Funding - Debt

February 3, 2023

There are 5 posts in this series:

Debt provides money that is expected to be repaid, usually with interest. Aside from those elements, debt can come in many forms - depending on the terms agreed upon between lender and borrower. Debt can be money that your company borrows from:

you
your friends and family
some other individual, foundation, or non-profit
a financial institution or credit union

While debt will always involve contractual obligations to the lender, what distinguishes it from “equity” is that the lender generally does not have rights to participate in company decision-making, or to receive a percentage of company profits in perpetuity.

Most loans will require the borrower to offer “collateral”: assets the lender has the right to sell (if necessary) to repay the loan. In general, lenders will wish the value of all collateral to be at least 20% more than the loan amount, so that market value fluctuations are less likely to lead to it being worth less than the outstanding loan balance. Collateral can include:

company assets (land, buildings, machinery, inventory, accounts receivable, etc.)
your personal assets (home, car, investments, etc.)
assets of a third party willing to guarantee repayment of your loan, such as a relative or government program

While small business loans are usually made to your entity ( LLC, S corp or partnership), owners of the business are often expected to also provide a personal guarantee. If your business is unable to repay a personally guaranteed loan, the lender will look to you individually to continue to make the loan payments or satisfy the loan obligation.

Loan repayment schedules can take many forms - whatever is agreed to by both parties. However, commonly used approaches include:

A series of fixed monthly payments that include both interest and principal
Interest-only payments for some period of time before principal payments begin
No payments until a final “balloon” payment of all amounts due
Some combination of the above

There is also “convertible debt”, which allows the debt to be converted into equity under certain conditions. However, this is generally only used by companies which are working their way toward being in a position to offer equity in the company to investors within a few years.

Loans to Startup Organizations

Most startups will find it easiest to obtain debt financing from owners or friends and family.

Startups that wish to own (as opposed to lease) significant assets that could be resold, such as land, buildings, vehicles, or machinery might qualify for bank loans for a significant percentage (but probably not more than 80%) of the appraised market value of such assets.

Startups will find that banks are usually not willing to make loans for working capital, payroll, facility renovations, marketing expenses, or product development expenses. While banks may lend for such purposes to established businesses that are operating profitably, startups will generally need to prove they are able to operate profitably for several years before a bank is likely to consider such loans.

Some startup businesses may qualify for short-term loans even though they may not have a long operating history yet. The past or projected pattern of cash flows in a business determines if these are appropriate:

A Line of Credit can be useful when a business is seasonal, and needs to acquire inventory, machinery, equipment, or vehicles in advance of the expected seasonal surge. The loan amount is expected to be reduced as seasonal revenues increase.
Receivables factoring is often used when the time between sale and payment receipt is likely to be weeks or months due to use of terms, purchase order conditions, or credit cards. The loan amount is expected to be reduced by customer payments - often sent directly to the lender.

Loans to Existing Organizations

Existing organizations can offer lenders the same types of collateral as a startup. They can also offer their operating history (2-4 years of financial statements) which, if it shows profitable operations, will generally allow existing organizations to qualify for loans more easily than startups, or to qualify for larger loans.

Maine Non-Bank Loan Sources

Finance Authority of Maine
Broad financial incentives for job creation & retention
Maine Technology Institute
Grants and Loans to technology projects
Community Concepts
Existing and startup businesses
USDA Rural Development
Federal program for rural areas
CEI (Coastal Enterprises, Inc.)
Loans for small to medium-sized businesses

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When considering who you might wish to borrow from, keep the following in mind:

Financial institution lenders may insist on having all of your business accounts
What services do you require, versus which would be “nice to have”?

Each type of institution tends to offer differing sets of capabilities. Your specific needs will determine which is most appropriate for you. For example, if you do business with companies in foreign countries, a larger bank with a strong presence in the countries where you do business may be needed. On the other hand, if you seek to develop a long-term relationship with a banker who understands your business as well as the economics in your region, one of the smaller banks may appeal to you more.

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When considering which banks to approach, proximity to your business is only one of many potential considerations. Typical options in Maine:

National Banks
Include Bank of America, Wells Fargo, TD Bank
Regional Banks in Maine
Include Camden National, Peoples United, Key
Community Savings Banks in Maine
Include Bath, Bangor, Gorham, Norway, Saco-Biddeford
Credit Unions in Maine
Include Evergreen, Town & Country, Infinity
Internet-based Banks
Include Ally, Capital One, Discover, Barclays

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Applying for a Bank Loan

Submitting an application for a loan will become a part of your credit history, so do not apply for a loan unless you know you wish to work with the bank you are applying to and you have every reason to believe they are willing to lend to you. To reach this point, visit multiple banks and talk with their loan officers to learn more about questions like:

Are they familiar with your industry?
Are they interested in and able to lend the amount you seek?
Where will a lending decision be made - locally or by underwriters in another office?

A bank will typically ask for the following as part of your loan application:

Personal background / Resume
Business plan with complete financial projections
Federal tax returns (business and personal) for last three years
Bank statements (past three months)
Personal Financial Statement
Collateral (Accounts Receivable Aging, Inventory, Appraisal, Equipment List)
S Corp / LLC / Partnership formation documents/bylaws/operating agreement
Detailed sources & uses of funds table

Banks will also look at your credit history, as reported by one or more of the credit reporting agencies (TransUnion, Equifax, Experian). You can request a free credit report once per year. If you have not done so recently, do so now and verify that all information in your credit history is accurate so that you have time to request any needed corrections before applying for a loan. Banks generally prefer to see a FICO score over 700, but may consider lending to other applicants if additional conditions like a Federal Small Business Administration (SBA) guarantee or a co-borrower can be satisfied.

Lenders will also typically wish to see projected (and historical, if available) Earnings Before Interest Taxes Depreciation & Amortization (EBITDA) that is at least 20% - 35% higher than the total of all forecasted annual debt servicing payments. This is usually called a “coverage ratio”. Lenders will focus on your total debt obligations, not just the loan being applied for. Before you seek a commercial loan, be sure that your personal credit profile and household finances are in good order. Lenders may be willing to include outside sources of income, such as those from a spouse or business partner, in determining whether coverage ratio requirements are met.

How the Lender Will Make Their Decision

Cash Flow

Does the borrower demonstrate the ability to repay all existing and/or proposed loans?
Historical financials compared to projections
Business alone vs considering other household income

Collateral

Does the business have sufficient collateral to secure the proposed loan?
Business Assets: Accounts Receivable, Inventory, Equipment, Real Estate
Personal Assets: Home, Savings, Investments

Character / Capacity

Does the business owner have the ability to handle debt obligations and run the business?
Prior industry experience or business ownership
Personal credit history
Reputation/integrity/reliability
Industry considerations and barriers to entry by competitors

If a borrower does not meet enough of a bank’s lending criteria, the bank may recommend that the borrower apply for a SBA guaranteed loan. These loans are made through a traditional lender (your bank), with the SBA offering the lender a guarantee of between 50% and 85% of the loan’s value. The borrower is generally required to fund between 10% and 20% of the total project cost themselves.

If you seek to finance the purchase or upgrade of facilities, equipment, or machinery with a 10-25 year loan, another option can be an SBA “504 loan”. These can be applied for through your existing financial institution and a Certified Development Company.

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The other articles in this series each describe a few of the other funding sources in more detail.

Additional resources you may find helpful include:

To ask questions and/or learn more about funding for your business, register for a “Funding Your Business” workshop in the SCORE workshop calendar or request to meet with a SCORE Mentor (a free service).

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