Financing A Hotel Ownership or Management Business – Practical Advice

Financing A Hotel Ownership or Management Business – Practical Advice

By Andy Anderson, and Russell C. Savrann

“Money isn’t everything, but its way ahead of whatever’s in second place”.
(Author unknown)

You need money; and you know you need a plan to get it. What is it about money that evokes the fear in getting it? We have a great idea; why doesn’t the world rush to our door with money to make it happen? We see projects being funded that don’t hold a candle to ours, so how did they do it?

You Need a Plan

Some of us plan intuitively, while others require the discipline of structure. Regardless, most of us need to be mindful of seeing through the eyes of the lender or investor.

Some Good News and Some Bad News

It is not critical that you understand all details of the contents of this article. Instead think about how the broader concept of planning, information and execution apply to your situation. Please understand that the process is more like a triathlon, than an Olympic sprint. It is OK if you walk when others are running. Your commitment to crossing the finish line is what matters.

Creating a Business Plan

People who have money and are in the business of leveraging it, by lending it out, want to know you have a plan to get it back to them; with interest, of course.

Creating your business plan is the first and most important step in this process. The business plan is the foundation of your vision and blueprint for your path to success. But more importantly, unless you’ve found the one true altruistic lender, it’s the document that gives your lender insight that you know what you’re doing and have a good chance that he or she will get his or her money back.

Your business plan will be one of the first items requested by any lender interested in either giving you capital in exchange for a loan or an ownership stake in your venture. Whether you are sourcing debt or equity, your business plan is the cornerstone. You’ve likely seen business plans, or read literature on what they contain. If so, this may resurrect some of the old cob webs in the back of your mind. If not, read on, this may provide a useful outline to what you’ll need to get the dollars you need from a lender.

The Executive Summary (Where the Plan Starts)

This is where you get to share your idea from 40,000 feet. The purpose of the summary is to capture the attention and get the interest of those you are asking to support you financially. This is the one section where you get to take poetic license. You’re allowed to paint the rosiest picture possible. The one caveat to that is, once you have the lenders attention, you need to be prepared to drill it down with facts and hard data to be credible. Bottom line: don’t make promises you can’t prove you can keep.

There is a limit to the liberties you’re allowed to take. Perhaps Bill Cosby said it best, “Don’t write checks with your mind your body can’t cash!” Don’t make promises to a lender you’re not prepared to prove you can keep.

Ask yourself, “What’s the main objective of my business?” Write it as simply as possible. Don’t get esoteric (words only few understand) to get your point across. You’re already smart enough to be in business for yourself, the only thing you have to prove is your plan is logical and can return an investment.

How do you do that? You outline your strategies and define goals that are measurable. Keeping it simple in the summary will infer there’s meat in the bun later in the plan. You’ll have plenty of opportunity, later, to dazzle the lender with detailed descriptions and economic data that supports your marketing and business plan. Suffice, at this point, to get them interested to read more. If the idea grabs them your job will be to demonstrate the “how”, in the details.

It’s appropriate to highlight:

• The Legal and Tax structure, i.e., Sole Proprietor, Sub S Corp, C Corp, etc.
• The location and number of outlets
• The nature of operations
• Your management team and the relevant expertise they will contribute to the success of your business. Note: The more experience your team has in your specific business, the more likely a lender will be in assessing a positive risk in lending you money. Without that it will be more difficult to raise capital. This isn’t to say individuals who are evaluating your business as an investment won’t recognize the value of thinking outside the box. But, it’s important to address the credibility question when it comes to your ability to follow through on you vision.

Making You, and Your Team, Credible in the Eyes of an Investor

Investors will tend to look more favorably at an entrepreneur who has experience in what he or she is about to undertake as an aspiring owner. In other words, if you want start a copy company, it would be very helpful it you worked for IBM or Zerox, or some other notable company in that business. Is it absolutely critical? No, but, and it’s a big but; there needs to be some sensible transition from where you are now to where you’re going.

