Is bank capital out of reach for start ups?

Given the difficulty that some established businesses are having with gaining access to bank credit, is it a complete waste of time for a start-up business to pursue a loan or a line of credit? Not necessarily.

Entrepreneurs looking for capital have several options, but how can they demonstrate to bankers that they are "loan worthy?"

According to Ken Thompson, president and CEO of Capitol Bank, loans are based on the lender's ability to predict the probability of future occurrences. Today, underwriting is more difficult, the state of the economy has made banks less willing to lend, there is a higher degree of difficulty when it comes to evaluating future cash flows, and placing a value on collateral is increasingly tricky — especially in troubled markets like commercial real estate.

"That's what is really stacked up against borrowers, and it's helpful for a borrower to understand that, to really talk to a lender as to what they would need to eliminate those uncertainties," Thompson said.

The first thing an entrepreneur would need is sufficient cash flow to service debt. They will need to convince lenders that top-line revenue will be at certain levels, and dial into the underlying assumptions with convincing evidence. One factor in their favor would be any signed contracts that would help bankers forecast whether they can lend off of accounts receivables.

"If you know what your accounts receivables will be, you can predict the type of receivables they are," Thompson noted, "and a lender will be more willing to use that as viable collateral."

The other side of the coin is to be very realistic with projected expenses. Bankers will give those "burn rates" heavy scrutiny, in part because they are easy to underestimate. It's not a particularly enjoyable exercise for an entrepreneur to examine expenses line by line, but lenders certainly will.

"We often see people kind of backing into those numbers, so they really need to go through them and look at each line item, and test in their minds how feasible it is because if you get one month into your business plan and you are way off on your numbers, that's generally not a good sign," Thompson stated.

Entrepreneurs tend to be visionaries, so they aren't intensely focused on the nuts and bolts of business formation. That's why the smart ones enlist the help of accountants, attorneys, and even bankers who turn them down. If prospective borrowers can't meet bank requirements, it's not unusual for bankers to refer them to other sources like the Small Business Administration, which issues loans through banks, angel investors, and organizations like the Madison Development Corp., which makes loans to small businesses.

A few things to consider: the SBA has received more funding for its various loan programs, and angel investors will require a piece ownership (and control) in exchange for helping under-capitalized businesses. Angels also will insist on a defined exit strategy.

Many start ups will be launched with the personal assets of the entrepreneur, or friends and family members, and the home equity loan is a primary source. However, in an era of suppressed home values, about one in four homeowners "are probably sitting on more debt than equity in their homes," according to Savant Capital Management's Brent Lindell. "If you are one of the lucky ones whose house is worth more, and you've got some equity built into it, it's probably a fairly viable source of capital," he said.

In better economic times, home values were appreciating and some lenders were willing to lend up to 90% of the value of a home, but with today's less stable home values, that limit has dropped to 80% for most lenders. "Lenders must justify their lending decisions with the [federal] regulators and demonstrate that they have sound practices and procedures in place," Thompson noted.

Of the other types of personal assets — retirement accounts, certificates of deposit, and mutual funds — the most viable option from a tax standpoint is reaching the age of 59-1/2 and tapping into a retirement account that you've been paying taxes on all along.

Accessing the funds in a retirement account before reaching that age is not advisable due to the 10% penalty on top of the income and other taxes that would normally be due. "The thing you would need to think about is the tax status of any kind of asset you have," Lindell noted. "If you took out $100,000, you've got to pay the tax due on it. If you're in the 25% bracket, tack on another 10% for the penalty, and up to 35% of what you're getting out has disappeared."

Tax ramifications, including capital gains, also factor into using CDs (at the end of the term) and mutual funds, some of which have varying penalties for "getting out" before the established time commitment expires.

Entrepreneurs should not completely give up on bank financing because there are signs that lending gridlock is starting to loosen. Recent reports indicate that large U.S. banks are increasing their lending to businesses, and that demand for loans is finally starting to rise. Thompson sees the same dynamic beginning to occur in community banks, which he said have enjoyed a renewed level of interest by local businesses because they want to deal with local decision-makers who make loan decisions based on local markets.

"Banks are very liquid, and I think the appetite for quality loans is very high," he said, emphasizing the word quality. "We are as liquid as we've ever been, so we'd like to grow our loan portfolio with quality loans. It's more difficult to do it because I think a lot of businesses are still in wait-and-see mode with expansion and investment plans."

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