A Venture Capital Primer For Small Business Small businesses never seem to have enough money. Bankers and suppliers, naturally, are important in financing small business growth through loans and credit, but an equally important source of long term growth capital is the venture capital firm. Venture capital financing may have an extra bonus, for if a small firm has an adequate equity base, banks are more willing to extend credit. This Aid discusses what venture capital firms look for when they analyze a company and its proposal for investment, the kinds of conditions venture firms may require in financing agreements, and the various types of venture capital investors. It stresses the importance of formal financial planning as the first step to getting venture capital financing. What Venture Capital Firms Look For One way of explaining the different ways in which banks and venture capital firms evaluate a small business seeking funds, put simply, is: Banks look at its immediate future, but are most heavily influenced by its past. Venture capitalists look to its longer run future. To be sure, venture capital firms and individuals are interested in many of the same factors that influence bankers in their analysis of loan applications from smaller companies. All financial people want to know the results and ratios of past operations, the amount and intended use of the needed funds, and the earnings and financial condition of future projections. But venture capitalists look much more closely at the features of the product and the size of the market than do commercial banks. Banks are creditors. They're interested in the product/market position of the company to the extent they look for assurance that this service or product can provide steady sales and generate sufficient cash flow to repay the loan. They look at projections to be certain that owner/managers have done their homework. Venture capital firms are owners. They hold stock in the company, adding their invested capital to its equity base. Therefore, they examine existing or planned products or services and the potential markets for them with extreme care. They invest only in firms they believe can rapidly increase sales and generate substantial profits. Why? Because venture capital firms invest for long-term capital, not for interest income. A common estimate is that they look for three to five times their investment in five or seven years. Of course venture capitalists don't realize capital gains on all their investments. Certainly they don't make capital gains of 300% to 500% except on a very limited portion of their total investments. But their intent is to find venture projects with this appreciation potential to make up for investments that aren't successful. Venture capital is a risky business, because it's difficult to judge the worth of early stage companies. So most venture capital firms set rigorous policies for venture proposal size, maturity of the seeking company, requirements and evaluation procedures to reduce risks, since their investments are unprotected in the event of failure. Size of the Venture Proposal. Most venture capital firms are interested in investment projects requiring an investment of $250,000 to $1,500,000. Projects requiring under $250,000 are of limited interest because of the high cost of investigation and administration; however, some venture firms will consider smaller proposals, if the investment is intriguing enough. The typical venture capital firm receives over 1,000 proposals a year. Probably 90% of these will be rejected quickly because they don't fit the established geographical, technical, or market area policies of the firm--or because they have been poorly prepared. The remaining 10% are investigated with care. These investigations are expensive. Firms may hire consultants to evaluate the product, particularly when it's the result of innovation or is technologically complex. The market size and competitive position of the company are analyzed by contacts with present and potential customers, suppliers, and others. Production costs are reviewed. The financial condition of the company is confirmed by an auditor. The legal form and registration of the business are checked. Most importantly, the character and competence of the management are evaluated by the venture capital firm, normally via a thorough background check. These preliminary investigations may cost a venture firm between $2,000 and $3,000 per company investigated. They result in perhaps 10 to 15 proposals of interest. Then, second investigations, more thorough and more expensive than the first, reduce the number of proposals under consideration to only three or four. Eventually the firm invests in one or two of these. Maturity of the Firm Making the Proposal. Most venture capital firms' investment interest is limited to projects proposed by companies with some operating history, even though they may not yet have shown a profit. Companies that can expand into a new product line or a new market with additional funds are particularly interesting. The venture capital firm can provide funds to enable such companies to grow in a spurt rather than gradually as they would on retained earnings. Companies that are just starting or that have serious financial difficulties may interest some venture capitalists, if the potential for significant gain over the long run can be identified and assessed. If the venture firm has already extended its portfolio to a large risk concentration, they may be reluctant to invest in these areas because of increased risk of loss. However, although most venture capital firms will not