Obtaining Debt Capital

By Spinelli, S., Adams, R.J.

Edited by Paul Ducham


History suggests a favorable credit environment can and will change sometimes suddenly. When a credit climate reverses itself, personal guarantees come back. Even the most creditworthy companies with enviable records for timely repayment of interest and principal could be asked to provide personal guarantees by the owners. In addition, there could be a phenomenon viewed as a perversion of the debt capital markets. As a credit crunch becomes more severe,banks face their own illiquidity and insolvency problems, which might result in the failure of more banks as happened in the 1990s. To cope with their own balance sheet dissipation, banks can and might call the best loans first. Thousands of high-quality smaller companies can be stunned and debilitated by such actions. Also, as competition among banks lessens, pricing and terms can become more onerous as the economy continues in a period of credit tightening. Debt reduction could then become a dominant financial strategy of small and large companies alike.


Lenders have always been wary capital providers. Because banks may earn as little as a 1 percent net profit on total assets, they are especially sensitive to the possibility of a loss. If a bank writes off a $1 million loan to a small company, it must then be repaid an incremental $100 million in profitable loans to recover that loss.

Yet lending institutions are businesses and seek to grow and improve profitability as well. They can do this only if they find and bet on successful, young, growing companies. Historically, points and fees charged for making a loan have been a major contributor to bank profitability. During parts of the credit cycle, banks may seek various sweeteners to make loans. Take, for instance, a lending proposal for a company seeking a $15 million five-year loan. In addition to the up-front origination fees and points, the bank further proposed a YES, or yield enhancement security, as part of the loan. This additional requirement would entitle the bank to receive an additional $3 million payment from the company once its sales exceeded $10 million and it was profit Lenders have always been wary capital providers. Because banks may earn as little as a 1 percent net profit on total assets, they are especially sensitive to the possibility of a loss. If a bank writes off a $1 million loan to a small company, it must then be repaid an incremental $100 million in profitable loans to recover that loss. Yet lending institutions are businesses and seek to grow and improve profitability as well. They can do this only if they find and bet on successful, young, growing companies. Historically, points and fees charged for making a loan have been a major contributor to bank profitability. During parts of the credit cycle, banks may seek various sweeteners to make loans. Take, for instance, a lending proposal for a company seeking a $15 million five-year loan. In addition to the up-front origination fees and points, the bank further proposed a YES, or yield enhancement security, as part of the loan. This additional requirement would entitle the bank to receive an additional $3 million payment from the company once its sales exceeded $10 million and it was profitable, or if it was sold, merged, or taken public. While this practice hasn’t happened frequently in the current economic climate, it could be revived, depending on the cycle.


Trade credit is a major source of short-term funds for small businesses. Trade credit represents 30 percent to 40 percent of the current liabilities of nonfinancial companies, with generally higher percentages in smaller companies. It is reflected on the balance sheets as accounts payable, or sales payable—trade.

If a small business is able to buy goods and services and be given, or take, 30, 60, or 90 days to pay for them, that business has essentially obtained a loan of 30 to 90 days. Many small and new businesses are able to obtain such trade credit when no other form of debt financing is available to them. Suppliers offer trade credit as a way to get new customers, and often build the bad debt risk into their prices. Additionally, channel partners who supply trade credit often do so with more industry-specific knowledge than can be obtained by commercial banks. 

The ability of a new business to obtain trade credit depends on the quality and reputation of its management and the relationships it establishes with its suppliers. Continued late payment or nonpayment may cause suppliers to cut off shipments or ship only on a COD basis. A key to keeping trade credit open is to continually pay some amount, even if it is not the full amount. Also, the real cost of using trade credit can be very high––for example, the loss of discounts for prompt payment. Because the cost of trade credit is seldom expressed as an annual amount, it should be analyzed carefully, and a new business should shop for the best terms.

Trade credit may take some of the following forms: extended credit terms; special or seasonal datings , where a supplier ships goods in advance of the purchaser’s peak selling season and accepts payment 90 to 120 days later during the season; inventory on consignment, not requiring payment until sold; and loan or lease of equipment.


Commercial banks prefer to lend to existing businesses that have a track record of sales, profits, and satisfied customers, and a current backlog. Their concern about the high failure rates in new businesses can make banks less than enthusiastic about making loans to such firms. They like to be lower-risk lenders, which is consistent with their profit margins. For their protection, they look first to positive cash flow and then to collateral, and in new and young businesses (depending on the credit environment) they are likely to require personal guarantees of the owners.

Like equity investors, commercial banks place great weight on the quality of the management team.

