Developing Your Financial Information: When developing prospective financial information, it is very important to explain and disclose your assumptions. Some assumptions you should include are:
As a check on your operations, you should compare your present expense levels with those of the past. You should also compare your operating results with those of your competitors and your industry. Local libraries are a rich source of information, much of which can be computer-searched by standard industry code (SIC), sales volume, location, number of employees, or any combination of criteria. Some of the better known sources include the following:
operating ratios for various businesses and industries.
If your competitors are publicly held, you can easily obtain financial information, either directly from them or through financial-information sources. Many stock brokerage and investment banking firms prepare research reports analyzing these companies and their industries. Financial information on privately held companies may often be obtained through Dun & Bradstreet or other credit sources. In addition, your accountant, banker, or trade association can provide useful information. Commercial Banks Commercial banks have long been the cornerstone of lending for growing and midsize businesses. Unfortunately, during the early 1990s many were adversely affected by turbulent financial conditions created in part by unsettled real estate conditions. Problems with real estate loans caused many commercial banks to become less receptive to making loans to midsize companies. The turbulence, of course, did not adversely affect all commercial banks, and many have continued to fulfill their traditional role. As "full-service" institutions, these commercial banks offer the greatest variety of loans from which executives can generally obtain the most appropriate financing for their companies. Commercial banks grant loans on either an unsecured or a secured basis. An unsecured loan is granted on the basis of a company's credit and the strength of its financial statements. Since growing businesses in general do not have the financial track record necessary for an unsecured loan, most of the lending by a commercial bank is done on a secured basis. A secured loan requires a pledge of some of all of the assets of the company as collateral for the loan. In many cases, the owner must also give a personal guarantee (that is, the owner's personal assets become collateral as well). The principal types of loans available from a commercial bank include:
Working-capital lines of credit are the most common form of secured loan available to growing businesses. They are tied directly to the receivables or inventory levels of the borrowing company. These loans provide funds that can increase as sales increase, while providing the bank with collateral that can easily be liquidated (that is, turned into cash in case of default on the loan). Working-capital financing is normally contracted for a year and may be renewed for additional periods by the lender. The borrowing arrangement will have a stated maximum amount and will be limited to an agreed-on percentage of the assets being pledged as collateral. The interest rate on these lines of credit will usually be variable and fluctuate with the prime rate. There are two primary types of working-capital lines: Accounts-receivable financing is usually limited to between 75% and 85% of the eligible receivables balances (typically receivables less than 90 days old). Thus, as sales are made, a significant portion of the unpaid invoice can immediately be converted into cash. As amounts are collected from the customer by the company, the loan is paid down or new receivables are pledged as collateral for the loan. Receivables financing thus provides a revolving line of credit in which funds are continually advanced, repaid, and readvanced. The key factors for you in obtaining receivables financing are determining the receivables that are eligible for the loan and the percentage that will be advanced. To do this, the bank will conduct a thorough investigation of your company, reviewing such items as your customers' credit histories, the types of receivables, and the quality of the accounts. The better the condition of your receivables (e.g., a small number of accounts outstanding over 90 days and good customer credit ratings), the more the company will be allowed to borrow against those accounts. You should have a credit résumé for each of your customers to aid in this process. Inventory financing, like accounts-receivable financing, provides a revolving line of credit. Funds are advanced to the company on the basis of a certain percentage of eligible raw material and finish-goods inventories. Advances are generally not made on work-in-process inventory because of its unfinished state and limited liquidation value. Since inventories are less "liquid" assets than accounts receivable, the amount advanced under an inventory loan is not as great as in the case of a receivables loan. Amounts advanced under an inventory loan vary dramatically with the nature of the inventory, ranging from 30% to 70% of the value. On some sophisticated inventories that would be hard to dispose of, lenders may be unwilling to lend at all. Inventory loans come due as the products are sold; thus, they are often used in tandem with a receivables line of credit to provide financing until proceeds of the sale are collected. Inventory financing presents special problems for both borrower and lender. The latter must ascertain the liquidation value of the inventory and be assured that it is secured in a safe location before advancing funds. Therefore, there may be additional administrative procedures, such as monthly reports and calculation of obsolescence rates, turnover rates, and gross profit margins, to justify the borrowing base. In addition, improved procedures for controlling the inventory may have to be implemented, sometimes even to the extent of locating inventories in independent bonded warehouses, to satisfy the bank's conditions.