consider a great many proposals from start-up companies, there are a small number of venture firms that will do only "start-up" financing. The small firm that has a well thought-out plan and can demonstrate that its management group has an outstanding record (even if it is with other companies) has a decided edge in acquiring this kind of seed capital. Management of the Proposing Firm. Most venture capital firms concentrate primarily on the competence and character of the proposing firm's management. They feel that even mediocre products can be successfully manufactured, promoted, and distributed by an experienced, energetic management group. They look for a group that is able to work together easily and productively, especially under conditions of stress from temporary reversals and competitive problems. They know that even excellent products can be ruined by poor management. Many venture capital firms really invest in management capability, not in product or market potential. Obviously, analysis of managerial skill is difficult. A partner or senior executive of a venture capital firm normally spends at least a week at the offices of a company being considered, talking with and observing the management, to estimate their competence and character. Venture capital firms usually require that the company under consideration have a complete management group. Each of the important functional areas--product design, marketing, production, finance, and control--must be under the direction of a trained, experienced member of the group. Responsibilities must be clearly assigned. And, in addition to a thorough understanding of the industry, each member of the management team must be firmly committed to the company and its future. The "Something Special" in the Plan. Next in importance to the excellence of the proposing firm's management group, most venture capital firms seek a distinctive element in the strategy or product/market/process combination of the firm. This distinctive element may be a new feature of the product or process or a particular skill or technical competence of the management. But it must exist. It must provide a competitive advantage. Elements of a Venture Proposal Purpose and Objectives--a summary of the what and why of the project. Proposed Financing--the amount of money you'll need from the beginning to the maturity of the project proposed, how the proceeds will be used, how you plan to structure the financing, and why the amount designated is required. Marketing--a description of the market segment you've got or plan to get, the competition, the characteristics of the market, and your plans (with costs) for getting or holding the market segment you're aiming at. History of the Firm--a summary of significant financial and organizational milestones, description of employees and employee relations, explanations of banking relationships, recounting of major services or products your firm has offered during its existence, and the like. Description of the Product or Service--a full description of the product (process) or service offered by the firm and the costs associated with it in detail. Financial Statements--both for the past few years and pro forma projections (balance sheets, income statements, and cash flows) for the next 3-5 years, showing the effect anticipated if the project is undertaken and if the financing is secured. (This should include an analysis of key variables affecting financial performance, showing what could happen if the projected level of revenue is not attained.) Capitalization--a list of shareholders, how much is invested to date, and in what form (equity/debt). Biographical Sketches--the work histories and qualifications of key owners/employees. Principal Suppliers and Customers Problems Anticipated and Other Pertinent Information--a candid discussion of any contingent liabilities, pending litigation, tax or patent difficulties, and any other contingencies that might affect the project you're proposing. Advantages--a discussion of what's special about your product, service, marketing plans or channels that gives your project unique leverage. Provisions of the Investment Proposal What happens when, after the exhaustive investigation and analysis, the venture capital firm decides to invest in a company? Most venture firms prepare an equity financing proposal that details the amount of money to be provided, the percentage of common stock to be surrendered in exchange for these funds, the interim financing method to be used, and the protective covenants to be included. This proposal will be discussed with the management of the company to be financed. The final financing agreement will be negotiated and generally represents a compromise between the management of the company and the partners or senior executives of the venture capital firm. The important elements of this compromise are: ownership, control, annual charges, and final objectives. Ownership. Venture capital financing is not inexpensive for the owners of a small business. The partners of the venture firm buy a portion of the business's equity in exchange for their investment. This percentage of equity varies, of course, and depends upon the amount of money provided, the success and worth of the business, and the anticipated investment return. It can range from perhaps 10% in the case of an established, profitable company to as much as 80% or 90% for beginning or financially troubled firms. Most venture firms, at least initially, don't want a position of more than 30% to 40% because they want the owner to have the incentive to keep building the business. If additional