Notwithstanding these factors, certain banks do (rarely) make loans to start-ups or young businesses that have strong equity financings from venture capital firms. This has been especially true in such centers of entrepreneurial and venture capital activity as Silicon Valley, Boston, Los Angeles, Austin, Texas, and New York City.

Commercial banks are the primary source of debt capital for existing (not new) businesses. Small business loans may be handled by a bank’s small business loan department or through credit scoring (where credit approval is done “by the numbers”). Your personal credit history will also impact the credit scoring matrix. Larger loans may require the approval of a loan committee. If a loan exceeds the limits of a local bank, part or the entire loan amount will be offered to “correspondent” banks in neighboring communities and nearby financial centers. This correspondent network enables the smaller banks in rural areas to handle loans that otherwise could not be made.

Most of the loans made by commercial banks are for one year or less. Some of these loans are unsecured, whereas receivables, inventories, or other assets secure others. Commercial banks also make a large number of intermediate-term loans (or term loans) with a maturity of one to five years. On about 90 percent of these term loans, the banks require collateral, generally consisting of stocks, machinery, equipment, and real estate. Most term loans are retired by systematic, but not necessarily equal, payments over the life of the loan. Apart from real estate mortgages and loans guaranteed by the SBA or a similar organization, commercial banks make few loans with maturities greater than five years.

Banks also offer a number of services to the small business, such as computerized payroll preparation, letters of credit, international services, lease financing, and money market accounts.

There are now over 7,401 commercial banks in the United States—a 5 percent reduction in three years. A complete listing of banks can be found, arranged by states, in the American Bank Directory ( McFadden Business Publications), published semiannually.


A line of credit is a formal or informal agreement between a bank and a borrower concerning the maximum loan a bank will allow the borrower for a oneyear period. Often the bank will charge a fee of a certain percentage of the line of credit for a definite commitment to make the loan when requested.

Line of credit funds are used for such seasonal financings as inventory buildup and receivable financing. These two items are often the largest and most financeable items on a venture’s balance sheet. It is general practice to repay these loans from the sales and reduction of short-term assets that they financed. Lines of credit can be unsecured, or the bank may require a pledge of inventory, receivables, equipment, or other acceptable assets. Unsecured lines of credit have no lien on any asset of the borrower and no priority over any trade creditor, but the banks may require that all debt to the principals and stockholders of the company be subordinated to the line of credit debt.

The line of credit is executed through a series of renewable 90-day notes. The renewable 90-day note is the more common practice, and the bank will expect the borrower to pay off his or her open loan within a year and to hold a zero loan balance for one to two months. This is known as “resting the line” or “cleaning up.” Commercial banks may also generally require that a borrower maintain a checking account at the bank with a minimum (“compensating”) balance of 5 percent to 10 percent of the outstanding loan.

For a large, financially sound company, the interest rates for a “prime risk” line of credit will be quoted at the prime rate or at a premium over LIBOR. LIBOR stands for “London Interbank Offered Rate.” Eurodollars—U.S. dollars held outside the United States—are most actively traded here, and banks use Eurodollars as the “last” dollars to balance the funding of their loan portfolios. Thus LIBOR represents the marginal cost of funds for a bank. A small firm may be required to pay a higher rate. The true interest calculations should also reflect the multiple fees that may be added to the loan. Any compensatingbalance or resting-the-line requirements or other fees will also increase effective interest rates.


Many dealers or manufacturers who offer installment payment terms to purchasers of their equipment cannot themselves finance installment or conditional sales contracts. In such situations, they sell and assign the installment contract to a bank or sales finance company. (Some very large manufacturers do their own financing through captive finance companies— such as the Ford Motor Company and Ford Credit. Most very small retailers merely refer their customer installment contracts to sales finance companies, which provide much of this financing, and on more flexible terms.)

From the manufacturer’s or dealer’s point of view, time-sales finance is a way of obtaining short-term financing from long-term installment accounts receivable. From the purchaser’s point of view, it is a way of financing the purchase of new equipment.

Under time-sales financing, the bank purchases installment contracts at a discount from their full value and takes as security an assignment of the manufacturer/ dealer’s interest in the conditional sales contract. In addition, the bank’s financing of installment note receivables includes recourse to the seller in the event of loan default by the purchaser. Thus the bank has the payment obligation of the equipment purchaser, the manufacturer/dealer’s security interest in the equipment purchased, and recourse to the manufacturer/dealer in the event of default. The bank also withholds a portion of the payment (5 percent or more) as a dealer reserve until the note is paid. Because the reserve becomes an increasing percentage of the note as the contract is paid off, an arrangement is often made when multiple contracts are financed to ensure that the reserve against all contracts will not exceed 20 percent or so.

