Accounting, Financial, Taxation

Success of a business depends on the business owner or the financial management. Too much reliance on the lending institution to help run the business may prove disastrous. There should, therefore, be flexibility in the agreement to let the business grow and be successful. Advice and help from the lender should not be overlooked. Lenders may have had experience with other similar businesses, and you can profit from that experience. As a borrower, you should request these considerations in the lending agreement:

1. There should be an option available to you to refinance at any time. Often the lender will qualify this provision to permit refinancing only after a certain period of time or with a prepayment penalty. You may need this provision in order to take advantage of lower prevailing interest rates should they occur.
2. A conversion agreement should allow for more favorable loan conditions once certain “growth forecasts” have been met. This provision takes into consideration the fact that as your business grows, its risks may decrease. Because interest rates should be tied to perceived risk, as you prove your viability and success, you are entitled to pay less of an interest premium; arguably, your riskiness has been reduced.
3. Agree on no prepayment penalty. Changing financial conditions may provide you with sufficient cash to prepay the loan. This may be done to realize significant tax benefits, as a requirement for the obtaining of additional financing, or to put you in a better business posture. Prepayment generally will work no hardship on the lender other than to take away the guarantee of expected future earnings. There would be nothing to stop the lender from reloaning this money to other individuals and thus recovering the future earnings from someone else. The lender’s risk is that the money cannot be reloaned at equal or better rates.
4. Request limitation on interest rates. Banks prefer to charge a variable interest rate. You should negotiate limitations or caps on rates and make this a major consideration in determining whether to enter into the financing agreement. Agree on the possibility of an increased loan based on meeting certain tests. Often, if you are successful and the business is growing within certain predictable ranges, additional debt financing may be necessary to continue the growth pattern. As such, you may want the loan agreement to provide for additional advances of debt to aid in sustaining that growth. A lender should consider itself an ongoing business partner in these agreements. As you grow, so does the income of the lender. Some loans have an absolute upper credit limit, and you may borrow up to that limit without further formal application.
5. The agreement should specify identifiable assets that are pledged as collateral.
6. Seek a loan “grace” period of 30 to 60 days for noncompliance with debt arrangements. Very often this provision requires you to notify the lender in advance that you will use the provision. There probably will be a limit on how frequently this can be done.

Lenders may be more willing to permit minimum defaults when you submit a plan showing how you will make it up after appropriate notice to the lender. The worst thing you can do is surprise your lender. In most cases, a lender would rather work out a mutually agreeable accommodation than seek legal redress.

When an institution is considering making substantial loans to a company, it often requires, as part of the loan, agreements to control the business activities and obtain reports about the current status of the firm. Typically these arrangements include:

Limitations on the purchase of new assets - Some lenders have a policy to keep additional expenditures low after a loan has been made. This has the effect of slowing or stopping growth. Negotiate with the lender to ensure that this is not an absolute limitation on acquisition of new assets. Be sure that additional new assets can be purchased on a regular basis if there is provable growth associated with the need for those purchases. Show the lender that through planned growth, the risk of default is lessened. Planned growth can be accomplished only by the acquisition of additional assets based on a good business plan.

Limitations on additional debt - Once again, a lender may try to restrict the incurring of additional debt. This too has the detrimental effect of limiting growth. When negotiating with the lender, make it clear that additional debt may have to be incurred in order to sustain regular growth. An adequate business plan will certainly help as bargaining leverage for the execution of the appropriate terms in the lending agreement. The selling point to the lender is that additional debt supports additional income through growth. As the company grows, so does the lender’s security of repayment.

Salary restrictions - Because salaries of chief executives and other executives are a direct expense, lenders typically will want some restriction on these salaries so they do not skyrocket. Large increases in these salaries will dig into the profits of the firm, sometimes radically increasing expenses. Counter with a reasonable alternative, which may include tying the increases to the profitability of the firm. This also has the beneficial effect
of motivating management.

Dividend restrictions - If the company pays dividends, you should attempt to negotiate a reasonable formula for payment. The company is confronted with the competing interests of debt holders and holders of equity. The lender may prohibit the payment of any dividends. This allows for the additional retained earnings to be used for debt servicing. But it may have a chilling effect on the raising of additional equity capital. A company’s attraction as an equity investment opportunity is based on two factors: its absolute growth in net worth and the income stream of dividends. A no-dividends policy reduces the attractiveness of an equity investment possibility. Typically firms will be required to provide lenders with regular financial reports. Lenders generally will require financial statements accompanied by a certified public accountant’s (CPA’s) report. Audited reports certified by CPAs are costly and time-consuming documents to prepare. Look to reduce the requirement to a cheaper alternative such as a review or a compilation. Some people think that when they incorporate, they absolve themselves of any personal liability for the debt incurred by the business in its operation. Legally, that might be true.

