Small business is big business for banks. They provide almost 70% of small business capital. Although many banks have decided that the higher interest rates and fees they can charge small businesses do not provide an adequate return for the higher risks and higher costs involved, many others actively seek small business borrowers.

Lenders have three concerns:

Will the loan be repaid?
Will the lender be paid first?
How much can the lender get for his money?

After a loan is made many financial institution will amend the terms as the financial condition of the company changes. In the worst case , they will call the loan if it looks like the borrower is in trouble. On other hand, the lender may be persuaded to release some collateral if the company is doing better than expected.

Since lending is an extremely competitive business, there is a great deal of room for negotiation. Never accept the first terms offered.

How long you want to use the money before you pay it back helps determine the rate you pay. The longer you want to use the money, the higher the cost of that money. Loans are usually put into one of three durations: Short term, intermediate term and long term..

Short term loans--used to finance inventories and accounts receivable. Sometimes this is financed by a type of short term loan called a line of credit which gives the borrower access to credit when needed without having to reapply for a loan. In both cases, the loans are expected to be repaid within a year.

Lines of credit are sometimes called revolving terms of credit, or revolvers. They are something like credit cards in that they have a limit beyond which the borrower cannot go, and the borrower is expected to make regular payments.

Short term debt should be paid from the proceeds of sales (i.e., when inventories are turned and when receivables are taken in.

Intermediate term loans are for from one to five years. They are used to finance equipment purchases.

Long term loans are for periods of more than five years. They can be used to finance real estate, acquisitions, leverage buyouts and major future expansions.

Medium and long term debts are to be paid out of increased earnings. Short term debt is discharged from operating funds.

Risk--Borrowers risk straining the cash flow of the company which could stymie growth. Worse, it is possible to borrow oneself out of business. That is to so load the company with debt that the principal and interest cannot be paid. The result of default or late payment could be denial of credit later, foreclosure or bankruptcy.

Even if you recover, it could be very difficult and expensive to get credit again.

Maneuverability--Covenants can include a prohibition on selling or borrowing against receivable or inventories

Avail yourself of as many capital sources as possible. Not using available capital to generate sales will result in lower growth and profits.

Cost of Capital

Whether you rent it or purchase it, there are several costs to capital. some, like interests rates, are straight forward and universal. Other, like opportunity costs, can be very subtle, extremely variable, and specific to the situation.

Example

A company needs $50,000. It can borrow for one year at the rate of 20%. With the additional funds, the company expects to make $100,000.

The company can raise the needed $50,000 by selling a 20% stake.

In either case, the effective tax rate is 30%.

Under those conditions, the cost of debt is computed as follows:

Cost of debt = interest rate x (1-tax rate) = 20 x (1-.30) = 20 x 0.70 = 14%

net income to owners = 100,000 - 14,000 = $86,0000

The traditional case for equity:

Cost for equity = new investors= share of company/the amount received from investors

The investors bought 20% of the company for $50,000, therefore,

Cost of equity = $20,000 (20% of the $100,000 expected earnings)/$50,000 = 40%

The original owners get $80,000.

The problem with the above analysis is that it ignores the fact that while the $50,000 debt investment must be paid back, the $50,000 equity investment does not.

In the case of debt, the $50,00 had to be paid back, in the case of equity it did not.

Therefore, the company had $150,000 ($100,000 net profits, plus the $50,000 principal that would have had to be paid back if the funds were borrowed) at the end of the year, not $100,000. Thus the original owners ended up with $120,000 ($150,000 x 80%), not $80,000.

The original investors end up with 80% of a company that produced $150,000 rather than 100% of something that produced less than $100,000. Had they borrowed the money, they would have ended up with $86,000.

In the second year, the company may need another $50,000, since the one year term indicates borrowing for operations (e.g. to pay for raw materials). The company may take that money from retained earnings, meaning that the owners really only get to keep $34,000 of their $84,000 profits. At the end of two years, the owners of this company end up with $134,000.