The purchase price of equipment under a sales financing arrangement includes a “time-sales price differential” (e.g., an increase to cover the discount, typically 6 percent to 10 percent) taken by the bank that does the financing. Collection of the installments may be made directly by the bank or indirectly through the manufacturer/dealer.


Bank term loans are generally made for periods of one to five years, and may be unsecured or secured. Most of the basic features of bank term loans are the same for secured and unsecured loans.

Term loans provide needed growth capital to companies. They are also a substitute for a series of shortterm loans made with the hope of renewal by the borrower. Banks make these generally on the basis of predictability of positive cash flow.

Term loans have three distinguishing features: Banks make them for periods of up to five years (and occasionally more); periodic repayment is required; and agreements are designed to fit the special needs and requirements of the borrower (e.g., payments can be smaller at the beginning of a loan term and larger at the end).

Because term loans do not mature for a number of years, during which time the borrower’s situation and fortunes could change significantly, the bank must carefully evaluate the prospects and management of the borrowing company. Even the protection afforded by initially strong assets can be wiped out by several years of heavy losses. Term lenders stress the entrepreneurial and managerial abilities of the borrowing company. The bank will also carefully consider such things as the long-range prospects of the company and its industry, its present and projected profitability, and its ability to generate the cash required to meet the loan payments, as shown by past performance. Pricing for a term loan may be higher, reflecting a perceived higher risk from the longer term.

To lessen the risks involved in term loans, a bank will require some restrictive covenants in the loan agreement. These covenants might prohibit additional borrowing, merger of the company, payment of dividends, sales of assets, increased salaries to the owners, and the like. Also, the bank will probably require financial covenants to provide early warning of deterioration of the business, like debt to equity and cash flow to interest coverage.


Assigning an appropriate possession (chattel) as security is a common way of making secured term loans. The chattel is any machinery, equipment, or business property that is made the collateral of a loan in the same way as a mortgage on real estate. The chattel remains with the borrower unless there is default, in which case the chattel goes to the bank. Generally, credit against machinery and equipment is restricted primarily to new or highly serviceable and salable used items.

It should be noted that in many states, loans that used to be chattel mortgages are now executed through the security agreement forms of the Uniform Commercial Code (UCC). However, chattel mortgages are still used in many places and are still used for moving vehicles (i.e., tractors or cranes); and from custom, many lenders continue to use that term even though the loans are executed through the UCCs security agreements. The term chattel mortgage is typically from one to five years; some are longer.


Conditional sales contracts are used to finance a substantial portion of the new equipment purchased by businesses. Under a sales contract, the buyer agrees to purchase a piece of equipment, makes a nominal down payment, and pays the balance in installments over a period of from one to five years. Until the payment is complete, the seller holds title to the equipment. Hence the sale is conditional upon the buyer’s completing the payments.

A sales contract is financed by a bank that has recourse to the seller should the purchaser default on the loan. This makes it difficult to finance a purchase of a good piece of used equipment at an auction. No recourse to the seller is available if the equipment is purchased at an auction; the bank would have to sell the equipment if the loan goes bad. Occasionally a firm seeking financing on existing and new equipment will sell some of its equipment to a dealer and repurchase it, together with new equipment, in order to get a conditional sales contract financed by a bank.

The effective rate of interest on a conditional sales contract is high, running to as much as 15 percent to 18 percent if the effect of installment features is considered. The purchaser/borrower should make sure the interest payment is covered by increased productivity and profitability resulting from the new equipment.


Loans made to finance improvements to business properties and plants are called plant improvement loans. They can be intermediate or long-term and are generally secured by a first or second mortgage on the part of the property or plant that is being improved.


The commercial bank is generally the lender of choice for a business. But when the bank says no, commercial finance companies, which aggressively seek borrowers, are a good option. They frequently lend money to companies that do not have positive cash flow, although commercial finance companies will not make loans to companies unless they consider them viable risks. In tighter credit economies, finance companies are generally more accepting of risk than are banks.

The primary factors in a bank’s loan decision are the continuing successful operation of a business and its generation of more than enough cash to repay a loan. By contrast, commercial finance companies lend against the liquidation value of assets (receivables, inventory, equipment) that it understands and knows how and where to sell, and whose liquidation value is sufficient to repay the loan. Banks today own many of the leading finance companies. As a borrower gains financial strength and a track record, transfer to more attractive bank financing can be easier.

