Obtaining Debt Capital

'Leveraging a company is like driving your car with a sharp stick pointed at your heart through the steering wheel. As long as the road is smooth it works fine. But hit one bump in the road and you may be dead."

- Warren Buffet

A Cyclical Pattern: The Good Old Days Returned but Again Faded

For small business owners and their investors, the punishing credit crunch and stagnant equity markets of 1990-1993 gave way to the most robust capital markets in U.S. history into the new millennium. Declin­ing interest rates reached historical lows in 2003 and the credit envi­ronment was much friendlier, mimicking the heady days of precrash 1987. Not only did interest rates decline, the availability of bank loans and competition among banks increased dramatically from the dormant days of the early 1990s.

The improved credit environment led to a greater marketing aware­ness by lenders of the potential represented by the growth companies in the new entrepreneurial economy. Bank presidents and loan officers were aggressively seeking out entrepreneurial companies as prospective clients. They worked with local universities and entrepreneurial associ­ations to sponsor seminars, workshops, and business fairs, all to culti­vate entrepreneurial customers. This was a welcome change in the credit climate for entrepreneurs. A smaller and less severe credit crunch (even with extremely low interest rates) began in 2000 and increased into 2002, but k is important to remember that the availability of credit is cyclical and the fundamentals of credit don't change that much. As the economy has emerged from recession in 2003 the credit environment has improved also. Low rates and high availability makes debt financ­ing an attractive capital alternative.

A Word of Caution

Even if a credit environment is favorable, history suggests that this can and will change, sometimes suddenly. Entrepreneurs who are mindful of this can appreciate just how onerous borrowing can become. What can be expected when a credit climate reverses itself? For one thing, personal guarantees* come back. Even the most creditworthy compa­nies with enviable records for timely repayment of interest and princi­pal could be asked to provide personal guarantees by the owners. The following is a phenomenon that can be viewed as a perversion of the debt capital markets. As a credit crunch becomes more severe, banks face their own illiquidity and insolvency problems, which might result in the failure of more banks (as happened in the 1990s). To cope with their own balance-sheet dissipation, banks can call the best loans first. Thousands of high-quality smaller companies would be stunned and debilitated by such actions. It is also true that with less competition among banks, pricing and terms can become more onerous as the econ­omy continues in a period of credit tightening. Debt reduction could then become a dominant financial strategy of small and large compa­nies alike. Robert Frost said, "A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain."

*The entrepreneur personally guarantees that the loan will be repaid. If the company fails, the entrepreneur is personally liable to repay the loan from her or his personal assets (which can lead to personal bankruptcy on top of entrepreneurial failure).

The Lender's Perspective

Lenders have always been wary capital providers. Understandably, since banks may earn as little as a 1 percent net profit on total assets, they are especially sensitive to the possibility of a loss. Imagine writing off a $ 1 million loan to a small company. The bank has to turn around and lend and be repaid an incremental $100 million in profitable loans just to recover that loss. Yet lending institutions are businesses and seek to grow and improve profitability as well. They can do this only if they find and bet on successful, young, growing companies. Historically, points and fees charged for making a loan have been a major contribu­tor to bank profitability.

Sources of Debt Capital1

The principal sources2 of borrowed capital for growing businesses are trade credit, commercial banks, finance companies, factors, and leasing companies. The advantages and disadvantages3 of these sources, sum­marized in Exhibit 7.1, are basically determined by such obvious dimen­sions as the interest rate or cost of capital, the key terms, conditions and covenants, and the fit with the owner's situation and the company's needs at the time. How good a deal you can strike is a function of your relative bargaining position and the competitiveness among the alter­natives. What is ultimately most important, given a deal at or above an acceptable threshold, is the person with whom you will be dealing, rather than the amount, terms, or institution. In other words, you will be better off seeking the right banker (or other provider of capital) than just the right bank. Once again, the industry and market characteris­tics, stage, and health of the firm in terms of cash flow, debt coverage, and collateral are central to the evaluation process. Clearly the prof­itable small business with a smart growth plan has great advantages in gaining debt capital. And remember, debt capital is almost always cheaper than equity capital. Finally, an enduring question entrepreneurs ask is, What is bankable - how much money can I expect to borrow based on my balance sheet? Exhibit 7.2 summarizes some general guide­lines in answer to this question. Since most loans and lines of credit are asset-based loans, knowing the guidelines employed by lenders to deter­mine how much to lend the company is very important. When you observe the percentages of key balance-sheet assets that are often allow­able as collateral, note that these are only ranges and will vary from region to region, for different types of businesses, and for stages in the business cycle. For instance, nonperishable consumer goods versus tech­nical products that may have considerable risk of obsolescence would be treated very differently in making a loan collateral computation. If the company already has significant debt and has pledged all of its assets, there may not be a lot of room for negotiations. A bank with full col­lateral in hand for a company having cash-flow problems is unlikely to give up such a position in order to enable the company to attract another lender, even though the collateral is more than enough to meet these guidelines.

