Credit Worthiness

Types of Loans

Amount of Money Needed

Collateral

Loan Restrictions and Limitations

Applying for a Loan

Business Maturity & Financing Requirements

Commercial and Business Loan Structures

Commercial Real Estate Financing Overview

Business Strategies in Relation to Business Lending

Summary of Commercial Financing Alternatives

Credit Worthiness

Is Your Business Credit Worthy?

The ability to obtain money when one needs it is just as important to a person's business as the right location and equipment, reliable sources of supplies and materials, or an adequate labor force. Before a bank or any other funding agency will lend money, the following questions must be sufficiently answered by the borrower.

About the borrower...

• What type of person are you?
• What is your commitment to the business?
• What is your ability to manage the business?

About the loan...

• What plans do you have for the money?
• Do you want a short or long term loan?
• When and how do you plan to repay the loan?
• Is the loan large enough to cover all expenses?

About the business...

• What is the national economical status?
• What is the outlook for business in general?
• What is the outlook for your business in particular?
• Does The Business Have Adequate Financial Data?

The lender wants to make loans to businesses which are solvent, profitable, and growing. The two basic financial statements used to determine these conditions are: 

1) balance sheet (the major yardstick for solvency) ; and 

2) profit-and-loss statement (documentation for profits). 

A continuous series of these two statements over a period of time is the principle device for determining solvency, profitability, and growth potential.


Information Needed

In interviewing loan applicants and studying their records, the lender will be especially interested in the following facts and figures:

General Information...

• Are the books and records up-to-date and in good condition?
• What is the condition of accounts payable?
• What is the condition of notes payable?
• What are the salaries of the owner/manager and other company officers?
• Are all taxes being paid currently?
• What is the order backlog on products you sell?
• How many people does your business employ?
• How much insurance coverage does your business have?

Accounts Receivable...

• Have any of the accounts receivable been pledged to another creditor?
• What is the accounts receivable turnover?
• What percent of accounts is current and how many are past due?
• Has a large enough reserve been set up to cover doubtful accounts?
• How much do the largest accounts owe and what percentage of your total accounts receivable does this amount represent?

Inventories...

• Is merchandise in good shape or will it have to be marked down?
• How much raw material is on hand? 
• How much work is in process?
• How much of the inventory is finished goods?
• Is there any obsolete inventory?
• Has an excessive amount of inventory been consigned to customers?
• Is money being tied up too long in inventory?

Fixed Assets...

• What is the type, age, and condition of the equipment?
• What are the depreciation policies?
• What are the details of mortgages or conditional sales contracts?
• What are the future acquisition plans?

Types of Loans

What type of loan is needed?

When one sets out to borrow money for his/her business, it is important to know the type of money that is needed from a bank or other lending institution. There are generally three kinds of loans or financing available for businesses:

1. Short Term Loan
2. Term Loan
3. Equity Capital

The purpose for which the funds are to be used and the manner in which it will be paid back are the important factors in deciding what type of loan to request. A very important distinction between the types of loans is the source of repayment. Generally, short-term loans are repaid from the liquidation of current assets which they have financed. Long-term loans are usually repaid from earnings of the business.


Short Term Loans

Short term loans are just that, loans which can be paid back in a relatively short period of time. Short term bank loans can be used for purposes such as financing accounts receivable or building a seasonal inventory. Usually, lenders expect short term loans to be repaid after their purposes have been served. For accounts receivable loans, the payback would be when the outstanding accounts have been paid by the borrower's customers (i.e.: 30 to 60 days). For inventory loans, the payback would be when the inventory is converted into salable merchandise (i.e.: 5 to 6 months).

Banks and other lenders grant short term loans either on the borrower's general credit reputation with an unsecured loan or on a secured loan. The unsecured loan is the most frequently used form of lender credit for short term purposes. You do not have to put up collateral because the lender relies on your good credit reputation. The secured loan involves a pledge of some or all of the borrowers' assets. The lender requires security as a protection against the risks of loss that are involved even in business situations where the chances of success are favorable.


Term Borrowing

Term borrowing provides money which will be paid back over a fairly long period of time. These can be divided into two categories:

• Intermediate Loans which are longer than 1 year but less than 5 years; and
• Long Term Loans which are more than 5 years.

For the purpose of matching the kind of money to the needs of the borrower, think of term borrowing as a type of loan which will be paid back in periodic installments from
earnings.


Equity Capital

Some people confuse term borrowing and equity (investment) capital, yet there is a big difference, You don't have to repay equity money. It is money you get by selling a part interest in your business.

In order to secure equity capital, you take people into your company who are willing to invest money in it. These people are interested in potential income rather than in an immediate return of their investment.

Amount of Money Needed

The amount of money the borrower needs depends on the purpose for which he/she needs funds. Figuring the amount of money required for a term loan or equity capital is relatively easy. Estimates and projections can be determined whether the loan is for business construction, conversion, or expansion.

Equipment manufacturers, architects, and builders will readily supply cost estimates which can assist in determining the loan amount. On the other hand, the amount of working capital needed depends upon the type of business the borrower is in. While rule-of-thumb ratios may be helpful as a starting point, a detailed projection of sources and uses of funds over some future period of time (i.e.: 12 months) is a better approach. In this manner, the characteristics of the particular situation can be taken into account. Such a projection is developed through the combination of a predicted budget and a cash forecast.

The budget is based on recent operating expense plus the best judgment of performance for the coming period. The cash forecast is the estimate of cash receipts and disbursements at the time they occur. These elements are listed in the profit-and-loss statement which can be adapted to show cash flows. These should be projected for each month.