In the case of inventories or equipment, liquidation value is the amount that could be realized from an auction or quick sale. Finance companies will generally not lend against receivables more than 90 days old, federal or state government agency receivables (against which it is very difficult to perfect a lien and payment is slow), or any receivables whose collection is contingent on the performance of a delivered product.

Because of the liquidation criteria, finance companies prefer readily salable inventory items such as electronic components or metal in such commodity forms as billets or standard shapes. Generally a finance company will not accept inventory as collateral unless it also has receivables. Equipment loans are made only by certain finance companies and against such standard equipment as lathes, milling machines, and the like. Finance companies, like people, have items with which they are more comfortable and therefore will extend more credit against certain kinds of collateral.

How much of the collateral value will a finance company lend? Generally 70 percent to 90 percent of acceptable receivables under 90 days old, 20 percent to 70 percent of the liquidation value of raw materials and/or finished goods inventory that are not obsolete or damaged, and 60 percent to 80 percent of the liquidation value of equipment, as determined by an appraiser, are acceptable. Receivables and inventory loans are for one year, whereas equipment loans are for three to seven years.

All these loans have tough prepayment penalties: Finance companies do not want to be immediately replaced by banks when a borrower has improved its credit image. Generally finance companies require a three-year commitment to do business with them, with prepayment fees if this provision is not met.

The data required for a loan from a finance company includes all that would be provided to a bank, plus additional details for the assets being used as collateral. For receivables financing, this includes detailed aging of receivables (and payables) and historical data on sales, returns, or deductions (all known as dilution), and collections.

For inventory financing, it includes details on the items in inventory, how long they have been there, and their rate of turnover. Requests for equipment loans should be accompanied by details on the date of purchase, cost of each equipment item, and appraisals, which are generally always required. These appraisals must be made by acceptable (to the lender) outside appraisers.

The advantage of dealing with a commercial finance company is that it will make loans that banks will not, and it can be flexible in lending arrangements. The price a finance company exacts for this is an interest rate anywhere from 0 to 6 percent over that charged by a bank, prepayment penalties, and, in the case of receivables loans, recourse to the borrower for unpaid collateralized receivables.

Because of their greater risk taking and assetbased lending, finance companies usually place a larger reporting and monitoring burden on the borrowing firm to stay on top of the receivables and inventory serving as loan collateral. Personal guarantees will generally be required from the principals of the business. A finance company or bank will generally reserve the right to reduce the percentage of the value lent against receivables or inventory if it gets nervous about the borrower’s survivability.


Factoring is a form of accounts receivable financing. However, instead of borrowing and using receivables as collateral, the receivables are sold, at a discounted value, to a factor. Factoring is accomplished on a discounted value of the receivables pledged. Invoices that do not meet the factor’s credit standard will not be accepted as collateral. (Receivables more than 90 days old are not normally accepted.) A bank may inform the purchaser of goods that the account has been assigned to the bank, and payments are made directly to the bank, which credits them to the borrower’s account. This is called a notification plan. Alternatively, the borrower may collect the accounts as usual and pay off the bank loan; this is a nonnotification plan.

Factoring can make it possible for a company to secure a loan that it might not otherwise get. The loan can be increased as sales and receivables grow. However, factoring can have drawbacks. It can be expensive, and trade creditors sometimes regard factoring as evidence of a company in financial difficulty, except in certain industries.

In a standard factoring arrangement, the factor buys the client’s receivables outright, without recourse, as soon as the client creates them by shipment of goods to customers. Although the factor has recourse to the borrowers for returns, errors in pricing, and so on, the factor assumes the risk of bad debt losses that develop from receivables it approves and purchases. Many factors, however, provide factoring only on a recourse basis.

Cash is made available to the client as soon as proof is provided (old-line factoring) or on the average due date of the invoices (maturity factoring). With maturity factoring, the company can often obtain a loan of about 90 percent of the money a factor has agreed to pay on a maturity date. Most factoring arrangements are for one year.

Factoring can also be on a recourse basis. In this circumstance, the borrower must replace unpaid receivables after 90 days with new current receivables to allow the borrowings to remain at the same level.

Factoring fits some businesses better than others. For a business that has annual sales volume in excess of $300,000 and a net worth over $50,000 that sells on normal credit terms to a customer base that is 75 percent credit rated, factoring is a real option. Factoring has become almost traditional in such industries as textiles, furniture manufacturing, clothing manufacturing, toys, shoes, and plastics.

