The Challenges Clients Face Applying for Financingby
We all know that businesses need financing to get started, but when times get tough or cash flow becomes uneven, obtaining timely access to capital is the difference between staying in business and closing shop. This article series, in collaboration with Forward.ai, a lender-first API that delivers a suite of cash flow, accounting, and financial data for small business lending, kicks off by looking at what lending institutions large and small look for when small businesses apply for financing.
It’s important that accountants help leave no lending option unturned by understanding how banks make lending decisions and the conditions they set. So,what are the primary challenges facing your business clients that are seeking financing?
The accountant adds value by having this knowledge ahead of time, so the client isn’t disappointed as they try reinventing the wheel and find they are often turned down. Why might your client think borrowing is easy? Because they continually get offers to add a new personal credit cards or refinance their home mortgage. They don’t understand business lending is different.
Dealing With the Big Banks
The government has an interest in keeping the small business segment of the market thriving. There are programs offered at the state and local level, but for the purposes of this article, let’s look at how banks approach small business lending in general:
1. Banks want to lend to businesses, just not yours. Borrowing from a bank is the traditional way businesses get financing. It’s often been said banks are eager to lend to businesses, yet steer clear of startups along with established companies in certain industries.
2. Why do banks avoid lending to new businesses? It’s been said “You can’t poison a rabbit.” Why? Because they sniff and examine everything before they decide to eat it. Banks follow the same logic. Before they lend to a business, they want to see a history of positive earnings. Is the business profitable? The logic is simple: Since the business will be paying interest on the borrowed money, the bank wants to see the cash flow making interest payments possible.
3. Banks want collateral. Banks prefer to lend against an asset they can seize or sell if the company defaults on their loan. The loan is secured by a specific asset. Homes and mortgages are good examples.
4. Valuation of assets. The bank might grant a loan if it’s collateralized, but they have a voice in determining the value of the collateral. Their valuation might be more conservative than yours, especially in a volatile market.
5. Will you assume personal liability? Businesses incorporate and maintain separate finances because the corporate veil between business and professional liability is a major advantage. A bank might not extend a loan that is strictly a liability of the business, but they may reconsider if the business owner is willing to accept personal liability for the loan. The business might fail, but since the owner has assets, the bank gets a second chance to recover their money.
6. Spotless credit rating. The mutual fund industry often quotes the expression “Past performance is no guarantee of future results.” The banking industry takes a totally different position. The borrower’s previous credit history is an excellent indicator of the likelihood they will honor their commitments and make timely payments. The business has a credit rating, unless it’s new. The borrower has a credit rating that follows them throughout their lives.
7. Some now, some later. Unlike poker players, banks are reluctant to say “I’m all in” and slide a pile of chips into the middle of the table. The bank may extend a loan, yet not make all the money available at one time. They might require a compensating minimum balance to be held in the business checking account, which they require be maintained at their bank. The business finds itself borrowing money at a rate of interest with a requirement to keep another sum of money inactive, earning little or no interest. This is another way the bank limits its liability.
8. Cleanup requirement. Lines of credit are meant to enable a business to borrow in the short term, paying down the balance when they collect from clients. A business might be seasonal. Lines of credit are not designed to be long-term loans. The bank may have a cleanup requirement, written into the agreement the line of credit must be completely paid off at a certain point and not touch the line of credit for a certain time. This can be a problem if the business has inadequate cash flow.
9. What is the interest rate? The Prime Rate has traditionally been defined as the rate of interest banks charge their best customers. This usually requires having an outstanding credit rating. Small businesses and new ventures don’t fit into this category. Your interest rate will likely be “Prime + (#).”
10. What will the loan cost? Banks don’t stop at merely charging interest. There’s often a loan origination fee. They will likely charge a service or administrative fee over the life of the loan. If the loan is not a line of credit, you may face a prepayment fee. This can be an issue if you later find more attractive terms elsewhere. If a broker acted as an intermediary in connecting you with the lender, there’s a fee for them too. If you aren’t timely with your payments there are late payment fees.
11. Business banking. You are shopping for a business loan and you find a bank that is interested in lending. They may require you do additional business with the bank as a precondition. The first step is maintaining your business checking account at the bank along with a savings vehicle. This would be necessary if you need to keep a compensating balance where the bank can see it. They will also want to collect interest on the loan through an automatic debit. This may lead to establishing the retirement plan for the business at your bank and possibly some of your personal banking as well. This is made attractive using the logic: “The more you do, the cheaper it gets.” All these requirements provide opportunities for the bank to earn additional income.
12. Only one lender? Many businesses develop mutually rewarding long term relationships with their bank. Others can run into problems if they work with only one lender and their business runs into financial trouble. Your business needs ready access to capital at all times. If the bank decides to call a loan or not renew the loan, the survival of your business is at stake. You would need to find another lender quickly. This could also be an issue if your company’s financial condition is borderline and the bank merges with another bank that has stricter credit requirements or doesn’t lend to your industry.
Working with Community Banks
There are about 5,000 community banks in the US. These are institutions focused on the local market and a key source of lending for small businesses. A major advantage is their deep knowledge of the local market and a great, alternative source for lending to your clients. Here’s what you and your clients should know about working with them:
1. How’s your credit score? Local banks don’t ignore the criteria used by major banks when making lending decisions, but they consider other factors like other business the applicant already does with the bank, longevity, and the future potential of the relationship.
2. Where do you get your advice? Community banks have a sharp focus on the local market. They often understand the borrower’s business very well and are positioned to offer business advice. Community bankers also understand who the borrower’s business is competing with locally. As their accountant, you often do the same.
3. They are competitive. Local banks compete for business with other local banks. They are motivated to lend because they often understand the potential of the local market better than major banks. If they consider you a good risk, they will compete to close the deal.
4. Speed of decision making. Big banks often take time to make decisions. The key decision makers for community banks are local. Their staff likely live and work in the area where your clients are and, often, decisions can be made quicker.
Using Fintech for Business Borrowing
Technology has entered the banking space. Online banking eliminates the cost of brick and mortar branches and allows for back office cost savings. Financial technology or Fintech fits into two primary areas: Interacting with a major bank minus the human element in the bank branch and independent companies working outside traditional banks. Here’s what you can expect:
1. Applying online. The business owner can apply for a loan bypassing the traditional channels. You’ve seen the ads for mortgage application apps where the process is done online.
2. Serving the underserved. There are geographic and cultural elements of the market that have traditionally not had the same access and choice of providers are customers in major markets. Fintech firms have sprung up to service this market segment.
3. Lenders with poor credit. Other fintech firms have targeted the market segment traditional lenders tend to avoid. They will lend and work with clients, teaching them how to improve their credit scores.
4. Microloans. These are gaining popularity in the developing world. Firms use alternative measures to determine creditworthiness and lend small sums that can make a big difference.
The business owner seeking to borrow money faces many challenges: Will money be available and, if so, at what interest rate? What is the total cost including fees? Is the loan good for an extended period of time or can payment be demanded early? Business owners need to see the big picture and you can help.
|Accounting professionals that are looking to offer financing application support for small business clients are invited to download ForwardAI’s latest guide on How Lenders View Financing Applications. Learn how to review your clients’ General Ledger with the mindset of a lender and help them position their business for success. Download it here.|
Bryce Sanders is president of Perceptive Business Solutions Inc. in New Hope, Pennsylvania. He provides high-net-worth client acquisition training for the financial services industry. His book, Captivating the Wealthy Investor, can be found on Amazon.com.