Mixed Signals: The State of Small Business Funding

by | Small Business Financing, Small Business Funding

Is the glass half full or half empty? Are some observers wearing rose colored glasses (of the other kind), or are others just too doom-and-gloom?

Welcome to the world of small business funding, or if you’re just an observer of these things, the art of trying to figure out what the heck is going on in the world of said funding.

Small businesses – defined by the Small Business Administration as an enterprise with fewer than 500 employees in most cases – need start-up, expansion, and working capital to survive. It’s a system that’s been in place in one form or another for roughly 6,000 years.

The problem is that, in the aftermath of the worst economic downturn since early last century, a lot of the old rules don’t always apply. Or do they? It depends on whom you ask. A bank analyst, an expert from the U.S. Small Business Administration, and a commercial lender who specializes in mid-market financing, all weigh-in later in this document.

A Tough Lending Environment: How We Arrived There

There’s little doubt that the “easy money” environment of the late 1990s and early last decade has all but disappeared. How did that happen? Consider the big picture. The point has been made in this space many times that the people who run businesses – including banks – hate uncertainty more than almost anything, and the last dozen years have brought uncertainty by the truckload.

The September 11 attacks, which impacted the economy in a very broad manner, two lengthy wars that drained resources and demanded attention in Washington, and the mortgage, banking and financial crises of late 2008, all led to lengthy periods of indecision, business stagnation or contraction, uncertainty, and stricter lending standards imposed by traditional lenders. Maybe the lenders can’t be blamed. The trends were not favorable, and it became easy to assume that more bad news was probably on the way.

Would-be borrowers, especially in the small business category, found themselves at the mercy of lenders that suddenly, and sometimes for the first time, needed to more intimately than ever understand the business structures, collateral arrangements, financial projections, and sometimes even individual customer transactions, of the companies for which they might approve funds.

That’s a lot of leg work, and – let’s face it – a lot of apprehension on the lending side. So approval rates plunged. But another, under-reported result of the tighter credit standards was that evaluations and closings slowed dramatically, as lenders scrutinized each potential loan during the application and collateral reviews. This led to business slowdowns or interruptions, an inability to fill customer orders or seek out new business and, probably, slower growth in the overall economy.

The hyper-selectivity by lenders has mostly run its course (more about that later), but the damage had been done, both to the dynamics of the nation’s economy, and to the attitudes of many growing businesses toward the lending community. After all, what sane person would play a game where the deck is seemingly stacked against him every time?

How Small Business Funding Usually Works

Even in the best of times, securing business was funding was never especially easy, but it has seldom been as hard as it was over the previous few years. Remember that banks are in business to make money, and they make money primarily through their loan portfolios. By some estimates, banks earn more than 60% of their revenues through lending activities.

Traditionally, all lenders have used some configuration of the “Five Cs” when making their funding decisions. These include: Capacity, Capital, Collateral, Conditions, and Character.

Capacity. Most lenders would agree that capacity – your company’s ability to repay the loan – is the most important of the five lending criteria.

Lenders want to know exactly how you’re going to repay them. Factors determining your loan capacity include projected cash flow from your company’s operations, and the schedule and timing of proposed payments.

Simply put, lenders need to feel comfortable that enough money is coming in to your business to support a potential loan and its debt service obligations. Positive cash flow is key. You’ll probably have to provide an estimate of projected revenues and expenses, and perhaps even the number of sales you need to reach the targets.

Lenders will also consider the volume of debt and expenses you have already incurred and how you’re handling your payment obligations. Usually some sort of debt-to-income or debt-to-revenue ratio is calculated for your company. A lower ratio generally indicates a lower credit or lending risk.

(An interesting side note: During times of booming economic growth, like the mid and late 1980s or late 1990s, under-utilized debt capacity, which indicated that a company could borrow more in order to grow and expand, was considered by some analysts to be a wasted asset. In other words, companies would often be criticized for not borrowing enough! Obviously, times have changed.)

Capital. In this case, capital indicates how much money you and the other owners or stakeholders in the company have invested in the business. When lenders and investors talk about “skin in the game,” this is what they’re referring to.

The reasoning is that people who have personally invested in their companies and exposed themselves to substantial risk have a higher interest in ensuring that the business succeeds.

Fair warning: If your personal investment is considered too small, lenders could view it as a lack of commitment to the business.

The bottom line is that lenders expect to see evidence of substantial commitments from you before you ask them for funding.

Collateral. Most people are familiar with the concept of loan collateral, even if they haven’t tried to secure a business loan. Collateral is an asset that you pledge to your lender  – equipment, real estate, or other physical assets – to be taken as payment in the event that the loan can’t be repaid.

Types and amounts of collateral vary by industry, your company’s credit worthiness, and the amount of money loaned.

Tip: The established useful life of the collateral should meet, or preferably exceed, a loan’s duration. That means that short-term assets such as receivables and inventory are not appropriate as collateral for long-term loans. But receivables can be suitable for shorter-term financing like invoice factoring. Contact MPStar Financial for information on this funding option.

Conditions. Strangely, “conditions” are defined very differently by various lenders, but both versions are important enough to be described here, and would warrant your attention in the application process. And certainly both are considered when your loan request is under scrutiny.

One version considers “conditions” the intended or described purpose of the loan. As in, will the funds be used as working capital, or for additional equipment, materials, or inventory?

In the other context, the lender takes into consideration broader economic conditions – for both your industry and industries that could impact your company in terms of customers, suppliers and other partner businesses. These are the “conditions” that were largely responsible for the stifling lending environment that was problematic for many small companies in recent years.