Collateral

Sometimes, the borrower's signature is the only security a lender needs when making a loan. At other times, the lender requires additional assurance that the money will be repaid. The kind and amount of security depends on the lender and on the borrower's situation.

If the loan required cannot be justified by the borrower's financial statements alone, a pledge of security may bridge the gap.

The types of security are:

1) Endorsers
     a) Comaker 
     b) Guarantor
2) Assignment of Lease
3) Commodities
     a) Warehouse Receipts
     b) Trust Receipts/Floor Planning
     c) Chattel Mortgages
4) Real Estate
5) Accounts Receivable
6) Savings Accounts
7) Life Insurance
8) Stocks and Bonds


Endorsers

Borrowers often get other people to sign a note in order to bolster their own credit. These endorsers are contingently liable for notes they sign. If the borrower fails to pay the loan, the lender expects the endorser to make the note good. Sometimes the endorser may be asked to pledge assets or securities too.

A Comaker is one who creates an obligation jointly with the borrower. In such cases, the lender can collect directly from either the borrower or the comaker. A Guarantor is one who guarantees the payment of a note by signing a guarantee commitment - both private and government lenders often require guarantees from officers of corporations in order to assure continuity of management. Sometimes, a manufacturer will act as guarantor for customers.


Assignment of Lease

Sometimes, a lender may grant a loan for a building and then be assigned the lease in such a manner that the rent payments are automatically sent to the lender. The lender is then guaranteed repayment of the loan.


Warehouse Receipts

Lenders also secure loans by lending money on a warehouse receipt. Such a receipt is usually delivered directly to the bank and shows that the merchandise used as security has been either placed in a public warehouse or has been left on your premises under the control of one of your bonded employees. Such loans are generally made on staple or standard merchandise which can be readily marketed. The typical warehouse receipt loan is for a percentage of the estimated value of the goods used as security.


Trust Receipts and Floor Planning

Merchandise such as automobiles, appliances, and boats has to be displayed in order to be sold. The only way many small marketers can afford such displays is by borrowing money. Such loans are often secured by a note and a trust receipt. This receipt is the legal paper for floor planning. It is used for serial-numbered merchandise. When a borrower signs the trust receipt, he/she acknowledges receipt of the merchandise, agrees to keep the merchandise in trust for the lender, and promises to pay the lender as you sell the goods.


Chattel Mortgages

If equipment such as a cash register or a delivery truck is purchased by the borrower, a chattel mortgage loan may be needed. This gives the lender a lien on the equipment the borrower buys. The lender will evaluate the present and future market value of the equipment being used in order to secure the loan. The borrower should protect the equipment with the proper insurance.


Real Estate

Real Estate is another form of collateral for long-term loans. When taking a real estate mortgage, the bank
inquires about:

• the location of the real estate;
• its physical condition;
• the foreclosure value; and
• the amount of insurance carried on the property.

Accounts Receivable

Many banks lend money on accounts receivable. In effect, the borrower counts on his/her customers to pay the note. The lender may take accounts receivable on a notification or a non-notification plan. Under the notification plan, the purchaser of the goods is informed by the lender that their account has been assigned to it and they are asked to pay the lender. Under the non-notification plan, the borrowers' customers continue to pay the sums due on their accounts to the borrower and in turn, the borrower pays the lender.


Saving Accounts

It is possible to obtain a loan by assigning to the lender a savings account. In such cases, the lender receives an assignment and keeps the passbook. If you assign an account which is held by another bank, the lender will ask the account bank to mark its records to show that the savings account is held as collateral.


Life Insurance

Another kind of collateral is life insurance. Lenders will loan money up to the cash value of a life insurance policy and the policy will be assigned to the lender. If the policy is on the life of an executive of a small corporation, corporate resolutions must be made authorizing the assignment. Most insurance companies allow the borrower to sign the policy back to the original beneficiary when the assignment to the lender ends. The advantages in using life insurance as collateral rather than borrowing directly from the insurance company are that it is easier and more convenient to obtain and it is available at a lower interest rate.


Stocks and Bonds

If stocks and bonds are used as collateral, they must be marketable. As a protection against market declines and possible expenses of liquidation, lenders usually lend no more than 75% of the market value of high grade stock. On Federal Government or municipal bonds, they may be willing to lend 90% or more of their market value. The lender may ask the borrower for additional security or payment whenever the market value of the stocks or bonds drops below the lender required margin.

Loan Restrictions and Limitations

What are the Lender's rules?

Lending institutions are not just interested in loan repayments. They are also interested in borrowers with healthy profit making businesses. Therefore, whether or not collateral is required for a loan, depends upon the specific criteria and the given requirements of the business. Lending institutions set loan limitations and restrictions to protect themselves against unnecessary risk and at the same time against poor management practices by their borrowers. Often some owner/managers consider loan limitations as a burden. Yet others realize that such limitations offer an opportunity for improving their management techniques.

Especially in making long-term loans, the borrower, as well as the lender should consider factors which will ensure loan repayment. Limitations generally increase as the duration of the loan increases. Such factors are:

• net earning power of the borrowing company;
• capability of the company's management;
• long range prospects of the company; and
• long range prospects of the industry of which the company is a part.

What type of limitations?

The types of limitation which an owner/manager finds set upon the company depends, to a great extent, on the company. If the company is a good risk, only minimum limitations need be set. A venture risk, of course, is different. Its limitations will be greater than those of a stronger company.