• The analogy of securing a piano teacher for your child comes to mind. You read the resume of the teacher in contention for the job and it reads, “Moved Piano’s for five years”. You’re probably going to pass.
• If you are just starting out in a new field or are new to business, you can seed your advisory board with senior seasoned business advisors who are willing to guide you. Having these “big” names behind you can be of real value. For example we are assisting a person with bringing a product he invented to market. Our client is an entrepreneurial sales representative. We have invited on his advisory board the retired chairman of a nationally recognized consumer products company (for strategy), the former president of a national marketing agency (for marketing), a senior executive from within the industry to whom the product will be sold (for industry credibility and testing) and myself (for legal). In creating this advisory team outside the day to day operations, our client proves to investors and lenders he has the wherewithal to surround himself with credible senior people who believe in the business.

Bottom Line:

• If this is a first time venture, have plenty of relevant experience in the pursuit you are about to undertake or surround yourself with people willing to lend their support to you who do have the experience.
• Be able to prove you are, or were, successful in the job or business you are leaving qualifying you to start, or capitalize the new venture.
  • Examples may include awards, letters of recommendation, or recognition from affiliated associations.
• It’s important to iterate your awareness of potential changing business conditions like; emerging new competition, proposed governmental regulation, potential inventory fluctuation, etc. This will lend confidence to a lender or investor you are aware, and prepared, to deal with market vacillations.
• Anticipating change does not mean jumping ship. If you’re in the burger business you may need to add salad to the menu to stay current with demand but you wouldn’t add a drive through laundry drop off to bolster revenue. You want to inform your investor you intend to stick to the knitting.

The Marketing Plan

The marketing plan is the place in your business plan where you convince your audience that you have a product or service that is high in demand or that your product / service will be in increasing demand.

The marketing plan will provide third parties with a view of your short and medium range marketing strategies. Since markets and strategies are constantly changing, your marketing plan must reflect the evolution of your market entry. It’s not at all uncommon to have a “Pre-opening plan” followed by one, two, and three year plans. Each marketing plan initiative will be measured by expected milestones that convey market capture as well as the expenditures that will impact cash flow.

One of the most important elements in any marketing plan is identifying your target customers supported with the benefit analysis of why they would want to buy your product or service. This could be the single most important component in influencing an investor. The due diligence and research you conduct will reflect the depth of your knowledge about your business. A competitive survey of like businesses will support your rationale for capturing your target segment. Knowledge of your competition will also serve useful in developing your strategic initiatives. If your most aggressive competitor is selling Happy Hamburgers for two for a dollar, you’ll likely want to develop a unique selling proposition that won’t undermine you margins. Your rationale supporting the price point for your product or service will be heavily scrutinized. “What makes you think your value proposition will steer the market away from your two for a dollar competitor?” Those are the types of questions you’re likely to hear while you’re defending, and we do mean “defending” your proposal.

Your marketing plan may well include a media schedule and budget exposing costs of trade shows, webinars, travel budgets, and third party affiliations.

Don’t be shy about “footnoting” your data. An addendum supporting your statistics gains the investors trust and respect for what you are proposing. When it comes to the numbers, be succinct and to the point but be able to back it up.

The level of finesse required in a marketing plan is commensurate with both the amount of money you’re trying to raise, and the level of sophistication in your industry.

The goal of the marketing plan is to convince a commercial banker or investment banker that you have done your marketing homework, that you have a full command and knowledge of your intended consumer, your target market and your marketing strategy. Remember, this is your sales pitch. It is in this section the world will judge whether you and your idea have a chance of success.

The Economic Plan

The economic plan is the section of your business plan that lays out the cold hard facts: If you make a widget or agree to provide a service, what will it cost to provide that product or service and can you actually be profitable doing it?

Let’s get inside the mind of an investor, or lender, for just a minute. He or she is thinking, “Ok, this looks good: great idea, good strategy, their experience is right. But will it be a profitable venture?”

This is where the rubber meets the road. At the end of the day, to coin an old, tired expression, (still being used today), it’s all about cash flow and return on investment. Your job is to demonstrate that your fancy marketing plan, worldly experience, and energetic team can deliver the goods: the ROI –Return on Investment. Unless you’re dealing with mom or some rich relative, the asset manager making the decision about whether your deal is the one they’re going to take the risk on, the Pro Forma, sometimes spelled Per Forma, is the road map that guides the decision. These guys live in the world of spreadsheets and hurdle rates (don’t ask). This is the playbook from which they determine the worth of your business or idea.

