Small Firms Hide Their Light Under Bushel Basket

Would your bank extend credit to a company with $3 million in revenue that had not generated more than $85,000 in net income in any of its 12 years?

If not, you are not alone. Several banks recently turned down the company, a Maryland supplier of galvanized products.

But after the company's financials were reconstructed to reflect the owner's $500,000 annual salary and numerous other perks, several banks were eager to provide working capital.

This is not a lesson in financial wizardry and accounting alchemy. Rather it shows that many profitable banking opportunities are ignored because entrepreneurs and bankers speak different languages.

While both groups are deeply interested in the viability of a business, they approach the enterprise from different angles, think about it in different ways, and use different yardsticks to measure success.

Neither is right, neither is wrong. Yet for bankers to benefit from lending opportunities in the small-business community - and for business owners to appreciate bankers' needs - they must be aware of how the other views the world.

The entrepreneurial small business owner is usually much more concerned with personal cash flow than with corporate profit in the strict accounting sense. His focus is on minimizing taxes while maintaining a comfortable lifestyle.

Bankers' Concerns

A banker's view is elegant in its simplicity. Through glasses that screen out the extraneous, the banker asks, Can a business pay the interest on the debt as it repays the principal?

The language of the banker, therefore, is one of risk measurement, coverage, debt ratios, legal covenants, and credit limits. Rationality, not passion, is the overriding concern.

A business owner's view is frequently much more complex. A high tolerance for risk is a helpful prerequisite when setting out to establish a business. Optimism and drive frequently substitute for security and hard facts. The entrepreneur typically starts a business to actualize a dream. The dream may be the desire to manufacture the most advanced stainless steel sprocket, to build the biggest carpet plant, or to serve the best Portuguese food in town.

Sometimes the dream is motivated by a practical response to necessity - a job is lost, obligations must be met, money is needed, or a boss is intolerable. Whatever the reason, it is entrepreneurial vision that builds successful businesses, and each successful business is truly a reflection of the entrepreneur's personality and style.

Thinking Big

The language of the entrepreneur is expansive. He talks of bigger plants, new lines, added sales staff, visiting trade shows, taking over adjacent properties. Passion and emotion flow freely.

Business owners often speak in the present tense. Most want to enjoy the prosperity that typically comes with each step of progress as they work to make their dream come true. That's what the founder of the Maryland company did when he drew a hefty salary and benefits from his business. That's what most business owners try to achieve, producing the maximum income and benefits for themselves and their families, and the minimum for the tax collector.

However, when the dream grows larger or when a business is no longer able to finance its growth internally, the entrepreneur must rely on outsiders, often banks or other financial institutions, for financing. Since they have historically dealt with banks as an individual customer or as an executive with a large corporation, small businessmen often misinterpret, resist, or resent the requirements of bankers.

Time to Communicate

Moreover, since few if any entrepreneurs start a business to engage in finance, much less for the pleasure of repaying creditors, they are disinclined to suppress their autonomy and speak the bankers' language. In this regard, their behavior is often self-defeating. Many of the very traits that helped build their business - pride, conviction, independence - can act to their detriment if misinterpreted by traditional bankers.

When the need for expansion capital becomes critical, however, entrepreneurs need to start talking about themselves and their business in a convincing way to bankers. That means translating the business vocabulary - its operating results and other numerical measures of performance as well as the accounting methods it has been using - into bankerese.

Properly presented, a small business' financial story can quickly dissolve a banker's natural skepticism. A case in point: A Pennsylvania distributor could not qualify for significant bank credit because its payment history was poor. In truth, credit was not the underlying problem; it was undercapitalization.

The company had grown from $7 million in revenue to $45 million in three years, despite having been undercapitalized from the start; moreover, it had been awarded contracts promising $100 million in business over the next few years. Grappling with this problem, the company restated its financial history, providing reasons why it had a promising future, and longer-term bank credit was made possible.

As another example, a small Ohio manufacturer had grown from $3 million to $10 million in annual revenue, financing its growth through factors. With factoring fees of 2.5% a month on 85% of the receivables, the factor was making more from the business than its owner was.

Realizing that decisive action was needed, the company packaged its financial story so it became "bankable." As a result, it was able to obtain bank financing and eliminate the factor. As a result, the company's net worth improved by $1 million the next year, substantially enhancing its creditworthiness.

Diamonds in the Rough

Clearly, the accounting and financial records of many smaller businesses often disguise their creditworthiness and hinder their ability to grow. As a result, while not every small business is a diamond in the rough waiting for the astute banker's loupe, there are countless businesses that offer profitable lending opportunities for bankers who are willing to look behind the numbers.

Based on our experiences with small companies, the following issues create the communications gap between entrepreneurs and bankers.

* Has the small company experienced extremely rapid growth? If revenues have doubled, tripled, or quadrupled within a short period, a firm's apparent credit problems may actually be capitalization problems.

* Where is the company's cash going? Many small businessmen maximize cash flow for their own purposes, not the company's. Many corporate expenses could be reallocated to the company's principals if they had shareholders to report to.

* What is the nature of the company's existing debt? Often, long-term debt should be considered equity. A rational program to convert debt into equity, usually preferred stock, could free the balance sheet.

* What are the tax ramifications of a company's existing capital structure? Frequently, small companies' finances are tax driven rather than capital market driven. By changing certain tax assumptions, a small company may dramatically improve its ability to borrow.

With credit conditions as they are, market forces compel business owners to speak the bankers' language when seeking loans.

Conversely, like smart merchants down through history, astute bankers are learning the language and ways of today's entrepreneurs - their future customers.

Mr. Nixon is managing principal of the Carpediem Group, an investment banking firm in Princeton, N.J.

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