The kinds of limitations and restrictions which the lender may set are important for the borrower to know. Knowing what they are can help the borrower see how they affect his/her operations. The limitations usually encountered when borrowing money are:

• Repayment term;
• Pledging of the use of security;
• Periodic reporting; and
• Increased insurance requirements.

A loan agreement is a tailor-made document covering (or referring to) all the terms and conditions of a loan. With it, the lender protects its position as a creditor and assures repayment according to the terms.

The lender reasons that the borrower's business should generate enough funds to repay the loan while taking care of other needs. The lender considers that cash inflow should be great enough to do this without hurting the working capital of the borrower.


What are covenants?

The actual restrictions in a loan agreement come under a section known as covenants. Negative covenants are actions which the borrower may not do without prior approval from the lender. Some examples are:

• Further additions to the borrower's total debt;
• Further pledge of assets; and
• Issuance of dividends in excess of the terms of the loan agreement.

On the other hand, positive covenants spell out things which the borrower must do. Some examples are:

• Maintenance of a minimum net working capital;
• Carrying adequate insurance;
• Repaying the loan according to the terms of the agreement;
• Supplying the lender with financial statements and reports.

Overall, loan agreements may be amended from time to time and exceptions made. Certain provisions may be waived from one year to the next with the consent of the lender.

Applying for a Loan

Collateral Offered

A company's books should show the net value of assets such as business real estate and business machinery and equipment. "Net" means what was paid for such assets less depreciation.

If an owner/manager's records do not contain detailed information on business collateral, such as real estate and machinery and equipment, the lender sometimes can get it from the Federal Income Tax returns. Reviewing the depreciation which has been taken for tax purposes on such collateral can be helpful in arriving at the value of these assets.


Business Financial Statements

If the borrower is a good manager, he/she should have his/her books balanced monthly. However, some businesses prepare balance sheets less regularly. In addition to the prior two or three years, balance sheets and income statements should also be as prepared for the current period, preferably within 60 days of the date on the loan application. It is best to get expert advice (such as a C.P.A.) when preparing such vital information. A reviewed financial statement is better than a compiled one. An audited one is better than both compiled and reviewed.

Again, if the records do not show the details necessary for preparing profit and loss statements, the Federal Income Tax returns may be useful in collecting facts for the lender loan application process.


Insurance

The lender will also need information concerning the type of insurance the company carries. The owner/manager gives these facts by listing various insurance policies.


Personal Finances

The Lender must know something about the financial condition of the applicant. Among the types of
information are: 

• Personal cash position;
• Source of income including salary and personal investments;
• Stocks, bonds, real estate, and other property owned by the applicant; and
• Personal debts including installment credit payments, life insurance premiums, and so forth.

Standards of Evaluation

Once the necessary information has been supplied, the next step in the borrowing process is the evaluation of the loan application. Whether the processing officer is with a bank or another type of lending institution, the officer considers the following items:

• The borrower's debt paying record to suppliers, banks, other lenders, home mortgage holder, and other creditors;
• The ratio of the borrower's debt to net worth;
• The past earnings of the company;
• The value and condition of the collateral which the borrower offers for security;
• The borrower's management ability;
• The borrower's character; and
• The future prospects of the borrower's business.

Business Maturity and Financing Requirements

Business Maturities And Appropriate Business Strategies

Commercial and Business Loan Structures

In commercial and business lending there are four basic types of loan structures that can be made to a borrower: seasonal, term, bridge, and permanent capital.


Seasonal Loans

The seasonal loan generally funds an increase in inventory, such as purchases of Christmas wares by retailers. The cash created by the loan is disbursed immediately to suppliers or after taking advantage of supplier terms. The inventory is eventually sold, any resultant receivables collected, and the lender repaid. In a service business, loan proceeds can fund expenses until receivable are created and collected, such as with an accounting firm.

The analysis of a seasonal loan is best accomplished by analyzing projected balance sheets and income statements on a quarterly and monthly basis. The projected balance sheets can tells both the borrower and the lender the peak credit needs, the relationship of lender and trade creditors, timing of peak lender exposure and degree of reliance on inventory at that point, and timing of loan repayment. Other means of analysis include a projection of sources and uses of cash, but the former two statements are the most efficient means of answering the questions posed by this type of loan.

A lender usually will not issue a commitment on a seasonal loan. A commitment is rarely used is small business lending. By definition, a line of credit is a revocable facility and cannot be committed.

The seasonal loan is normally handled under an advised, revocable line of credit in which the maximum amount of the line is sufficient to take care of the peak borrowing. The maturity on the note under the seasonal line should correspond with the low point in current assets and liabilities when it is expected that the lender and the trade should be paid out. When advancing under a line of credit, the lender will ensure that loan proceeds are being used for the intended purpose - inventories or payables - and not for other purposes such as the acquisition of fixed assets.

Generally, advances are handled on one note. A lender is secured by a perfected security interest in accounts receivable, inventory, and equipment. In a truly seasonal loan (where the lender and the trade are paid out), a borrowing base and advance formula are unnecessary. A borrowing base is unworkable because in the normal course of events, the lender relies heavily on inventory at the beginning of the current asset expansion and on receivables toward the end. The lender will want to understand the nature of the inventory and also the credit policy of the borrower to its customers. The lender may desire to obtain a receivable listing at the peak inventory point in case it had to collect at a later point.


Term Loans

Term loans are repaid from the cash generated by earnings installments over a period longer than one year or longer than the normal operating cycle of the business. The purpose of a term loan frequently is to purchase fixed assets, but there can be other reasons for a term loan.

