation.

• Be a focused, proactive listener. Often the art of listening well is the key to a successful conversation. You provide better responses if you excel in listening. This may be harder to do if you feel nervous, but try to silence your inner chatter anyway.

Here are some strategies to use once the preliminaries are over.

• Above all, try to anticipate and focus on your lender’s interests and concerns. You could even make the transition from greeting to meeting by saying something like, “As I prepared for our meeting today I asked myself what you might want to know. So I thought I’d first tell you briefly about my business, then zoom in on our specific needs that brought me to see you today, and finally, explain how we expect to use the money you lend us. Does that work for you?”

• Always think before you respond to a question. Organize your thoughts and provide a clear, direct answer. This demonstrates your knowledge of the information and your business, but it also shows you think carefully.

• If a question is unclear to you, do not try to answer without clarification. You may come across as unqualified, stupid, or unprofessional if you respond incorrectly simply because you did not understand the question. There is no harm in respectfully asking for clarification.

• Avoid saying “I don’t know.” If a question comes up that you cannot answer right now, simply explain you will get back to the lender with a more qualified or more accurate response as a follow up. Note it down on the spot and don’t fail to deliver.

• Be confident and self-assured but not cocky when discussing your business. You want the lender to believe in your ability to execute your plan and repay the loan.

• Avoid phrases like “I hope to achieve” or “I want to try to accomplish,” and instead say “We will achieve,” or “When we accomplish.” Positive statements work much better than hopeful or wishful phrases. And even if you are a one-person business, use “we” in place of “I” when you mean your business. For example, say “When we receive an order, we.…” Use “I” when you mean your function in the business or you’re talking about something you yourself do. “When we receive an order, I first check the customer’s open balance.…”

• Be respectful of the lender’s time and recognize when she indicates she has received all the information she needs at this time. At that moment, ask if there is any other information the lender needs. When the lender confirms she does not, then thank her for meeting with you, while rising to shake hands (or bow or whatever else, if appropriate), and preparing to exit.

• Before parting, offer to be available to the lender for any follow-up questions and reconfirm next steps and timelines politely.

• When you return to your office, send a brief cordial email (or a written note sent by mail), expressing your appreciation for the meeting and providing your contact information for any follow-up questions.

Make sure you fulfill any obligations to provide additional material or data, or whatever else you agreed to deliver, promptly and professionally. If you follow these strategies, you’ll put your business in the best possible position for getting your loan approved!