Character. Uh oh. Sounds scary, but it needn’t be. Well, maybe a little…but that’s because it’s the most subjective – or “judgment call” – factor of the Five Cs.

Character refers to the impression you make on the potential lender. Hmm. Wear a new suit and shine your shoes. Seriously, who knows what primitive instincts lead some people to trust or like us and others to run out of the room?

Expect to answer questions about your education, experience, and reputation in your industry, and be able to back up your claims. Your prospective lender probably won’t hire a private investigator to dig up any dirt (although it’s probably happened), but expect your professional references and the experience and credentials of your key employees to be reviewed.

Tip: Here are questions lenders ask when evaluating the “character” of a potential borrower. 

  • Does the loan applicant have a good track record of successful business experience?
  • Does the applicant have experience in the specific industry?
  • Does the applicant have positive relationships with the lender, or other lenders?
  • Are the applicant’s references respected members of his industry or community?
  • Does the applicant have a record of industry or community involvement?
  • Was the applicant diligently involved in the business planning process?

What About Business Credit?

Good question. It’s important, of course. Some lenders include it in their Five Cs, usually, adding “credit” and dropping “capital,” to keep the number at the traditional five. (Although capital remains at least a secondary consideration, or is folded-in with “character.”)

Other lenders deem the credit factor so important that it stands on its own, aside from the five.

Prior to even thinking about looking for a loan, you need to view your company’s credit report. Access a free report on your business – assuming you’ve been in operation for a while – from Dun & Bradstreet.

If D&B hasn’t compiled a report for your company, you can ask for a listing by providing some very basic information and data about your company. You should definitely do this.

Most lenders want to see a minimum of five trade experiences – that’s business to business transactions based on a signed contract, delivery, and payment met – before a company is deemed worthy of serious consideration.

Tip: If your company is new, and you’ve run primarily without business credit, or with your own assets, try to make some trade credit purchases, so you can begin to build a credit profile on behalf of the company.

To work on making your case for credit worthiness, view yourself from the lender’s perspective. Ask yourself what concerns you would have regarding lending you money. (You might even be tougher on yourself than the lending officer.)

The View from the Front

So that’s how it’s all supposed to work, except it often hasn’t over the last several years. But remember that in both good times and bad, lenders have to make money. And they make money by lending money. Lenders might have a perfect, absolutely ideal loan applicant in mind, but they often need to compromise or even roll the dice a little bit.

So have conditions for would-be borrowers improved? Fred Cummings, president and managing partner of Elizabeth Park Capital Management certainly thinks so. Cummings’ company has more than $140 million under management, tracks and analyzes the performance of 360 US-based banks, and aggressively seeks investment opportunities in the financial services sector.

“Here’s what I’m seeing,” says Cummings. “It’s (competition between lenders) getting extremely competitive – almost cutthroat – out there. C&I (commercial and industrial) loans appear to have made a genuine comeback. Manufacturing loans are doing very well. You have lending officers aggressively calling on other bank’s customers, and that’s something we hadn’t seen much of in a while.”

Cummings said that while balance sheets and revenue statements are still important as ever, some applications that might not have been considered just a couple years back are being given serious looks.

“A lot of M&A (merger and acquisition) activity has left banks with pressure to meet revenue and earnings projections,” he added. “Any asset-based loan application is going to be given serious consideration.”

Cummings acknowledges that historically low interest rates have helped spur demand, but also says that a mild jump in rates of even 100 or 200 basis points (1 or 2 percent) would likely have little effect over the near term.

Cummings added that some lenders are still shying away from hotels, motels, restaurants, and similar properties, but most other applications are given serious consideration.

David Hall, a public affairs and lending data specialist with the Small Business Administration in Washington, D.C., provides data that seems to validate Cumming’s evaluations.

Lending in mid-pointf of 2013 was ahead of the pace at the same point a year ago by more than 13 percent,” he said. “Loan approvals reached $10.7 billion by the end of the second quarter.”

While SBA-backed loans may represent a particular segment of the lending landscape, Hall believes the positive trends indicate good news for small business funding in particular, and for the broader economy in general.  “Overall, the pace of SBA loan-making is a healthy sign for the economy and the credit markets,” he said. “These loans are a foundation for ensuring the availability of financing to small businesses trying to establish themselves, grow and create new jobs.”

Of course, even in an improving environment, some applicants tend to have better chances of approval than others – and this example might surprise you. The manufacturing sector, after nearly 30 years of sometimes sketchy perception, is getting new respect.

“A lot of these manufacturing companies have right-sized,” says Michael Bender, a Chicago loan broker specializing is small business funding. “They’ve shaped up their balance sheets and are operating in a very lean manner. These can be very attractive loans for a commercial lender.”

There are other factors at play, according to Bender, that are helping U.S.-based manufacturers. “Some buyers have figured out that buying from China or India might appear to be cheaper up front, but when quality, reliability, shipping, logistics, customs, and those kinds of factors are considered, it turns out that better deals can sometimes be found here.”

So, if Things are Better, What Now?

If based on better conditions you’re ready to enter or re-enter the business funding arena, consult an expert and get help. Your accountant should be able to both get your documents in order, and also recommend lenders that might be able to help.

For lower cost help, you can consult business incubators, regional small business development centers, and other not-for-profit groups with a business bent.


Image courtesy Sa’ad Jafar

Having trouble with cash flow management? MP Star Financial provides invoice factoring and other asset-based lending services. For more information, call (800) 833-3765, extension 150.


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