The same data required from a business for a receivable loan from a bank are required by a factor. Because a factor is buying receivables with no recourse, it will analyze the quality and value of a prospective client’s receivables. It will want a detailed aging of receivables plus historical data on bad debts, return, and allowances. It will also investigate the credit history of customers to whom its client sells and establish credit limits for each customer. The business client can receive factoring of customer receivables only up to the limits so set.

The cost of financing receivables through factoring is higher than that of borrowing from a bank or a finance company. The factor is assuming the credit risk, doing credit investigations and collections, and advancing funds. A factor generally charges up to 2 percent of the total sales factored as a service charge.

There is also an interest charge for money advanced to a business, usually 2 percent to 6 percent above prime. A larger, established business borrowing large sums would command a better interest rate than the small borrower with a one-time, short-term need. Finally, factors withhold a reserve of 5 percent to 10 percent of the receivables purchased.

Factoring is not the cheapest way to obtain capital, but it does quickly turn receivables into cash. Moreover, although more expensive than accounts receivable financing, factoring saves its users credit agency fees, salaries of credit and collection personnel, and maybe bad debt write-offs. Factoring also provides credit information on collection services that may be better than the borrower’s.


The leasing industry has grown substantially in recent years, and lease financing has become an important source of medium-term financing for businesses. There are about 700 to 800 leasing companies in the United States. In addition, many commercial banks and finance companies have leasing departments. Some leasing companies handle a wide variety of equipment, while others specialize in certain types of equipment—machine tools, electronic test equipment, and the like.

Common and readily resalable items such as automobiles, trucks, typewriters, and office furniture can be leased by both new and existing businesses. However, the start-up will find it difficult to lease other kinds of industrial, computer, or business equipment without providing a letter of credit or a certificate of deposit to secure the lease, or personal guarantees from the founders or from a wealthy third party.

An exception to this condition is high-technology start-ups that have received substantial venture capital. Some of these ventures have received large amounts of lease financing for special equipment from equity-oriented lessors, who receive some form of stock purchase rights in return for providing the start- up’s lease line. Equate (of Oakland, California, with offices in Boston, New York, and Dallas) and Intertec (of Mill Valley, California) are two examples of companies doing this sort of venture leasing. Like many financing options, availability of venture leasing may be reduced significantly in tight money markets.

Generally industrial equipment leases have a term of three to five years but in some cases may run longer. There can also be lease renewal options for 3 percent to 5 percent per year of the original equipment value. Leases are usually structured to return the entire cost of the leased equipment plus finance charges to the lessor, although some so-called operating leases do not, over their term, produce revenues equal to or greater than the price of the leased equipment.

Typically an up-front payment is required of about 10 percent of the value of the item being leased. The interest rate on equipment leasing may be more or less than other forms of financing, depending on the equipment leased, the credit of the lessee, and the time of year.

Leasing credit criteria are similar to the criteria used by commercial banks for equipment loans. Primary considerations are the value of the equipment leased, the justification of the lease, and the lessee’s projected cash flow over the lease term.

Should a business lease equipment? Leasing has certain advantages. It enables a young or growing company to conserve cash and can reduce its requirements for equity capital. Leasing can also be a tax advantage because payments can be deducted over a shorter period than can depreciation.

Finally, leasing provides the flexibility of returning equipment after the lease period if it is no longer needed or if it has become technologically obsolete. This can be a particular advantage to high-technology companies.

Leasing may or may not improve a company’s balance sheet because accounting practice currently requires that the value of the equipment acquired in a capital lease be reflected on the balance sheet. Operating leases, however, do not appear on the balance sheet. Generally this is an issue of economic ownership rather than legal ownership. If the economic risk is primarily with the lessee, it must be capitalized and it therefore goes on the balance sheet along with the corresponding debt. Depreciation also follows the risk, along with the correspond ing tax benefits. Startups that don’t need such tax relief should be able to acquire more favorable terms with an operating lease.


Obtaining a loan is, among other things, a sales job. Many borrowers tend to forget this. An entrepreneur with an early-stage venture must sell himself or herself as well as the viability and potential of the business to the banker. This is much the same situation that the early-stage entrepreneur faces with a venture capitalist.

The initial contact with a lender will likely be by telephone. The entrepreneur should be prepared to describe quickly the nature, age, and prospects of the venture; the amount of equity financing and who provided it; the prior financial performance of the business; the entrepreneur’s experience and background; and the sort of bank financing desired. A referral from a venture capital firm, a lawyer or accountant, or other business associate who knows the banker can be very helpful.

If the loan officer agrees to a meeting, he or she may ask that a summary loan proposal, description of the business, and financial statements be sent ahead of time. A well-prepared proposal and a request for a reasonable amount of equity financing should pique a banker’s interest.

