The Bottom Line

What do banks look for in a new business idea?  In the initial review they look for a few basic things:

A) Your plan must turn a profit at least before the time you run out of working capital (cash).  This tells them if the project is properly capitalized.  Undercapitalization is one of the leading causes of business failure.

B) Most lenders look for a debt coverage ratio of at least 1.25 or greater.  This means that after all operating expenses are paid the businesses should generate on a cash basis at least 125% of the annual loan payments.

C) Lenders are also are interesting in seeing that you are able to pay yourself a reasonable salary or owners draw.  If you aren’t able to pay your self you will not continue to run the business and may default on the loan.  

The C’s of Financing a Business

Beyond that, financial institutions are interested in one thing...reducing their exposure to risk.  In order to do this, financial institutions require borrower to secure loans with collateral, invest owners’ capital in projects, and apply for government guarantees.  The following list of criteria, known as the C’s of Credit, are used to analyze a project:

o         Credit – Know your credit Score.  Go to www.myfico.com to purchase a copy of your credit report that includes your score, a summary of factors affecting your score, ways to improve your score, and how lenders will view your personal credit history.  Generally scores over 700 are considered low risk, 650-699 moderate risk, and less than 650 high credit risk (although this varies with each lender and the reasons for a lower score).

o         Capital – Also called equity will be required by your lender.  Equity is the cash or assets that you contribute to the start-up costs of going into business.  Generally 10% of the total project is considered a minimum.  Projects that score low on other factors, particularly collateral, will have higher equity requirements.

o         Collateral – Assets used to secure a loan.  Common items include Building, Equipment, and Furniture & Fixtures.  Inventory and Accounts Receivable may be used on a more limited basis in some projects.  Intangibles such as Patents, Trademarks, Franchise Agreement and Goodwill provide little value for resale and are generally considered to have no collateral value.

o         Capacity – The project's ability to repay a loan from the cash flow it produces.  Lenders look for a debt coverage ratio of 1.25 or greater as explained above. 

o         Character – Character is the experience, education and background of the owners and key management.  For the most part the management section of your business plan should give the lender a good idea whether or not you and your team are qualified to successfully start and grow your business opportunity.

o         Conditions – Refers to the terms of the loan.  Most business loans have an interest rate of 1%-3% over the current prime rate (available at www.bankrate.com ) or the rate that the best businesses can borrow at.  Terms depend on the collateral used to secure the loan and are usually matched to the life of the underlying assets.

Small Business Friendly Banks

It is important to find a “Small Business Friendly Bank”.  Generally, these banks have a history of lending to small businesses and know how to utilize government backed loan programs.  One major characteristic of a “Small Business Friendly Bank” is a tendency to lend money with more weight given to the experience of the entrepreneur.  Consequently, these banks are known as Character Lenders. 

Banks that lend money with more weight given to credit, collateral, and capital invested are known as Ratio Lenders because they concentrate more on the numbers than the abilities of the owner.

Credit Unions are another possible source of small business friendly capital.  Not all credit unions offer commercial (business) loans so check with your area credit union before assuming they have financing available.  Most credit unions that offer business loans have a tendency to be more liberal in their lending practices and can many times offer better interest rates and lower fees.

Finally, as a general rule, locally or regionally based banks are typically friendlier to start-up companies than the national banks although there are exceptions to this rule.  Both Wells Fargo and US Bank run in house programs geared to small business and start-up businesses.