Borrowing from a bank By Leon Presser- author of What it Takes to become an Entrepreneur Borrowing on a bank line of credit For a start-up without assets or revenues, obtaining a bank line of credit guaranteed by the company alone is extremely unlikely. A bank may give you a line of credit but only if you have the supporting assets to guarantee repayment personally. Be aware that even though you may be guaranteeing the loan with an asset such as your home, the bank may not give you the loan when they learn that you are going to be unemployed and risking all the money in a start-up. If you own a home and have equity in the home, you may obtain a mortgage. During periods of loose lending practices, such as 2005-2007, banks will lend you 80% to 100% of the appraised value of your home. In difficult economic times, such as the present, lending criteria are much stricter, and banks will lend you a much lower percentage of the appraised value of your home. There is a difference between a line of credit and a mortgage. In both instances, you will be required to use your home to guarantee repayment of the money you are borrowing. With a line of credit, you have the ability to borrow as needed up to a preset limit. You may or may not, at your discretion, draw money on this line of credit. With a mortgage, you are borrowing a lump sum of money up front. Accounts receivable line of credit Once you have a revenue stream, you can approach the bank for a line of credit based on your accounts receivable (i.e., the money owed to you by customers). In this case, you are guaranteeing any monies you borrow with your accounts receivable. After the bank eliminates any accounts receivable that are not acceptable to them, they will give you a line of credit of typically 70% to 85% of what is left. In difficult economic times the bank will be much more selective in the accounts that it accepts, and the line of credit will be at a lower percentage of the accounts receivable. You have to provide the bank with an updated list of your accounts receivable at agreed intervals of time, such as at the end of every month or every quarter. You must be aware of the following potential problem with this type of credit line. Suppose your current credit line is for $400,000, and you have borrowed $400,000. You deliver to the bank your updated accounts receivable showing the total amount of receivables as less than in the previous period. The bank will recalculate your new maximum credit line. If they determine your maximum is now $300,000, they will demand immediate payment of the extra $100,000 you have already borrowed.
It is very likely the reason your accounts receivable are down is that you have hit a period of low sales. By the time you update your accounts receivable, you may have identified the problem and begun to fix it or you may have already fixed it; however, it takes time for the accounts receivable to build up again. This is precisely when you need your credit line, and the bank is asking for repayment of $100,000! Such a situation can keep you awake at night, so plan carefully before you draw on all of your available credit. Here’s a word of caution about using your accounts receivable as collateral. It is important that your customers feel confident you are a growing firm that is going to survive over the long term. In order to gain business, your bigger competitors will say that you are a small company with weak financials and that you will not be around long. If the bank starts contacting customers in your accounts receivable list, they will in fact be providing ammunition to your competitors. You should discuss this problem with the bank. A reasonable bank officer will understand the issue and work with you. If that is not the case, look for another banker. When you initially set up your accounts receivable line of credit, it is almost a certainty that the bank will also ask you for a personal guarantee. If your company defaults on its debt, the bank will be able to come after you personally. When you begin your relationship with the bank, try to negotiate a written agreement that defines at what point the personal guarantee will be eliminated as your company grows. Also be aware that your loan agreement with the bank will probably have an “annual clean-up” clause in it. This means that once a year you must pay off any money you have borrowed and refrain from borrowing for a specified time period, usually thirty days. If your agreement with the bank incorporates such a clause, you need to plan accordingly. Once you have a revenue stream and a revenue history, it is an excellent time to prepare for the eventuality that you may need to borrow money. Banks are hierarchical organizations in which lower level staff members typically have impressive titles but little power. You need to make certain that you are dealing with someone who has the authority to make a decision on the loan you are seeking. For example, if you are seeking a $400,000 line of credit, you will be wasting your time talking to a bank officer who has an approval limit of $100,000. Do not hesitate to ask a bank officer to tell you his/her approval limit. In my experience, you have to persist to get this question answered. Of course, I must tell you that I do cover this topic and related issues in more detail in the book. I do want you to read the book. I also encourage you to go to the book’s website (www.whatittakestobeanentrepreneur.com) and subscribe so that you will be notified each time a new post occurs.