The first meeting with a loan officer will likely be at the venture’s place of business. The banker will be interested in meeting the management team, seeing how team members relate to the entrepreneur, and getting a sense of the financial controls and reporting used and how well things seem to be run. The banker may also want to meet one or more of the venture’s equity investors. Most of all, the banker is using this meeting to evaluate the integrity and business acumen of those who will ultimately be responsible for the repayment of the loan.

Throughout meetings with potential bankers, the entrepreneur must convey an air of self-confidence and knowledge. If the banker is favorably impressed by what has been seen and read, he or she will ask for further documents and references and begin to discuss the amount and timing of funds that the bank might lend to the business.

Small Print, Big Problems

Matt Coffin, founder of LowerMyBills.com, was less than two years into his venture when the markets began to
soften during the summer of 2001. Matt had just received a term sheet from a respected venture capitalist and
a most unwelcome call from his bank:

In the late 1990s we had established a million-dollar line through a big bank in Silicon Valley— which at the time was giving
out credit lines like candy. We had drawn down that line and now our cash balance was $750,000—less than what we owed them.

So they sent over what they call an adverse change notice. At the time I had signed the documents I didn’t even know
what that meant; yeah sure, just give me the million dollars.

Now I realize that an adverse change notice is a small print clause that allows the bank to demand immediate
repayment of the outstanding balance—pretty much at any time they felt like it. If you can’t do that, they can take all
the cash on hand and begin calling in assets. So now, instead of running my business and raising money, I was meeting with
lawyers and fighting with my bank just to stay alive. Over time, it became clear that they were basically trying to squeeze
me for more—that is, warrant coverage as a percentage of the loan.

Seeing how dire the situation was becoming at LowerMyBills.com—and how close the venture had been to
turning the corner—original investors came forward to help out. Investor Brett Markinson said that they all
understood that Matt was the type of individual to support in a down market:

Everyone, including myself, had gotten sucked into the idea of raising as much money as you could and spending it on
making noise. Matt had focused on raising as little as possible; he just kept his head down and concerned himself with
driving value.

Since Matt hadn’t raised too much money and had maintained a lean infrastructure, he was in a good position to really
take advantage of the circumstances. While everyone else was cutting back or going out of business, Matt was able to rent
space at a great price and hire excellent talent at a great price.

With a couple of investors putting in their own money, LowerMyBills.com was able to pay off the bank and
secure the round. In the last quarter of that year, LowerMyBills.com posted its first profit, and in May 2005
Matt harvested the company for $330 million.



You first need to describe the business and its industry. Exhibit 16.5 suggests how a banker “sees a company” from what the entrepreneur might say. What are you going to do with the money? Does the use of the loan make business sense? Should some or all of the money required be equity capital rather than debt? For new and young businesses, lenders do not like to see total debt-to-equity ratios greater than 1. The answers to these questions will also determine the type of loan (e.g., line of credit or term):

1. How much do you need? You must be prepared to justify the amount requested and describe how the debt fits into an overall plan for financing and developing the business. Further, the amount of the loan should have enough cushion to allow for unexpected developments (see Exhibit 16.6).

2. When and how will you pay it back? This is an important question. Short-term loans for seasonal inventory buildups or for financing receivables are easier to obtain than long-term loans, especially for early-stage businesses. How the loan will be repaid is the bottom-line question. Presumably you are borrowing money to finance activity that will generate enough cash to repay the loan. What is your contingency plan if things go wrong? Can you describe such risks and indicate how you will deal with them?

3. What is the secondary source of repayment? Are there assets or a guarantor of means?

4. When do you need the money? If you need the money tomorrow, forget it. You are a poor planner and manager. On the other hand, if you need the money next month or the month after, you have demonstrated an ability to plan ahead, and you have given the banker time to investigate and process a loan application. Typically it is difficult to get a lending decision in less than three weeks (some smaller banks still have once-a-month credit meetings).

One of the best ways for all entrepreneurs to answer these questions is from a well-prepared business plan. This plan should contain projections of cash flow, profit and loss, and balance sheets that will demonstrate the need for a loan and how it can be repaid. Particular attention will be given by the lender to the value of the assets and the cash flow of the business, and to such financial ratios as current assets to current liabilities, gross margins, net worth to debt, accounts receivable and payable periods, inventory turns, and net profit to sales. The ratios for the borrower’s venture will be compared to averages for competing firms to see how the potential borrower measures up to them.