The company which sold equity may fund the $50,000 internally as well. But in that case, the $50,000 comes out of the $150,000 since the new investors are owners and should shoulder their share of the cost of doing business. After funding their share of the second year=s requirement, the original owners end up with $90,000 from the first year and $120,000 from the second year.

Availability

There are a number of reasons that source of capital dry up.

Economic conditions may change on either a national or local level. A national recession or the closing of a local large employer can dry up sources of funds.
Perceptions of the company=s industry may change. Companies in trendy industries usually have an easier time raising funds, but trends don't last very long.
Company factors

Earnings or sales fall below expectations

The company has already borrowed heavily

The company's management team has changed.

Control

Fear of losing control of the company is one of the reasons entrepreneurs advance for not buying capital with equity. While it is true that many entrepreneurs find themselves out of a job because the white knight with the equity capital turned into a voracious dragon, those situations usually come about for one of two reasons. The first is that the entrepreneur was not a good manager, in which case, the company would have failed anyway. The second is that the entrepreneur did not act prudently and did not investigate the investor to discover what he had done with other companies. In general the control issue is highly overrated. Managers who do good jobs should fear neither lenders nor investors.

Sources of Capital

Yourself--Borrowing against passbooks or CDs should be the cheapest money you can find. The bank has no risk and should only charge you a little more than it is paying in interest. If the institution wants to charge more than 2% above the rate it is paying, find a more accommodating institution. The drawback is that you have to keep you money on deposit until the loan is repaid.

Example: Assume that you have $4,000 in a passbook savings account paying interest at the rate of 5% and $25,000 in CDs paying 8%. You should be able to borrow up to 90% of those amounts ($24,300). Assume you wish to borrow only $10,000. You can borrow the whole $10,000 against the CDs, which would give you money at 10% (the 8% the CDs pay, plus 2%). The interest payments on the $10,000 is $1,000 a year, but the CDs pay at total of $2,000 a year. So, in point of fact, you have to make no interest payments. These loans can be structured so that the borrower pays interest only, or principal and interest. In the interest only case, there is no time limit on the loan. The borrower could "pay" nothing, i.e. the bank takes $1,000 a year of the interest the CDs are paying, until the borrower decides to pay back the principal.

If the loan is for a specific period of time, say a year, then each payment will usually include a portion of the principal as well as the interest.

Why, if the money is already in the bank, can you only borrow part of it? Banks are in the business of renting money. They want to make sure that you actually pay back what you borrowed, along with the interest. the difference between what is on deposit and what the bank will let you borrow its to cover interest and expenses.

Life insurance policies are the second least expensive source of debt. You can borrow on the cash value (not the face value, but the amount you have paid into it plus the interest earned by those payments) at a very favorable rate. However, if you die, the insurance company will deduct the amount you have borrowed and not pay the full face value of the policy.

Assume you have a life insurance policy which will pay you beneficiaries $100,000 when you die. The longer you have had that policy, the higher the cash value since you have paid your premiums and they have generated interest income. Insurance companies invest the premiums in a number of areas including real estate projects, stocks, bonds, venture capital funds, etc. They share part of the profits from those investments with the policy holders.

Home equity loan. Most states will allow you to recover the equity in your house through a second mortgage. Many lenders will advance as much as 80% to 90% of the value of the house and land minus the amount remaining on the first mortgage. The term for the second mortgage can be up to 15 years, although most lenders prefer a term of between seven and 10 years.

How a home equity loan works

Assume you bought your house for $75,000 in 1980. Further assume that a certified appraiser has determined that the house and land are now worth $150,000 and that you owe $25,000 on the first mortgage. A company will advance up to 80% of the net value of the house and land. Thus:

80% of $150,000 = $120,000

- $25,000 First mortgage

= $95,000 Equity available to homeowner

Family, Friends and other Fools

These can all raise money in the ways described above. In most cases sensible family members and friends will want you either to post collateral or sell equity in the business.

Stewart-Gordon Associates, Inc.
P.O. Box 781992
Dallas TX 75378-1992
voice (972) 620-2489
fax (972) 406-0213
e-mail Tom Stewart-Gordon