Think like a bank

[ScottieK]

Interesting exercise. Since I help analyze business loans for a bank and make a recommendation on whether or not to extend the loan, maybe I can help by describing what my bank looks for when someone comes to us with a loan proposal for a new business venture. There are two things a businessman pitches to the bank: his reputation and his business idea. Both are important.

Reputation

If you are a person I’ve never met before, I am not familiar with your business track record or your personal financial situation. You will have to demonstrate that you know what you are doing from previous business ventures or experience. If you want to open a restaurant, have you ever opened or managed a restaurant before? How many years have you had in the restaurant business? Do you or anyone else you are bringing into the business have the necessary experience? If so, what is their experience and reputation? All the desire in the world won’t make a bank comfortable if it’s evident you have no idea what you’re getting yourself into.

A bank will pull your credit score and history to find out if you can manage your own debts and payments. A bank will require a personal financial statement for an estimate of personal assets and liabilities. The more net worth, the better. They will also require tax returns as proof of income. The more income, the better. Also, where is that income coming from? If you want to start a single-asset LLC to run a restaurant, and you already own three single-asset LLC’s that own profitable restaurants, that’s a good indication that you know what you are doing in the restaurant business. If you already own a business, the bank will want to look at the financials for that business to see how well it has done. The more history you have of successful operations, the better.

Your financial condition is important because you will most likely be required to pledge your personal assets as collateral to support the deal, either as the borrower or as the guarantor of the loan. The bank will rarely loan a borrower all the money required to start a business. You will have to come up with the difference. As a result, you will be personally invested in the success of the business venture. You also give the bank a secondary or tertiary source of repayment should the cash flow of your business be inadequate. It is common for a new business to operate at a loss during the start-up phase, when up-front expenses are high and revenue is just getting started. A bank may be willing to accept interest-only payments during the start-up phase, or even build in an interest reserve into the total loan, but the payments have to come from somewhere.

Business idea

The point of making a business plan is not to predict the future. The point of the business plan is to show the thought and planning methodology of the entrepreneur, and whether or not it makes sense. It is a blueprint from which the business can go from idea to implementation with a reasonable chance of success.

One thing I’ve learned about analyzing new business proposals is that the devil is truly in the details. The more little things you have pinned down, the better. Don’t just say you want to open a restaurant or a bookstore. Say you want to open a business at a specific location (or are considering several locations) that meets the square footage, zoning, structural, traffic, and all other requirements for your intended business. Don’t say people will just come to the door. Say what market will you cater to, how you will advertise to that market, and how you will compete with the competition. Don’t say you’ll make a bazillion dollars in the first year. Do some research. Find out typical revenue, margin, and net income figures for the type of business in the area you want to be in.

A bank will ask questions like:

-What makes you think your business will do well at this location? Can you show me where competitors are located? Can you show me where the additional demand will come from?
-Why do you expect to be making $x by the end of the first year of operation? Can you show me some market averages that justify these revenue and margin figures? Are those margins reasonable?
-What expenses do you need to incur before you open your doors? Can I see an expense budget and cost breakdown? How do you know these are good estimates of your expenses?
-Will you be running this business, or are you hiring someone with expertise to run it for you? What does their background look like?

Just about every relevant question should already be answered in the business plan. The more thorough and plausible the business plan, the better. Why? Well, if it passes the loan officer’s smell test, he will give it to an analyst for further investigation. That’s where I come in. The more questions I come up with that aren’t addressed in the business plan, the less faith the loan officer and I will have in extending the credit. Your idea doesn’t have to be brilliant, but it must be well thought-out. It shows that you’ve done your homework, and you’re serious about making this business work.

Regarding pro forma sales projections. I’ve seen a lot of pro formas, and they all claim to be conservative…but I haven’t seen one yet that failed to meet its expected loan payments [img]/images/graemlins/wink.gif[/img] We typically require three years of pro formas, preferably broken down by month. These pro formas are used to calculate revenue and profitability. But more importantly (to the bank), they are also used to calculate debt service coverage ability, which is the business’s ability to pay off the loan given the terms agreed upon. They are stress-tested in different ways to measure how bad things can get before the business is no longer able to pay the bank back. If things have to go just right for your business to barely make a profit, then the bank will investigate further. Perhaps your projections are too conservative, or perhaps your business won’t be profitable enough to service the debt. The more comprehensive the pro formas are, the better. Leaving material expenses out such as rent, utilities, or payroll shows that you haven’t been thorough enough in making your statements.

FWIW, my bank funds quite a few startups and new business ventures. Most of those loans are made to entrepreneurs with substantial track records in doing what they do, whether it’s opening restaurants, gas stations, building chain stores, buying and renovating strip malls, whatever.

