Expert Advice on Small-Business Lending
You’ve probably read plenty of articles about small-business lending. But what if you could talk to a lender and get inside information that might not appear in the advice columns?
The Intuit Small Business Blog recently spoke with Mitchell Weiss for that very reason.
Weiss (pictured), an adjunct professor of finance for the Barney School of Business, previously owned several commercial finance companies and served as an executive officer at several banks. He now runs a consulting practice that advises private equity firms, banks, and small to midsize businesses.
We asked Weiss for his expert insight into small-business lending.
ISBB: Why are small businesses finding it so difficult to secure bank funding right now?
Weiss: The banks are conflicted. On the one hand, they need to make more loans because they have more deposits, which are liabilities on the lender’s balance sheet. Then, they have receivables, which are assets. However, they’re also still wary about what took place a few years back.
Can a startup secure a loan before opening its doors?
[That’s] hard to do, especially now. A startup is more likely to bootstrap its start — utilizing personal resources such as savings, credit card capacity, and asking for money from family and friends.
How is the lender evaluating the applicant on the most basic level?
All lenders use the credit underwriting process to answer four fundamental questions: First, whether to make the loan. In other words, do they want you as a customer under any circumstances? Second, how much to lend. You can ask for as much as you want, but that doesn’t mean you’re going to get it. Third, how much to charge. There is a direct correlation between risk and reward; the higher the risk, the more reward a lender will demand in the form of interest and fees. Finally, what terms and conditions to require. That old adage regarding the golden rule applies in this case — those who have the gold make the rules.
To answer these four questions, lenders will apply what’s known as the five C’s of credit in the course of their credit underwriting process.
Capital: Simply put, the difference between what you own (your assets) and what you owe (your liabilities) is what you’re worth — known as your equity. Lenders focus on the extent to which you have skin in the game in terms of money left in the business.
Capacity: Although you may have great promise and a hugely talented team, unless you can prove you have enough cash flow to make the loan payments, the lender won’t want anything to do with you.
Collateral: This represents the thing you’re looking to finance or willing to pledge to back up your promise to repay the loan. It also represents a way out for a lender in the event of payment default. Let me also add that, although you may have the most amazingly valuable collateral in the world to pledge, it still boils down to sufficient cash flow.
Conditions: These are rules set by those who have the gold.
Character: This has nothing to do with what your spouse, parents, or friends think of you and everything to do with how you’ve conducted yourself in the past. In particular, if you had previously been granted credit, did you pay it back on time and in full? Do you have any blemishes on your personal or professional credit [reports]? The personal credit bureau report is important because most small businesses are closely held. In other words, few people control the business, in which case the lender will want those persons to be financially liable along with their company.
Is a formal business plan important to the lender?
Speaking as a lender and as a professor who teaches entrepreneurial finance, I thoroughly disagree with those who say that an elevator pitch is more important. Business plans serve two purposes: They fully articulate the idea you have in mind and how you plan to go about realizing it, and they force you to come face to face with the echo chamber inside your head.
In my view, unless you have an idea that can stand up to paper and pen, you have little more than cocktail chatter.
What are some of the common mistakes small-business owners make in the loan application process?
Failing to fully prepare and failing to fully disclose. The preparation part is straightforward: Understand the five C’s, and be clear about your purpose and justification.
As for the failure to fully disclose, lenders will view the first omission as the tip of the iceberg and dig deeper. They’ll begin looking for reasons to say “no” rather than “yes” once you’ve given them reason to doubt your representations.
Assuming there’s a face-to-face meeting, do you have any additional tips for impressing the loan officer?
Dress for the part. You’re asking for money, so respect your lenders by taking the time to make [your appearance] presentable. You only have one chance to make a good first impression.
Can small-business owners negotiate the terms of the loan? If so, what should they focus on?
First, focus on prepayments. Negotiate for the right to prepay your loan in full or in part during the course of its term. Lenders won’t easily yield on this point, but it’s worth playing hardball over, so that you have the option to use some extra cash to retire your loan or to refinance under better terms later on.
Second, focus on amortization. Term loans typically amortize the way mortgages do, where each payment consists of interest and principal. As the loan is paid down, the interest component becomes less and less, while the principal component becomes bigger and bigger.
That’s how the payments remain the same over time, if that’s what you want or need. However, the alternative would be to structure the loan with even-principal reduction, where the payments are higher at the start and lower later on. The principal will decline more rapidly and, consequently, the interest paid over the duration of the loan will be less.
Finally, focus on fixed vs. floating rates. The banks will push floating-rate loans because they cost less for them to do and, often times, yield a higher profit margin for the lender in the process.
I prefer fixed-rate deals because no one knows where interest rates will head. I also prefer them because it forces businesses to honestly address the affordability of the project they are contemplating undertaking. If you can’t make it work under a fixed-rate scenario, then you can’t make it work. However, if your only option is a floating-rate loan, then negotiate for a cap above which your rate won’t increase.