financing is required to support business growth, the outsiders' stake may exceed 50%, but investors realize that small business owner-managers can lose their entrepreneurial zeal under those circumstances. In the final analysis, however, the venture firm, regardless of its percentage of ownership, really wants to leave control in the hands of the company's managers, because it is really investing in that management team in the first place. Most venture firms determine the ratio of funds provided to equity requested by a comparison of the present financial worth of the contributions made by each of the parties to the agreement. The present value of the contribution by the owner of a starting or financially troubled company is obviously rated low. Often it is estimated as just the existing value of his or her idea and the competitive costs of the owner's time. The contribution by the owners of a thriving business is valued much higher. Generally, it is capitalized at a multiple of the current earnings and/or net worth. Financial valuation is not an exact science. The final compromise on the owner's contribution's worth in the equity financing agreement is likely to be much lower than the owner thinks it should be and considerably higher than the partners of the capital firm think it might be. In the ideal situation, of course, the two parties to the agreement are able to do together what neither could do separately: 1) the company is able to grow fast enough with the additional funds to do more than overcome the owner's loss of equity, and 2) the investment grows at a sufficient rate to compensate the venture capitalists for assuming the risk. An equity financing agreement with an outcome in five to seven years which pleases both parties is ideal. Since, of course, the parties can't see this outcome in the present, neither will be perfectly satisfied with the compromise reached. It is important, though, for the business owner to look at the future. He or she should carefully consider the impact of the ratio of funds invested to the ownership given up, not only for the present, but for the years to come. Control. Control is a much simpler issue to resolve. Unlike the division of equity over which the parties are bound to disagree, control is an issue in which they have a common (though perhaps unapparent) interest. While it's understandable that the management of a small company will have some anxiety in this area, the partners of a venture firm have little interest in assuming control of the business. They have neither the technical expertise nor the managerial personnel to run a number of small companies in diverse industries. They much prefer to leave operating control to the existing management. The venture capital firm does, however, want to participate in any strategic decisions that might change the basic product/market character of the company and in any major investment decisions that might divert or deplete the financial resources of the company. They will, therefore, generally ask that at least one partner be made a director of the company. Venture capital firms also want to be able to assume control and attempt to rescue their investments, if severe financial, operating, or marketing problems develop. Thus, they will usually include protective covenants in their equity financing agreements to permit them to take control and appoint new officers if financial performance is very poor. Annual Charges. The investment of the venture capital firm may be in the final form of direct stock ownership which does not impose fixed charges. More likely, it will be in an interim form--convertible subordinated debentures or preferred stock. Financing may also be straight loans with options or warrants that can be converted to a future equity position at a pre-established price. The convertible debenture form of financing is like a loan. The debentures can be converted at an established ratio to the common stock of the company within a given period, so that the venture capital firm can prepare to realize their capital gains at their option in the future. These instruments are often subordinated to existing and planned debt to permit the company invested in to obtain additional bank financing. Debentures also provide additional security and control for the venture firm and impose a fixed charge for interest (and sometimes for principal payment, too) upon the company. The owner-manager of a small company seeking equity financing should consider the burden of any fixed annual charges resulting from the financing agreement. Final Objectives. Venture capital firms generally intend to realize capital gains on their investments by providing for a stock buy-back by the small firm, by arranging a public offering of stock of the company invested in, or by providing for a merger with a larger firm that has publicly traded stock. They usually hope to do this within five to seven years of their initial investment. (It should be noted that several additional stages of financing may be required over this period of time.) Most equity financing agreements include provisions guaranteeing that the venture capital firm may participate in any stock sale or approve any merger, regardless of their percentage of stock ownership. Sometimes the agreement will require that the management work toward an eventual stock sale or merger. Clearly, the owner-manager of a small company seeking equity financing must consider the future impact upon his or her own stock holdings and personal ambition of the venture firm's aims, since taking in a venture capitalist as a partner may be virtually a commitment