Be prepared to test your assumptions. For example in one recent hotel company budget review the chairman found a small incremental error in the cost of soap that undermined the multimillion dollar proposition. The proposed budget was intended to increase revenues by $20M over the prior year revenues of $130M. A 13% increase over the prior year would have been a nice bump to the bottom line. The problem was, it wasn’t all falling to the bottom line. (Meaning all the incremental revenue was not realized as marginal profit.) The reason it didn’t all hit gross operating profit? The incremental revenue was being generated, in part, by increasing volume (vs. all in rate, or price) and, therefore, lost some of the increase to variable expense. Believing the budget was bullet proof the Achilles heal was in the soap line item.

The point of the story is to arm you with awareness to understand scrutiny, (an understatement), will be applied to your numbers. Forewarned is forearmed, as the expression goes.

Your pro forma reflects your business intelligence, due diligence, and forecasting ability from which lenders will make their business decision.

About the time this book was written, many business’ pro formas or forecasting models were facing severe scrutiny and in fact, being discredited for failing to accurately predict the economic downturn.

The Great Recession of 2007 blindsided most who relied on Performa’s and forecast’s to predict financial results. The consequence of that fallout tightened the reins on lending, significantly. The contraction felt in the lending world intimidated those of us who, for years, felt reasonable assurance in our “guess work” when it came to predicting into the future.

The days of the Five Year Plan have been over for some time. But, now, a one year plan can raise the eyebrow of anyone lending money. How do we get by this new hurdle? Be honest. Present the facts as you have them. Lenders and investors expect a degree of guesswork in any Performa. Minimize their doubt by putting your cards on the table. Today, A=B and B=C; and, hopefully that will mean A will equal C, tomorrow. Here’s the ray of hope: LENDERS WANT TO LEND MONEY; that’s what they do.

Here’s the key to a solid economic plan:

• State the known facts (the things you are certain about, i.e. today’s costs to produce your product
• Anticipate increases in the cost of your debt or equity and make reasonable assumptions about how those facts will impact your cash flow and profitability.
• If a long term Performa is requested, as unlikely as that may be, use the “spread” (the term of the Performa) to demonstrate your awareness of fluctuating business cycles. Be realistic about long term revenue gains and cost components affecting your bottom line. After a year like 2007 no analyst will fault you for cautious optimism.

Third Party Reports – An Expert’s Opinion of Your Business

In most cases, equity and debt providers will require you to supplement your business plan with an outside expert’s opinion to validate your idea, strategy, market research, conclusions and the economic model set forth in your pro forma. Commonly, feasibility studies (defined below) and appraisals are two of the most popular gauges by an outside expert opinion on business forecasting and valuation.

Feasibility Studies

By definition, a feasibility study is a detailed analysis of a proposed business with respect to its anticipated cost, potential revenue, potential challenges, and possible outcomes. There’s good news and bad news in a third party feasibility study. The good news, if your plan is supported by the third party opinion, you’ve got an ace in the hole. The bad news is, the consultant doing the feasibility study is typically hired by the lender, and, although objectivity should prevail, an overly conservative approach to the study may result.

There is an upside for the small business person. Quite often these independent studies are well sourced and reveal information that can augment the Business Plan. And, given the studies come from experts in your industry, the information is not only valuable but often uncontested by the lender.

Following the same rationale that lenders like to lend money, so it is appraisers and consultants, whose business is to create feasibility studies, like to report on “feasible businesses”. It’s no secret there have been arguments about the congruency of the feasibility study and business plan. Like any other supplier wanting to please his customer there’s a tendency to tell the client what they want to hear. If the consultant knows his client, the lender, wants to make the loan happen, he will find evidence to support that wish. The key is that ultimately someone has to perform to the expectations of the lender. If you receive too rosy of a report, then you will be held to that high standard. Better to under promise and over perform.

Curiously, as a commercial structured finance provider, Andy never saw a feasibility study that advised the client not to proceed with their plan and his institution not to lend. Is it possible those transactions just didn’t make it to his desk?

