By Dennis LaRue

A small-business owner faces two daunting challenges: The first is securing the financing needed to open his enterprise. The second is ensuring he maintains the financing needed to stay open.

“Startups are the hardest to finance,” says Steve A. Spencer, president of the Youngstown chapter of Score, formerly the Service Corps of Retired Executives. Spencer should know. He’s the former president of three commercial banks.

“The success ratio of startups is low,” he says, “because of their lack of capital.”

“Borrowing starts even before a business is created,” notes his colleague, Nick Moliterno, treasurer of Youngstown Score. To secure funding, the entrepreneur “needs a good [personal] credit record and to demonstrate he has some management experience.”

“Eighty-five percent of small businesses borrow from a commercial bank,” reports Ann Marie Wiersch, a senior policy analyst with the Federal Reserve Bank of Cleveland, the route she recommends.

The remaining 15%, of which small-business owners should be wary, include lending clubs, finance companies and online sources. “The news coverage of alternative lenders is disproportionate to their share of the market,” she says. Moreover, “venture capitalists and angel investors are not as strong as they once were.”

“Smaller loans are very tough to get,” says Harold Davis, CEO and principal owner of HD Davis CPAs, LLC, in Liberty Township. He reinforces Wiersch’s research that commercial banks find other lending more attractive because they tend to require less effort and time to review and administer. The other loans tend to carry less risk and be more profitable.

Banks are leery of lending to small-business owners for yet another reason. “People will say anything to get money [to start a business],” Spencer has found. And when sales are less than expected, “People will say anything to not pay you back.”

“Many ideas to start a small business don’t need a large influx of capital, only a small loan of $10,000 or $15,000,” Moliterno says. “[To a bank,] these are at the top of the scale for risk, bottom of the scale for reward. … Sixty percent of folks are looking for a storefront that offers food or a craft business, a candy store, a yogurt store.” 

Even when banks grant credit to small-business owners, they increasingly are imposing covenants, Davis is finding. “Covenants are very tough,” reports the certified public accountant who works mostly with small businesses. “They used to be an afterthought. Now they change every time an owner renews his line of credit.”

The Federal Reserve System is encouraging banks to impose and enforce covenants, Davis says, despite the strengthening recovery and that borrowers are doing better in repaying their debts.

Covenants are binding agreements lenders impose to reduce their risk and ensure the borrower continues to repay in full and on schedule. They restrict the borrower’s ability to deploy or employ his assets, especially those he offered as collateral.

They also limit the owner’s ability to withdraw funds to pay his shareholders dividends. “Banks want you to leave equity in your company to secure your loan,” Davis says.

And banks expect small business to experience growth every year, he adds.

Where bank covenants once usually required annual audits, that condition is disappearing.

“Audits [by an outside public accounting firm] are so expensive,” Davis explains, and often “arrive too late” to alert the lender if something’s amiss.

CPAs perform three levels of analysis, compilations, reviews and audits. In a compilation, the most basic analysis, the accountant says the business complies with the basic requirements of professional standards and he can find no obvious departures from GAAP – generally accepted accounting principles – but offers no assurance that the company’s financial statement conforms with GAAP.

A review offers limited assurance that the company’s financial statements conform with GAAP. The CPA performs an inquiry and analytical procedures that exceed a compilation but their scope is less than an audit.

“We do a whole lot of reviews,” Davis reports, although lenders increasingly are willing to accept in-house financial statements. Reviews can be completed and provided the lender within a month after a quarter ends and in-house statements even quicker.

“Banks need financial statements,” Spencer states, and it wants them authenticated. In-house “statements can look wonderful but they look even better coming from a CPA.”

For many considering whether to start a business, Score is their first stop.

“Most are just looking for general information,” Moliterno says, but some have taken a stab at opening a business and either thought better of it or failed.

“Forty percent come to us with, ‘I’ve got an idea. Now where do I 
go?’ ”  he relates.

Few would-be entrepreneurs realize that how they’ve maintained their personal finances is a huge determinant in whether they’ll secure financing. “You need a good credit record,” Moliterno says, “and some management experience.”

Quite a few who approach Score “don’t have stellar credit ratings,” he relates, a turnoff to lenders, although some would-be entrepreneurs have poor credit because they lost their jobs. Still others who approach Score never applied for a credit card and have no record with the three major credit-reporting agencies.

“Half lack any management experience, he elaborates. “They haven’t even gone online” to learn what they’re facing.

Only one in 10 who come in will have a good business plan, Spencer says. “If they have a good business plan, they have a good basis for starting a business.”

Business plans are fluid, Moliterno emphasizes. “You must continually refine and adjust, refine and adjust” to demonstrate to your lender you’re on top of the situation.

If developing and fine-tuning a business plan once a month seems overly demanding, entrepreneurs might want to consider obtaining a franchise. “We have an alliance with advisers who specialize in franchises,” Spencer says.

In exchange for a licensing fee and royalties, not only will the franchisor provide the small-businessman with nearly everything needed to set up and get started, banks are more willing to extend credit.

“There’s less risk to a bank,” Spencer says. “A bank would find comfort in that. [The franchisees] would be shepherded. Franchisors exercise tight control.”

Moreover, what the bank won’t extend in credit, the franchisor usually will if it determines the franchisee is a fit.

Moliterno cautions, “The rules are comforting to a point,” that point being a level of control the franchisee could find suffocating. The franchisor expects the franchisee to buy all his supplies, carried on company trucks, from company distribution centers, not locally at possibly lower prices.

In the end, those giving serious consideration to starting their own businesses will find what those who’ve opened know very well. The lender expects “Your fingers have to be in the pie,” Spencer says. Or as other lenders put it, “You have to have some skin in the game.” This means putting up one’s primary residence as collateral.

And it means saying good-bye to working eight hours a day, five days a week.

“You may be your own boss,” Moliterno says, “but you’re going to an 80-hour week, not a 40-hour workweek.”

This story was published in the April edition of The Business Journal.

Copyright 2014 The Business Journal, Youngstown, Ohio.


Why Small Businesses Find It Hard to Borrow from Banks