to sell out or go public. Types of Venture Capital Firms There is quite a variety of types of venture capital firms. They include: Traditional partnerships--which are often established by wealthy families to aggressively manage a portion of their funds by investing in small companies; Professionally managed pools--which are made up of institutional money and which operate like the traditional partnerships; Investment banking firms--which usually trade in more established securities, but occasionally form investor syndicates for venture proposals; Insurance companies--which often have required a portion of equity as a condition of their loans to smaller companies as protection against inflation; Manufacturing companies--which have sometimes looked upon investing in smaller companies as a means of supplementing their R&D programs (Some "Fortune 500" corporations have venture capital operations to help keep them abreast of technological innovations); and Small Business Investment Corporations (SBIC's)--which are licensed by the Small Business Administration (SBA) and which may provide management assistance as well as venture capital. (When dealing with SBIC's, the small business owner-manager should initially determine if the SBIC is primarily interested in an equity position, as venture capital, or merely in long term lending on a fully secured basis.) In addition to these venture capital firms there are individual private investors and finders. Finders, which can be firms or individuals, often know the capital industry and may be able to help the small company seeking capital to locate it, though they are generally not sources of capital themselves. Care should be exercised so that a small business owner deals with reputable, professional finders whose fees are in line with industry practice. Further, it should be noted that venture capitalists generally prefer working directly with principals in making investments, though finders may provide useful introductions. The Importance of Formal Financial Planning In case there is any doubt about the implications of the previous sections, it should be noted: It is extremely difficult for any small firm--especially the starting or struggling company--to get venture capital. There is one thing, however, that owner-managers of small businesses can do to improve the chances of their venture proposals at least escaping the 90% which are almost immediately rejected. In a word--plan. Having financial plans demonstrates to venture capital firms that you are a competent manager, that you may have that special managerial edge over other small business owners looking for equity money. You may gain a decided advantage through well-prepared plans and projections that include: cash budgets, pro forma statements, and capital investment analysis and capital source studies. Cash budgets should be projected for one year and prepared monthly. They should combine expected sales revenues, cash receipts, material, labor and overhead expenses, and cash disbursements on a monthly basis. This permits anticipation of fluctuations in the level of cash and planning for short term borrowing and investment. Pro forma statements should be prepared for planning up to 3 years ahead. They should include both income statements and balance sheets. Again, these should be prepared quarterly to combine expected sales revenues; production, marketing, and administrative expenses; profits; product, market, or process investments; and supplier, bank, or investment company borrowings. Pro forma statements permit you to anticipate the financial results of your operations and to plan intermediate term borrowings and investments. Capital investment analyses and capital source studies should be prepared for planning up to 5 years ahead. The investment analyses should compare rates of return for product, market, or process investment, while the source alternatives should compare the cost and availability of debt and equity and the expected level of retained earnings, which together will support the selected investments. These analyses and source studies should be prepared quarterly so you may anticipate the financial consequences of changes in your company's strategy. They will allow you to plan long term borrowings, equity placements, and major investments. There's a bonus in making such projections. They force you to consider the results of your actions. Your estimates must be explicit; you have to examine and evaluate your managerial records; disagreements have to be resolved--at least discussed and understood. Financial planning may be burdensome but it's one of the keys to business success. Now, making these financial plans will not guarantee that you'll be able to get venture capital. Not making them, will virtually assure that you won't receive favorable consideration from venture capitalists. The ABC's of Borrowing Summary Some small business persons cannot understand why a lending institution refused to lend them money. Others have no trouble getting funds, but they are surprised to find strings attached to their loans. Such owner-managers full to realized that banks and other lenders have to operate by certain principles just as do other types of business. This Aid discusses the following fundamentals of borrowing: (1) credit worthiness, (2) kinds of loans, (3) amount of money needed, (4) collateral, (5) loan restrictions and limitations, (6) the loan application, and (7) standards which the lender uses to evaluate the application. Introduction Inexperience with borrowing procedures often creates resentment and bitterness. The stories of three small business