Bank Loan

A bank loan is a loan obtained through and issued by a commercial bank. The are the most straightforward and usually the most cost effective form of financing. It is also one of the more difficult to obtain.

Types of Loans

Term Loan. A term loan is always funded upfront in its entirety and is paid back of the term of the loan, usually in quarterly or monthly payments of principal and interest. With small businesses, term loans will typically have a term of 1-2 years unless there is very strong collateral behind the loan, such as real estate or an investment portfolio of stocks and bonds.

Line of Credit. A line of credit is an amount of credit that is established up front (the line) but is funded as the business needs and requests it. It may be paid back at any time during the term and at any one point in time the total outstandings cannot exceed the amount that was established upfront. Lines of credit are intended for short term use to cover timing and seasonal issues. In order to insure the line is being used for these purposes, the bank may require that the line be fully paid down for a period of some duration (e.g. 60 days) during the term of the line.

Pricing

It is important to know what you will be paying for the loans. The following fees may or may not be a part of your loan:

Interest Rate: This is a part of every loan. It is frequently quoted as a percentage over the prime rate. The prime rate, in theory, is the rate banks charge to their customers with pristine credit. It is published in the Wall Street Journal and banks usually follow that rate.

Origination Fees: These are charged upfront to issue the loan and may be substantial. It important, when shopping for a loan, that you ask what the upfront costs are.

Commitment Fees: This is most often associated with a line and is a fee, charged as a rate on the unused portion of the line, for the bank to commit to the line.

Personal Credit Score

Banks will typically consider the personal credit of any person who owns 20% or more (sometimes 10% ore more) as a critical part of the loan decision. All owners will usually be required to personally guarantee repayment of the loan. This means that your personal assets become collateral against the loan. This is common for other forms of financing as well. Banks use a personal credit score, also called a FICO score or Beacon Score that is calculated based on a report they get from one or more of three credit reporting companies: Experian, TransUnion and Equifax. The highest possible score is 850 and the higher the score, the better the credit. Several factors influence the credit score:

Payment history--One of the most important, have you paid your obligations on time?
Amount of credit--How much credit do you have outstanding and how much do you have available.
Number of accounts--Debt spread over a limited number of accounts is more positive than having alot of different accounts, particularly credit card accounts.
New vs. old credit--Accounts such as credit cards that you have had for a long time hellp your credit score vs. having accounts recently opened. A history of closing and opening accounts will negatively impact your score.
Number of inquiries--every time you authorize an potential creditor to access your report, it is recorded. Too many inquiries will negatively impact your score.

It is very important that you know your credit score. There are many places that will run your credit report for free or for a nominal charge, such as www.myfico.com. Your credit score will impact your ability to obtain a loan and the rate on any loans you qualify for.

Qualifying for a Bank Loan

You apply for a bank loan through your local bank. Banks vary considerably in their requirements, but typical underwriting requirements are:

Personal credit score for all owners of 20% or more of the business of 650 or higher.
Business financial history and forecast of free cash flow sufficient to cover anticipated debt payments.
Assets/Collateral to secure the loan
Personal Guaranty

Banks typically do not lend to startups because of the risk involved, but may do so if there is real estate or an investment portfolio of stocks and bonds to collateralize the loan.

Loan Interview

You apply for a loan through your local bank, usually at a branch. You will be interviewed by the Branch Manager or a loan officer. Please keep in mind that the person interviewing you may not be the person who makes the decision on your loan. It is strongly recommended that you have a well prepared, written business plan. There are many resources that can assist you with this, please see SCORE under links. These are questions which will commonly be asked in an interview:

What is the loan to be used for? You will need a specific answer. "Equipment", for example, would be a broad answer, you should be prepared to discuss exactly what equipment you will be buying and demonstrate that you have identified and priced this equipment properly to arrive at your funding needs.
What is the background of the key management people?
What is the business, who is the target customer, and what is the competition?
What other sources of funding are being used? Banks and other institutions will want to see that the owners have some personal participation in funding the business.

Monitoring

Once a loan is issued, there is a monitoring process. You will usually be required to submit financial statements to the bank on a quarterly basis. IN addition, there will be provisions in the loan agreements where you agree to certain terms, known as covenants. Examples of covenants are:

Maintain a certain ratio of debit to equity in the business
Maintain a specified level of free cash flow.
Agree that you will not add any more debt or otherwise pledge your assets without permission from the bank.
Agree that you will not sell assets except in the course of ordinary business.
Agree that you will not materially change the ownership of the business without the bank's consent.

If you violate any of these terms, it is known as breaking a covenant and the bank may terminate the loan and any outstanding amounts will be immediately payable. Often there is negotiation with the bank and the bank agrees to waive the covenant(s) on a one time basis. Ther may be a cost associated with waiving a covenant.

Renewal

Finally, when the loan comes to the end of its term (usually before), you will decide whether to pay the loan off or renew it. Renewal processes vary, but usually repeat the underwriting process, although it will be more streamlined since the bank now has experience with the business. You may also be assesed origination fees again.