Most small business owners focus upon conserving cash for working capital and for the growth of their businesses. Government-backed financing, with the SBA loan program, is a popular form of small business real estate financing to achieve this goal.
Small businesses may qualify for financing with longer repayment terms, lower down payment requirements, and more lenient underwriting guidelines with the SBA loan programs 7(a) and 504. Qualifying for a small business real estate loan is different than qualifying for an investment real estate loan. With investment real estate, the lender focuses upon the quality of tenants in the project along with the quality of the location. With small business real estate financing, the lender focuses upon the health and viability of the small business which will own and occupy the real estate. A small business lender uses five components in his analysis of a small business loan request.
Business Management Experience
The foremost reason for business failure, and therefore a loan default, is the lack of sufficient management experience in the industry in which the small business owner participates. A lender will gather information about the business owners to evaluate the education and business track record of the owners to ascertain their likelihood of continued success in the subject business. The more education and successful industry experience the business owner has, the less risk is perceived in lending money to that business.
Business Cash Flow
The business’ income is recognized as the primary source of repayment for a small business real estate loan. The historical track record of the business’ income is the best indicator of its profitability and success in the future. A small business lender typically uses the business’ last three years income tax returns, plus current interim financial statements, to evaluate the amount of cash flow available to make loan payments. The available cash flow in each period is compared to the proposed loan payment requirements to compute debt coverage ratios. Small business lenders generally like to see debt coverage ratios of 1.2X or better. A debt coverage ratio of 1.2X indicates the business has available cash flow which is 120% of its operating expenses and loan payments. That 20% cushion gives the lender comfort that the small business has adequately planned for unanticipated business expenditures.
While a small business lender becomes a partner in the business by extending credit, they are not an owner. A business owner (or equity partner) invests in the business, assumes risk, and he or she is rewarded for that investment risk with dividends and other forms of compensation. A small business lender, however, receives only a stated rate of interest on the money they have invested, and their risk should be commensurate with limited return on their investment. The small business lender expects to see a small business borrower with sufficient “skin in the game” to work hard and achieve success. Once again, the lender will employ ratios to ascertain safe levels of owner equity when making loan decisions.
The most common ratio is the debt-to-equity ratio. Small business lenders have access to statistics for various industries which indicate an appropriate level of leverage for the type of business for which a loan is being considered. Fortunately with the SBA loan program, lenders are more flexible with types of equity (or “skin in the game”) which can be considered. Not only can the SBA lender recognize cash dollars invested in the business by its owners; but also, assets outside the business pledged as additional collateral for the loan, will enhance what the lender considers equity.
Finally, if a small business owner is buying business assets, and the seller agrees to subordinate standby financing, the SBA lender can enhance its debt-to-equity ratio this way. For instance, a seller of real estate may not be willing to negotiate a lower sale price; however, they are willing to carry a second lien note to help the buyer qualify for financing with a lower down payment requirement. If that seller agrees not to require payments before the SBA loan is paid, the SBA lender can add that amount to the buyer’s qualifying equity. The down payment requirement for SBA financing of a business acquisition or a business real estate purchase is typically half the amount of down payment required for a conventional bank loan and can be as low as 10%.
Lenders love statistics. The best indications of how a borrower will meet his loan obligations in the future are the statistics reflected on a credit investigation that shows how other creditors have been paid by the borrower in the past. Small business lenders evaluate the repayment records of the individuals who own the business, as well as for the business itself. Credit reports are available from credit reporting agencies, as well as from direct contact with previous creditors. The more debt that reflects satisfactory payments in accordance with the loan terms, the more comfort the small business lender will derive from them.
We have established the fact that a lender is not an owner, and the lender should only assume a level of risk that is appropriate for the limited income they will receive from lending money. It should be evident, therefore, that the lender will look for other ways to decrease their lending risk when approving loan terms. Besides evaluating risk based upon management experience, “skin in the game”, cash flow repayment ability and credit history, the business lender will also look at collateral offered for the loan. Collateral is represented by assets that can be sold to recover losses if loan payments can no longer be made by the small business borrower. Typically a lender will use the assets being financed as collateral. Other business assets and personal assets can be added to the collateral package to decrease the lender’s risk and to enhance a borrower’s chances for loan approval.
Every small business lender will perform a strength and weakness analysis for each of the five afore mentioned criteria. When strengths outweigh weaknesses, the loan is approved.