A term loan can convert a permanent capital loan from a loan with no repayment understanding to a loan repaid over time on an agreed-upon basis. A term loan might be used to finance a change of ownership, such as in a treasury stock transaction, or to finance an acquisition. A term loan also can be used to repay the balance of a seasonal loan that was not paid out at the bottom of the operating cycle.

Seasonal loan analysis emphasizes the balance sheet; term loan analysis emphasizes the income statement. Whereas the seasonal loan is repaid from the conversion of current assets, the term loan is repaid from earnings. For this reason, the long-term profit potential of the company must be understood and analyzed. To do this a lender will want to understand the borrower's management, industry, and position in the market. An analysis focuses on long- term cash generation and may include a sensitivity analysis using different assumptions for sales volumes, margins, current asset and liability turns, expenses, interest rates, and taxes. The lender will determine the margin of error, or how wrong can the lender be and still be paid out.

Many borrowers ask how long they can take to repay, when they really should focus on how fast then can realistically pay the debt. In financing fixed assets such as equipment, the borrower should ensure that the loan is repaid before the useful life of the asset financed has ended. It is to the borrower's advantage to be in a position to borrow again when new assets are needed. Another useful analysis that should be accomplished is to ensure that an acquired asset is generating sufficient profit for the borrower after financing costs.

A term loan implies that the funds advanced by the lender will be outstanding for a defined period of time and amortized on a periodic basis. Cash payments are generally applied first to interest and then to principal. A term loan longer than one year should be posted in the long-term section of the balance sheet (except for current maturities), thus conforming the current ratio to the reality of the term loan facility. A lender may want to place restrictions on the borrower such as cash payments for fixed assets, dividends, and salaries to agreed-upon levels.

The lender is often secured by a mortgage on land and buildings or a security interest in equipment. Receivables and inventory can obviously be taken as well, but they are often collateral for seasonal loans or permanent capital facilities. The collateral value of an asset is usually its liquidation value. This means the cash value of the asset when sold at the worst possible time under the worst possible conditions and at the highest possible expenses of liquidation.


Bridge Loans

Bridge loans function as a "bridge" until a specific event occurs that repays the loan. Bridge loans and the circumstances that create them are generally exceptions to normal operations of the borrower and require special decisions by management. These types of loans can be repaid from three different sources:

1. The sale of noncurrent assets. For example, in a swing house loan, the lender lends the equity on a new house and is repaid from the equity generated by the sale of the old house.

2. Refinancing debt with debt. In an interim construction loan, a lender extends funds to complete a project and then is repaid from the placement of a permanent mortgage.

3. The infusion of equity. Utilities and finance companies occasionally retire bank debt through the sale of stock in the equity markets.

In analyzing bridge loans the borrower should focus on two areas: the likelihood of the event that will repay the loan occurring and the ability to service the debt in case the event does not occur. If the event were not to occur (for example, the failure of a stock offering), the lender then is usually left with a long-term loan or a permanent capital loan.

Bridge loans are normally structured with maturities that coincide with the anticipated event. When a maturity date falls on a bridge loan, the loan should be repaid in full. If it is not paid, either the event has been delayed or a failure has occurred. Interest is usually paid monthly or quarterly.

In a sale of a noncurrent asset, the lender usually secures itself with the asset being sold. This also applies to an asset being refinanced. This collateral not only gives the lender the asset being financed but helps control the proceeds of the new loan because the permanent lender needs a release of collateral before an advance is made. Where infusion of equity is anticipated to pay the loan, the lender will want to be at the closing table when funds are disbursed.


Permanent Capital Loans

Permanent capital lending is revolving credit financing to purchase current assets or pay current liabilities in which the amount of the loan always would be secured by the liquidation value of accounts receivable and inventory. The term "permanent capital lending" is used because this form of debt is really a substitute for owner's equity.

This type of lending is often called asset-based lending, accounts receivable and inventory lending, or revolving credit. The following two features distinguish this type of loan:

1. Advances should increase current assets or decrease current liabilities. Purchases of noncurrent assets, payment of dividends, and treasury stock purchases should be considered separate issues.

2. This lending facility truly revolves. Advances are continually being repaid from customer collections, and new advances are made against the creation of new inventory and receivables. Advances outstanding fluctuate up and down as current assets expand and contract.

A normal working capital configuration appropriate to a permanent capital loan consists of slower turning receivables and inventories and faster turning payables and accruals. The receivables should represent true sales where a contractual obligation has been created. A number of situations commonly give rise to permanent capital lending:

• Rapidly expanding sales that outstrip the owner's equity position.
• New businesses that cannot demonstrate repayment capability.
• Depletion of working capital through purchases of noncurrent assets, treasury stock, and acquisitions.

One of the most common reasons for permanent capital financing is that a seasonal, term, or bridge loan cannot be repaid because of some setback, such as unexpected losses or the inability to sell assets. Repayment is indefinite with a permanent capital loan, so the lender's ability to withdraw from the loan is limited. The best means of repayment is eventual conversion of the permanent capital loan to a term loan. Another source of repayment is refinancing with another lender. The final source of repayment could be liquidation if the borrower is consistently unprofitable and no infusion of equity is available. Permanent capital lending is, therefore, the riskiest form of lending a lender can undertake.

