Category: Entrepreneurial Finance

Follow-up on Community Banks Outlook for 2009

In a follow-up to the post I wrote yesterday, the Nashville Post has a story today that confirms my outlook for bank lending to entrepreneurial ventures in 2009.

From Geert De Lombaerde’s story:

The credit crisis taking its toll on parts of Nashville’s banking sector could be setting the stage for a clear 2009 division of the haves and the have-nots.

A NashvillePost.com analysis of Federal Deposit Insurance Corp. third-quarter filings shows that four of the top nine banks based in Middle Tennessee or doing most of their business here trimmed their loan portfolios from July to September.  

Such is the case with community banks all across the country, although in some markets small business lending has come to a complete stop.

Geert used my analysis from yesterday as support for his assessment that this “tight lending environment will be with us for a while.” 

However, the surveys of business owners are all beginning to tell us the same story — most entrepreneurs are not really looking for new credit right now, anyway. 

Financing Outlook for 2009

So what will be the watchwords for financing entrepreneurial ventures in 2009? 

  • Bootstrapping 
  • Angel investments.

I have had some interesting conversations with several small business friendly bankers over the past couple of weeks.  They are telling me that with the tight margins created by the interest rate cuts, they will be very stingy with new lending for entrepreneurial deals during the foreseeable future.  And that was before the recent cut by the Fed.

Family and friends will be tight on investing in new deals as their investment portfolios have tanked.  They no longer feel wealthy, so will not be as interested in altruistic investments into high risk start-ups.

VCs are reeling right now.  From Techcrunch:

The number of partners listed on some VC Websites is already quietly shrinking. Some new VC funds are having difficulty raising money and even existing funds are running into problems collecting commitments from strapped limited partners.

The carnage on Wall Street is having a trickle-down effect on venture capital firms. The limited partners who typically invest in VC funds–university endowments, pension funds, investment banks, other institutions, and wealthy individuals–are short of cash right now. Harvard’s endowment lost $8 billion in the past four months alone. Many limited partners simply cannot honor capital calls from VCs.  (When a VC firm creates a new fund, it does not collect all the money at once. Instead, it receives promises from limited partners that they will invest when the capital is needed). 

Angel investors seem to be in a little better shape.  Those who work with angels tell me that deals are still being funding.  They see opportunity in the current market for significant long term returns.  They tend to have a longer time horizon than VC firms and have only themselves to be accountable to for the deals they fund.  This backs up a recent report from Angel Capital Association which stated:

Angel group leaders report in a recent survey by the Angel Capital Association (ACA) that investments have decreased this year and will decline as well in 2009 compared to 2007 due to the current recession. However, some angel groups have increased their investment activity this year and believe they will make additional investments in 2009 as new opportunities arise from difficult economic conditions.

And those new opportunities also will be what prudent bootstrapping entrepreneurs who know how to get the most out of every dollar can pursue over the next couple of years.  As Rick Newman points out at US News:

But recessions are times of “creative destruction,” and while the destruction tends to dominate the headlines, new opportunities often sprout as companies seek new ways to grow and those resistant to change drift into obsolescence. Plus, recessions end. And when this one does, we’ll all be ready for a party–on a careful budget.

Credit and Real Estate are Not Top Worries of Entrepreneurs

I just received a copy of a new study from the NFIB Research Foundation looking at the current state of small business credit.

 

First of all, the recession is clearly on the minds of many small business owners.  One-third (34%) of small business owners, defined as small employers having 250 or fewer employees, think the nation’s financial problems have “significantly” affected their business and one-quarter (26%) think it threatens their survival.

 

So what is their short term worry?  Is it access to credit or the real estate crisis as those in Washington seem to be fixated on right now?  Nope.  Here are their immediate worries in order of importance:

 

  • 45% responded that slow or lost sales
  • 23% the unpredictability of business conditions
  •  9% falling real estate values
  •  9% an inability to obtain credit.

Since the beginning of early September, 30% of small employers applied for credit in one form or another, at least half of which applied more than one time (after all, persistence is one of our virtues).  Of those 70% who did not apply, 12% of them (8% of the population) did not apply because they thought they could not get credit they wanted.

 

Of those who went after credit since September, 41% obtained all the credit they wanted, while 8 percent obtained most of it. We are consistently told that nobody can get credit, but half of small business owners who tried got all or most of what they asked for!  In addition, 14% got some of what they asked for.  That makes it two-thirds of those who tried got at least some credit.

 

As one would expect, the ability to obtain credit appears statistically related to financial strength, as measured by greater sales growth in the last two years, fewer mortgages taken out to finance other business activity, fewer upside-down properties, as well as the owner’s positive evaluation of firm performance against the competition, and firm maturity, more specifically, years of operation.

 

Discouraged borrowers, that is, owners who do not attempt to borrow for fear of rejection, are statistically related to what appears to be weak balance sheets.  Specifically, falling real sales over the last two years, ownership of more upside-down properties, lesser use of real estate for collateral, more mortgages taken out to finance other business activity, and the owner’s negative evaluation of firm performance against the competition.