In generating a feasibility study, an industry recognized expert will test your market research and economic model and if (s)he agrees with your conclusions, some of your information will be regurgitated. The expert will use current industry data and information to support their expert opinion as the basis for their study. This is why it is critical that the expert is actively engaged in your industry. The expert will have micro level knowledge of the industry including recent trends, issues and events.

Appraisals

The valuation of existing business assets, real estate or an ongoing business will require an appraisal rather than a feasibility study for third parties. An appraisal examines the current value of an existing business. Similar to feasibility experts, appraisers generally specialize in a particular industry. In each of the approaches utilized by appraisers, industry specific knowledge is necessary and critical to the information obtained and analyzed and the conclusions drawn.

Whether you are seeking equity or debt for your business, the selection of the appraiser is a critical function. Normally, equity providers and lenders have a stable of appraisers who have significant experience in the industries in which they commonly transact. In many situations, regulations require the lender or investor to retain the appraiser and control the information provided to the appraiser. After the 2007 banking crisis, restrictions and regulations in this regard are likely to be even more stringent to reduce the influence of the business owner on the appraiser during the appraisal process.

Customarily, appraisers provide at least three analyses of the business or some derivative of these approaches. These are:

• Income Approach

The Income Approach identifies the fair market value of a business by measuring the current value of projected future cash flows. Under the income approach, the appraiser will examine the current net cash flow of the business.

One strategy relies on the Net Operating Income (“NOI”) of the business, which applies a capitalization rate, also known as the “cap rate,” to derive value. The cap rate is determined by dividing the net operating income by the asset sale price. For example, if a golf course generates $500,000 in net operating income and is sold for $5,000,000, the cap rate would be 10% or a “10 cap” as it is known in most industries. This method is referred to as the Capitalization of Earnings Method and is the most commonly used method. The appraiser relies on his/her experience and current industry expertise in arriving at a cap rate. Generally, at any point in time, there is a generally accepted cap rate range in which assets are trading in any given asset class.

 

Other methods used in the Income Approach are known as the Discounted Cash Flow Method and Multiple of Discretionary Earnings Method, both focusing on the time value of money. Future cash flows are estimated and discounted to give their present values. The sum of all future cash flows is the net present value, which is taken as the value. The Discounted Cash Flow Method is commonly used in commercial real estate and corporate finance.

The Multiple of Discretionary Earnings method involves the calculation of an asset’s discretionary earnings and factors those earnings with a reasonable EBIT (earnings before interest and taxes) multiple.

Much like the Discounted Cash Flow Method, there is a variance in this method. In this case, the accepted multiples, (generally those percentages supported by actuaries for any given industry) are applied to discretionary earnings. This method is commonly used in the valuation of operating businesses.

• Cost Approach

The second approach is the Cost Approach, which is also known as the Asset Approach. This approach focuses on the cost of reproducing or replacing a business’ assets with deductions for liabilities, physical deterioration and obsolescence. The basis for this approach is that a willing buyer would not likely pay more for something comparable that he can build.

• Market/Comparison Approach

The third approach is the Market Approach. In this approach the appraiser seeks out comparable assets in a similar geographic area operating in the same industry. The approach is based on the assumption that a willing buyer will not pay more for an asset than a comparable asset that is currently on the market. This approach takes into account current market conditions amongst active business buyers and recent buy-sell transactions and other fairly comparable assets. The value of these comparable assets and the prices at which they have transferred serve as strong indicators of fair market value of the subject asset.

 

Private Placement Memorandums (PPM)

At some stage of your business, it may become necessary for you to raise equity for your business. Equity is a share in your company. You raise capital or cash by selling shares of your firm.

The sale of the shares is referred to as an equity raise. Equity raises can take on many characteristics and many different audiences, but all will require specific details of your business.

Private Investors, Venture Capitalists or even Public Investors will require you to not only have a business plan, a feasibility study or appraisal, but also information on which they can rely even at their detriment. This information is contained in a document referred to as a Private Placement Memorandum (“PPM”). This is a confidential sales document that is provided to potential investors.

The Private Placement Memorandum (“PPM”) contains relevant information about the financial, economic and demographic characteristics of your business, while providing the investor with specific information needed to make an informed investment decision. This information may include the offering format, structure, operational and organizational information on the company, required disclosures about the securities being sold, potential risks of the investment and company financials and/or projections. The PPM will also include the subscription agreement which serves as the sales contract for any shares purchased.