The analysis of a permanent capital loan focuses on several areas. Because of the heavier-than-average debt burden, margins for error are considerably reduced. Therefore, management must be exceptionally capable and flexible enough to adapt quickly to changing circumstances. Earnings over the long term usually provide the best means of ultimate repayment for this type of loan. Consequently the lender will want to understand the borrower's industry and position in the marketplace. Because of the reliance on accounts receivable, the borrower's credit policy's and procedures will be scrutinized. Finally, the lender will periodically analyze the receivables and inventory to ensure their liquidation value.

Permanent capital loans are extended under advised, revocable lines of credit that set forth the maximum amount of credit available at any one time and the terms and conditions of advances and repayment. Before extending the loan, the lender will analyze the collateral to determine appropriate eligibility for advances and adequate margins. Accounts receivable are examined in such areas as: credit policies, general credit quality, concentrations, selling terms in comparison with the industry, aging, returns and allowances, collectability, and repurchase agreements. Lenders generally look at
inventories as poorer collateral unless the lender has significant expertise in lending against this type of collateral. The inventory will be valued at liquidation value and not "going concern" value. Many factors are considered such as: costs of storage, transportation, and security; obsolescence; warranties; perishable items; costs of disposal; demand for the items. Inventories normally cannot give much comfort to commercial lenders unless the inventories are fungible goods or commodities with established markets or items such as packaged goods with brand names.

Once eligibility is agreed on, the lender should devise a borrowing request form containing a certification of collateral levels. When an advance is needed the borrower presents the borrowing request containing the collateral level certification to the lender. The lender then authorizes the advance and funds are disbursed. If the lender is a bank, whenever the borrower receives funds (generally in payment of accounts receivable) the borrower brings them to the bank intact and deposits them in a collateral account under control of the bank. After the funds are collected, the collateral account is debited, and the proceeds are applied to the revolving credit note.

Commercial Real Estate Financing Overview

Mortgage Loan

There are two parts to a mortgage loan: the note and the the mortgage. Both note and mortgage must be executed in order to create an enforceable mortgage loan.

• Note or Financing Instrument: The promise, or agreement to repay a debt in definite installments with interest. The mortgagor (borrower) executes a promissory note to
  the total amount of the debt.
  
• Mortgage or Security Instrument: The document that creates the lien, or conveys the property to the mortgagee as security for the debt.
  
• Trust Deed: is sometimes used instead of a mortgage; the lender is the beneficiary, who is the legal owner and holder of the note. In states where trust deeds are generally preferred, foreclosure procedures for defaulted trust deeds are usually simpler than those for mortgage loans.
  
• Hypothecation: is the term used to describe the pledging of property as security for payment of a loan.
  
• Interest: is the charge for the use of money. It may be due either at the end of each payment period (payment in arrears) or at the beginning of each payment period (payment in advance). Charging interest in excess of the maximum allowed by state law is usury and lenders are penalized for making these kinds of loans. Loans made to corporations are generally exempt from usury laws.

Loan Payment Plans

• Fully Amortized: Also called direct reduction loans, each payment is a constant amount being applied first to the interest owed and then applied to the balance to reduce the principal of the loan. The portion applied toward repayment of the principal grows and the interest due declines as the unpaid balance of the loan is reduced.

• Straight-line Amortized: Each payment consists of a fixed amount credited toward the principal plus an additional amount for the interest due on the balance of the principal outstanding. Each installment is lower than the previous.
  
• Interest Only or Straight Payment: Each payment is for interest only, with the principal to be paid in full at the end of the loan term.
  
• Adjustable Rate or Floating Rate: The interest rate fluctuates up or down during the loan term based on a certain economic indicator, such as the current Treasury bill yield. There are two interest rate caps, one for the amount it go up in one year and the other for the life of the loan.
  
• Partially Amortized with Balloon: Periodic payments will not fully amortize the amount of the loan by the time the final payment is due. The last or balloon payment is much larger. This is used extensively in commercial real estate deals where a loan might be amortized for 20 or 30 years but principal due in seven years.
  
• Renegotiable Rate: Loan terms loans that are renewable every three, four or five years, at which time the interest rate is increased or decreased.
  
• Shared-appreciation: Interest rate is very favorable to the borrower in return for a guaranteed share of the gain (if any) the borrower will realize when the property is eventually sold.

Other Financing Techniques

• Purchase-Money Mortgage or Trust Deed: This is given at the time of purchase by the purchaser to the seller who "takes back" a note for part or all of the purchase price. It becomes a lien on the property when title passes.
  
• Blanket Mortgage or Trust Deed: A blanket mortgage covers more than one parcel or lot and is usually used to finance subdivision developments. Includes a partial release clause, releasing any one lot upon payment of a specific amount.
  
• Wraparound Mortgage or Trust Deed: Enables a borrower who is paying off an existing mortgage to obtain additional financing from a second lender. The new lender assumes payment of the existing loan and gives the borrower a new, increased loan at a higher rate.
  
• Open-End Mortgage or Trust Deed: Secures a note executed by the borrower to the lender, as well as any future advances of funds made by the lender, up to a specified amount.
  
• Construction Loan: This type of loan is made to finance the construction of improvements or real estate. The lender commits to the full loan amount, but makes partial progress payments to the general contractor for that part of the construction work that ha s been completed since the previous payment. Waivers of lien releasing all mechanics' lien rights must be provided to the lender on each partial payment. This type of financing is generally short-term, or interim financing.
  
• Permanent or Take-out Loan: This loan repays the construction loan financing lender when the work on a new development project is completed. This loan can typically be for a long period, such as 7 to 10 years.
  
