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Business Unplugged™
This blog features Carol Roth's tough love on business and entrepreneurship, as well as insights from Carol's community of contributors.

Four Reasons Businesses Borrow Money: Where to Go for What You Need

Written By: Niles Costello | Comments Off on Four Reasons Businesses Borrow Money: Where to Go for What You Need

Know what you want to know where to go. It may seem obvious, but business owners seeking loans should know the fundamental reason why they are borrowing money in the first place.

Not understanding the basic need the proposed financing fulfills can set the stage for wheel-spinning struggle sessions and epic square peg round hole cramathons.

This is because, too often, businesses limit their borrowing options to traditional banks. Seems logical enough, that’s where the money is after all.

Or is it?

Turns out only about 50% of the outstanding domestic commercial loan balances as of December 2020 were held by traditional banks, according to the FDIC.

Before going further, the following are the four fundamental reasons that a business borrows money:

  1. To fund working capital, such as accounts receivable and/or inventory, for short-term liquidity needs.
  2. To fund the purchase of fixed assets, such as real estate, equipment, or vehicles – or to make other long-term capital investments.
  3. To fund growth, whether to keep up with increased demand or to add products or services to new markets. A growth play often occurs in combination with reasons 1 or 2 above. Think of a delivery company buying new vehicles (2) in order to keep up with increased demand (3), which will in turn increase their working capital needs (1).
  4. To fund losses, which actually is a thing. State and municipal governments float bonds to cover operating expenses like salaries and retirement benefits. Small businesses typically didn’t have this opportunity, other than perhaps credit cards. But then COVID hit, and PPP came along, what a time to be alive! (We won’t spend too much time with reason 4. It’s kind of depressing.)

Let’s take a closer look at the delivery company mentioned in reason 3 above. Say they’re buying refrigerated cargo vans because, I don’t know, the stuff they’re delivering needs to be kept cold.

Anyway, they go to their regular banker for a loan to buy refrigerated cargo vans for their cold-thing delivery business. Remember when George Costanza was talking about being at the mechanic, pretending to know what a “Johnson Rod” is? That is your typical commercial banker trying to get his head wrapped around refrigerated cargo vans. Some initial bluster, followed by a quick tangent along the lines of, “Hey, speaking of refrigerated cargo vans, do you remember Refrigerator Perry?” before a final pivot to, “So we’ll think about it and be in touch.”

What are the alternatives?

For small businesses, finance companies are non-bank lenders that provide capital resources for a wide variety of needs. Whereas banks take a conservative and generalist approach, finance companies specialize in a narrow range of asset types, such as accounts receivable, vehicles, heavy equipment, or industry-specific machinery. This focus allows them to lend against the underlying value of the assets alone, so the operating stability of the borrower is secondary.

Finance company lenders are more like Miss Mona Lisa Vito from My Cousin Vinny. She knows absolutely everything there is to know about refrigerated cargo vans down to which ones have cooling systems that feature reverse coil freon exchanges (I just made that up), and can make value-based loans against that knowledge.

Non-bank loans tend to be more expensive than a traditional bank product, but this is largely a marginal cost, compared to the accessibility of the capital being provided. And capital accessibility is pretty important!

So to recap, traditional banks do best when financing stable businesses with historic cash flow sufficient to repay all debts, whether working capital, fixed assets, or both.

When growth is a factor, or if specialized knowledge of the collateral asset is valuable, non-bank finance companies are reliable capital providers.

Article written by
Niles Costello is a veteran banker with extensive experience working with small- to medium-sized businesses and commercial real estate investors.