Equipment term loans provide a company with funds to purchase new equipment, or they may be used to obtain cash by borrowing against the appraised value of equipment already owned. From 60% to 80% of the equipment value may be borrowed with this kind of loan (so the company will have to make a "down payment" with its own cash). By not loaning on the entire value of the equipment, the bank improves its ability to recover its investment in case of default. These loans are generally repaid in monthly or quarterly installments over one to five years (a period that reflects the expected life of the equipment). Interest rates may be fixed or variable, depending on the bank and the credit situation of the borrower. Borrowers are often given an equipment line of credit, allowing them to purchase various pieces of equipment over an agreed-on period of time without making a separate loan agreement for each item. The borrower pays only interest until the "rollup" date, when all the borrowings are written as one term loan with one repayment schedule. Equipment leasing is increasing by being used as a method of financing. Equipment leases provided by commercial banks are generally long-term rather than, short-term leases. The bank purchases the equipment needed and enters into a noncancelable agreement to lease it. The payments required may be sufficient to cover the cost of the equipment and of financing; the lease payment may even be variable and fluctuate with the prime rate. Even though the bank owns the equipment, the user, orlessee, is usually responsible for the insurance, maintenance, and any associated taxes. From a tax standpoint, there are two types of full-payout lease arrangements: A true lease, or "operating lease", results in the lessor (the bank) receiving any potential tax benefits of ownership-primarily accelerated depreciation. The tax benefits reduce the cost of the lease to the lessor, and a reduction usually results in lower lease payments by the lessee. The agreement often provides that the lessee will pay additional amounts if the lessor fails to obtain the tax benefit anticipated when negotiating the lease. For the arrangement to be accepted as a true lease for tax purposes, the lessee cannot be given an option to acquire the property at a bargain price at the end of the lease term; however, the lessee can obtain title to the equipment at the end of the lease period by purchasing it at its fair market value at that time. Thus, while a true lease may initially be attractive from a cost standpoint, it may be more expensive than other kinds of financing if the equipment is to be used beyond the original term of the lease. A financing lease, or "capital lease", on the other hand, is treated as a borrowing, and the lessee is considered the owner of the equipment. A financing lease usually provides for the sale of the asset to the lessee at a nominal or prearranged price. Regardless of the type of agreement, the advantage usually sought in equipment leasing is that 100% of the cost of the equipment can be financed. However, the bank may require you to maintain a security deposit equal to 20% to 30% of the equipment cost, which would negate this advantage. Depending on whether this deposit pays you interest and when it can be freed up, leasing may still be a more attractive alternative than a term loan. You will need to analyze the costs of all the terms when considering this form of financing. Leasing can be used not only to finance equipment additions but also to generate cash from equipment already owned. In a sale-and-leaseback arrangement, the used equipment is sold to the bank at its appraised value and leased back. Commercial real-estate loans, or industrial mortgages, are usually from 10 to 25 years in length and in amounts of up to 75% of the property value. These loans are comparable to mortgages on residential property. Interest rates are usually fixed, and payments are made monthly. The payments may fully amortize the loan, or there may be a balance still unpaid at the end, called a balloon payment, which must be either paid off or refinanced. If the value of your real estate has appreciated since it was purchased, you can convert that into cash by obtaining a second mortgage. A "second" means just that-the lender is second in line for the collateral in case of a default; therefore, the interest rate on a second mortgage is normally higher than on a "first." As an alternative, you may refinance your entire mortgage, if current interest rates make this economically sensible. Commercial term loans are often granted to businesses with strong financial histories. With this type of loan, there is no direct relationship between the amount of the loan and an individual asset of the company (unlike working-capital or equipment financing). However, the assets of the company are generally pledged as collateral. Banks monitor these loans by requiring the