As with all types of financing, there are upsides and downsides to getting a bank loan. The upside to the business owner is that the bank does not want any percentage of ownership or profit. Once the loan is paid off, it’s paid off. The downside is that, if the business fails, the business owner must still pay the bank. Both my parents are entrepreneurs, and they both started their businesses with bank loans. I think one was a home equity loan, not sure. Not saying that it's the only way to go, just saying it's a viable and common way to fund a startup.

As I mentioned earlier, a bank understands that the first few months or even first year of opening a business will most likely be unprofitable. If a bank is going to make a loan, they want the business to succeed. They’re not going to impose payments on a startup that the business can’t possibly be expected to pay back. The bank can work with the entrepreneur to structure the loan to compensate for that initial period of unprofitable operations. Maybe that means allowing interest-only payments for the initial phase, and then the amortizing the loan. Maybe it means building in the amount of those interest payments into the total loan package, so that the business pays off the interest with money already borrowed.

I’m sure the Small Business Administration (SBA) has its own loan guidelines as to what structures are allowed in a SBA loan, but that’s typically how my bank structures startup deals. I checked out the SBA website (sba.gov), and they have some pretty good ideas on how to write up a business plan.

ScottieK

[Tien]

[ QUOTE ]

Tien, do you really care what they write as a 10 year goal? That is almost never going to have any meaning even 2 years from now. Business structures and outside conditions can change so much in that sort of time span that trying to project that far into the future is really useless. For many businesses (pretty much any sort of web service, for instance) it's probably not even worth reading their 1 year plan. Read stuff from any successful startup founder and you will see that even core fundamentals of the business can change 180 degrees in the first few months.


[/ QUOTE ]

You are 100% correct.

Every single business plan will be completely different than the business plan it had 1-2 years ago. Too many things change.

However, I do believe every single business needs to have a certain very long term goal before it enters the business.

I read in a Robert Allen book: "Multiple Streams of Income" that the average Japanese company has 150 years planned out whereas the average American company only has 10 years planned out.

Maybe for startups a 10 year business plan isn't quite important, but I believe any business needs to have the end goal in mind to work towards, not randomly floating about year after year.

[Tien]

[ QUOTE ]
This thread isn't working at all the way I hoped. I was hoping to start a lively discussion about what it takes to succeed in your own business. Any ideas as to why this thread has been such a failure? Was the question difficult to understand? Was the scenario confusing? Suggestions?

[/ QUOTE ]

No one has any business plans themselves!

hahahaha, this thread had great potential however.

[spex x]

HA! I knew something worthwhile would come out of this thread. Great post, thanks.

[Evan]

[ QUOTE ]
the average Japanese company has 150 years planned out whereas the average American company only has 10 years planned out.

[/ QUOTE ]
Hahaha, come on man. I'll write a plan for 1,000 years out if someone really wants to read it. It's not going to mean a damn thing though. How can you possibly write a 150 year plan. 150 years ago the civil war hadn't started yet. Radio hadn't been invented yet. Cars hadn't been invented. Do you really think that any business plan written at that time would be even remotely relevant today?

[BradleyT]

Never underestimate the Japanese!

[Tien]

I'll quote the book word for word:

"The average American Corporation operates on 5-year planning horizons. The average Japanese corporation operates on a 150-year planning horizon. You might wonder how the Japanese know what is going to happen in 150 years. They don't have to. Remember, the future is not something that happens. The future is something you make happen"


Robert G Allen from "Multiple Streams of Income". His other book "nothing down" has been the highest selling real estate book in the entire world.


I am not sure how accurate his information is, but I am sure as hell impressed with Japanese companies and how efficient they are.

I guess the point is not to ask how accurate the plan will be 150 years from now, but you need to plan out what options you have when the future comes, instead of planning for the present when it is already happening.

[Tien]

And yes he is a "guru" that sells his material after every seminar.

So all you anti-guru / guru bashers can take it that comment for what its worth.

He is also an author of the best selling real estate books in the world.

I personally have adopted the strategy of planning out my business for years to come and it has given me a very clear picture of what I have to do.

Of course things will change, but the end goal / end vision I have in mind for it most likely won't.

[Evan]

Check out this video at the 10:20 mark for an interesting commentary on Japanese business. http://video.google.com/videoplay?do...=warren+buffet

[Tien]

Interesting.

His comment on how even though the Japanese economy was booming real hard, there weren't many companies earning high return on equity.

So if I understood correctly:

Japanese have a bunch of average companies doing well but none of them are doing exceptionally well?

I'd like to know how far into the future the best companies in the world have planned out. The best American companies, the best Chinese Companies, the best european companies. I hardly doubt they plan no more than 5 years into the future.