persons illustrate this point. "I'll never trade here again," Bill Smith said when his bank refused to grant him a loan. "I'd like to let you have it, Bill," the banker said, "but your firm isn't earning enough to meet your current obligations." Mr. Smith was unaware of a vital financial fact, namely, that lending institutions have to be certain that the borrower's business can repay the loan. Tom Jones lost his temper when the bank refused him a loan because he did not know what kind or how much money he needed. "We hesitate to lend," the banker said, "to business owners with such vague ideas of what and how much they need." John Williams' case was somewhat different. He didn't explode until after he got the loan. When the papers were ready to sign, he realized that the loan agreement put certain limitations on his business activities. "You can't dictate to me," he said and walked out of the bank. What he didn't realize was that the limitations were for his good as well as for the bank's protection. Knowledge of the financial facts of business life could have saved all three the embarrassment of losing their tempers. Even more important, such information would have helped them to borrow money at a time when their businesses needed it badly. This Aid is designed to give the highlights of what is involved in sound business borrowing. It should be helpful to those who have little or no experience with borrowing. More experienced owner-managers should find it useful in re-evaluating their borrowing operations. Is Your Firm Credit Worthy? The ability to obtain money when you need it is as necessary to the operation of your business as is a good location or the right equipment, reliable sources of supplies and materials, or an adequate labor force. Before a bank or any other lending agency will lend you money, the loan officer must feel satisfied with the answers to the five following questions: 1. What sort of person are you, the prospective borrower? By all odds, the character of the borrower comes first. Next is your ability to manage your business. 2. What are you going to do with the money? The answer to this question will determine the type of loan, short or long-term. Money to be used for the purchase of seasonal inventory will require quicker repayment than money used to buy fixed assets. 3. When and how do you plan to pay it back? Your banker's judgment of your business ability and the type of loan will be a deciding factor in the answer to this question. 4. Is the cushion in the loan large enough? In other words, does the amount requested make suitable allowance for unexpected developments? The banker decides this question on the basis of your financial statement which sets forth the condition of your business and on the collateral pledged. 5. What is the outlook for business in general and for your business particularly? Adequate Financial Data is a "Must." The banker wants to make loans to businesses which are solvent, profitable, and growing. The two basic financial statements used to determine those conditions are the balance sheet and profit-and-loss statement. The former is the major yardstick for solvency and the latter for profits. A continuous series of these two statements over a period of time is the principal device for measuring financial stability and growth potential. In interviewing loan applicants and in studying their records, the banker is 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? 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? What is the number of employees? What is the insurance coverage? Accounts Receivable: Are there indications that some of the accounts receivable have already been pledged to another creditor? What is the accounts receivable turnover? Is the accounts receivable total weakened because many customers are far behind in their payments? 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 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 inventory turnover in line with the turnover for other businesses in the same industry? Or 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? What Kind of Money? When you set out to borrow money for your firm, it is important to know the kind of money you need from a bank or other lending institution. There are three kinds of money: short term, term money, and equity capital. Keep in mind that the purpose for which the funds are to be used is an important factor in deciding the kind of money needed. But even so, deciding what kind of money to use is not always easy. It is sometimes complicated by the fact that you may be using some of the various kinds of money at the same time and for identical purposes. Keep in mind that a very important distinction between the types of money 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. Short-Term Bank Loans You can use short-term bank loans for purposes such as financing accounts receivable for, say 30 to 60 days. Or you can use them for purposes that take longer to pay off--such as for building a seasonal inventory over a period of 5 to 6 months. Usually, lenders expect short-term loans to be repaid after their purposes have been served: for example, accounts receivable loans, when the outstanding accounts have been paid by the borrower's customers, and inventory loans, when the inventory has been converted into saleable merchandise. Banks grant such money either on your general credit reputation with an unsecured loan or on a secured loan. The unsecured loan is the most frequently used form of bank credit for short-term purposes. You do not have to put up collateral because the bank relies on your credit