company to maintain certain financial ratios; if these loan covenants are not met, the bank can call the loan (require immediate repayment). Loan covenants are individually negotiated and may cover such items as working-capital levels, the current ratio (ratio of current assets to current liabilities), the debt-to-equity ratio, future profitability, and levels of equity. They may also restrict payment of dividends, additional borrowings, or capital expenditures without prior bank approval. If the financial position of the company is extremely solid, the bank may be willing to make these loans on an unsecured basis (that is, with no collateral). Usually, the loan covenants will be even stricter in this case, so the bank can closely monitor the company's financial condition. Most small and growing businesses will not be in a position to obtain unsecured loans. Short-term commercial loans are usually written for a period of from 30 to 90 days, primarily to meet seasonal needs, such as a buildup of inventories. These loans are expected to be liquidated once the temporary need is past. Medium- and long-term commercial loans are usually for a period of more than one but not more than ten years. The amount advanced ranges from 40% to 50% of working-capital needs, supplementing any short-term financing. Interest rates vary with the creditworthiness of the applicant, but are normally 0 to 4 percent above the prime rate.
Government-guaranteed loans are loans guaranteed against loss to the lender by the Small Business Administration (SBA), an agency of the federal government. The guarantee is for up to 90% of a maximum of $500,000 of loan proceeds. Because of the reduced risk of loss, the interest costs on such a loan are usually less than for a comparable commercial loan. However, you must meet specific criteria to be eligible. Normally, personal guarantees are required, and loans are on a secured basis. Personal loans are often the only form of debt financing available to a startup company. They are made on the basis of the creditworthiness of the business owner and are secured by your personal assets. Because these loans are made to you as the owner of the company, you are personally liable for their repayment, regardless of the fate of the business. A revolving line of credit provides your company with a committed source of money against which it may borrow as long as certain negotiated conditions are met. Like commercial term loans, a line of credit may be collateralized by a general pledge of all of the assets of the company, or it may even be unsecured. It will always involve strict loan covenants. With a revolving line of credit, the borrower may draw the funds as needed, with interest charged only on the outstanding funds. There is usually no defined repayment date, although generally the lines are expected to be repaid in full once a year for at least a thirty-day period. Banks typically charge an annual commitment fee of 0.25% to 0.50% of the unused portion of the line. Most businesses will get this financing only when they have an established track record. A letter of credit is a special form of financing often used by companies dealing in foreign markets. A letter of credit is a bank-issued document, promising that the bank will pay a third party an agreed-on amount of money, provided that certain documents described in the letter of credit are properly prepared and received by the bank within a specified time period. The most common use of an "LC" is for the purchase of goods from a foreign company. Upon receiving an LC from you, a seller ships its product and can take the LC to its bank for immediate payment. Your bank, which issued the LC, may require a deposit, or it may add the balance to your outstanding loans. "Irrevocable" letters of credit are preferable to "revocable" ones, but more difficult to obtain. An irrevocable letter of credit, once accepted by the seller, cannot be altered or canceled by the buyer without the seller's consent.
If, on the basis of preliminary discussions, the lender decides to pursue your business, additional information such as the following will probably be requested:
Selecting the Lender As you discuss your loan request with potential lenders, you should be evaluating their suitability to your needs at the same time. Important items to consider include the following:
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Venture capitalists usually have stringent requirements for investing. Generally, they are as follows:
venture-capital financing. IPOs For a public offering to be successful, a company must meet certain criteria. A public offering is appropriate for a company with:
Small Business Administration The major source of government financing available to small and midsize businesses is the Small Business Administration (SBA). The SBA offers the following services:
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