 

Financial institutions have changed the terms or conditions of a line of credit loan, line or credit card for 18 percent of small employers. The changes include a lower limit on a credit card or higher interest on a line of credit, though not all changes, particularly with respect to lines, were adverse.

 

Trade credit (borrowing from suppliers) is growing more difficult to procure. Of the 80 percent who use trade credit, 30% think it has been getting tighter since early September, 14% a lot tighter, while 46% see no change.

 

Small business owners are heavily invested in real estate. A whopping 96% own their personal residence, 49% own all or part of the building and/or land on which their business sits (excluding the one-quarter who operate primarily from the home), and 41% own investment real estate, excluding their residence and business.

 

Real estate, particularly home mortgages, is frequently used to finance or collateralize other business assets. 76% percent have at least one mortgage on the real estate they own with 13% having three or more mortgages.  22% have taken out at least one mortgage to finance business activities. 16% use real estate to collateralize other business assets, including 10 percent who use their homes as collateral. 9% own at least one currently upside-down property.

Keeping a Steady Cash Flow

My column from this week’s Tennessean:

A previous column examined reasons why managing cash flow is critical in today’s tough economic times.

Remember, there are some basic steps that can be taken to help ensure that cash will continue to flow into your business in a consistent and timely manner.

The first step to bolster cash flow is to improve operating profit margins. In today’s economy improving productivity is the best strategy for improving margins.

Generally, in a small business productivity can be improved through one of two means. First, focus on improving the utilization of your physical resources. Idle equipment and space present an opportunity to improve sales without adding to fixed costs. Second, push for greater productivity from your employees; you need to find ways to get more revenues from your current staff.

It is wise to bring employees into this planning. Be honest with them that times are tough and that if productivity improves it helps to protect everyone’s jobs. They will often have the best ideas on how to improve productivity.

The second step is to make sure to target better customers to increase sales. The tendency in a down market is to chase any and all customers. But some customers are definitely better than others. Focus on customers who have been stable and reliable in their businesses. Spend marketing efforts on keeping these customers happy and loyal.

It’s cheaper to keep the customers you have than to chase wildly after new ones. Also, when you pursue new customers go after those who will give you higher profit margins.

The third step is to cut overhead. It is your enemy more than ever before. By lowering your overhead it lowers your break-even point, which is critical if sales soften.

Cut out the extras

Look long and hard at every non-operating and non-revenue generating expense. Agonize over any addition to overhead such as more space or more administrative staff. Get back to your bootstrapping roots.

Finally, your customers are also feeling the impact of these tough times so their buying behaviors will change. If you offer credit to your customers, it is important to keep a close eye on accounts receivable. Stay on top of it; don’t wait too long to take action if a customer is slowing down payments.

You may have to put more pressure on them to get paid on a timely basis. Even good customers who get behind on payments should be put on a cash basis for future sales. As much as you might want to help them out, you are not a bank.

How to develop a clear plan for your cash once it starts to build will be the topic of my next column in this series.

Why Cash is King

Here is the first of my three columns for the Tennessean that will be focusing on managing cash flow in tough times:

The phrase “Cash is King” has become a mantra in today’s tougher economic times. Several readers of this column have begun to ask specific questions about why cash is so important. They want to know how they can improve cash flow, and what to do with the cash they’re able to build up in their businesses.

There are four key reasons why watching cash flow in a business is more important than ever.

First, you can anticipate greater uncertainty of sales over the next several months. Most businesses are seeing smaller and less frequent purchases by customers.

Where a strong cash position is particularly important is during “sales shocks,” which can occur when large, steady customers suddenly stop ordering. If this is because they have found a better price from a competitor, you have a chance to win them back. But, more and more businesses are waking up one morning to discover that one of their longtime customers has suffered a business failure.

Secondly, as I have written about in the past, bank credit is getting more difficult for small businesses to obtain and some entrepreneurs are beginning to have their loans called by their banks.

SBA loans are drying up

The news last week that the Small Business Administration loan program funding also is drying up makes finding credit even tougher. SBA loan funding is down more than 50 percent from this time last year. The SBA program offers guarantees for qualified small-business loans.

Third, just as your business may be feeling the effects of the economic slowdown, so are your suppliers. You should anticipate that your suppliers may begin to tighten their terms on trade credit to help shore up their cash flow.

Some may even begin to refuse to sell to you on credit, even if you have been paying on a timely basis in the past.

Finally, even in a bad economy you may find new opportunities. Don’t count on any external sources such as banks or investors to fund new initiatives.

If you do not have the cash to fund expanding into new products, new markets, or even to buy up struggling competitors, you may not be able to pursue these opportunities.

If you do not do so already, watch your cash flow statements very carefully. And if the business starts to have consistent negative cash flow, you need to also measure and monitor how long your current cash will last.