The PPM should be drafted by an attorney familiar with equity raises, United States Securities and Exchange Commission (“SEC”) rules and regulations, PPM drafting and your business to insure that the PPM affords all of the necessary protections to the company during the process. One of the main reasons for the PPM is to provide SEC and civil fraud liability protection for the company and those companies and individuals that are raising equity or selling the securities on behalf of the issuer.

By retaining an attorney familiar with the process, you are less likely to have exposure for untrue statements of a material fact or omission of a material fact which are the usual bases for a fraud claim. A well-drafted PPM can significantly reduce the chances of a securities fraud claim. Lastly, the PPM makes a written record of what was communicated to potential investors about the offering and the company.

 

Raising Equity: The Involvement of Other People and Their Money in Your Business

Sourcing Equity

Raising equity is transferring an interest in your business in exchange for capital. This can be accomplished in several ways with various types of relationships and participants. Generally, shares or units of ownership of the business are exchanged for cash. The formalities and cost of the process increase as you move away from those within your circle of influence and toward the general public and increase the amount of capital you are raising.

Friends, Family and Other Related Parties

One of the most common sources of start up equity is friends, family and other related parties. Once you are armed with an idea, a competent business plan and your credibility, the most likely place to find capital is with those who believe in you and in your ideas and trust you. Generally, investments made by friends, family and other related parties are made using “gut check” underwriting. In essence, these individuals make an investment decision based on you, your track record and your reputation, rather than the underwriting of your business plan.

Unfortunately, most businesses fail in the very early stages of a businesses cycle. As a result, your friends and family generally undertake the most risk. Since the parties are likely less sophisticated investors, it is unlikely that they are compensated for the risk that they are assuming. In addition, future investments are likely to reduce the level of their investment. If a start up can raise a few hundred thousand dollars from this source, it has exhausted this group’s customary resources. In many circumstances, the equity raised with this audience is either deferred or convertible debt.

Angel Investors

An angel investor is customarily a wealthy individual with some ties, although not necessarily familial, to the business’ owners or management. Many times, these investors have participated with the business owners on other ventures. Angel investors use their own funds much like friends and family and have proven to be very fertile grounds for start up businesses in the last twenty years.

Angel investors can be retired executives from the industry of the business, who may be interested in angel investing for many reasons including the desire to keep informed of current developments in an industry, mentoring less experienced entrepreneurs and remaining in an industry from a consultative approach. Since angel investors are not formally organized, the best approach to locate them is to network within your business as to who may be interested in investing in your business or interested in mentoring you and your management staff. Please do not underestimate the importance of actively networking within your industry; it can mean the difference between the success and failure of your business. It is that simple.

Without the involvement of angel investors, most businesses do not make it to the next stage of raising capital. Angel investors have been referred to as the first financial bridge of a start up business and recently have been the largest source of early committed equity. Since the angel investors usually fund the early stages of a business, much like friends and family, they undertake substantial economic risk. However, they differ because they command a very high return on their investment. Herein lays the fundamental difference between these two capital groups, investor sophistication.

It is not uncommon for an angel investor to require up to ten times the return on their original investment in recognition of the business’ investment risk. Angel investors also require a stated exit strategy for their investment meaning that the stated repayment must occur within a certain number of years. These exit strategies vary from venture capital investments to initial public offerings (“IPO-s”) At that point, the business can source less costly capital and pay off the angel investor and “stop the premium meter from running.”

Limited and Qualified Private Investors

Once you have exhausted friends, family and those individuals known through your personal network and your industry, it is time to raise equity through a larger audience. The next step in the hierarchy of raising equity capital is to solicit private investors on a limited and qualified basis. The most popular equity raising strategy at this level is a Regulation D offering, also known as a Reg. D offering.