For an existing business, the lender will want to review financial statements from prior years prepared or audited by a CPA, a list of aged receivables and payables, the turnover of inventory, and lists of key customers and creditors. The lender will also want to know that all tax payments are current. Finally, he or she will need to know details of fixed assets and any liens on receivables, inventory, or fixed assets.

The entrepreneur–borrower should regard his or her contacts with the bank as a sales mission and provide required data promptly and in a form that can be readily understood. The better the material entrepreneurs can supply to demonstrate their business credibility, the easier and faster it will be to obtain a positive lending decision. The entrepreneur should also ask, early on, to meet with the banker’s boss. This can go a long way to help obtain financing. Remember that you need to build a relationship with a bank—not just a banker.

Exhibit 16.5

Exhibit 16.6


First and foremost, as with equity investors, the quality and track record of the management team will be a major factor. Historical financial statements, which show three to five years of profitability, are also essential. Well-developed business projections that articulate the company’s sales estimates, market niche, cash flow, profit projections, working capital, capital expenditure, uses of proceeds, and evidence of competent accounting and control systems are essential.

In its simplest form, what is needed is analysis of the available collateral, based on guidelines such as those shown in Exhibit 16.3, and of debt capacity determined by analysis of the coverage ratio once the new loan is in place. Interest coverage is calculated as earnings before interest and taxes divided by interest (EBIT/interest). A business with steady, predictable cash flow and earnings would require a lower coverage ratio (say, in the range of 2) than would a company with a volatile, unpredictable cash flow stream—for example, a high-technology company with risk of competition and obsolescence (which might require a coverage ratio of 5 or more). The bottom line, of course, is the ability of the company to repay both interest and principal on time.

Exhibit 16.3


A loan agreement defines the terms and conditions under which a lender provides capital. With it, lenders do two things: try to assure repayment of the loan as agreed and try to protect their position as creditor. Within the loan agreement (as in investment agreements) there are negative and positive covenants. Negative covenants are restrictions on the borrower: for example, no further additions to the borrower’s total debt, no pledge to others of assets of the borrower, and no payment of dividends or limitation on owners’ salaries.

Positive covenants define what the borrower must do. Some examples are maintenance of some minimum net worth or working capital, prompt payment of all federal and state taxes, adequate insurance on key people and property, repayment of the loan and interest according to the terms of the agreement, and provision to the lender of periodic financial statements and reports.

Some of these restrictions can hinder a company’s growth, such as a flat restriction on further borrowing. Such a borrowing limit is often based on the borrower’s assets at the time of the loan. However, rather than stipulating an initially fixed limit, the loan agreement should recognize that as a business grows and increases its total assets and net worth, it will need and be able to carry the additional debt required to sustain its growth; but banks (especially in tighter credit periods) will still put maximums after allowed credit because this gives them another opportunity to recheck the loan. Similarly, covenants that require certain minimums on working capital or current ratios may be difficult for a highly seasonal business, for example, to maintain at all times of the year. Only analysis of past financial monthly statements can indicate whether such a covenant can be met.


Before borrowing money, an entrepreneur should decide what sorts of restrictions or covenants are acceptable. Attorneys and accountants of the company should be consulted before any loan papers are signed. Some covenants are negotiable (this changes with the overall credit economy), and an entrepreneur should negotiate to get terms that the venture can live with next year as well as today. Once loan terms are agreed upon and the loan is made, the entrepreneur and the venture will be bound by them. Beware if the bank says, “Yes, but . . .”

  • Wants to put constraints on your permissible financial ratios. 
  • Stops any new borrowing. 
  • Wants a veto on any new management. 
  • Disallows new products or new directions. 
  • Prevents acquiring or selling any assets. 
  • Forbids any new investment or new equipment. 

What follow are some practical guidelines about personal guarantees: when to expect them, how to avoid them, and how to eliminate them.


Personal guarantees may be required of the lead entrepreneur or, more likely, shareholders of significance (more than 10 percent) who are also members of the senior management team. Also, personal guarantees are often “joint and severable ”—meaning that each guarantor is liable for the total amount of the guarantee.

When to Expect Them

  • If you are undercollateralized . 
  • If there are shareholder loans or lots of “due to” and “due from” officer accounts.
  • If you have had a poor or erratic performance. 
  • If you have management problems. 
  • If your relationship with your banker is strained. 
  • If you have a new loan officer. 
  • If there is turbulence in the credit markets. 
  • If there has been a wave of bad loans made by the lending institution, and a crackdown is in force. 
  • If there is less understanding of your market. 

