When you are trying to figure out how to raise some funds for a business, particularly if you’re starting up, the typical go-to solution is usually to tap some friends and family. To help convince family and friends, you prepare a business plan that demonstrates that you have thought through thoroughly what it will take to make the business a success and will show a good return on their investments. Depending on the magnitude of the requirements, you may also need to tap other sources to approach for a loan like of course the banks. However, we also know that a bank will not give you the time of day unless you come with some credentials.
Carrot and stick credentials
And what are these credentials that could prompt a bank to seriously consider extending a loan?
Well, a start-up suggests that the business model still needs to be proven. In other words, there is no track record to speak of that could cause a bank to rely on the business’ previous performance to demonstrate that a loan extended to the business can be paid back from the cash flow arising from its operations. In such a situation, the bank would have to think in terms of a fallback.
A standard fallback is collateral, preferably real estate, which could provide comfort to a lender that the borrowed funds can be recovered if projections don’t materialize and foreclosure and sale of the real estate is resorted to. Other than real estate, a chattel mortgage over the business assets such as equipment and machinery, especially those that have wide application of use such as transportation equipment or computers or lathes, could also provide decent recovery values. In addition, if the assets arising from the cash-conversion cycles of the business can be closely monitored and controlled, repayment prospects are enhanced.
I refer to assignments of sales contracts, pledge of account receivables, customers’ post-dated checks discounting and chattel mortgage or a trust receipt lien over raw materials and finished goods inventories. Of the different modes of possible recovery tactics, violation of a trust receipt lien or bouncing of checks are particularly effective deterrents since litigations are criminal rather than civil in nature.
Shareholders’ personal guarantees
To convince the bank of the shareholders’ resolve to support the business, offering the joint and several personal guarantees of the shareholders is an important message of commitment that is conveyed to the bank. The personal guarantee of a well-known personality with an unblemished reputation is critical and for most banks, in fact, become the single most important consideration for granting a credit accommodation. Note that a joint and several guarantee of the owners essentially say that if the business will need additional capital in the future, the shareholders jointly are prepared to step up and put at play all of their other personal assets such as their residences or savings to pay off the business’ liabilities. These guarantees could even be buttressed by the pledge of their respective shareholdings in the company.
Other financing tools
Suppliers’ credit terms can also be counted on to be a regular source of working capital since suppliers will always be motivated to spur more purchases from them. Credit terms come with a cost however very much like an interest expense which are usually built into the purchase price of the goods. For capital expenditures, leasing could be another realistic option. These lease arrangements can either be an operating lease or a financial lease.
An operating lease is treated generally as renting wherein the leased assets are just rented and not reflected in the balance sheet of the lessee because the ownership is retained by the lessor. A financial lease on the other hand is more like a loan and interest expenses instead of rent are incurred. The legal ownership of the leased assets can revert to the lessee upon exercise of a purchase option.
Generally speaking, a lease structure is more expensive than a regular loan but there are various considerations for entering into a lease instead of a loan. For example, a company’s balance sheet might already be loaded with too much debt so adding more loans to support a capital expenditure could portray a highly leveraged business triggering possibly a lower credit rating or a breach of a leverage ratio financial covenant.
There are other circumstances wherein different modes of financing arrangements would be necessary that encompass both debt and/or equity or quasi-equity structures. These include tools such as project finance, bond issuances, mezzanine or subordinated financing, perpetual preferred shares, crowdfunding, IPOs or even ICOs. But that’s another story.
Until then, one big fight!