A Primer on Bank Financing for Small Business
Small businesses may be financed in a variety of ways. Two of the most basic are through the investments of founders and key backers, and through loans provided by banks. Although bank loans are not appropriate for all small businesses, they can be a valuable lifeline for many. In order to receive such bank financing, the borrower will undergo a process called underwriting, which will rely on a few key considerations.
Underwriting A Loan
The primary task of a bank that performs commercial credit functions (loans for business purposes) is the underwriting of loans. Although this process varies from bank to bank, and may sound intimidating, it can be boiled down to a broad description helpful to entrepreneurs and small business owners. At its most basic, underwriting commercial credit is the process by which the bank will determine whether not to extend a loan to any particular party who requests it. What the bank is doing is making the decision of whether or not the requested loan is an appropriate risk for it to take on. This decision reflects a judgment about a few core criteria.
First, a small-business owner seeking bank credit should understand the goals of the bank, or other financial institution, from which they have requested a loan. A bank makes its profits primarily through something called its net interest margin. This metric is a simple calculation that attempts to quantify the difference between what a bank pays out to its depositors as interest on their accounts, and the amount that a bank receives from its borrowers on their loans. As common sense would suggest, a bank will only make money if it is able to charge its borrowers a rate of interest higher than it is paying to its depositors. This is not, however, the end of the story.
In addition to charging borrowers a greater rate of interest than it pays depositors, the bank will also need to account for the possibility that its borrowers do not pay back their loans at all — and therefore reducing the total amount it receives from borrowers as a group. This is the primary consideration a bank undertakes in its underwriting process. Put simply, if the bank does not believe that a small-business will be able to repay the loan, it will not enter into the transaction. This is why it is sometimes difficult for new start-ups and small businesses to get bank financing. Because the risk in a new venture is often hard to quantify, the bank will require extra assurances that it will be paid back, including with interest. These assurances come in a variety of forms, but the two below usuallyrepresent the most important considerations to a lender.
What A Bank Looks For
A primary consideration in the underwriting process is the cash flow of the proposed borrower. There are a number of ways to calculate this figure, but one of the simplest is a measure called EBITDA (earnings before interest, taxes, depreciation, and amortization). What this accounting figure attempts to reflect is the actual amount of cash coming into and going out of a business. A bank will want this figure to be large enough that when loan payments are taken into account, the business will not struggle to fund its necessary operations.
This presents a challenge for start-ups in particular because they often do not have a history of cash flows at all, let alone a history of positive cash flows. Entrepreneurs often start businesses which will take months or even years to show profitability. Further exacerbating this problem, a bank will often require a borrower to be able to show at least a few years of positive cash flow, to reassure the bank that it will be paid back. Although this is often a disqualifying factor for many small businesses, as will be seen below, it may not foreclose the possibility of funding a business with bank loans.
Collateral means something specific in the context of banking. It refers to some other property the borrower commits to the lender as way of guaranteeing repayment. For example, in a simple transaction a borrower may grant the lender a lien or security interest on the business’s tangible property. Perhaps on the building in which the business operates, or on valuable equipment the borrower uses to create its goods. From the bank’s perspective good collateral is often essential in that it represents a kind of back-stop against possible losses in the event the business is unable to pay back its loan through cash flows.
From this description, it may already be apparent that good collateral may represent another way for a small business to gain bank financing, even in the absence of a history of positive cash flows. If the bank is satisfied that the collateral it holds against a loan will be sufficient to satisfy the debt, they are more likely to lend to a new-and-unproven enterprise. Examples of strong collateral include property whose value greatly exceeds the size of the loan requested, and such property as may be easily sold by the bank. The gold standard would be cash held at the bank financing the loan, because it has a readily-ascertainable value, and can be easily converted to satisfy the borrower’s debt. Therefore, even in the absence of positive cash flows, a small-business may be able to reassure the bank of repayment by committing adequate collateral.
For many new and emerging start-ups, bank financing may not be a realistic goal. However, for a business that has a history of positive cash flows, or one that has access to high-quality collateral, it remains a potentially valuable source of funding. It has the benefit of allowing the entrepreneur to retain ownership of their business (rather than selling part ownership to investors), and can provide a ready source of funds for the entrepreneur to invest back into the business. Through the process of underwriting, a bank will look at a number of factors to determine whether it wants to take the risk of extending a loan. Cash flow and collateral are only two considerations, but are often the most important to the lender.