Those of you who have been reading my column over the years will recall that I spend a significant amount of my time helping companies secure funding. The funding process is complex and can be very time-consuming. It can also be very frustrating for the entrepreneur, particularly when facing a serious deadline or cash flow crunch.
I find that confusion about the funding process itself, and more specifically about how lenders make their decisions, can contribute to the frustrations of entrepreneurs. Worse, a lack of understanding of the process can result in delays or possibly even the dreaded “no.” Understanding the funding process well can reduce or eliminate delays, reduce stress, and increase the entrepreneur’s chances of successfully securing funding.
In general, there are two types of funding – debt and equity. In today’s column, I will focus mostly on the debt side of the funding process, and more specifically on lender funding. Financial institutions have many criteria, constraints, and objectives when contemplating making loans, many of which may not be apparent to the potential borrower, and frankly may not make much sense, at least on initial review.
We must understand that financial institutions are regulated by various governmental entities, and as a result, must meet stringent lending and capital reserve requirements. In addition, the character, diversity, and quality of their loan portfolios can affect these requirements. The result of this can be that a given lender may say no to a loan application, simply because they have a high concentration in the same type of loan already on their balance sheet. They may also have a high concentration in a give industry, and therefore may not want to add another loan for a company operating in that same industry.
Another common misconception with regard to the lending process is that, with the current 90% guarantee from the SBA (Small Business Administration), borrowers incorrectly assume that the bank is only risking 10% on an SBA-approved loan. Some borrowers even offer to deposit that additional 10% with the bank, which would seem to fully indemnify the bank against any potential loss. The problem is that the bank is not just concerned with collecting the money they have loaned out, in the event of a default. They are also concerned with having a bad loan on their books, with the time it takes to collect the money if the borrower defaults, and with the negative impact a bad loan has on their balance sheet with regard to capital ratios, regulator requirements, etc. This is especially important in today’s environment, given the collapse of the financial markets that occurred at the end of 2008.
Each bank has its own specific criteria for making loan decisions. Some banks are “asset lenders” while others are “cash flow lenders.” An asset lender, in general, cares more about collateral for loans in the form of assets – either physical or financial. Cash flow lenders care more about the borrower’s cash flow being sufficient enough to cover the debt service. Many banks will consider both assets and cash flow when making a loan decision. Borrowers should understand what is most important to the specific bank they are approaching for a loan, so that they can match their strengths with the requirements of the lender. In other words, if the borrower has strong cash flow but doesn’t own a lot of assets, they will want to approach cash flow lenders; if they have a lot of assets but not as much cash flow, they will want to approach asset lenders. By understanding the criteria of the chosen financial institution, the borrower can avoid a lot of confusion and frustration with the lending process.
Understanding cash flow is also critical to successfully securing funding. When working with clients, I spend a lot of time developing extensive and complete financial models that clearly define projected cash flows for at least a three-year period of time and usually five years. A simple definition of cash flow would be EBITDA – earnings before interest, taxes, depreciation and amortization – typically the cash left over after all of the cash expenses have been paid.
However, EBITDA is not always the measure of cash flow that a lender will use to make their decisions. Although depreciation and amortization are non-cash expenses that are added back to calculated EBITDA, the business, on a cash basis, may be spending a lot more money than is reflected in the expenses used to calculate EBITDA. For example, if the business is spending a lot of money on product development and is therefore capitalizing the expenses associated with that product development, the normal EBITDA calculation will not properly reflect true cash earnings.
Business owners looking for funding must understand what their true cash flows are – cash coming in versus cash going out – on a monthly basis, so they can then understand their ability to service their loan. As an example, a $1 million loan with a 5-year term (5-year amortization) and a rate of interest of 6%, will require a monthly payment of $19,333. To meet the required debt service, the business will need to generate enough cash to cover all cash expenses each month, plus that payment amount, in order to not go cash flow negative.
In reality, lenders will not only require that the business generate enough to cover all cash expenses plus the monthly payment on the proposed loan, but will require a cushion in addition to that amount. A typical SBA lender will usually add 300 basis points (3 percentage points) to the loan calculation to “test” the business’s ability to cover the debt service with that cushion. In our example above, this would mean that the lender would increase the rate to 9% from 6%, recalculate the monthly payment, (which would be $20,758 instead of the $19,333), and then compare that new payment amount with the cash flow of the business. The business would need to generate monthly net cash flow after all cash expenses of at least that $20,758 to qualify for the loan.
Another consideration would be the consistency of the cash flow of the business. Lenders will evaluate the source of the monthly cash flows of the business to determine if they can be relied upon to be consistent, month in, month out. Entrepreneurs can help the lender understand the consistency of their cash flow sources by showing any contracts they may have with customers. The longer that the contract has been in place, and the length of the term of any existing contracts will help determine the lender’s comfort level with the cash flow of the business.
Also, the number of different contracts is important. If the business is dependent on one or only a few customers for the bulk (or all of) their revenues, lenders will typically feel less comfortable with the loan, and may require a larger cushion, either for monthly cash flows or larger cash reserves in the bank.
I work with local lenders routinely, in my capacity as a funding consultant. After I have prepared the company’s business plan, financial model, executive summary, slide presentation, Private Placement Memorandum, etc, I work with the lender to help them understand the business, its financials, debt service coverage, etc. The Bank of Santa Barbara is one of the few local banks that have the flexibility and the willingness to think outside the box to put together packages to provide the funding my clients need. I work directly with Eloy Ortega and his team, and I have found them to be highly responsive and professional.
There is no doubt that this is a tough lending environment, and many banks are struggling just to stay in business. Understanding the lending process and the specific lender will assist entrepreneurs in successfully navigating the funding process and securing the funding needed to execute their business plan.