There’s an old joke that says, "If you ever need a heart transplant, be sure you get a lender’s heart … because you know it’s never been used!" Well…as former bankers
we know this is just a joke … uh, er, right?!

While lenders can sometimes be ornery (especially if their loan isn’t being paid), borrowers need to share some of the blame for their lender’s congeniality (or lack of it). Small business owners and entrepreneurs are oftentimes good salespeople, and, being natural optimists and risk-takers, they will put themselves in debt, then … see if they can sell their way out of it!

Too often, business owners are so anxious to get a loan they don’t take the time to make sure it’s the right type of loan with the right terms and conditions. Being over-leveraged or having the wrong debt structure is a major reason why so many businesses fail. While we cannot guarantee business success, we can guide you through the most common forms of debt financings, ranging from short-term to long-term debt structures:

• Trade debt financing (the most fundamental of all financings) is utilizing the full terms granted by your trade creditors (suppliers), or even stretching out payments beyond normal 30-day terms. Although trade debt financing is often an option, requires no collateral, and offers flexibility, there are hidden costs. In addition to friction created between you and your suppliers, some creditors will charge late fees (typically 1 _ percent per month) and you may forfeit financial benefits from discounts on early payment. For example, not taking advantage of discount terms of 2/10, net/30 can result in losing an opportunity cost of over 18 percent. Almost all businesses can take advantage of trade debt financing to some extent in order to optimize their cash flow; at the very least, you should utilize trade terms to their fullest.
• Factoring is selling accounts receivable to a lender at a discounted rate and without recourse to your company. While you receive cash immediately, discount rates are high (typically ranging from 2 to 15 percent). On an annualized basis, this could mean a cost higher than 50 percent. Factoring is helpful only to businesses with extreme short-term cash needs that cannot, for whatever reason, obtain traditional bank financing.
• Bank loans to businesses are frequently written as 90-day notes. Generally appearing on a company’s financial statement as "notes payable", the 90-day note is secondary in importance to trade credit as a source of short-term financing. It usually provides financing for a singular purpose and is priced aggressively --- floating at or above a short-term index such as the prime rate. Although an excellent source of financing, a 90-day note is typically available only to the most"credit-worthy" companies with a strong cash flow, balance sheet, and history of profitable operations. Ironically, when your company is in the best position from a credit risk standpoint is when typically you need it the least!
• A line of credit is an agreement between a lender and your company for loans up to a specified committed amount (commonly referred to as asset-based, receivable, or inventory financing). It typically allows for multiple advances (not exceeding the maximum amount the lender has agreed to commit) and repayment of the line of credit over the committed term. Your company will most likely have to provide collateral, usually consisting of short-term current assets such as inventory and receivables. Credit advances are based on a borrowing formula of a percentage of inventory and receivable values (typically 75 percent of current receivable balances and 50 percent of viable inventory balances). The lender will charge an interest rate that fluctuates at or above the prime rate, and a commitment fee of one to three percent of the committed line of credit amount. A line of credit is a good source of financing for manufacturing and distribution companies with short-term working capital needs.
• A term loan is a contract under which your company agrees to make a series of interest and principal payments on specific dates to a lender. You will need to show the lender that your cash flow will cover monthly payments (called debt service) and you will need to commit collateral such as equipment (long-term equipment financing) or real estate (mortgage financing). A fixed rate will most likely be put in place for the entire duration of the loan and appraisals on the equipment or real estate may have to be completed at your expense. Term loans are a good fit for companies with large amounts of fixed assets and equipment such as manufacturing, farming, and construction-related businesses.
• Lease financing is a monthly rental / lease fee for equipment, rather than an out right purchase of equipment. Lease financing is similar to term loan financing and is a popular form of financing for capital-intensive businesses with high investments in fixed assets or equipment that becomes obsolete quickly (like computers). The two most common types of leases are:
  • Operating leases, sometimes called service or true leases, provide both financing and maintenance. They are typically short term and, when completed, have not fully amortized the asset. At the end of the term of the lease, you will return the asset to the leasing company. This type of lease is a good fit for companies that do not want to capitalize equipment and incur liabilities on their balance sheet.
  • Financial leases, sometimes called capital leases, are more long term in duration. They also do not provide for maintenance service, are not cancelable, and are fully amortized when completed. Financial leases are considered to be a type of long-term debt financing, and therefore the asset is capitalized and the offsetting liability is recorded on your balance sheet.
• Although we don’t have room in this article to discuss them, other specialized types of debt financings include hybrid forms of debt financing with equity conversion options, such as mezzanine financing and convertible debentures.

Whichever option you decide, applying for commercial credit can be complex and requires a significant amount of preparation on your behalf. To increase your likelihood of success, you should prepare a credit initiation memorandum with complete financial information, an abbreviated business plan, and an explanation of the purpose and repayment plan for the debt. We can’t stress enough the importance of a good credit initiation memorandum and business plan!

Loan documents aren’t exactly known for being user-friendly, and can contain such provisions as negative and positive covenants, 10 percent offset-rules, unused line fees, etc. If you are confused about all the options and loan document provisions, or don’t have the time or skills to prepare the credit initiation memorandum and business plan, consult an expert in financing for assistance. This expert should also be able to help you identify which type of financing is right for you and where you can obtain the optimal amount of credit with the best terms.

Choose a financial institution with a reputation for supporting small, growing businesses. Some lenders focus principally on consumers, so choose one that is in touch with your needs --- ask other entrepreneurs who are their sources for credit, and their experiences in obtaining financing.

Lenders want to do business with companies that can demonstrate their ability to repay the debt. You will need to show the lender that your cash flow projections will cover monthly payments and that you have build sufficient collateral (accounts receivable, inventory, and equipment) to cover the value of the loan in case of default.

Financing is a continual process for growing companies. By making sure that you find the right types and terms of debt financing for your company … debt will not become a four-letter word for you.