by Paul Pillat
Businesses in need of funds generally look to banks first, which have traditionally been the largest source of capital for small to medium-sized companies. Historically, banks have also been the cheapest source of funds and since the 1980s have broadened their offering of services. They now not only lend, but advise – and among larger banks offer a number of services designed to assist their customer’s businesses. The effectiveness of your banking relationship depends to a large extent on the individual banker managing your account and to some extent on the constraints imposed on him via a bank’s credit policies.
Loans can take different forms including term, revolving, letters of credit and are designed to handle specific business needs. All loans come with different fee structures, terms and conditions, and collateral requirements. Most larger loans include financial metrics and other parameters in the form of loan covenants that customers must meet in order to continue to receive the extension of credit.
Terms loans, just as the name implies are loans for a specific period of time and are generally used to finance fixed asset additions and fund long-term growth (permanent working capital) or debt consolidation of a business. The term is usually no more than five years (unless the financing of real estate is involved) and the rates are either fixed or variable. The interest rate charged is based upon a bank’s perception of the inherent risk in the loan and a calculation of the spread required between a financial institution’s cost of funds and requirement to earn a profit on those funds. Term loans allow a business to spread the cost of the asset being acquired over its useful life and provides the borrower with a manageable monthly payment. Term debt is normally collateralized by a first lien on all current and long-term assets.
Credit lines, on the other hand allow businesses to borrow money in order to meet their short-term working capital needs. Credit lines are for up to a fixed amount and are not intended to mirror a company’s growth curve. The interest rate is either variable or fixed and these lines of credit are most often secured primarily by inventory and accounts receivable. Borrowers also need to consider additional costs which may be associated with a line of credit such as closing or underwriting points, unused lines fees and compensating balances. Very often, a financial institution extending a line of credit to a customer requires that the customer maintain their primary depository accounts with the same financial institution.
Letters of Credit (“L/Cs”) are issued by banks on behalf of their customers (borrower) to pay to a third party (seller of goods) an agreed-to sum of money upon the presentation of satisfactory documents, and whatever other stipulated conditions pertaining to a purchase of goods are met. One initial thing that often surprises new users of letters of credit is the attention to detail that is employed in reviewing and approving the required documentation. Delays are often result from incomplete or improper documentation. L/Cs come in many forms but are generally import, export, irrevocable, etc. Banks sometimes also issue “standby letters of credits” which are generally used as a payment guaranty for either the occurrence or non-occurrence of some event in conjunction with a business transaction.
There are three primary steps I would suggest a business use in establishing their banking relationship when buying a business as follows:
Step one is to analyze what their projected lending requirements are for the next twelve months, the next 24 months and the next five years. Use financial projections, economic trend analysis as to interest rates and engage an outside advisor who is skilled in this area.
Step two is to interview potential financial institution partners, tell them your story, try to understand their level of interest in your business needs and then request proposals from at least three different candidates. Clients often ask me how many we should interview and I usually recommend that one talk with at least five different financial institutions. Each proposal should be carefully analyzed based not only on its financing merits, but also on the interest and creativity exhibited by the banker who will be your primary contact with the lending institution.
Step three is often left out of the process and that is to negotiate…..negotiate……negotiate. The demand to put new loans on the books ebbs and flows among financial institutions. Only through continuous business sale negotiation can one determine who really has an interest in obtaining your business. Business owners who are uncomfortable with a proposed term, condition or loan covenant(s) should engage in a dialogue with the financial institution, providing compelling arguments why a change to or elimination of a requirement should be made.