For many entrepreneurs, applying for bank financing is an elusive process. While not always easy, assessing your financing application is also not a black box.
In fact, it's very simple: it's all about the guy, the tent and the penny.
Small bank financing, big risk
Suppose you are on the board of a bank and have a maximum of 100 million euros per month available to lend to businesses. Naturally, you want to make a return in order to break even or operate profitably. You also want to minimize the risk of default; the situation in which your client is no longer able to meet its interest and repayment obligations.
Well you can lend that hundred million euros to a thousand entrepreneurs who all get a ton, or five hundred businesses who all get two tons. But to get to these amounts of entrepreneurs and businesses, in practice you will often have to screen quadruple it - currently only 25% of all SME loan applications are honored.
Whichever of these two variants you choose, in any case it's going to cost you a lot of paperwork, time and therefore money. It's much more attractive to lend that hundred million euros to a hundred or maybe even just ten businesses in portions of one or ten million euros. Much less handling costs, much better and more stable businesses with professional management (better risk/return ratio) and - not unimportantly - a much lower downside risk to your career within the bank.
Credit director
Officially, banks won't readily tell you this - "good plans are still funded by us" - but right now a banker barely gets out of his chair for a loan under a million euros. So for every 1,000 euros lent, more money has to be kept in the coffers. There is also simply less money available to lend in absolute terms. With these facts in mind, you may better understand why banks now consider the bottom of the credit market a no-go-area.
Too many handling costs, too much risk of defaults and thus a limited and probably even negative return. In practice, the three major banks (Rabobank, ABN AMRO and ING) have also already largely abandoned the bottom end of the credit market.
Segment €200,000 - €500,000
For the segment between two tons and half a million euros, there are mainly possibilities - via special counters - for financing on accounts receivable or inventory (factoring) or can be borrowed on the basis of fixed assets (leasing and asset-based lending). In addition, businesses are increasingly referred by their banks to other parties in the market: informal investors, private equity firms, SME stock exchange, SME bonds or Credit Unions.
And for the lower end of the market, the banks, together with the government and some insurers, have established Qredits. At this non-profit foundation, starting and mostly small entrepreneurs can apply for a credit of up to EUR 150,000. This combined with a credit coach to keep the entrepreneur on track.
Instead of providing financing themselves, banks in the lower end of the credit market increasingly see themselves as referral stations - they themselves refer to themselves as "credit directors" - and from a business perspective, you can't blame them.
Financing application
But suppose you have a successful business and you see opportunities for growth or a business acquisition. To realize this growth step, you need 1.5 million euros. You can cough up two tons of that from your own reserves and you have found an informal who is willing to provide you with a subordinated convertible loan of three tons. You would also like the bank to participate - in this case for an amount of one million euros.
How do you approach it?
In any case, it is crucial that your plan (including yourself and your business) is well presented to the bank. After all, you only get one chance and you don't want to waste it. You can do it all yourself, but it is generally wiser to hire an experienced adviser to do so. Within 4 to 6 weeks, this adviser will prepare a well-founded and professional financing memorandum that contains everything the bank wants to know about you and your business:
- Strategy
- Earnings model
- Background of the management
- Historical figures
- Forecasts for the next 3 to 5 years (preferably on a monthly basis)
- Worst case scenario
Then you - together with your adviser - and possibly other members of your management team present and explain this plan to the bank in person. You are thanked for your enthusiastic story and you say goodbye with the promise that the bank will let you know within two to four weeks whether the financing request will be honored.
Credit risk
You are a growth entrepreneur. The bank is obviously very interested in your plan, but the most important question the bank's credit committee is trying to answer is: how likely is it that this entrepreneur will be able to repay the financing burden - interest and principal - over time? And because a bank generally doesn't think in terms of opportunities but in terms of risks, the question is usually phrased the other way around: how likely is it that you won't be able to meet your interest and repayments, the so-called credit risk.
Based on the agreements of the Basel Committee, banks are obliged to determine the credit risk of every entrepreneur on an annual basis. This analysis results in a rating. A rating determines the probability that you will not be able to meet your payment obligations for three consecutive months in the coming year. This includes the financial consequences (loss) for the bank.
When assigning a rating, the risk of default plays a key role. The higher the risk of default, the worse the rating and the less likely you as an entrepreneur will get or keep the requested credit. The reverse is also true. The risk of default is also a measure of the interest rate you have to pay to the bank for the credit provided.
It is good to realize that the information you provide to the bank largely determines the outcome of your own rating. The bank may additionally use data from other providers, such as economic agencies of an industry, the Central Bureau of Statistics.
Collateral
After the bank has determined your credit risk based on the information provided, it looks at how much financing you have requested (in this case, one million euros) and - very importantly - what collateral you can bring in. These securities in particular are important negotiating elements at a time when a bank does not feel entirely comfortable.
In the case of the case study, the informal investor might still want to guarantee half of his initial investment. You should also think about pledging cash, accounts receivable, inventories, inventory, company buildings or stocks and bonds.
Finally, a bank is very keen on a personal guarantee from the entrepreneur or management. Entrepreneurs often don't like it, but it is a very clear demonstration of commitment. From experience, the bank knows that entrepreneurs who are guarantors are also more cooperative in limiting losses in the event of a default.
Given the current rigorous financing climate, it is expected that a personal guarantor will become increasingly important in obtaining financing in the current banking climate.
Shopping pays off
The situation outlined above depicts the credit process at one bank, but in fact this process is the same at all banks. It is also important not to limit the credit application to one bank; a rejection at Bank A does not necessarily mean automatic rejection at Bank B.
If bank A has just had a bankruptcy of a business that was active in the same sector as your company, the chances of a rejection of the financing application are high. That's regardless of the quality of your proposition.
Another pitfall is that many entrepreneurs think the house bank is their best friend, but this is by no means always the case. The house bank may be more inclined to honor an additional loan request, but that may not necessarily be the best proposal.
Tip: It makes sense to submit your application to other banks at the same time in order to compare offers. In that respect, credit purchasing works no differently than other services you purchase. Shopping pays off, even at the bank.
