How to Get Financing from a Bank (#264)
/In this podcast episode, we discuss how to obtain financing from a bank. Key points made are noted below.
Overview of Lending
Banks prefer to lend to companies that don’t actually need the money, because they’re in such solid financial positions already. Banks mostly – but not entirely – base their lending decisions on two criteria. The first is the cash flows of the borrower. You need to have a history of generating enough cash flow to pay back the loan. This presents two problems. If you have a history of solid positive cash flow, then why would you bother to apply for a loan? And second, if you’re with a new company with no financial history at all, then there’s no way to prove that you have any cash flow. So just based on this first criterion, you can see that banks are going to limit their lending to well-established and fairly successful businesses, which means that their preferred lending arrangement is for something like a company with seasonal sales that only needs the cash to pay for its peak season receivables, or maybe to a larger company to pay for a new headquarters building. Banks are not interested in giving money to a startup company that only has a business plan.
The second criterion that a bank uses for its lending decisions is whether the company has enough assets to pay for the loan if its cash flows don’t materialize. Banks will legally attach these assets to the loan as part of the lending agreement, so that if you don’t pay on time, they can seize the assets and sell them in order to get back the remaining balance on the loan. If the company goes bankrupt because they seized the assets, that is not their concern. They just want their money back.
Collateral
And to be really safe, they’ll try to attach every single asset in the company, which is called the collateral on the loan. When they do that, and then you want to take out another loan – you can’t, because there aren’t any assets left for the next lender to use as collateral on the next loan.
There are three additional issues related to collateral. One is that, whenever a bank wants to use all company assets as collateral, you have to get into a dogfight with them to narrow the number of assets to be used as collateral down to the absolute minimum. Otherwise, as I just pointed out, you have nothing left to use for any later loans. This can be next to impossible if the company is fairly new, because the bank will classify the company as being high risk, and so will want to scoop up every asset in sight.
The second issue is that the bank will be really interested in taking the company’s most liquid assets as collateral – so it will be most interested in your cash and receivable balances. If you can’t pay back a loan, the cash balance will probably be quite low, but the receivable asset may be very high. If so, customers will probably pay off their receivable balances within a month or so, and then the bank will have its money back.
Working Capital Loans and Lines of Credit
If the loan is structured as a working capital loan or line of credit, the total amount of the loan is capped at the amount of cash and receivables on hand, usually reduced by some sort of a discount factor on the receivables. For example, if you have $100,000 of receivables, and $10,000 of that amount is more than 90 days overdue, then you can only use $90,000 of the asset base that supports the loan. And on top of that, the bank will only allow a percentage of the remaining balance in its calculation of the maximum amount of the loan that can be outstanding. So out of that initial $100,000 of receivables, if the bank only accepts 70% of the allowable receivables, then the maximum loan balance would be $63,000. If the remaining loan balance is higher than the amount of collateral on hand, you have to pay back the difference right away – which can be difficult.
Borrowing Base Certificate
For this type of loan, the bank requires that you create what’s called a borrowing base certificate at the end of each month and send it to the bank. This certificate states all of the ending balances for the asset classes being used as collateral, reduced by any deductions mandated by the lending arrangement.
It also subtracts out the ending balance on the loan, so that the bottom line on the certificate states either the available amount of the loan that has not yet been used, or the excess amount of the loan that has to be paid back. You have to sign the certificate, which means that you can be legally on the hook for fraudulent reporting if you put incorrect information in the certificate.
When You Have Few Liquid Assets
What if your company has less liquid assets, like inventory or buildings? In that case, the bank may not be so interested in granting a loan, because it could take a long time to convert these assets into cash – and the bank may be forced to accept a lot less than book value for them. What this means that the company could have a massive amount of less liquid assets, and find that no banks want to deal with it.
Personal Guarantees
Which leaves us with the third collateral issue, which is that the bank may not be satisfied with just the assets held by the company – it may also want a personal guarantee by the owners, or whoever else is willing to guarantee the loan. So if the company goes under, and the company’s collateral is not sufficient, the bank will seize the owner’s assets too. And, depending on the lending arrangement, if the bank thinks it’s easier to get its cash back by going straight to the owner’s assets and ignoring the company’s assets, then that’s what it will do.
Lender Risk Aversion
In short, a bank is not really in the business of issuing loans. It’s really in the business of making a profit, so it’s highly risk averse. If there’s any hint of a problem in the financial history of a company, or if its asset base isn’t sufficient, then don’t expect to get a loan. In case you hadn’t noticed, I have a fairly negative attitude when it comes to banks. While working for a series of startup companies, I’ve always had trouble getting loans from them.
The only cases in which we managed to secure bank financing were when we had a rich investor who was willing to guarantee the full amount of a loan. In those cases, the bank pretty much took the attitude that it was making a personal loan to the investor, who happened to then be forwarding the cash to the company. Of course, the bank insisted on taking the company’s assets as collateral, too – even though the investor had more than enough cash to pay back the full amount of the loan.