How to Avoid Them

  • Good to spectacular performance. 
  • Conservative financial management. 
  • Positive cash flow over a sustained period. 
  • Adequate collateral. 
  • Careful management of the balance sheet. 
  • If they are required in the deal, negotiate elimination upfront when you have some bargaining chips, based on certain performance criteria. 

How to Eliminate Them (If You Already Have Them)

  • See “How to Avoid Them.” 
  • Develop a financial plan with performance targets and a timetable. 
  • Stay active in the search for backup sources of funds.

After obtaining a loan, entrepreneurs should cultivate a close working relationship with their bankers. Too many businesspeople do not see their lending officers until they need a loan. The astute entrepreneur will take a much more active role in keeping a banker informed about the business, thereby improving the chances of obtaining larger loans for expansion and cooperation from the bank in troubled times.

Some of the things that should be done to build such a relationship are fairly simple. In addition to monthly and annual financial statements, bankers should be sent product news releases and any trade articles about the business or its products. The entrepreneur should invite the banker to the venture’s facility, review product development plans and the prospects for the business, and establish a personal relationship with him or her. If this is done, when a new loan is requested the lending officer will feel better about recommending its approval.

What about bad news? Never surprise a banker with bad news; make sure he or she sees it coming as soon as you do. Unpleasant surprises are a sign that an entrepreneur is not being candid with the banker or that management does not have the business under the proper control. Either conclusion by a banker is damaging to the relationship.

If a future loan payment cannot be met, entrepreneurs should not panic and avoid their bankers. On the contrary, they should visit their banks and explain why the loan payment cannot be made and say when it will be made. If this is done before the payment due date and the entrepreneur–banker relationship is good, the banker may go along. What else can he or she do? If an entrepreneur has convinced a banker of the viability and future growth of a business, the banker really does not want to call a loan and lose a customer to a competitor or cause bankruptcy. The real key to communicating with a banker is candidly to inform but not to scare. In other words, entrepreneurs must indicate that they are aware of adverse events and have a plan for dealing with them.

To build credibility with bankers further, entrepreneurs should borrow before they need to and then repay the loan. This will establish a track record of borrowing and reliable repayment. Entrepreneurs should also make every effort to meet the financial targets they set for themselves and have discussed with their banker. If this cannot be done, the credibility of the entrepreneur will erode, even if the business is growing.

Bankers have a right to expect an entrepreneur to continue to use them as the business grows and prospers, and not to go shopping for a better interest rate. In return, entrepreneurs have the right to expect that their bank will continue to provide them with needed loans, particularly during difficult times when a vacillating loan policy could be dangerous for business survival.


1. Your banker is your partner, not a difficult minority shareholder.
2. Be honest and straightforward in sharing information.
3. Invite the banker to see your business in operation.
4. Always avoid overdrafts, late payments, and late financial statements.
5. Answer questions frankly and honestly. Tell the truth . Lying is illegal and undoubtedly violates loan covenants.
6. Understand the business of banking.
7. Have an “ace in the hole.”


According to the theory, one can significantly improve return on equity (ROE) by utilizing debt. Thus the present value of a company would also increase significantly as the company went from a zero debt-to-equity ratio to 100 percent, as shown in Exhibit 16.7. On closer examination, however, such an increase in debt improves the present value, given the 2 percent to 8 percent growth rates shown, by only 17 percent to 26 percent. If the company gets into any trouble—and the odds of that happening sooner or later are very high—its options and flexibility become seriously constrained by the covenants of the senior lenders. Leverage creates an unforgiving capital structure, and the potential additional ROI often is not worth the risk. If the upside is worth risking the loss of the entire company should adversity strike, then go ahead. This is easier said than survived, however.

Ask any entrepreneur who has had to deal with the workout specialists in a bank and you will get a sobering, if not frightening, message: It is hell and you will not want to do it again.

Exhibit 16.7


There is a much less known tar pit that entrepreneurs need to be aware of when considering leveraging their companies. Once the company gets into serious financial trouble, a subsequent restructuring of debt is often part of the survival and recovery plan. In such a restructuring, the problem becomes that the principal and interest due to lenders may be forgiven in exchange for warrants, direct equity, or other considerations. Such forgiven debt becomes taxable income for the entrepreneur who owns the company and who has personally had to guarantee the loans. Beware: In one restructuring of a Midwestern cable television company, the founder at one point faced a possible $12 million personal tax liability, which would have forced him into personal bankruptcy or possibly worse. In this case, fortunately, the creative deal restructuring enabled him to avoid such a calamitous outcome; but many other overleveraged entrepreneurs have not fared as well.