Trade Credit4

Trade credit is a major source of short-term funds for small businesses. In fact, trade credit represents 30-40 percent of the current liabilities of nonfinancial companies, with generally higher percentages in smaller companies. Trade credit is reflected on the balance sheets as accounts payable, or sales payable - trade. If a small business is able to buy goods and services and be given, or take, thirty, sixty, or ninety days to pay for them, that business has essentially obtained a loan of 30 to 90 days. Many small and new businesses are able to obtain such trade credit when no other form of debt financing is available to them. Suppliers offer trade credit as a way of enticing new customers, and often build the bad-debt risk into their prices. Additionally, channel partners who supply trade credit often do so with more industry-specific knowledge than can be obtained by commercial banks.5 The ability of a small business to obtain trade credit depends on the quality and reputation of its man­agement and the relationships it establishes with its suppliers. A word of warning: continued late payment or nonpayment may cause suppli­ers to cut off shipments or ship only on a COD basis - and you develop a reputation, both formally through credit reports and informally through word of mouth, very quickly. A key to keeping trade credit open is to pay continually, even if not the full amount. Also, the real cost of using trade credit can be very high - for example, the loss of dis­counts for prompt payment. Because the cost of trade credit is seldom expressed as an annual amount, it should be analyzed carefully, and you should shop for the best terms. Trade credit may take some of the fol­lowing forms: extended credit terms; special or seasonal datings, where a supplier ships goods in advance of the purchaser's peak selling season and accepts payment 90-120 days later during the season; inventory on consignment, not requiring payment until sold; and loan or lease of equipment.

Exhibit 7.1 Debt Financing Sources for Types of Business

Source Available to Small Business?

Trade credit Yes, with a history of sound relationships

Finance companies Yes, with strong equity

Commercial banks Yes (if assets are available)

Factors Depends on nature of the customers

Leasing companies Yes, depending on machinery and equipment mix

Mutual savings banks Depends on strength of personal guarantee

Insurance companies Rare, except alongside venture capital

Exhibit 7.2 What Is Bankable? Specific Lending Criteria

Security Credit Capacity

Accounts receivable 70-85% of those less than 90 days of acceptable receivables

Inventory 20-70% depending on obsolescence risk and salability

Equipment 70-80% of market value (less if specialized)

Chattel mortgage 80% or more of auction appraisal value

Conditional sales contract 60-70% or more of purchase price

Plant improvement loan 60-80% of appraised value or cost

Commercial Bank Financing

Commercial banks prefer to lend to existing businesses that have a track record of sales, profits, satisfied customers, and a current backlog. Their concern about the high failure rates in new businesses can make them less than enthusiastic about making loans to such firms. They like to be lower-risk lenders, which is consistent with their profit margins. For their protection, they look first to positive cash flow and then to collat­eral, and in new and young businesses (depending on the credit envi­ronment) they are likely to require personal guarantees of the owners. Like equity investors, they place great weight on the quality of the man­agement team. Notwithstanding these factors, certain banks do, rarely, make loans to small businesses that have strong equity financings. This has been especially true in such centers of entrepreneurial and venture capital activity as Silicon Valley, Boston, and Los Angeles.

Commercial banks are the primary source of debt capital for exist­ing (not new) businesses. Small business loans may be handled by a bank's small business loan department or through credit scoring (where credit approval is done "by the numbers"). It is worth noting that your personal credit history will also impact the credit scoring matrix. Larger loans may require the approval of a loan committee. If a loan exceeds the limits of a local bank, part of (or the entire) loan amount will be offered to "correspondent" banks in neighboring communities and nearby financial centers. This correspondent network enables the smaller banks in rural areas to handle loans that otherwise could not be made.

Most of the loans made by commercial banks are for one year or less. Some of these loans are unsecured, while receivables, inventories, or other assets secure others. Commercial banks also make a large num­ber of intermediate-term loans (or term loans) with a maturity of one to five years. On about 90 percent of these term loans, the banks require collateral, generally consisting of stocks, machinery, equipment, and real estate. Most term loans are retired by systematic, but not necessarily equal, payments over the life of the loan. Apart from real estate mort­gages and loans guaranteed by the SBA or a similar organization, com­mercial banks make few loans with maturities greater than five years.

Banks also offer a number of services to the small business, such as computerized payroll preparation, letters of credit, international ser­vices, lease financing, and money market accounts.

There are now approximately 6,500 commercial banks in the United States. A complete listing of banks can be found, arranged by states, in the American Bank Directory (McFadden Business Publications), pub­lished semiannually.

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