Regulation D can be located under Title 17 of the Code of Federal Regulations Rules 501 through 508. Regulation D essentially permits companies to buy and more importantly for this chapter, sell securities without being required to comply with the United States Securities Commission’s (“SEC”) regulations. The idea is that these exemptions would apply to smaller firms that are not able to undertake the compliance expenses of larger enterprises. Regulation D consistently exempts certain persons and entities within its rules, describing them as “accredited investors.” An accredited investor could be a lending institution, other professional organizations, such as broker-dealers and individuals making more than $200,000 per year, or with a net worth in excess of $1,000,000.

There are several general conditions to qualify as Regulation D offerings and take advantage of the statutory exemptions. The most basic of these conditions are (1) that all sales within a certain time period, (2) information and disclosures must be provided to prospective investors, (3) there must be no “general solicitation”, and (4) that the securities being sold contain restrictions on their resale. 17 C.F.R. §230.502. The form and substance of your PPM is important for purposes of complying with these provisions. The disclosures regarding investment risk, the financial status of the company and the prospective financial performance of the company are critical for compliance and liability limitation purposes. Properly drafted disclosures will put prospective investors on notice and reduce the possibility of being the target of a fraud or breach of fiduciary duty cause of action.

The remainder of Regulation D under Title 17 of the Code of Federal Regulations provides for specific regulation. Under Rule 504, for example, a business is restricted to raising $1,000,000. Rule 505 restricts the business to raising $5,000,000 dollars through no more than 35 non-accredited investors. Rule 506 restricts the business to no more than 35 non-accredited investors, but permits an unlimited number of accredited investors.

Both Rules 505 and 506 offerings require a disclosure whereas, Rule 504 offerings are not required to provide disclosures, do not have a limit on the number of purchasers and have no investor sophistication standards. However, most prudent businesses provide a disclosure to limit risk, despite the lack of a statutory requirement.

Venture Capital

Venture capital is private equity that is provided to start up businesses after they have exhausted the resources of their own personal assets, their friends and family and angel investors. The distinction between venture capital as a capital source and the two previous investor classes mentioned is that venture capital funds are aggregated assets of wealthy individuals and or institutional investors, rather than one investor. The “pooling” of an individual investor’s assets into a fund and then spreading those assets across several or numerous venture capital opportunities lessens the risk of catastrophic failure of a fund and consequently a single investor’s investment.

Generally, in exchange for a significant venture capital investment, a business must not only provide aggressive returns, sometimes approaching 40%, but must also relinquish some or all of the control of the business. It is common for a venture capital fund to have input or outright decision making authority on leadership, management, board of directors and even the business plan itself. The investment of most venture funds has an established horizon. Seven to ten years is a common benchmark horizon for many funds that were started in the late 90’s and early 2000’s. By end of that horizon, the business must pay off the investment either through a sale, an Initial Public Offering, bank debt or another investor.

Initial Public Offering (“IPO”)

An Initial Public Offering (“IPO”) is a company’s first effort at raising capital from the general public. An IPO is the next logical step in a company’s evolutionary life of raising capital. In this process, the company issues new shares, diluting current investors, through one of the public exchanges such the New York Stock Exchange (“NYSE”), the National Association of Securities and Dealer Automated Quotation (“NASDAQ”) or the NYSE Amex Equities (formerly the American Stock Exchange”). In exchange for the capital paid by the purchasing shareholders, the company pays shares of the company profit and upon liquidation, the pro rata, or per share amount, value of the business.

An IPO is a sophisticated and expensive process not without risk to the company. There are significant costs relating to the retention of multiple investment banks for underwriting, legal and accounting firms to comply with multidiscipline and multijurisdictional compliance issues and issuance charges.

After all of those costs have been incurred, the IPO process itself can have significant risk. There is a delicate balance between setting an issuance price that will be accepted in the market when the stock is listed for trading and maximizing the capital a company can raise in the process.

The benefit of raising capital through becoming a public company can be momentous. Traditionally, once the company is public it has paved a much easier and less costly road to sourcing debt. Through its recognition in the markets, the company has credibility with large institutional lenders. Up until 2007, that credibility based on public ratings insured public companies that there would always be some market for their debt. It is unclear going forward whether that benefit will return to the corporate lending world based on current events.

Once the company is publically traded, it receives an inherent marketing benefit. The company name, logo and products are frequently included in the media and therefore provide wide scale brand awareness that private companies do not automatically receive. As an employer, the company is well recognized and talent seeks them out. Recruiting employees, including emerging talent, becomes easier as well.