• Sale and Leaseback: These arrangements are used rather extensively as a means of financing large commercial or industrial plants. The land and building, usually used by the seller for business purposes, are sold to an investor, such as an insurance company. The real estate is then leased back by the buyer (the investor) to the seller, who becomes the tenant.
  
• Installment Contracts: Also known as a contract for deed, land contract or articles of agreement for warranty deed. Real estate is often sold on contract when mortgage financing is unavailable or too expensive, or when the purchaser does not have a sufficient down
  payment.

Real Estate Investment Syndicates

• General Partnership: Organized so that all members of the group share equally in the managerial decisions, profits and losses involved with the investment. A certain member of the syndicate is designated to act as trustee for the group and holds title to the property and maintains it in the syndicate's name.
  
• Limited Partnership: One party, called the general partner, organizes, operates and is responsible for the entire syndicate. The other members, called the limited partners, have no voice in the direction and are merely investors. The limited partners share in the profits but stand to lose only as much as they invest.
  
• Real Estate Mortgage Investment Conduit (REMIC): Has very complex qualification, transfer and liquidation rules. Qualifications include the "asset test" (substantially all assets after a startup period must consist of qualified mortgages and permitted investments) and the requirement that investors' interests consist of one or more classes of regular interests (paying a fixed or variable interest rate) and a single class of residual interests (paying any other distributions on a pro rata basis).
  
• Real Estate Investment Trusts (REITs): Set up to take advantage of the same tax advantages as mutual funds: no corporate income tax liability as long as 95% of its income is distributed to investors; 75% of the trust's income must come from real estate investments.
  
• Equity Trusts: These pool an assortment of large-scale income producing properties and sell shares to investors. Profits are derived from the income and not the sale of real estate properties.
  
• Mortgage Trusts: These buy and sell real estate mortgages (usually short-term, junior instruments) rather than real property. Income is interest and origination fees. These REITs may make construction and commercial loans.
  
• Combination Trusts: These invest shareholders' funds in both real estate assets and mortgage loans. This type of REIT may be able to withstand economic slumps better because of the more efficient balance of real estate investments and liabilities.

Please see Commercial and Investment Real Estate Financing for more information on this type of financing.

Business Strategy in Relation to Business Lending

When approached by a business or commercial borrower, a lender will adhere to a customary procedure to request financial statements, pro-forma projections, and the usual documents needed to evaluate the creditworthiness of the borrower. In many instances, the lender will require
collateral as well as the personal endorsements of the borrower. While such practices are certainly wise, they do not necessarily guarantee the integrity of the loan.

Sometimes the lender will fail to investigate properly how the proceeds of the loan will be used. It is not too farfetched to suspect that some funds may not actually get into the business in question. However, in most instances, the borrower's objective is to apply the proceeds of the loan to either working capital needs or asset purchases. What is often overlooked is the manner in which the borrower plans to operate the business, that is, business strategy. This is particularly true is start-up situations in which the small businessperson approaches the lender to finance a beginning operation with limited personal equity and a majority of debt financing. This makes the evaluation of the loan request all the more critical and all criteria must be looked at in deciding whether to move forward.

Even before any discussion of collateral, the first question to ask the prospective borrower is: What is your strategy for operating your business? There are generally three types of strategies a business might pursue. They are the low-cost producer strategy, the differentiation strategy, and the focus strategy.


Low-Cost Producer Strategy

To be a low-cost producer, the business must gain some competitive advantage in operating expenses that allows setting prices below competitors' prices. In most instances, the low-cost producer in any given industry will be the giant firm that enjoys benefits that a small business cannot possibly match, including economies of scale, learning and experience curve advantages, and
national and international distribution channels.

Nevertheless, a small business might be the low-cost producer within its local market, thus offering prices at a level difficult for the competition to match. Crucial to achieving a low-cost producer advantage is designing a realistic cost system. Typically, an entrepreneur sets up shop by mobilizing whatever scarce resources he or she already owns and, with the anticipated loan proceeds, securing additional equipment, supplies, furnishings, and personnel to initiate operations. These decisions, in effect, create a cost-generating system.

Two questions should be addressed. The first one is: How well does the cost system relate to anticipated revenues? The second one is: What level of gross revenues can realistically be anticipated during the initial operating period? The first question addresses the borrower's assumptions about fixed and variable operating expenses that are a direct result of the borrower's perceptions and decision-making processes. Many times the aspiring businessperson designs and builds the cost-generating system without investigating the second question. Ignoring these two questions presents an immediate danger: the business commences operations and then the borrower and the lender both ultimately discover that expected revenues are not sufficient to cover operating costs. The message is obvious: estimate the revenues first, realistically, then design the cost- generating system to accommodate that revenue estimate.


Differentiation Strategy

The second type of strategy is called a differentiation strategy. It is based on the fact that there is a distinguishing element, either real or perceived, about the product or service that gives the business a unique advantage over competitors' products. With manufacturing, the distinguishing element may be their product's superior materials or workmanship; in the case of service companies, it may be courteous, prompt, and dependable treatment of customers by the firm's employees.


Focus Strategy

The third strategy is called a focus strategy, wherein the business focuses on specific segments or niches in a given market rather than attempting to cover all segments of that market. Many small businesses have enjoyed success by carving out a small segment of a larger market and catering to the special needs of a particular group of customers, by concentrating on a limited geographic market, or by concentrating on certain uses for the business's product/service. Unless the lender considers carefully the particular strategy that a borrower is going to pursue, the loan might be much less attractive than the collateral alone would indicate.


