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You’ve got a great idea for a business. Or maybe you’ve had your eye on an existing business and you want to approach the owner about buying it. Either way, once you’ve made the decision that business ownership is right for you, now what?
In most cases, it’s time to start preparing for financing. Unless you have 100 percent of the cash on hand required to start or buy a business, you’ll need some help. Most businesses are started or purchased with some of your money and some financing from a supportive lender.
After reviewing your situation and your project, if the lender wants to help you move the project forward, the lender will also consider whether to use an in-house loan program or use a guaranteed loan program like those offered by the U.S. Small Business Administration (SBA).
In most instances, the SBA doesn’t offer direct financing to owners and entrepreneurs. With the exception of disaster relief loans, the SBA works through intermediaries. For business financing, this includes lenders, micro-loan programs and economic development programs.
Every project requires you–the owner– to put some of your own money at risk. It’s rare any lender will finance 100 percent of a proposed project. Your contribution to the project is “owner’s equity” and may come from cash or similar assets that have real market value; assets that will be used in the venture including buildings, equipment, inventory and other tangible goods.
Intangible assets like goodwill or proposed intellectual property are not good sources for owner’s equity because they are not easily converted to cash if the project fails. For a traditional in-house business loan, your lender may ask for an owner equity level of 30 to 50 percent of the project’s total value depending on the level of risk perceived in the project. Then the lender will finance the balance if the loan is approved.
SBA provides lenders with government-backed loan guarantees to make it easier for business loans to be approved. It offers loan guarantees of 75 percent or higher to lenders who use its programs.
These guarantees ensure that the lender is able to minimize exposure to risk in the loan and encourages them to make loans using smaller owner equity values. This increases the number of would-be business owners who are able to successfully apply for and receive business financing.
SBA programs recommend owner equity levels starting at only 20 percent. But SBA is primarily a cash-flow lender. If the deal’s annual cash flow or net income looks good, a lower owner equity level may be acceptable for SBA to qualify for approval.
What lenders and the SBA are concerned about is your ability to consistently make your loan payments in a reliable manner. One of the tools SBA uses when considering a deal for financing is a debt-coverage-ratio (DCR). Simply put, it looks at how many dollars of profit are available to service each dollar of financing. If it’s too tight, SBA worries that the borrower won’t be able to always meet his or her obligation and the loan will end up in default.
A good rule of thumb is $1.30 in cash flow after all expenses and salaries are paid for each $1.00 of principal and interest due, or a 1.3 : 1.0 DCR.
A $300,000 project would require an estimated $120,000 in owner equity and $180,000 in financing using a traditional in-house loan, or $60,000 in equity and $240,000 in financing using an SBA-guaranteed loan program. There are some fees for the SBA guarantee, but they are reasonable and off-set by the real opportunity to become a business owner.
Other factors may also influence how much owner equity is required by a lender. Industries that have a high or low rate of failure will affect equity requests. So will secondary collateral. Additional available owner collateral may be leveraged for a project. Lenders may place liens on other assets not associated with the business project as a form of security, ensuring their money will be repaid if the project isn’t successful.
SBA requires the borrower and their spouse to sign repayment guarantees that pledge any and all assets they own toward the loan’s outstanding balance, if required. In most cases, an entrepreneur needs to have some other personal assets or “net worth” to have borrowing success. This may include CDs and saving accounts, a home, cars or trucks, stocks or mutual fund investments, or other tangible assets. Retirement investments may be considered, but are not good forms of collaterals because they are hard to access until retirement age.
One lending manager for a national firm told me he “always gets the house” as collateral. He said it keeps owners focused on what’s important and keeps them motivated. “No one wants to go back and tell their spouse they just lost their home. It’s a measurement of their belief in the project and willingness to be responsible for the outcome.”
For anyone who will own 20 percent or more of the business, the borrower will need to provide his/her and their spouse’s, if married: three years of personal tax return; an updated and detailed personal financial statement with all income, assets and debt listed; a statement of personal history disclosing previous addresses, felonies and misdemeanors (if any); and any bankruptcies or credit issues. Usually, a FICO credit score of 650 or higher is required.
If you’re buying a business, you’ll need three years of historical financial statements from the business for sale including income and expense statements, matching balance sheets and tax returns. You’ll also need a 12-month trailing report– an income and expense report for the most recent 12 months– to bring the numbers up-to-date from the last fiscal or calendar year report.
Depending on the size of the project, you may need a third-party business valuation report substantiating the value of the business. If the project includes buying building and land, a real estate appraisal will be required and will be ordered by the lender.
A comprehensive business plan is required, along with forward looking month-by-month income and expense statements. The business plan needs to be as long as required to substantiate the real opportunity for the business within the scope for which it is being applied. A 50-page plan is not required for a $50,000 loan request, and a 10-page plan probably won’t be enough for a $600,000 loan. By the way, regarding content – no fluff please. If you say it, be able to back it up. Business plans need real data and facts, not just claims.
The financials are often the most difficult item for new would-be owners to produce, especially for new businesses. How successful will they be? How do they know? Lenders and SBA will use these forecasts to determine your project’s eligibility for financing. In most cases, producing two sets of financials are the best strategy; one showing the expected performance of the business based on your business plan, and another break-even model demonstrating what the business must accomplish to at least meet ongoing expenses and not lose money. Include a “Use of Funds Statement” too, showing, in detail, how all the money will be used.
As a proposed owner, you must have a reasonable level of education or experience to have success in the field or industry you are pursuing, or similar fields that will contribute to your success. Plan to include a resume with your loan application. Begin your planning early and allow enough time for other professionals to help with the project.
Putting together all of the information required to have success, and receiving assistance from business planning professionals who work with multiple projects and clients at any one time, requires time. Allow at least 30 days to get all of the your information together, another 30 days for professional assistance after everything requested from you has been provided, and another 30 days for a lender or SBA to review and consider the request.
Odee Ingersoll is an experienced valuation analyst, exit advisor, entrepreneur and national speaker. He is currently the director of the Nebraska Business Development Center (NBDC) at UNK.
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