Dealing with the Credit Crunch: Insights for Business Owners and Budding Entrepreneurs
By Bill Zimmerman
Recently, tightening credit markets have created new challenges for countless small business owners. Just as it has become more difficult for homeowners to qualify for a mortgage, small business owners are finding that it is becoming more and more challenging to obtain bank financing to launch a new business venture or expand an existing business.
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Bill Zimmerman is a member of The Hartford's team of retirement solutions consultants.
In conversations with business owners and their financial advisors, I've heard that lenders today are looking more closely than they had been in recent years at a range of factors, including collateralization, existing debt obligations, the type of business seeking financing, and the business owner's expertise and experience. Given that less than half of new businesses started in the U.S. survive past the first four years, according to a 2005 Bureau of Labor Statistics report, the numbers are not in favor of start-ups.
However, by understanding what lenders are looking for when they analyze a credit application, and by working closely with trusted advisors with experience in such matters (i.e., accountants and financial planners), a business owner may improve the likelihood of getting approved for a loan.
Regarding collateralization, quality of collateral is key. Often business owners will pledge personal assets to qualify for small business financing. When looking at a business owner's collateral, lenders tend to assign greater value to safer assets such as cash and treasuries than they do to riskier asset classes such as equities. A good rule of thumb is to look at margin-lending terms, which reflect the loan value against the business owner's portfolio. Margin rates on treasuries, for example, could be as high as 90%, whereas one can generally borrow just 50% of the value of one's stocks. So, $100,000 worth of treasuries could get a small business owner a $90,000 credit line, while the same amount in stocks would only raise $50,000.
In addition, business owners can improve the likelihood that they will get financing, and at more attractive rates, by putting more "skin in the game." The more cash that he or she can put into the business, the more comfortable a lender may feel about extending credit.
With this being said, now is a good time for business owners to sit down with their trusted professional advisors to discuss the extent to which they should consider shifting their holdings in stocks and other relatively risky asset classes to less volatile investments, as well as to discuss how much cash they can afford to invest in the business.
Another key to attracting the interest of a lender is to reduce the business's debt-to-equity ratio. A big mistake entrepreneurs often make is trying to expand too quickly and taking on too much debt in the process. Business owners can improve their debt-to-equity ratios by using some existing cash flow to pay down debt. This way, when they sit before a lender, they can show that more of their profits are flowing to their bottom line and will likely be viewed more favorably by bank loan officers. Business owners should discuss this strategy with their trusted advisors to determine how much, if at all, they can afford to direct cash flow to paying down debt.
In my discussions with business owners, I've heard that lenders appear to be carefully scrutinizing the experience of the owner and the type of business for which he or she is seeking financing. For example, a start-up website design business might be seen as one that faces stiff competition from established industry players and would be at risk of becoming outdated as new technology makes it increasingly easy for businesses to design their own websites. In this case, such a business also may not have much collateral other than a few computers. As such, it likely would be seen as a risky loan candidate by a bank. However, if the business owner is a computer industry veteran who has held high-level positions with technology industry giants, the risks start to seem much smaller to the lender. While this same business owner might find it challenging to find financing for a new restaurant, his or her experience would likely make it easier to obtain credit for this web design venture in today's environment.
It may pay to be organized and present complete data when applying for business credit. Being able to show that one has a plan and is well organized seems especially important in this market, based on my discussions with business owners and their advisors. For those with unusual businesses or those with less-than-perfect credit, now may be a good time to cast a wider net when seeking bank financing. For example, a local bank may take a more qualitative view of a local small business than a larger national bank, which would tend to make lending decisions based purely upon quantitative criteria. Another reason to shop around is that some banks offer specialized lending programs for small businesses owned by women or minorities. For business owners within either of these categories, it may make sense to reach out to banks that offer such programs.
Despite the challenging environment, small business credit still appears to be available. Earlier this year, it was relatively common for lenders to offer home mortgages for more than 90% of the value of a home, even to those with questionable employment histories. Today, this practice has slowed considerably, as lenders require more of a down payment and are requiring documentation of an applicant's employment history. Home buyers can still get financing; however, they need to be stronger loan candidates than in the past.
The same may hold true for entrepreneurs seeking financing to launch and grow their businesses. Business owners who understand what lenders are looking for when extending credit may make themselves more attractive loan candidates and improve their odds of obtaining needed financing, despite market conditions. Of course, each business owner's situation is unique and should be discussed carefully with a team of trusted legal, financial, and business advisors.
About the Author
Bill Zimmerman is a member of The Hartford's team of retirement solutions consultants who works with financial advisors to help educate both individuals and small business owners about retirement challenges due to longer life expectancy, inflation, and other factors. To help business owners and their advisors identify and address issues related to protecting their business, growing their assets, and planning for their future, The Hartford has created The Business Owner's Playbook, which can be ordered or downloaded free of charge at www.thehartford.com/businessowner.
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