The 3 C’s of Credit

Have you ever thought about opening a business line of credit, or buying a commercial building for your business? What about financing an equipment purchase, or simply borrowing capital to finance a business need?  You might have also thought, “ What are lenders looking for?”  

At times, this can seem to be an unnecessary mystery.  So, let’s try to break this down a little so that you, as a Key Decision Maker, can have a basic understanding of what Lenders are looking for.

As a Key Decision Maker and owner of your business, understanding the 3 C’s is important. The 3 C’s of Credit, in this context, are Character, Collateral, and Capacity. A lender will be looking for all three things in order to determine whether or not to lend you money, as well as how much they will lend you and at what terms.

What do the 3 C’s of Credit actually mean? Let’s take a deeper dive.

But before we do that,  let’s make a few assumptions: 

1. Your business has been in business for more than two years (prior to this, there are typically different underwriting requirements).
2. You are going to a Bank or traditional lender. While there are many other lenders out there (hard money, factoring, Friends and Family, etc.) for our purposes, you are looking for traditional lending from your banking partner.
3. You are a small business, as in less than $30 Million in revenue or so (after this point you are often considered Middle Market and different requirements may apply).

Now that have an understanding of being an established small business going to a traditional Lender, let’s discuss what the banks are often looking for (in no particular order because they are all important):

Character

This is who you are, as the Guarantor for this proposed loan. Yes, they, being the Lender, will look at your personal credit, which means they will likely pull your credit. Poor credit history (bankruptcy, short sales, late / no payments, high utilization, etc.) could affect the loan decision and/or need further explanation.  

Many owners will ask “why are you looking at my credit if this is under the business?” So, let’s quickly explain this, simply put, business lending is a high risk for a bank (which is also a reason the rates for a loan connected to your business are usually higher than personal loans; in order to mitigate that risk – but, more on that in another post).   WHO YOU ARE, as the business owner and key decision maker, is the best indication a Bank has to ensure you will fulfill your obligation (essentially, you will make your payments as you committed to).

Other items included in the “Character of the Guarantor”, besides Credit, include (but are not limited to): your industry, legal history, negative news, and any other information that background and internet searches can yield.

Oh, and a side note, most business loans and lines with a traditional lender will have a Personal Guarantee (PG) clause.  This means that you, as the Guarantor of the loan, will back the repayment of the loan, should your business not be able to fulfill the terms. Typically, a PG is required until you reach the Middle Market but, every Bank may have slightly different stances on when a PG is less of a requirement and more of a request. So while you may or may not be able to get around it, it’s still important to understand.

Capacity

Also known as Cash Flow! What is your business’s capacity to pay back the loan? To bring it to the personal side of a home mortgage, this is the “debt service” that is needed.

Lenders will look at financial metrics such as Annual Revenue, Net Income, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and other metrics in order to create an understanding of the capacity of your company to handle the payments and fulfill the loan obligation without causing strain to your company.

Collateral

By definition, collateral is: something pledged as security for repayment of a loan, to be forfeited in the event of a default. The most common collateral is cash, accounts receivable, inventory, or real estate.

The stronger the collateral, the more favorable. You may find that lenders “discount” the collateral, meaning that this is the way a lender views the value of the collateral you offer. They will build in a “discount” for your asset’s depreciation or the fact that it will hold less value over time. Therefore, cash is typically the strongest collateral.

Furthermore, some borrowing mechanisms, such as a line of credit vs. a business loan vs. a real estate loan, will all have different collateral requirements. The amount of money you are asking to borrow will also play a role in the collateral necessary to secure your loan. The more money you are asking for, the more collateral you will need to provide. This is because lenders want to ensure that if something happens with the business and they are unable to collect from it, they still have some value in the property or equipment being used as collateral.

Also – it’s important to note that every lender may have slightly different underwriting requirements, so don’t be surprised if you see certain lenders asking for more, or less, or something not on this list. 

Wow – that’s a lot of information! Need help?  We’ve got you.  Reach out to us and we’ll be happy to help.