The Motives for Borrowing

Typically, a businessperson approaches a lender for a loan when he or she is in one of three situations:

Situation 1: The borrower needs additional funds to finance growth (seasonal or permanent).

Situation 2: The borrower needs additional funds to increase working capital to pay off past-due obligations that cannot be paid out of internally generated funds.

Situation 3: The borrower is seeking a loan to start a business.

Of the three possible motives, the first is probably the least risky if the business is growing and the borrower needs to support that growth with additional working capital to fund increases in receivables, inventory, or other assets. The borrower will need to have a good market for the inventory and effective credit policies established. In the second situation, borrowing additional funds to pay overdue bills, the lender will generally be more cautious. If the prospective borrower is behind in paying current liabilities, namely vendors, payroll taxes, sales taxes, or other obligations of that nature, the lender must be considerably more skeptical. The third type of borrower, the start-up company, presents the greatest amount of risk to the lending institution. The first thing a lender must consider is not the borrower's collateral or endorsement, but the feasibility of the business idea - is it a viable concept? The important questions here are: Is there a need for the business? Is there a sufficient market for the business? Does the borrower have a distinctive competence that will allow him or her to take market share away from existing competition? In this situation the borrower may be exposed to the danger of over optimism- the "it can't fail" syndrome.


Strategic Checklist

The importance of collateral should not be discounted when analyzing a small business loan request. However, borrower strategy is an extremely important area to scrutinize. The following checklist is recommended as a starting point in evaluating the business strengths and weaknesses in pursuing a new business venture or managing an ongoing enterprise.

• What is the borrower's business strategy? What are the strategy's key components?
  
• What is the borrower's market? Where is the market?
  
• Who are the borrower's customers? What does he or she know about them?
  
• Who are the firm's competitors? Where are they? How do they compete? What are their strengths? Weaknesses?
  
• What distinctive competencies do the borrower's competitors have?
  
• How does the borrower's product line or service compare with that of the competition?
  
• What distinctive competencies does the borrower have (location, product line, service, proprietary know-how)?
  
• Can the borrower identify his or her firm's strengths? Weaknesses? What is the borrower's competitive advantage, if any?
  
• What forces are driving the borrower's market or industry?
  
• What is the borrower's overall track record? Experience?
  
• How good is the borrower's collateral?

Summary of Commercial Financing Alternatives

Bank Lines of Credit or Revolving Credit

Terms & uses: 1-2 years; amount often floats as percent of receivables and/or inventory; seasonal working capital use.
Security: Unsecured or secured by receivables, inventories, property, plant, equipment, fixtures, etc.
Requirements: Have collateral, established sales/earnings record, and predictable cash flow.
Advantages: No equity dilution; support services; interest deductions; interest predictable; flexibility to borrow and repay funds.
Disadvantages: May need collateral; leverage can be expensive; can impede additional financing; restrictive debt covenants.
Sources: Commercial banks, Hybrid lenders, Commercial finance companies.


Short Term Notes

Terms & Uses: 60 -180 days; seasonal working capital use; fixed rate.
Security: Unsecured or secured.
Requirements: Have collateral; established sales/earnings record, predictable cash flow.
Advantages: No equity dilution; Support services; interest deductions; interest predictable; may be fixed rate.
Disadvantages: May need collateral; new documentation required for each borrowing; must meet maturity.
Sources: Commercial banks, individuals.


Revolver / Term

Terms & Uses: 2-3 year revolver converting to a 3-7 year term loan; working capital use; equipment needs; acquisitions; expansion.
Security: Unsecured or secured. 
Requirements: Have collateral, established earnings record, predictable cash-flow.
Advantages: No equity dilution; support services; interest deductions; flexibility to borrow and repay funds; postpones repayment until cash flow is available; provides long-term commitment; able to package assets purchased over time into a single loan; may be able to renew revolving portion indefinitely, subject to performance.
Disadvantages: May need collateral; hard to obtain in difficult times; leverage can be expensive; can impede additional financing; restrictive debt covenants; prediction of interest may be difficult with floating loan rates.
Sources: Commercial banks, Hybrid lenders, Institutional lenders.


Term Loan

Terms & Uses: 3-7 years; equipment needs; acquisitions; expansion.
Security: Unsecured or secured.
Requirements: Have collateral, established sales/earnings record, predictable cash flow.
Advantages: No equity dilution; support services; interest deductions; interest predictable with interest rate protection; may be fixed rate interest ; repayment over time.
Disadvantages: May need collateral; hard to obtain in difficult times; leverage can be expensive; can impede additional financing; restrictive debt covenants; interest rate may be higher.
Sources: Commercial banks, Hybrid lenders, Commercial finance companies, Institutional lenders, Individuals, Government sources.


Mortgage Note

Terms & Uses: 7-30+ years amortization; 5-10 years call available; equipment needs; real estate purchase; acquisitions; expansion.
Security: Real Estate.
Requirements: Have collateral, established sales/earnings record, predictable cash flow.
Advantages: No equity dilution; support services; interest deductions; interest predictable with interest rate protection; may be fixed rate of interest; lower repayment terms over longer periods.
Disadvantages: Need collateral; prepayment penalty on fixed rate loans possible.
Sources: Commercial banks; Commercial finance companies; Institutional lenders; Individuals; Government sources; Savings and Loans; Life Insurance Companies; Pension Funds.


