Borrowing Money

Why Banks Think the Way They Do

Gene Dailey, SCORE 513 Counselor

Banks don’t lend the Bank President’s money or the directors’ or officers’ money; they lend YOUR money, the depositor’s money. Therefore they are subject to periodic exams to determine that the risks that they take are prudent and do not exceed the standards established by the regulatory authorities (FDIC, Comptroller of the Currency, Federal Reserve, and State Banking Departments.)

Lending to small business is considered, in most cases, very risky. The principal (s) are usually inexperienced and untried. Can they manage the cash flow to assure that the bank loans, the accounts payable and other debt is paid when due? Can they manage the business in a way that will produce profits? If there is no profit the debts will not be paid.

Banks require that the owners of a business contribute capital, whether it is cash, inventory, or equipment, i.e., some asset that has true value. This is common sense. It is the incentive to cause the owner to work harder to conserve the money he/she put into the business. Without it the owner could wake up some morning and decide that operating the business is too difficult. If the business were shut down the bank would be the big loser, not the owner.

Everybody talks about Collateral.  Yes it is important, very important. However, it is not the number one consideration. The most important consideration is Cash Flow. Can the bank be reasonably sure that there will be sufficient cash flow to pay the loan? This is the bank’s primary consideration. Collateral is secondary. Banks do not like to liquidate collateral to pay off a loan. It is costly and it is time consuming. Any good bank-lending officer will attest to this statement. In most cases the principals will be required to personally guarantee a business loan and will be required to allow the bank to place a lien on their real estate. However, banks hate to foreclose on personal real estate. Not only is it a costly and lengthy procedure but the banks are concerned about the adverse public relations that it causes in the community.

It is extremely difficult to get a bank loan to start a business simply because there is no history to determine if the business will be profitable. Therefore the risks are greater then the bank can afford. Banks like to see at least 3 years of profitable business history before they are willing to consider a business loan. A home equity loan is usually the best way to borrow to acquire the money to start a business, assuming the borrower has equity in their real estate. Of course, the borrower then risks the loss of the home in the event the business fails. The borrower should apply for the home equity loan while still employed.

Other ways to finance a start-up: savings, loans from family and/or friends, venture capital firms. Be advised that venture capital firms will only consider high-profit business and in almost all cases will require that the owner (s) give up a piece of the business.

SBA does not give loans directly. They may guarantee business loans that banks consider marginal. Most banks will ask the SBA to guarantee loans if they feel that the risks involved are greater than they are willing to accept. A business loan borrower may ask the bank to consider a SBA loan if the bank rejects a conventional business loan request. In all cases the SBA will require the guarantee of the principals and spouses and in most cases will require the principals to pledge their personal assets, including real estate. SBA will also require that the owners contribute capital. The interest rate on SBA loans is usually comparable to conventional business loans.