As the U.S. economy continues its slow but steady recovery, many business owners are hoping to expand their companies.
“Nearly 89 percent of business owners report having the enthusiasm to execute growth strategies, yet just 46 percent report having the necessary financial resources to successfully execute growth strategies,” reports Pepperdine’s Dr. Craig Everett in the 2014 Capital Markets Report. The research is part of the Graziadio School of Business and Management’s Private Capital Markets Project that aims to understand the true cost of private capital across market types and the investment expectations of private business owners, according to the school’s site.
Plans for expansion combined with a lack of resources mean that private business owners will be searching for sources of capital during 2014. And if Dr. Everett’s research is any indication, many business owners will turn to banks for financing.
When the 951 privately held businesses were asked where they attempted to raise capital, banks were the most popular source, with 31 percent of owners contacting a bank in the last 12 months. Thirty-three percent did not seek additional capital.
Even though the majority of business owners polled were successful in securing funding, those that get turned down often don’t know why. But the 2014 Capital Markets Report sheds light on this frustrating topic for small business owners.
Why Small Business Loans Are Rejected
Dr. Everett asked banks why they turned down business loans. The banks identified “quality of earnings and/or cash flow” and “insufficient collateral” as the top two reasons.
Courtesy of Pepperdine 2014 Capital Markets Report
Lenders are looking at one critical feature when evaluating a loan – the level of risk.
For quality of earnings and cash flow, lenders like to see steady earnings that are predictable and related to the company’s core competency. They also like revenues to come from a diverse customer base, rather than one or two major clients providing the majority of revenues.
Keep in mind that special one-time transactions are not factored into a company’s earnings. For instance, a bank cannot count on a software business selling a piece of real estate year after year. Since real estate deals are not part of a software company’s core business, they won’t be considered as part of the company’s typical earnings.
Pepperdine inquired about collateral in regards to loans ranging from $1 million to $100 million. With a $1 million loan, collateral was a requirement 100 percent of the time, said bank survey respondents. Contrast that to a $100 million loan, where lenders required collateral only 63 percent of the time.
What To Do
To secure financing, private business owners need to take the same steps they would take if they were preparing their companies to be acquired.
While this may seem drastic, lenders and business buyers are both looking for the same thing when analyzing a potential loan or acquisition – low risk. If a company is taking steps to make it “buyer ready,” it’s also leaving the door open for other possibilities – such as getting a loan or infusion of capital from an investor.
Some of the same things that hurt small or medium businesses when they’re shopping for buyers for their companies are the same things that appear risky to lenders. Here are a few items that are perceived as risky by buyers/lenders:
- The business can’t function without the owner. This includes the absence of a middle management team or one that hasn’t been groomed to oversee day-to-day operations.
- The majority of the revenue comes from one or two clients.
- There are no recurring revenue streams.
- The company has a relationship with only one supplier.
- The business has zero or few written agreements with customers.
If your company has any of these traits, meet with your team and discuss the best way to change the situation. Very few companies can expand and grow without a source of capital. Bank lending, even lines of credit, is harder to come by today than it was before the Great Recession. But the good news is that you can implement steps to reduce the risk associated with the areas above that are not complex and time consuming.
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