reputation. The secured loan involves a pledge of some or all of your assets. The bank requires security as a protection for its depositors against the risks that are involved even in business situations where the chances of success are good. Term Borrowing Term borrowing provides money you plan to pay back over a fairly long time. Some people break it down into two forms: (1) intermediate--loans longer than 1 year but less than 5 years, and (2) long-term--loans for more than 5 years. However, for your purpose of matching the kind of money to the needs of your company, think of term borrowing as a kind of money which you probably will pay back in periodic installments from earnings. Equity Capital Some people confuse term borrowing and equity (or 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. You take people into your company who are willing to risk their money in it. They are interested in potential income rather than in an immediate return on their investment. How Much Money? The amount of money you need to borrow depends on the purpose for which you need funds. Figuring the amount of money required for business construction, conversion, or expansion--term loans or equity capital--is relatively easy. Equipment manufacturers, architects, and builders will readily supply you with cost estimates. On the other hand, the amount of working capital you need depends upon the type of business you're 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--usually for 12 months--is a better approach. In this way, 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 experience plus your best judgment of performance during the coming period. The cash forecast is your estimates of cash receipts and disbursements during the budget period. Thus, the budget and the cash forecast together represent your plan for meeting your working capital requirements. To plan your working capital requirements, it is important to know the "cash flow" which your business will generate. This involves simply a consideration of all elements of cash receipts and disbursements at the time they occur. These elements are listed in the profit-and-loss statement which has been adapted to show cash flow. They should be projected for each month. What Kind of Collateral? Sometimes, your signature is the only security the bank needs when making a loan. At other times, the bank requires additional assurance that the money will be repaid. The kind and amount of security depends on the bank 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: endorsers; comaker and guarantors; assignment of leases; trust receipts and floor planning; chattel mortgages; real estate; accounts receivables; savings accounts; life insurance policies; and stocks and bonds. In a substantial number of States where the Uniform Commercial Code has been enacted, paperwork for recording loan transactions will be greatly simplified. Endorsers, Co-makers, and Guarantors Borrowers often get other people to sign a note in order to bolster their own credit. These endorsers are contingently liable for the note they sign. If the borrower fails to pay up, the bank expects the endorser to make the note good. Sometimes, the endorser may be asked to pledge assets or securities too. A co-maker is one who creates an obligation jointly with the borrower. In such cases, the bank can collect directly from either the maker or the co-maker. A guarantor is one who guarantees the payment of a note by signing a guaranty commitment. Both private and government lenders often require guarantees from officers of corporations in order to assure continuity of effective management. Sometimes, a manufacturer will act as guarantor for customers. Assignment of Leases The assigned lease as security is similar to the guarantee. It is used, for example, in some franchise situations. The bank lends the money on a building and takes a mortgage. Then the lease, which the dealer and the parent franchise company work out, is assigned so that the bank automatically receives the rent payments. In this manner, the bank is guaranteed repayment of the loan. Warehouse Receipts Banks also take commodities as security 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 either has been placed in a public warehouse or has been left on your premises under the control of one of your employees who is bonded (as in field warehousing). 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 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 trust receipt is the legal paper for floor planning. It is used for serial-numbered merchandise. When you sign one, you (1) acknowledge receipt of the merchandise, (2) agree to keep the merchandise in trust for the bank, and (3) promise to pay the bank as you sell the goods. Chattel Mortgages If you buy equipment such as a cash register or a delivery truck, you may want to get a chattel mortgage loan. You give the bank a lien on the equipment you are buying. The bank also evaluates the present and future market value of the equipment being used to secure the loan. How rapidly will it depreciate? Does the borrower have the necessary fire, theft, property damage, and public liability insurance on the equipment? The banker has to be sure that the borrower protects the equipment. Real Estate Real estate is another form of collateral for long-term loans. When taking a real estate mortgage, the bank finds out: (1) the location of the real estate, (2) its physical condition, (3) its foreclosure value, and (4) the amount of insurance carried on the property. Accounts Receivable Many banks lend money on accounts receivable. In effect, you are counting on