Subordinated Debt

Terms & Uses: 3-10 years; working capital use; equipment needs; acquisitions; expansion.
Security: Unsecured.
Requirements: Subordinated to other senior lenders; have established sales/earnings record, predictable cash flow.
Advantages: Interest deductions; interest predictable with interest rate protection; may be fixed rate of interest; lower repayment terms over longer periods; may be perceived as additional equity by senior lender or may become equity later.
Disadvantages: Possible equity dilution; hard to obtain in difficult times; leverage can be expensive; restrictive debt covenants; interest rate may be higher. Sources: Commercial banks, Hybrid lenders, Institutional lenders, Individuals, Venture Capital.


Asset Based Lending

Terms & Uses: 1-3 year contract; working capital use; semi-permanent working capital; equipment needs.
Security: Secured; advance rate varies with industry: 55- 80% of receivables, 10-60% on inventory, 50-75% of liquidated value of fixed assets and real estates. 
Requirements: Have collateral, established sales/earnings record, predictable cash flow.
Advantages: No equity dilution; support services; interest deductions; interest predictable; flexibility to borrow and repay funds.
Disadvantages: Need collateral; leverage can be expensive; can impede additional financing; restrictive debt covenants; interest rate may be higher.
Sources: Commercial banks, Commercial finance companies.


Leases

Terms & Uses: Limited to life of asset leased; equipment needs; real estate.
Security: Asset based.
Requirements: Have collateral, predictable cash flow.
Advantages: No equity dilutions; support services; interest deductions; interest predictable; may be fixed rate interest; lower repayment terms over life of the asset; may not be capitalized.
Disadvantages: Need collateral; interest rate may be higher; payment may be required at end of lease.
Sources: Commercial banks, Leasing companies.


Corporate Bonds / Debentures

Terms & Uses: 5-30+ years; permanent working capital use; equipment needs; acquisitions; expansion.
Security: Unsecured.
Requirements: Established sales/ earnings record, predictable cash flow.
Advantages: Support Services; interest deductions; interest predictable; lower payment terms; may be perceived as additional equity; may be fixed-rate interest.
Disadvantages: Possible equity dilution; hard to obtain in difficult times; leverage can be expensive; can impede additional financing; restrictive debt covenants; interest rate may be higher; generally not available to smaller companies.
Sources: Institutional lenders, Public market.


Franchising

Terms & Uses: Long term; working capital use; equipment needs. Security: N/A.
Requirements: Developed sound product; recognizable individuality; rapid growth of concept; control over growth; ability to develop good relationship with franchisees.
Advantages: Immediate cash flow; no need to repay; no equity dilution; low risk; limited capital requirements; ability to expand rapidly; distributes start-up costs to others; provides long-term royalty stream.
Disadvantages: Costs to franchise; share profits with franchisee; requires extensive testing of concept; legal complexities.
Sources: Franchisees.


Venture Capital

Terms & Uses: 5-7 years; exploiting new products, services, or market niches; seeking equity capital in LBO; equipment needs; acquisitions; expansion.
Security: Equity in company.
Requirements: Need start-up seed capital with potential for rapid growth; need "early stage", "second" or "third" round capital, with potential for rapid growth; established and growing rapidly.
Advantages: Management and financial expertise from equity investor; greater leverage and cash flow; enables company to mature enough to make public financing feasible; no cash drain for debt repayments or interest and liquidity needs.
Disadvantages: Difficult to obtain; heavy equity dilution; process is time-consuming and difficult; no assurance of success; venture capitalists have high expectations and require various reports; management often gives up economic control to venture capitalists. 
Sources: Individuals ("Angels"), Private venture capital funds, Investment bankers, Government venture funds, Public venture funds, Institutional venture capital pools, SBICs and MESBICs.


Public Stock Offerings

Terms & Uses: Long term; working capital use; equipment needs; acquisitions; expansion.
Security: Equity in company.
Requirements: Proven management; established sales/ earnings; high growth potential.
Advantages: Capital available in large amounts; provides liquidity for investors and management; prestige and visibility; expands equity base; no repayment; provides vehicle for attractive stock incentives; improves marketability; increased value of stock; easier to value estate.
Disadvantages: Expensive; timing is critical; SEC regulation; SEC disclosure obligations; equity dilution; pressure to maintain earnings growth; outside directors; management subject to "insider" rules; shares owned before offering are "restricted".
Sources: Investment bankers, Public.


Limited Partnerships

Terms & Uses: Long term.
Security: N/A.
Requirements: Recognizable expertise in specific technology or attractive product with market appeal; engaged in development of new process or product; long R&D cycle.
Advantages: Tax benefits used to minimize risks; off balance sheet financing; flexible funds become available; management retains operating control; general partner gets no-risk capital.
Disadvantages: Exclusive rights to technology may be lost; must comply with legal and tax guidelines for R&D; risk of disallowance of tax benefits; exposure to tax law changes; requires extensive long-range planning.
Sources: Investment bankers, Syndicators, Corporate partners, Individuals.


Government Financing

Terms & Uss: Working capital use; equipment needs; expansion.
Security: Guaranteed portion cannot exceed certain dollar amounts; government will guarantee up to 80% of loan.
Requirements: Cannot be dominant in its field or market; must be independently owned and operated; must meet size standards, use funds only for eligible activities; sufficient collateral.
Advantages: No equity dilution; support services; interest deductions; unable to obtain commercial debt; typically lower interest rates; lower repayment terms over longer periods.
Disadvantages: Smaller dollar amounts; need collateral; leverage expensive; restrictive debt covenants; can restrict future expansion; no unessential assets or operations; cannot pay owners with the proceeds. 
Sources: SBA field offices, Commercial banks, State
agencies.