Recently I was asked to pinch hit for a presenter at an SBA-sponsored Reboot workshop for veterans interested in starting their own businesses. CEDF was pleased to host the event at our Meriden office.
The presentation was on access to capital and the material was part of a standard curriculum the SBA has developed. I was intrigued by this video (available on YouTube) from the Kauffman Foundation that is used as an intro for the segment. It provides a very clear and understandable overview of the small business funding landscape. And although the video was created in 2011, it still is current enough to be informative.
Using the white board sketch format of explainer videos, the Kauffman Foundation narrator described the sources of capital for young companies. More than half, he said get all they need from a combination of personal savings of the founder and business cash flow. That’s encouraging and it shows not only good planning toward capital accumulation but also the opportunity for quick success in the marketplace. I imagine these companies didn’t have founders taking much in the way of draws out of the business too soon either.
The next source highlighted was credit cards. It’s an understandable choice for working capital whether the founder uses a personal card or a business card. (Think plural -- cards -- because the reality is that many business owners tap several cards, often getting into trouble by not being able to repay on schedule and seeing interest rates climb into the penalty range.) Credit cards are also the little-discussed way that banks have chosen to stay involved in small business lending. While the increasingly tough terms and conditions for bank lending over the past 25 years have eliminated most new businesses as term loan borrowers, many banks will still offer them credit cards. To some degree, this is because a credit card more closely matches risk, with lower credit limits and higher potential interest and fees.
The video next discusses the use of friends and family for either loans or equity. They point out that many small businesses only resort to this after they have tapped out the easier sources like credit cards or personal savings.
Now, the discussion arrives at banks and the reality that banks provide very little funding for young companies because of shareholder and regulatory pressures to only make loans secured by assets, which young companies typically do not have.
Finally, despite the frequent attention given to famous start-ups, venture capital funds only a small fraction of firms. And of the fastest growing firm, the video states less than 20% took any venture money because most didn’t want it. They were willing to use other sources to avoid giving up ownership. Eight years after this video was made, this is likely still the case.
Only in passing, since these niches were reasonably new in 2011, is there a mention of angel investor groups and peer-to-peer funding. Both have grown in importance since the video was created. And there is no discussion of merchant cash advance lenders and what we call the “easy internet lenders,” who provide loans on stiff terms with little documentation. We suspect their market share is growing as people do more business online. And sadly many do not think through the impact of these expensive forms of capital and find themselves drowning.
Unfortunately, organizations like CEDF -- community development financial institutions -- have been established all over the nation for 25 years but they don’t get so much as mentioned.
CEDF and similar lenders fill in the gap left by the retreat of banks from the small business lending market. But it is clear from the video that while much attention goes to equity capital, the reality is that debt capital is much more common (as evidenced by the use of credit cards). We wish more small businesses would learn to use community lenders instead of the much more expensive alternatives. It’s the best set of training wheels to prove one’s company can become bankable.
As critical as it is in a lender’s decision making process for a term loan, what is often misunderstood by the owners of small and sometimes larger privately-held businesses is the need to have sufficient working capital to operate and an appropriately-balanced debt structure for the business.
The balance sheet must, then, have two kinds of balance. Obviously it must be assembled correctly to accounting standards, therefore allowing the numbers to add up. But there is also the prudent kind of balance. This means, among other things, that long-term debt is supported by ownership of long-lasting assets and there's not too much debt. Then, it presents a good picture along with an income statement that tells a good story, especially when you put them side-by-side, looking at a few years together. And most importantly the business with its owner must have the income resources to assure repayment.
It is very common that small business owners have insufficient funds to buy the equipment, fixtures, inventory, or to pay the operational costs to run the company. Desperate owners reach for nontraditional sources for funding like personal credit cards, private loans or a growing group of "easy internet lenders." These latter types, especially, may appear to be great funding sources in a tight situation, but these lenders are not right at all for supporting long-term assets or growth requiring permanent working capital. Once you dive in the easy internet pool it’s hard to swim out and retire high-priced debt unless you have high profit margins. So, count that out because if you had such good margins you probably wouldn’t have needed these lenders in the first place. Too many times I have seen borrowers accumulate loans from these quick-fix sources piled upon multiple credit cards to support financing needs that are really of a long-term nature. So the use of these sources is both risky and a mismatch against the financing needs of their businesses.
So, when you sit with a lender like CEDF or your bank to discuss funding for, say, a new piece of equipment or an expansion into the space next door, you should try to understand how your balance sheet and your income statement looks to the lender. What are they looking for and what story does your paperwork tell them when it’s all put together? Does it suggest you have good balance in your use of debt and strong sources of repayment? Is it one that might result in a supportive decision or does it immediately evoke questions that will result in a rejection of your request?
While not all businesses fit into an idealized debt structure, just ask yourself a few questions:
Does my business have a debt structure (long term loans) that support long term assets, with short term assets (accounts receivable and inventory) supported by short term loans?