your customers to pay your note. The bank may take accounts receivable on a notification or a nonnotification plan. Under the notification plan, the purchaser of the goods is informed by the bank that his or her account has been assigned to it and he or she is asked to pay the bank. Under the nonnotification plan, the borrower's customers continue to pay you the sums due on their accounts and you pay the bank. Savings Accounts Sometimes, you might get a loan by assigning to the bank a savings account. In such cases, the bank gets an assignment from you and keeps your passbook. If you assign an account in another bank as collateral, the lending bank asks the other bank to mark its records to show that the account is held as collateral. Life Insurance Another kind of collateral is life insurance. Banks will lend up to the cash value of a life insurance policy. You have to assign the policy to the bank. 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 you to sign the policy back to the original beneficiary when the assignment to the bank ends. Some people like to use life insurance as collateral rather than borrow directly from insurance companies. One reason is that a bank loan is often more convenient to obtain and usually may be obtained at a lower interest rate. Stocks and Bonds If you use stocks and bonds as collateral, they must be marketable. As a protection against market declines and possible expenses of liquidation, banks usually lend no more than 75 percent of the market value of high grade stock. On Federal Government or municipal bonds, they may be willing to lend 90 percent or more of their market value. The bank may ask the borrower for additional security or payment whenever the market value of the stocks or bonds drops below the bank's required margin. 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, they 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 a burden. Yet others feel that such limitations also offer an opportunity for improving their management techniques. Especially in making long-term loans, the borrower as well as the lender should be thinking of: (1) the net earning power of the borrowing company, (2) the capability of its management, (3) the long range prospects of the company, and (4) the long range prospects of the industry of which the company is a part. Such factors often mean that limitations increase as the duration of the loan increases. What Kinds of Limitations? The kinds of limitations, 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 poor risk, of course, is different. Its limitations should be greater than those of a stronger company. Look now for a few moments at the kinds of limitations and restrictions which the lender may set. Knowing what they are can help you see how they affect your operations. The limitations which you will usually run into when you borrow money are: (1) Repayment terms. (2) Pledging or the use of security. (3) Periodic reporting. A loan agreement, as you may already know, is a tailor-made document covering, or referring to, all the terms and conditions of the loan. With it, the lender does two things: (1) protects position as a creditor (keeps that position in as protected a state as it was on the date the loan was made) and (2) 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. Covenants--Negative and Positive The actual restrictions in a loan agreement come under a section known as covenants. Negative covenants are things which the borrower may not do without prior approval from the lender. Some examples are: further additions to the borrower's total debt, non-pledge to others of the borrower's 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: (1) maintenance of a minimum net working capital. (2) carrying of adequate insurance, (3) repaying the loan according to the terms of the agreement, and (4) supplying the lender with financial statements and reports. Overall, however, 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. You Can Negotiate Next time you go to borrow money, thrash out the lending terms before you sign. It is good practice no matter how badly you may need the money. Ask to see the papers in advance of the loan closing. Legitimate lenders are glad to cooperate. Chances are that the lender may "give" some on the terms. Keep in mind also that, while you're mulling over the terms, you may want to get the advice of your associates and outside advisors. In short, try to get terms which you know your company can live with. Remember, however, that once the terms have been agreed upon and the loan is made (or authorized as in the case of SBA), you are bound by them. The Loan Application Now you have read about the various aspects of the lending process and are ready to apply for a loan. Banks and other private lending institutions, as well as the Small Business Administration, require a loan application on which you list certain information about your business. For the purposes of explaining a loan application, this Aid uses the Small Business Administration's application for a loan (SBA Form 4 not included). The SBA form is more detailed than most bank forms. The bank has the advantage of prior knowledge of the applicant and his or her activities. Since SBA does not have such knowledge, its form is more detailed. Moreover, the longer maturities of SBA loans ordinarily will necessitate more knowledge about the applicant. Before you get to the point of filling out a loan application, you should have talked with an SBA representative, or perhaps your accountant or banker, to make sure that your business is eligible for an SBA loan. Because of public