By Joseph Pisani
If you are in the process of buying a franchise or have plans to expand your existing location, chances are you will need to seek some level of financial assistance. In most situations, this scenario will require you to submit an application for financing to your local bank. It is important for you to know in advance what the bank will expect to see in your application and what evaluation criteria will be used in assessing your application.
It is quite common for small business buyers and owners to experience some hesitation or even frustration when preparing their financing requests. Some are not sure as to how best to go about it, including how to communicate what is needed in the application. Others do not even know where to start.
A well-developed financing proposal should address the key points put forward by the banks and the marketplace through their own publications and brochures. All major financial institutions provide information on this subject and some materials even include examples of what details should be included and how they should be presented. There is no need to guess and, for that matter, no excuse for not being aware of what the banks expect.
The financing proposal
In very general terms, a bank financing proposal is a written document or presentation used by the potential borrower to convey the following details to the banker:
- An outline of the business activity.
- The amount of money required and from what sources.
- How the money will be used.
- How it will be repaid.
- What financial return the banker may expect on the business.
- What security will be provided.
While all such financing proposals are addressed as soon as possible, your banker is likely busy dealing with a number of them concurrently, so it is in your best interest to keep your proposal simple and factual.
If you honestly recognize in the proposal any downsides the business may entail, for example, this will help illustrate you are aware of relevant risks and how to manage them.
You should include a succinct, one- or two-page summary that briefly describes your business, its history, where its future lies and the money you require to get it there. These details can make a strong initial impression on your banker and help set your proposal apart from others.
Your proposal should also include or at least address all of the following:
- Business name, address, key contact names.
- Table of contents (including page numbers).
- Industry overview (key drivers, demographics, trends).
- Business management structure (background, qualifications, responsibilities).
- Product and/or service offering.
- Market (size, competition, supply, overall standing).
- Financing outline (emphasizing the use of requested funds).
- Basic corporate information (e.g. shareholders, lawyer, accountant).
- Appendices (biographies, product literature, historical financial statements, forecast income and cash flow statements).
Once you have presented all of this information, it is equally important for you to understand how your proposal will be assessed, including which areas in particular the banker will focus on.
As the banker conducts due diligence, i.e. the assessment, he/she will be keenly interested in parts of the proposal that specifically touch upon the six points mentioned earlier, as well as observations and issues relating the following 5 Cs:
Probably the most important factors in the overall assessment process and decision to extend credit are the franchisee’s stability and commitment to the business. In this sense, the banker is looking to identify such critical character traits as trustworthiness, demonstrated good judgment, credibility, honesty, integrity and reliability. Business experience, previous employment and education are also likely to be considered.
In your proposal, it would not be unreasonable for you to also include two or three personal and business references, particularly if you are a new client for the bank.
For your proposal to be deemed realistic, it will need to appear that the business will generate sufficient net earnings to service both your day-to-day and your longer-term credit obligations.
Thus, the assessment will include an evaluation of various business ratios, sales assumptions, operational obligations and carrying costs. In addition, the banker will check which possible financial reserves can be accessed should the need arise.
You should be as accurate and realistic as possible, even to the extent of being conservative. Any exaggeration of expectations may be to your disadvantage in the long run.
The banker’s assessment will also consider your salary and personal debt servicing obligations. In short, the question is whether or not you will have the capacity to repay your debt over an acceptable timeline.
Your credit is simple enough to evaluate, as this primarily involves an assessment of your personal credit history and the franchised business’ track record.
It is very important to maintain a good credit rating and divulge all of your credit obligations, both personal and business-related, to the bank as part of your financing proposal. If you try to conceal or otherwise do not convey financial problems, both previous and current, it could eventually be to your detriment when it comes to eliciting a favourable response from the bank.
No matter how convincing your business financing proposal may be, banks generally expect franchisees to provide some reasonable quantity of their own cash for their business. So, you will need to convey a personal financial commitment to the franchise.
There are many reasons for banks to expect owners to promise their own capital in their financing proposal. For one thing, it represents a tangible commitment on behalf of the owner and, to some extent, is an indication of his/her confidence level in the proposal as submitted to the bank.
In many new and/or startup situations, particularly among franchised businesses, there are certain capital requirements that are not normally financed by banks. Often referred to as intangibles, these include such expenses as the franchise fee, training costs, pre-opening expenses and security deposits.
Banks also have fairly rigid criteria in terms of the maximum level of financing available for certain business assets, such as equipment, leasehold improvements, inventory and accounts receivable.
It is worth keeping in mind the business simply could not afford to be 100 per cent financed from the outset, as this would place significant strain on the franchisee in terms of meeting debt obligations and maintaining enough reserve for daily working capital needs.
Indeed, in addition to conveying your commitment, capital informs the financial stability of the business. Being adequately capitalized at the outset means having a reasonable ‘cushion’ to fall back on, i.e. a reserve for contingencies.
Collateral is simply the value of assets available to support the various loan facilities you have requested.
Operating loans are often supported by a pledge to the bank of all inventory and receivables, but the extent to which the bank finances and accords a lending value to these assets is limited and will vary with individual circumstances.
Term financing is usually provided to support capital purchases, such as equipment, vehicles and leasehold expenditures. While these assets certainly have a tangible value, the lending value of these assets and corresponding loan availability would be less than their actual cost; hence the need for owner equity as a down payment toward these assets.
It is important to note the availability of certain loan facilities—such as financing arrangements under the Canada Small Business Financing Program (CSBFP), which are often referred to as ‘government-guaranteed’ loans—that would permit a higher level of financing and corresponding collateral support to the bank.
For new borrowers, where there is no financial history or a very limited track record, or where the bank requires an additional level of security to support the application, such as a collateral charge on real estate, it is not unreasonable for the banker to request personal guarantees from the owners.
Understanding business banking
When dealing with business banking, it is important to understand the bank does not look to its own security as the primary source of loan payment. Business profits and surplus cash repay bank loans, so it is imperative for your financing proposal to be realistic and convincing, to establish loan and repayment arrangements that are reasonable and attainable from both your perspective and your banker’s. One of your primary objectives in both your written financing proposal and in your subsequent discussions with the banker must be to present a sound business case, rather than focusing on the safety of the bank’s funds.
During your initial discussions with the banker—and regardless of the results of your negotiations—you should pay particular attention to the terminology that seems most important to the banker as he/she reviews your financing proposal. You may often hear terms like ‘liquidity,’ ‘leverage,’ ‘debt to equity’ and ‘debt servicing capabilities,’ to name a few. Your awareness of these areas of focus and your ability to ensure they are addressed in any subsequent loan applications or at your next business review will definitely improve your chances of receiving a favourable reply.
And indeed, in most business banking situations, it is likely for all major arrangements, including credit lines, to be subject to review on an annual basis. In this regard, as your business moves forward and you can demonstrate profitability and build tangible net worth, the banker should be in a position each subsequent year to more easily complete an assessment of the business as per the five Cs, resulting in an even stronger overall assessment, to your long-term benefit.
- What six details, in general terms, should your financing proposal contain?
- What are the ‘five Cs’ of obtaining financing from a bank?
- Why is it not important to focus on the bank’s security?
Joseph Pisani is the director of national franchising services for the Bank of Montreal (BMO). For more information, contact him at (416) 927-6025 or via e-mail at firstname.lastname@example.org.