Are the book values on my balance sheet of those short term assets (accounts receivable and inventory) and long term assets (equipment, machinery, vehicles, furniture, fixtures and real estate) larger than the loans that they support? If they are not and you don’t have sufficient liquidity (cash and investments), your balance sheet is not "in balance" regardless of what the equity section tells the banker.
How does my banker view my debt service coverage ratio (DSCR)?
Here's the quick definition of DSCR:
Business Annual Net Operating Income (less taxes, interest payments, depreciation and amortization) divided by the Current Year Debt Obligations (including principal and interest on existing and requested loans, loan fees and leases, if applicable).
Standards can vary with circumstances but a 1.25 ratio is an often used threshold for approving a loan. DSCR is a simple measure, but it can be complicated by other debt sources in the typically undercapitalized worlds of small business owners. Remember that lenders look to owners to guarantee repayment of the loans, so owners' own personal debt levels matter greatly.
Character and past performance matters a lot in the world of lending as every business owner knows. Lenders can only rely so much on personal interviews and evaluation of self-reported background information to judge character, so a personal credit score becomes a proxy. Most banks have hard cut-off points on personal credit scores for small business applicants. CEDF, since it is not subjected to the same kinds of state and federal regulation as banks are, has more latitude to judge a low personal credit score in light of the totality of the applicant's circumstances.
A new business is unlikely to have any kind of business credit score, just like a young person may have an insufficient credit history to generate a personal credit score. CEDF, recognizing this reality in many of our applicants, relies instead on personal credit scores. And in the early years of a business, practically speaking, this may be much of what matters in seeking financing.
Dun & Bradstreet, historically, was the primary source of business credit scoring. But as the financial technology (fintech) revolution has marched on, D&B has more competition. FICO Small Business Scoring Service now serves numerous banks and the SBA uses this credit reporting product for pre-qualification of 7(a) loan applicants. [SBA 7(a) loans are typically originated by banks.] Experian is another D&B competitor with a similar business score product. And the other two credit bureaus, Trans Union and Equifax, also offer delinquency prediction models.
One might see that as a business grows substantially and its operations begin to dwarf the size and importance of a founder's personal assets, a business credit score becomes more important for suppliers, lenders and insurance companies. Factors such as payment history, age of credit history, debt levels and usage, company size and industry risk factors are included in some calculations, but like in the personal credit scoring market, there are lots of different scoring models provided by D&B, FICO and the others. And, not surprisingly, personal credit history of the business owners is also included.
But be aware that business credit scores may contain errors, as this Wall Street Journal article explained back in 2013, and because it is harder for businesses to obtain a look a their scores (there's no FTC Free Annual Credit Report for businesses), these corrections may be hard to make. The Fair Credit Reporting Act does not cover businesses. A lender who uses business credit scoring information (as opposed to personal scoring) does not have an obligation to inform you if you are denied based on that score.
What do you do? If your business is small and new, pay more attention to your personal credit score and do your best to improve it. As your enterprise grows, be known as a solid corporate citizen that pays its bills on time and controls its use of debt. Develop good relationships with banks and respond to the financial benchmarks they use, which are widely understood. Keep aware of changes in the credit reporting industry and how they impact businesses of your size.
Among the options available to small businesses, revenue-based financing (RBF) seems to be getting more attention recently. It’s structured like a loan and the repayment is tied to a percentage of the company’s monthly revenue. The main attraction for entrepreneurs, accordingly, is that it’s promoted as a way to finance rapid growth without giving up equity and control.
These loan products are marketed through niche lenders. And like much in the internet age, the promise is that the deal can be done quickly and with less documentation. But as we shall see, they are much more expensive than conventional financing through a bank or a nonprofit lender, such as CEDF.
Looking at some of the funders’ websites showed some variety in the terms. The minimum monthly revenue of the business might range from $15K to $30K. Maximum funding was listed as 1/3 of annual revenue in once case and six times monthly recurring revenue in another. To qualify, businesses have to have gross margins better than 50%. This is because if one has to budget 3% to 10% of monthly revenue (debited out of your bank account) to repay the financing, there had better be enough profit left over to run operations.
The term repayment cap is used to describe the total cost of capital. This can range from 1.3 times to 3 times the amount borrowed. On the low side that would mean repaying $65K on a $50K loan or even $150K on the same $50K financing. A three-year $50K SBA Microloan at 7.5% would have a total repayment of $55,991, which equates to only 1.12X the financed amount. The terms are said to be three to five years, which is comparable to an SBA Microloan. So one can see there is an enormous cost associated with the corner-cutting that an RBF might provide when it comes to the application and qualification process.
Of course, it might be comforting to think that as revenue fluctuates the repayment commitment will flex too. But the lenders have baked this into their own qualifications. That’s why they are offering to fund businesses with subscription-based or other stable revenue sources.
Bottom line is that old-fashioned loans from banks or alternatives from community lenders are still the least expensive way to borrow, unless of course, your Uncle Bob is simply willing to forgive your debt.
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