Foundations of New Venture Finance 271- When is the money needed? Is it all going to be used now, or is it possible to draw
down a balance over time?
Of primary importance to the lender is the firm’s ability to repay the loan. That is the
first criterion. In considering the loan application, bankers also look for five things that
all begin with the letter C.^21
- Character. The banker’s best gauge of whether the entrepreneur will be willing and
able to repay the debt is his or her previous borrowing and business experience. To
pass the character test, the borrower must be credit-worthy and a person of demon-
strated integrity. - Capacity. This is a numbers game. The banker wants to be sure that the business has
the capacity (ability) to repay the loan—interest and principal. Evidence of capacity
is the cash flow, the coverage ratio (earnings divided by debt service), and any per-
sonal guarantees. - Capital. The lender is not interested in financing a business if the loan is its only
source of long-term capital. This would mean 100-percent leverage. In case of
default, the bank would own the business, and banks are already in a business of
their own. They are interested in companies with sufficient equity to indicate that
(1) the owners of the firm are putting up their own money in good faith because
they believe in the deal, and (2) the debt/equity ratio of the venture is in line with
comparable types of businesses. - Conditions. These particulars of the industry, the firm, the general economy, and the
current risk position of the bank add complexity to the lending decision. The entre-
preneur’s business may be in good shape and the entrepreneur of fine character, but
if the economy is taking a turn for the worse and the venture’s industry (for exam-
ple, construction) is leading the way, then the banker may deny the application.
Banks are always in a position of asking, “What can go wrong here and what hap-
pens to our depositors’ money when it does?” Bankers are generally risk-averse. - Collateral. If a loan has collateral, the creditor can sell a specific asset to ensure that
the principal and accrued interest obligations are met. Collateralized loans general-
ly have a slightly lower interest rate than unsecured loans, but the quality of the col-
lateral is important if the lower rate structure is to apply. Some assets may not be
salable at anything approaching the value of the loan, so although these may be
required as collateral, they will not lower the rate. For businesses with short oper-
ating histories and service businesses with little tangible property, collateral often
takes the form of personal guarantees and key-person life insurance.
Searching for a Lender. Entrepreneurs often find themselves in a seller’s market when
it comes to searching for a loan. Sometimes it may appear that the chances of receiving
a business loan are zero, but the entrepreneur can do a few things to improve those
chances. First and foremost, the entrepreneur must meet the requirements of the five Cs.
Then the management team can begin to shop around as if they were hiring the bank to
be their lender.
As in any hiring situation, they should check the bank’s references. Other people who
do business with the bank will be able to tell them whether it is a friendly institution,