On the other hand, most if not every major decision made in a public company faces public scrutiny by shareholders, analysts, the company’s lenders and maybe their business partners. The reduction in the cost of capital comes with a price. A public company must provide continuous profitability improvement to maintain their ratings and their ability to secure less expensive capital.

Sourcing Debt for Your Business: How to Leverage Your Business

Sourcing Debt

The basic principles of securing debt on your business or business assets are fundamentally the same as financing a home or a car. A lender provides you money or capital to acquire a home or car and in turn takes a lien against that asset.

For a new business, without an earning performance record or any assets, obtaining financing from a bank can be extremely difficult. This is one of the reasons entrepreneurs turn to friends and family and eventually, angel investors to raise capital. For small businesses, the Small Business Administration (“SBA”) has a lending program that assists small businesses. For businesses that do not qualify for SBA loans, the process of sourcing debt becomes easier once a business has an economic performance record or involvement from credible investors, such as a recognized venture capital firm.

Secured or Unsecured

There are different types of debt structure available to your business. One of the basic structural distinctions is whether the loan is secured or unsecured. A secured loan is one in which the lender takes an interest in the underlying collateral or in the asset for which you have used the loan proceeds. In the example of the home or car, they (the lenders) will take back a mortgage on the home or a lien on the car in exchange for the funds they have loaned to you.

In financing a business or an asset, most loans are secured. This security interest in the asset provides that the lender has the right to act adversely against the collateral, if you do not comply with the terms of the loan agreement. The most common evidence of a secured loan is the presence of a Deed of Trust, a Mortgage, and a Uniform Commercial Code (“UCC”) lien. Most loans in business at any significant level are secured.

Recourse or Non Recourse

The ability of a lender to pursue the borrower for performance of the loan agreement, in addition to action against the collateral, depends on whether the loan is with recourse or without (non-recourse). A non recourse loan means that the lender’s sole remedy is to pursue action with regard to the collateral. In the case of a loan on a car, the lender’s right is repossession or in the case of a home, a foreclosure.

A recourse loan means that in the case of default of the borrower the lender has rights beyond acting adversely to the collateral. In the case of a business loan with real estate involved, the lender will be able to pursue foreclosure and may be able to pursue other assets of the borrower. This additional security means that the lender has a better chance to recover the amount due on the defaulted loan.

The loan may have recourse to an additional entity or individual known as a guaranty. In this case, the lender would pursue the borrower for payment of the debt. In a separate action, they can pursue the guarantor for the amount owed as well.

A recourse loan can be full recourse or limited recourse. Generally, full recourse means that the lender can pursue the borrower for the full amount of the debt. Any ability to pursue the borrower for less than the full amount is considered limited recourse. In tight credit markets, banks will look for full recourse as a way to protect against default liability.

Loan to Value Ratios and Leverage

Considering the amount of debt to take out on your business is one of the larger operating decisions that you will make as a business owner. Loan to value or (“LTV”) ratios are the metric or measuring tool used by borrowers and lenders in analyzing debt on assets. The LTV is the amount of debt against the total current value of an asset or business. For example, a $6,000,000 loan on a $10,000,000 business would be a 60% LTV.

Proper LTV’s have been debated as long as politics among business strategists in many industries. Historically, LTV’s in the 60-65% range were sound lending policy for lenders and smart conservative decisions for business owners. However, in each market cycle where significant amounts of capital are available, competition among lenders increases and so do the LTV’s that lenders are willing to accept on assets. First lien debt in a competitive lending market can approach 80-90%, putting the lender at risk if the asset underperforms or an industry encounters a challenged economy.

Business owners who maintain single asset or company debt at or below 60% LTV can usually weather any economic storm. However, it can be difficult to grow and expand your business if your competitors all leverage their assets to 80% thereby having 20% more cash to grow their businesses. Essentially, this is the issue widely debated among borrowers and lenders.