Develop weekly, monthly and quarterly cash budgets to help make decisions on which bills need to get paid, or can get paid, and when.

In my next column, I will offer specific steps that can help to improve cash flow for a small business, even in a weak economy.

SBA Backed Loans Dry Up

The Wall Street Journal reports that credit is getting even tighter for small business:

When entrepreneurs can’t get conventional loans, they traditionally turn to loans backed by the Small Business Administration. But in recent months — as many banks turned away businesses and slashed credit lines — SBA lending also has dried up substantially. The retrenchment has become especially pronounced in the past couple of weeks.

sba loans fall 2008.gif

Although some of this is due to decreasing demand, tightening credit and standards seems to also be behind the steep drop in small business lending.

When corporate America is lining up for help we seem to be ready to bail them out no matter how bad their prospects.  But, it seems that at the same time we are turning our backs on small business.

Check and Monitor Loan Covenants

My column in this week’s Tennessean:

With all the news about trouble on Wall Street and the banking crisis, many entrepreneurs are scrambling to figure out how it all affects their banking relationships.

The economy has been slowing down for the past year. Since the third quarter of 2007, there has been a slowdown in the demand for loans from small business owners as they become more cautious. The National Federation of Independent Business reports that this drop in demand has resulted not so much in a credit crunch for small business as it has in a softening of demand for loans for expansion and growth.

However, banks are coming under increasing scrutiny by federal regulators. This is going to lead to some changes in the relationship between small businesses and their banks. Owners must prepare for the fact that their loans will be getting increased scrutiny.

Every business loan from a bank has covenants. The bank may require that insurance and tax payments be kept current, while at the same time it may put limits on things such as distributing profits or taking on more debt without approval from the bank.

Covenants also may define minimal financial performance expected from the business. These typically define minimal financial ratios for the liquidity of the business, debt ratios, minimal cash flow requirements, and the necessity of meeting certain profitability ratios.

Read the fine print

Many entrepreneurs pay little attention to these covenants after they close the loan. When times are good this may not become a serious issue. But in times like these, any loans that are out of compliance with stated financial covenants can be “set aside” by the regulators. The bank will be required to set aside additional reserves to cover these loans.

The result is that the bank no longer makes money on these loans. If this happens, banks may be forced to call in these loans, demanding immediate payment of all principal owed by the business. This can happen even if the business has never been late or missed a single loan payment.

Business owners who have bank loans should read all covenants carefully. Make sure that they are in compliance with all actions required in the covenants, for example, keeping insurance policies current and not doing things that may be restricted, such as taking on additional debt.

Any financial covenants require constant monitoring. The entrepreneur or his accountant should calculate and review all required ratios every month. If any of these ratios fall below the bank requirements, swift action should be taken to get them into compliance.

In a recent survey of small businesses conducted by American Express, about one in five owners voiced a concern that the current economic crisis is putting their business at risk of failure. Don’t put your business at risk by ignoring the covenants in your loans, especially during times like these.

VCs are Basically Conservative

The notion that VCs back the riskiest of ventures that are creating entirely new industries is not true.  VCs are cherry pickers.

A post at Tim Berry’s blog Up and Running, which reviews an interview with investor Naval Ravikant, highlights the conservative nature of VCs:

“I look for two things that are paramount above all:

  1. Great team. It’s obvious. It’s a tautology. Everybody says it. You have to be working with some of the best people in the industry you’re in.
  2. Huge market. Niche markets just don’t work because the first idea never works. You always have to change the idea, so you need room to maneuver in a big market.

Berry rightly took exception with the comment about niche markets:

Ravikant has more authority on this than I do, but his reference to niche markets bothers me a bit. I like niche markets in a world that is constantly splintering and dividing itself into finer and finer pieces. Some of the biggest markets there are started as niches: Facebook, for example, focused first on a few university campuses. Yahoo was a niche-the Internet-when it started. Starbucks was once a niche (gourmet coffee, affordable luxury) in the Northwest.

I also like innovative niches.  But generally VCs do not.  The truth is that VCs generally want proven people in proven markets — and really big markets, at that.  This is neither good nor bad.  It is just how VCs go about their business.

I just hate to see when entrepreneurs who do not meet these criteria waste time and energy chasing money that is probably out of their reach.

(Thanks to James Shewmaker for passing this along).

Small Business Credit Tightens

From the Wall Street Journal:

Small businesses are turning to angel investors, suppliers and personal credit cards as the financial crisis spreads to Main Street and access to commercial bank loans becomes more restricted.

After being rejected last month at two commercial banks, Education 4 Kids Inc. owner J.M. Ivler is back to financing his 5-year-old online retailer with personal credit cards. “I can’t get the banks to give me a loan,” complains Mr. Ivler, whose Las Vegas company is profitable and produced $350,000 in sales last year.

I have been warning about tightening credit for the past several months. More than ever entrepreneurs will have to rely on their bootstrapping prowess to keep moving forward.