policy, SBA cannot make certain types of loans. Nor can it make loans under certain conditions. For example, if you can get a loan on reasonable terms from a bank, SBA cannot lend you money. The owner-manager is also not eligible for an SBA loan if he or she can get funds by selling assets which his or her company does not need in order to grow. When the SBA representative gives you a loan application, you will notice that most of its sections ("Application for Loan"--SBA Form 4) are self-explanatory. However, some applicants have trouble with certain sections because they do not know where to go to get the necessary information. Section 3--"Collateral Offered" is an example. A company's books should show the net value of assets such as business real estate and business machinery and equipment. "Net" means what you 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 bank sometimes can get it from your Federal income tax returns. Reviewing the depreciation which you have taken for tax purposes on such collateral can be helpful in arriving at the value of these assets. If you are a good manager, you should have your books balanced monthly. However, some businesses prepare balance sheets less regularly. In filling out your "Balance Sheet as of ______ 19 ____, Fiscal Year Ends ________," remember that you must show the condition of you business within 60 days of the date on your loan application. It is best to get expert advice when working up such vital information. Your accountant or banker will be able to help you. Cash Budget (For three months, ending March 31, 19___) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴컴컴컴 January February March Budget Actual Budget Actual Budget Actual 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 Expected Cash Receipts: 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 1. Cash sales 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 2. Collections on accounts receivable 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 3. Other income 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 4. Total cash receipts 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 Expected Cash Payments 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 5. Raw materials 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 6. Payroll 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 7. Other factory expenses (including maintenance) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 8. Advertising 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 9. Selling expense 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 10. Administrative expense (including salary of owner-manager) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 11. New plant and equipment 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 12. Other payments (taxes, including estimated income tax; repayment of loans; interest; etc.) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 13. Total cash payments 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 14. Expected Cash Balance at beginning of the month 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 15. Cash increase or decrease (item 4 minus item 13) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 16. Expected cash balance at end of month (item 14 plus item 15) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 17. Desired working cash balance 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 18. Short-term loans needed (item 17 minus item 16, if item 17 is larger) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 19. Cash available for dividends, capital cash expenditures, and/or short investments (item 16 minus item 17, if item 16 is larger than item 17) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴컴컴컴 Capital Cash: 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 20. Cash available (item 19 after deducting dividends, etc.) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 21. Desired capital cash (item 11, new plant equipment) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 22. Long-term loans needed (item 21 less item 20, if item 20 is larger than item 20) 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴 컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴 컴컴컴컴컴컴 Again, if your records do not show the details necessary for working up profit and loss statements, your Federal income tax returns may be useful in getting together facts for the SBA loan application. Insurance SBA also needs information about the kinds of insurance a company carries. The owner-manager gives these facts by listing various insurance policies. Personal Finances SBA also must know something about the personal 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 in the applicant's own name; personal debts including installment credit payments, life insurance premiums, and so forth. Evaluating the Application Once you have supplied the necessary information, the next step in the borrowing process is the evaluation of your application. Whether the processing officer is in a bank or in SBA, the officer considers the same kinds of things when determining whether to grant or refuse the loan. The SBA loan processor looks for: (1) The borrower's debt paying record to suppliers, banks, home mortgage holders, and other creditors. (2) The ratio of the borrower's debt to net worth. (3) The past earnings of the company. (4) The value and condition of the collateral which the borrower offers for security. The SBA loan processor also looks for: (1) the borrower's management ability, (2) the borrower's character, and (3) the future prospects of the borrower's business.