Mezzanine Debt

Mezzanine financing is debt that is second in priority or “subordinated” to first lien or primary debt on an asset. Mezzanine financings can be structured either as debt or preferred equity. It is customarily unsecured. Mezzanine debt has historically allowed a borrower to increase their leverage from a first lien LTV of 60-65% up to as much as 90-95%. It is unclear as to what extent mezzanine debt will increase a borrower’s leverage after the banking industry crisis of 2007 and the lending policies that will be in place going forward. Since the mezzanine lender has taken on disproportionate unsecured risk, the cost of mezzanine debt is more than first lien debt.

Finding the Right Source for Your Loan: Knowing Which Door to Knock On

Private Debt

Similar to angel investors who provide equity to start up business, wealthy entrepreneurs can provide debt for businesses. In addition, friends, family and those acquainted with you at the outset of your business may choose to provide debt or have their equity include a convertible feature which allows their equity to be converted to debt.

Local Banks

One principle to keep in mind is that banks require in depth familiarity with the clients’ businesses. This principle should lead you and your business loan to the source of your first debt as a new business. Who would know your business better than your local or community bank? They are geographically close to you and your business and may even be familiar with you personally. For your initial debt, they are the best choice.

Local banks are good sources of debt because their underwriting and credit processes are more streamlined, more expedient and arguably produce more predictable results. You may personally know your commercial banker from the community. The commercial banker usually makes an assessment of your loan, may even do the initial underwriting and make the presentation to the bank’s executive or loan committee. As a result, the process is tight meaning that there are a limited number of professionals involved in the process, which means your loan request travels through the process quicker and more accurately.

The challenge with local banks is that inherently they may not be able to accommodate larger loans. Small local banks may be required to partner or participate with other small banks to fund your loan if it is above their lending limit. In addition, if a local bank has several outstanding loans with you, they may not be able to make additional loans due to limitations on loan concentration.

Regional Banks

Regional banks are larger than local banks, but do not rise to the level of a national or international, institutional bank. In some cases, a regional bank started as a local bank that grew and acquired other local banks. Therefore, many of their lending practices and policies are reflective of a smaller bank. As a result, a solid long standing relationship with a regional bank can prove to be very valuable to a growing business.

Regional banks have larger lending amounts and can have more active loans from one borrower without having concentration issues because their assets are more both diversified geographically and within an asset class. These banks tend to deploy their loan officers out through their various locations, reflective of a smaller community bank.

In many regional banks, the underwriting and credit processes are centralized. This can lead to a slower process as more volume flows through the process. Lastly, there may be one or more levels of approval beyond that of a local bank.

Institutional Lenders

The largest banks in the country are referred to as institutional or mega banks. These banks have extensive amounts of capital available to qualified borrowers. As would be expected, their lending limits are the most of all banks and asset, borrower and geographic concentration are less of an issue to these banks. These banks are highly centralized.

Their loan sourcing, underwriting credit and closing processes are more likely to be centralized. This provides the least amount of connection to the borrower and the borrower’s business. Although they may have offices or branches near the client’s business or asset, they really have no connection based on community or local reputation.

Institutional banks customarily have several levels of approval on both the underwriting and sales or business development side of the business. The approval processes can be long and unpredictable as the business strategy flows in a given asset class. While it is good business planning to have a relationship with an institutional bank for your business’ larger lending needs, be prepared for a slow loan approval and funding process.

Every Day is a New Day and a New Opportunity to be Successful

Undoubtedly, the search for capital is a grueling endeavor that requires unending preparation, commitment in the face of adversity, and a realistic outlook.

You must believe in your business plan and yourself to be successful. Most of the participants in this game are required to challenge your business knowledge and commitment level as part of their job description. Establish a time table at the start of the process. If you are unsuccessful within that time frame, take a break, evaluate your plan and seek counsel from one of your industry peers. Make adjustments in your goals and plans and refocus your efforts.

Conclusion

Have a plan. In fact, while you are at it, have three. Your Marketing Plan, Economic Plan and your overall Business Plans are a great starting point for the journey of raising capital. To the greatest extent possible, leverage your relationships, the expertise of peers and “mine” your own industry for capital. It is generally closer to you than you would ever believe. Lastly, at all costs, maintain a positive attitude during the search for the end of the rainbow. If it were easy, everyone would be raising capital in bushel baskets. Preparation, persistence, and patience are required to be successful in this venture.

 

---