Rory Earley, CEO of Capital for Enterprise, looks at the ramifications of getting a bank loan to fund growth opportunities.
Last month, we looked at whether the banks really were lending to small businesses and what was driving their behaviour. This month I’d like to pose a few questions about how growing businesses consider and decide on their financing needs.
Most small businesses can survive on their income and profits, paying suppliers, wages, rents, rates and taxes and hopefully leaving a bit over for the owners. They may have the odd cash hiccup, but can cope with some overdraft support or, woe betide, stealing a few days' extra credit from their suppliers. Even in tougher times, costs or margins can be shaved and life can remain bearable, if not necessarily pleasant.
But what about those businesses with a real opportunity to grow, even given the current state of the economy? A competitor may have gone under, you may have found a new lower-cost supplier or some other innovation. Remember, innovation is what gives you some competitive advantage. It’s only rarely about some spangly new technology, more often it’s just about finding a way of doing things better than the competition, better people, better systems, better marketing, better pricing, just different and better.
The first problem is how to find the investment that you inevitably need to finance that growth. You might need funds for an acquisition, new plant or equipment, more people and inevitably, working capital. If you don’t have the money to hand, you need to make a few decisions – and it really is worth spending some time thinking about what is best for you and your business.
Now, entrepreneurs are a pretty savvy bunch and the first thought that usually enters the mind goes like this: 'If I can borrow the money from the bank, I can repay it from the extra profits I’ll be making and then I’ll be left with a bigger and more profitable business for me. The sun is shining, let’s make hay!' Clearly, that’s a great strategy, you just need the confidence that the extra profits and cash are more than is needed to service the loan and you’re on the home straight. But let’s look a bit more closely at the merits of that option.
Firstly, the bank might not share your optimism about future income, profits and cash. If so, the answer is NO and the strategy crashes to a resounding halt. But what if you are making some progress with the bank, you’ve fawned over your relationship manager, demonstrated your excellent account behaviour in the past, convinced him or her that your projections are soundly-based and signed up to a charge on the business assets and a personal guarantee. The answer is yes and the future is bright.
Now let’s look at the risks. Boring and negative I know, but important all the same. What if:
• the lead times on new equipment are longer than promised?
• there are unexpected costs associated with extending/building/buying/leasing new plant capacity?
• you can’t recruit the right people or they have to serve 6 month’s notice before they come to work for you?
• your key salesperson leaves for a career change/break, for a competitor, goes on maternity leave?
• your biggest customer decides to pay you on 90 day terms, not 30 days?
These and many other things potentially mean that the extra profits and cash don’t come through when you expect them to. If your projections didn’t take all of the possible eventualities into account (and how could they?) you might be short of cash to meet your loan repayments. You might see this as a short-term issue, just timing, but for the bank it’s a big problem.
When you go to the bank to ask for a reschedule or a capital repayment holiday, you will likely be reminded about the covenants you signed up to in the loan agreement. You will probably find that you are either already in breach, or just about to be, and you will find that the bank has lots of rights over your business because of this.
Last month we looked at what is most important for the bank – protecting their depositors and shareholders by making sure that loans get repaid. That has to be their primary interest. If there is any doubt in their mind about whether you can repay, they now find themselves able to exercise all sorts of rights that you have agreed to in order to protect their money. At the very least, they will consider increasing the margin they charge on your loan. But they could appoint an investigating accountant, at your expense, they could ask you to appoint a receiver and, if so, you could find your business gone and your personal assets under threat. And, for you, nothing about the business prospects have changed.
So how great is the strategy of borrowing from the bank to finance growth? It can certainly work in many cases and does leverage returns to the business owners when things go well. BUT it does not come without risks. Those risks are higher in the current environment and you need to consider them carefully, and consider the alternatives, which may be more plentiful than you think.
Next month, I’d like to explore some of those alternatives; business angels, specialist lenders and venture capital. There are myths and legends around these that merit a good look at and it is worth comparing the risks they pose to your business and you, compared to the risks of bank finance.
See also: Financing routes