From Bank Loans To ‘Smart Capital’

By Cedric Muhammad
-Guest Columnist- | Last updated: Dec 21, 2007 - 10:26:00 AM

“... banks and other lenders, having already tightened mortgage-lending terms, will do the same with loans to small and medium-sized businesses...”
“Expectations Vary for Fed’s Move,” December 5, 2007, Wall Street Journal

“If there are six or eight Muslims with knowledge and experience of the grocery business–pool your knowledge, open a grocery store–and you work collectively and harmoniously, Allah will bless you with success.”
The Honorable Elijah Muhammad, “An Economic Blueprint,” Message To The Blackman

Graphic: MGN Online/Timothy Muhammad

If you are really looking for capital for your business, and from sources that bring more to the table than just money and a payment schedule that looks like a mortgage�then take that business plan, work the phones and e-mail, and hit the concrete�not just in search of money, but �smart money,� which allows your business to grow on its own merit.

A CM Cap client came to me once, disappointed and irritated.

He was telling me of his displeasure at having been turned down for a small business loan at a lending institution where he had deposited tens of thousands of dollars, over a period of time. The bank knew him, was familiar with his business, and the loan amount was not extraordinary.

Yet, he was turned down.

He, like so many other entrepreneurs, was not aware of what a bank truly is. And why it, by nature, can be the least likely source of capital for the entrepreneur. As Bloomberg’s David R. Evanson puts it in Where To Go When The Bank Says No:

“Rest assured the bank will say no. But a bank is not the right place for a small company to obtain capital for growth anyway. If you want to understand why this is so, visit the lobby of your local bank. There you will see some people putting money in the bank, and others taking it out again. People asking the tellers for cash have every expectation that their money will be available when they need it.

And that, in a nutshell, is the problem.

The bank can’t lend your fledgling business the money it needs for growth because that’s not the deal it has made with depositors. Money is deposited with the understanding that nothing too exotic is going to be done with it. After all, it’s a deposit—not a contribution to a hedge fund, venture capital partnership, or buyout group. In fact, if you’re a real purist, a deposit is itself a loan to the bank. If someone lent you funds that had to be repaid immediately upon demand, would you then lend money to a company that was developing a product, but had no sales?

This arrangement leads bankers down a very narrow and predictable path. They can only make loans in situations in which money is safe and repayment is almost certain. So, who qualifies for such a loan from a bank? Established companies may qualify if they can repay the loan from cash flow, and if that dries up, then from the liquidation of assets. Even if a company has the assets or collateral to cover a loan, it still might not be worth the risk. After all, if the deal goes south, the bank has to sell the assets to get its money back. These assets might not fetch as much as the bank thinks. Or they may be difficult to sell at all. Suddenly, the bank starts paying carrying costs and the whole situation quickly gets messy. Banks therefore, only want to lend to customers who can pay them back easily.”

Having read the above, you now probably know more than 85 percent of all entrepreneurs and 100 percent of all of those who just applied for a small business loan (smile).

Now this does not mean that banks have not been a historically important source of capital for small business owners. They have. And certainly, it has been shown in studies that Black-owned lending institutions are more likely to loan money to Blacks, than lending institutions headquartered outside of the community. But the bank—and the Black-owned variety—as important of a community institution as it is, will rarely be the premier or primary source of capital for your new or growing small business.

As I put it bluntly to my clients, banks don’t bet on ideas, they bet on your credit, your income, and what you own. Even loans that come backed by the government are still looking at your personal wealth and company assets more than you business plan. And they also are looking for their money back at a time that suits their bookkeeping interests.

Speak to someone who has gotten the most accommodating loan from a bank—even one with a government guarantee—and you will see this money can come with a payment schedule that makes your “business loan” look like a mortgage note—or what you are putting out for that big SUV that should have never been bought. When the business needs time to breathe and grow it is frequently being oppressed by debt—a monthly bill from the bank. At times it appears that a loan is the gift that keeps on taking, rather than giving.

This is one of the principal differences between formal debt and informal equity so necessary for entrepreneurs to understand today, as credit tightens and more and more banks make less and less loans.

In addition to their reluctance to finance entrepreneurs banks rarely provide the expertise, networking, and management know-how that more frequently come along with an equity investment. When entrepreneurs give up equity, it is often exchanged for “smart money.” That is, money that is combined with human capital, networking, sales and management resources.

The equity investor doesn’t just want their money back; they want their money back because the business succeeds. And because of that, they can be wonderful sources of professional advice, referrals and assistance.

This is why I consistently stress the importance of equity capital and the role that the entrepreneur can play in attracting it from informal sources.

Before an entrepreneur approaches a formal debt source like a bank (or even formal equity sources like a venture capital or private equity firms), I advise them to tap the more friendly sources of capital like family, friends and angel investors (rich folks they know or can contact).

I tell my clients, and all who will listen, that the Black entrepreneur’s most overlooked and underutilized source of capital are the social gatherings that they attend with friends and families. Those social settings, where trust and familiarity are high are ripe for an entrepreneur who is seeking capital on the best of terms.

There is plenty of room for business on the side at affairs and events where dancing, eating, drinking and small talk have previously dominated.

The days of just sending a business plan to someone you don’t know and relying on them to fund you is ending. If you are an entrepreneur, you now have the responsibility to organize pools of capital within your circle and network.

From utilizing the family reunion, annual conference, or dinner party, I have been advising CM Cap clients that wherever two or more are gathered together in a common name or common cause, not only is a greater spirit of trust present (than what you will find in the bank lobby), but also potentially the liquidity that one needs, on terms that are mutually beneficial.

Having good credit, a nice income, and collateral is a great accomplishment and the justification for a bank loan. But it isn’t the basis of a good business idea or model or the best relationship with a capital provider looking to back your promising venture.

If you are really looking for capital for your business, and from sources that bring more to the table than just money and a payment schedule that looks like a mortgage—then take that business plan, work the phones and e-mail, and hit the concrete—not just in search of money, but “smart money” which allows your business to grow on its own merit.

I think you will find that informal equity beats formal debt many more times than not.

(Cedric Muhammad is a business and political economist who advises entrepreneurs and small businesses through his company, CM Cap (http://www.cmcap.com/). He can be reached via e-mail at [email protected]. His weekly “Cedric Muhammad and Black Coffee Program” can be viewed every Wednesday from 12 p.m. to 4 p.m. EST at The Black Coffee Channel by visiting http://www.blackcoffeechannel.com/.)

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