Finally they approached a community bank that was willing to listen to their plans.
Shaun Merriman, president and CEO of Gateway Bank, says that two things set Aaron and his wife Kathy apart: their passion and their planning. “I could tell that this was something that they’d been working on a long time. It was one of the best designed business plans that I have ever seen in 28 years. Their plan was one of the most comprehensive, well-organized, and well thought through.” As a result, Gateway Bank was able to make the loan, and the Corr’s were able to launch a business that’s been garnering rave reviews.
When it comes to borrowing from a bank, who knows better than a banker? For this section, Tom Trafficante, the Executive Vice President and Chief Credit Officer at Heritage Bank of Nevada, provides his thoughts.
Before You Apply for Small Business Loan
You know the saying, “You only get one chance to make a first impression?” That’s true in many aspects of business, including when you apply for a small business loan. Before making a formal application to a bank for a small business loan, be sure to research banks and other lending institutions which are actively making small business loans in your community and arrange a meeting with at least two of these lenders.
There are multiple government and non-profit agencies in most communities to assist small businesses with planning and counseling, including assistance in preparing a business loan application. These include the U.S. Small Business Administration (SBA), Small Business Development Center, SCORE, Chamber of Commerce and Economic Development Agencies. By first contacting one of these agencies, you will be able to determine which banks are more aggressively seeking loans and obtain a referral to meet with them. You should also contact your own accountant, attorney, insurance broker or business associate for a similar reference.
Once your list of banks is narrowed down to two or three, set up a meeting with each bank to discuss your individual situation with them. You should take the opportunity to better understand the bank’s procedures for processing and approving the type and size loan you are looking for.
Factors Used by Banks to Evaluate Business Loans
The application process
The process used by a bank to evaluate small business loans varies considerably for each institution and is based on several factors. The size and complexity of loan request determines the depth and nature of the underwriting process. For smaller business loan requests (typically loan requests less than $100,000), most banks use a more streamlined approval process or automated underwriting process. Some banks utilize automated credit scoring systems for loan requests as high as $250,000.
Credit scoring models are heavily reliant on the strength of the credit reports of both the business and the principal owners of the business who will be required to guarantee the loan. In addition to information obtained from credit reporting agencies, the automated system will use income and asset information from the applicant’s tax returns and from the application to underwrite the loan for sufficient cash flow and liquid assets.
Most banks will require that they be able to review three years of operating history for the business and three years’ financial information from any principal owner with 20% or more ownership interest in order to obtain a commercial loan. Generally, for a business with less than two years of operating history, the business will be considered a “start-up” and generally will not qualify for a conventional loan with a bank. Only in cases where the principal owners have sources of income and strong cash balances to support the loan repayment without the business income, would they be considered by a bank for a start-up business loan. Some banks will consider a loan to a start-up business with an SBA guarantee, but even with the SBA guarantee (discussed in Chapter 4) most banks will not consider a start-up business for financing. If the loan request is declined by the automated system or when the loan request exceeds the threshold amount of $100,000, then the loan is processed with great detail and scrutiny.
What is required to apply for a small business loan
Typically, a small business loan request will require the following information:
• The business tax returns for the most recent three year period
• The personal tax returns of the all principal owners for the most recent three year period
• The fiscal year end business financial statements for the most recent three year period
• Interim financial statement (since the most recent fiscal year end)
• Personal financial statement of the principal owners
• Liquid asset verification and debt schedules for both the business and the principal owner
• Other pertinent information about the company and its principal owners
• A current year budget or projection may be requested
Once this information is received by the bank, a credit analyst will create a financial spreadsheet which displays the historical financial information in various formats, calculates numerous ratios and trends, and then compares the information to other companies of similar size in the same industry. You should request a copy of these spreadsheets whether your loan is approved or not, as there is often valuable information for your own consideration.
The financial spreadsheets are then sent to a loan officer for review and underwriting. If the loan officer determines that the request is eligible for consideration, the officer will compile a credit memorandum which summarizes the loan request, the financial condition of the applicant, variances from lending policy and risks associated with the request. The credit memorandum could be a few pages or longer than 100 pages, depending upon the size, nature and complexity of the loan.
Loan officers may have some direct authority to make a loan, but generally loan approval will require the signature of a credit administrator. If the credit request is larger, typically over $1 million or more, the loan request will need to be approved by a loan committee. In most cases, a loan which is approved by the loan officer and the credit administrator will rarely be declined by a loan committee.
Obtaining Loan Approval
The commercial loan underwriting process can be very complex and is beyond the scope of this book to fully describe. However, there are some basic financial data and ratios that are the key to obtain loan approval. The first is the amount and stability of historical and projected cash flow of the business. The second is the amount of debt and equity and available collateral for the loan. And lastly is the liquidity and financial strength of the principal owners of the business who guarantee the loan.
Loans are expected to be repaid from future excess cash flow, and thus the biggest issue for a loan officer to consider is if the cash flow is adequate to repay the loan. It is important to distinguish between net income and cash flow. A simplified approach, called Traditional Cash Flow method, will average the company’s prior three years of net earnings (net income), plus interest, plus other non-cash expenses like depreciation and amortization (this number is referred to as EBITDA). Using the EBITDA, the loan officer will calculate the current principal and interest payments of the existing debt, plus the principal and interest on the requested debt (this number is referred to as Debt Service). The loan officer calculates a debt service coverage ratio (DSCR) by taking EBITDA divided by Debt Service. This ratio should exceed 1.20. In other words, the company should show historically that it has 20% extra cash flow above the proposed loan’s payments.
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