Financing for Small Businesses
By: Thomas M. Nunnally,

The primary function of Finance (for the user of funds) is to manage the gap between the expenditure of funds and the later receipt of funds.  This not only involves planning for these gaps, but the acquisition of cash for those expenditures.  It also involves the timely return of the borrowed funds of those who have provided the cash, be it trade creditors or lenders. There are two “gaps” to be managed:

Long Term: the immediate need for capital investment (equipment, base [everyday] working capital in the form of inventory and carrying receivables), plus start up costs such as research and development, marketing and start up losses until the market (and breakeven sales) have been established).  These are necessary up front expenditures to generate future cash flow and are to be repaid from that cash flow.

Short term:   (seasonal or an abnormal sized contract) the need to expend funds for build up of inventory, and (increased) daily operating expenses, etc until the receipt of funds from the collection of receivables at the end of the surge. Financing for this cycle is to be paid from receipt of the cash from receivables, often called self liquidating (as the cycle goes from cash to inventory to receivables to cash).  Assets in this cycle is the correct definition of working capital (not capital to build up permanent asset levels or to recover losses).

Source and Application of Cash:

There is only four sources (inflow) and only four applications (outflow) of cash into and out of a business.

Sources 
Application
  1. Original equity investment 
  2. Excess of receipts* over expenditures* (profit) 
  3. Sale of assets (conversion of assets to cash)
  4. Borrowed funds (including trade credit) 
  1. Cash to equity holders (dividends/repurchase)
  2. Excesses of expenses over revenue* (losses)
  3. Purchase (increase in assets)
  4. Payment of borrowed funds

*cash only, not to include paper transactions (non cash expenses or write-up or write down of assets)

Risk/Reward:

Those who provide funds expect a return on the cash and the expectation or return (reward) should be proportionate to the expected risk.  The lowest return (reward) is on borrowed capital and increases as the risk increases, all the way to equity return (which is a share of all future profits).

The negotiation between the provider of funds and the user of funds (as the return to the provider is   the cost to the user) is a “dance” up and down this risk reward curve, arriving at the market “price.”

It would be most foolish to risk more than the corresponding return. Banks will want the lowest risk, as they get only the lowest return.  They are using other people’s (deposit) money and have to be able to give that back on demand or within a certain time period (on certificates of deposit).  Thus, they are not prepared (nor are they allowed by the FDIC) to take more than a nominal risk.  Don’t expect them to do so. Higher risk is borne by those who expect a higher return.

Risk is mitigated by experience, collateral of universal and lasting value, a good business plan, and personal commitment of the owners (in the form of personal guarantees or personal collateral such as real estate not tied to the fortunes of the company).  But the absolute most important element is personal character of those who are in control and make the decisions. Initially, this is indicated by the credit history. Later, it is demonstrated by timely submission of payments and financial data.

A lender (or provider of any funds) will look at four elements called “the 4 P’s:”

1. Purpose:     Is the purpose a sound business purpose (speculation is not a good purpose)

                   Is the purpose consistent with the experience and business of the lender?

2. Payment:    Is the payment sources adequate to repay the principal and interest

                         Is the payment source durable (through business cycles and new competition)?

3. Protection:  What is the secondary source of repayment, should the primary payment fail?

                         Does the lender have control over the collateral (liens) & does the collateral have sufficient value, if liquidated even under some adverse markets? Personal guarantees and protection and show commitment. Expect them to be required.

4. People:  Is the user of the funds willing to repay (indicated by past credit history)?

Is the user able to repay (over varying conditions, such as business cycles, competition)?
 
                                                         

Presentation of a Loan Application

  1. Know your credit history (review your credit bureau record).  If your Fair Issac Score is less      than 650, then you may have a problem.  If it is below 600, you had better have a very good      reason or you can expect a turndown on this alone. Past credit performance is a bank’s best indicator of your future behavior, especially when you are under pressure.
  2. Pick the correct provider of the cash.  Are they experienced in the field and are you asking the right lender, given the risk of your venture?  The SBA can be a tool that a bank can use to manage risk.
  3. Explain your niche (what you will do for a customer that will cause the customer to forsake other providers and vote with their dollars for your product or service).  What value will you provide (price, convenience, extraordinary customer service, etc.)?  Be careful not to present conflicting niches, as it is most difficult (perhaps impossible) for a small business to provide a high level of service at the lowest price.  You need to go down one path or the other.
  4. Clearly state the exact use (purpose) in great detail and what the funds will do for the company.
  5. Present a cash flow projection (by month for at least a year and annually for two more years) and make these realistic—for these are benchmarks against which you as the borrower will be measured and on which you should measure yourself.
  6. Present past financial statements (if the company is not new), tax returns and interim statements.  Personal financial statements are a must. List all jointly held assets and don’t net out debt (list both, as the lender will want to see the debt obligations).  Sign all forms (certification of their accuracy).
  7. Present a list of assets to be offered for collateral.  Don’t inflate the value; that destroys your credibility.
  8. Provide a resume (skills and experience) of those on your staff, including yourself, and a list of outside support (CPA, attorney, other advisors) and trade references.
  9. Don’t overkill and don’t go for bulk.  Make your presentation tangible, but brief.  Lenders are not impressed by sheer volume and, in fact, will look at reviewing a long presentation as a burden.
  10. Expect an exact reason for a turndown.  If the answer is yes, get a commitment letter so that you can meet all of the bank’s requirements (at the closing and for future financial submissions).                 

Thomas M. Nunnally is a retired banker with over 30 years of experience in business lending.  In addition, he is the co-author of The Smaller Business Insider’s Guide to Bankers from Oasis Press.  It is available at the Enterprise Small Business Resource Center