However, lenders too have learned that people try to limit their personal liability by incorporating and often require certain personal guarantees by the business owner. Some banks may want you to sign a general guarantee of the business loan as a sign of “good faith” or as a “personal commitment” to the business. Here are some points to consider regarding collateral and loan guarantees:

1. Specific personal assets - It is not wise to risk everything you own. If a pledge of “good faith” is required by the lender, pick one particular asset to risk. Do not risk more than you are willing to lose in any situation.
2. The value of business collateral already offered - Typically lenders will require as much collateral as they can reasonably get. They may even seek collateral that is unreasonable. In such cases, it may be beneficial to prepare reports showing the extent and valuation of those assets pledged to secure the loan. Often appraisals by independent groups as to the value of real estate and other assets tend to dissuade the bank from seeking further collateral.
3. Stock in the business as collateral - If the business has some attractiveness and a reasonably high probability of success, the lender may take back some stock as collateral. Be wary that you are not giving up so much stock that you lose control of your business.

Good news for you who are attempting to get some loans to finance your business, here I am posting types of loans that you can arrange. Several types of loans are possible. Some of these are:

Commercial Loans

The terms of a commercial loan are designed to repay the loan on the basis of specific assets or business-cycle activities. These loans may take the form of either short-term or long-term commitments.

Leases

Many lending institutions offer a choice between debt and a lease. Leases are obligations for the specific assets, and are generally fixed as to rate and payment. In addition, most offer a purchase option. Some caution must be exercised in selecting between leasing and outright purchase with a mortgage. Very often, under the terms of the lease, significantly higher costs are incurred over the costs of the outright purchase of the item.

Mortgages

A mortgage secures a loan by pledging an asset as collateral, with an associated repayment schedule. Amortization schedules of repayment show the principal and interest payments over the life of the mortgage.

Balloon Loans

Balloon loans are very similar to mortgages except that an unpaid balance or balloon payment is due and payable after a specified time. A typical example of a balloon payment is a 20-year mortgage with a requirement that after 5 years of payment on the mortgage, the unpaid balance of the principal is due. The advantage to a lender of a balloon mortgage is that it obtains significant interest payments during the early years of the mortgage. It is during this period that the interest constitutes the bulk of the payment. The benefit to borrowers is that they expect to pay off the principal without incurring further interest liabilities after a few years of operation. In addition, these interest payments represent significant deductions for tax purposes. Remember that if the firm is paying taxes at the rate of 46 percent on profits, the federal government is returning $.46 on each dollar of interest paid. Very often, these loans provide for refinancing in the event that the balloon payment cannot be met.

Leverage-financed Loans

These loans are used to acquire businesses. The largest percentage of funds used to acquire a business is supplied by a lender, who secures all assets. These loans ostensibly are attractive to borrowers because if a firm is heavily leveraged, a smaller increment of profit yields a much higher percentage return on equity.

Bonds

Bonds represent debt sold to lenders either privately or through public underwriting. Usually a business needs to be fairly substantial in size to float a bond issue. Bonds typically are not available to small businesses except in some special cases, where they are backed by local governmental units.

Commercial Paper

Commercial paper is offered by large, stable company intent on raising working capital for short periods of time. Commercial paper generally is sold in a public market and is in the form of short-term, unsecured promissory notes. The usual denominations are $25,000 and over.

Small Business Administration (SBA) Loans

The SBA generally guarantees a bank loan, thereby lowering the risk and interest cost for the borrower. These loans are intended for businesspeople who can qualify based on certain profiles. These loans may be based on needs such as a business in a hardship area or areas where unemployment is high. Occasionally these loans are extended for areas in which a natural disaster has occurred.

Economic Development Authority (EDA) Loans

EDA loans generally relate to social goals promoted by the authority, such as increasing minority employment or employment in depressed areas. These loans are made and administered through state agencies. The nature of these loans is to obtain working capital allowances and not generally to purchase specific assets.

Industrial Revenue Bonds (IRB)

IRBs are issued through governmental agencies and are intended for use in the acquisition of real estate and equipment. The governmental agency issues the bonds, which are then purchased by investors, often banks. Because they are governmental bonds, they are tax exempt. As such, the prevailing interest rate on IRBs is lower than the prevailing market rate. A great deal of criticism has been leveled against IRBs because some businesses, which compete with others that get IRBs, complain they are unable to acquire similar low-interest money and thus are less able to compete.

Research and Development (R&D) Financing Arrangements

Often companies and private investors have entered into creative financing arrangements in order to raise necessary funds to pay for research and development. In recent years these have taken the shape of limited partnerships. Typically, the sponsoring company contributes the right to a product in a limited partnership, in exchange for an interest in the partnership, often as the general partner. Capital contributions by limited partners usually provide funds for R&D that may be subcontracted to the sponsoring company or even to other entities. The limited partners expect to receive income in the form of royalties from the sale and development of the product. They may also receive income tax breaks in the form of capital gains rates. The major advantage to the sponsor is that if the project fails, no repayment of the loan is required and there is no liability for interest cost.