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Incubators often set up revolving loan funds to help clients meet their funding needs. A revolving loan fund is a pool of public- and private-sector funds that use interest and principal payments on existing loans to issue new ones. A flexible source of capital that can be used in combination with more conventional funding sources, RLFs help provide gap funding, purchase order finance or other capital for traditionally "unfundable" high-risk clients. However, developing and managing an internal loan fund can have many hidden costs. Incubator mangers share their experiences managing loan funds and help set parameters to guide the development and administration of new funds.

Revolving loan funds: How incubators establish and manage internal funds or network with others to serve client needs

by Bridget Lair

October 2011

Debt finance is the only viable funding option for many companies. They may finance their entire operation with debt or use it to build the company until they can access other types of funds. Even traditional debt finance may be out of reach for many incubator clients because their businesses are too new or they lack necessary collateral and experience required for a small business loan.

Incubator loan funds can help close that funding gap and help get start-ups off the ground, but these funds can be expensive and complicated to run. The trick is knowing when your incubator can best serve clients' needs through an internal loan fund and when it's better to assist them to access external resources.

Many incubators and other economic development organizations use a grant or long-term/low-cost loan to start, replenish and expand their loan funds. Often, an RLF provides a bridge between the amount a client can obtain on the private market and the amount needed to start or sustain a business.

Available funds vs. required resources

Incubation programs often consider starting a client-funding program in response to available capital from a private investor or a government grant, but the initial cash investment needed to start a loan fund is only a small portion of the program's real cost. Much of the real costs are the administrative requirements to manage and maintain the program. "The set-up, operation and staff qualification are all complicated and expensive," says Chuck Wolfe, president of Claggett Wolfe Associates in Auburn, Calif., who has administered multiple loan programs and trained at the national and state level on loan program design and operation for more than 20 years. "Lots of economic development organizations have $200,000 either donated or invested. That investment by itself is a liability because loan programs run $25,000-$65,000 annually for the basics. You would need 1.5 full-time staff to run a package or do your own underwriting."

Wolfe notes that expenses vary with program objectives, source of funds and existing infrastructure. "Different sources of funds give different sources of complexity," he says. "The regulatory measures associated with a microloan that can finance up to $5,000 differ from a seed loan that would typically finance $5,000 to $250,000." In addition to loan capital, incubators must consider staffing costs to initiate and administer the loan, provide follow-on advising and in the event of a default, refinance loan lengths or terms.

Loan fund managers need to understand the borrower's market, their management and their operating procedures, but with incubators, a lot of that background work is already done. "Incubators do the support and follow-up consulting," Wolfe says. "It's the added expense if someone defaults that could make the difference."

"Costs to develop a loan program could range upwards of $15,000 to $40,000 for programs that need to do a market assessment and plan – it would depend on the sophistication of the program," Wolfe says.

Chris Reddin, former executive director of the Business Incubator Center in Grand Junction, Colo., says generally, loan administration requires about 16 percent of the loan, and lending small amounts can be the most expensive arrangement. "Smaller loans require the same inputs in terms of administration, but they have less revenue for you," she says.

Carlton Crothers, former CEO at Michigan Tech Enterprise Corp. in Houghton and Hancock, Mich., says MTEC offers three revolving loan funds to incubator clients and averages about 12 loans per year. MTEC clients can apply for an internal RLF issuing short-term loans of $1,000 to $50,000; an RLF run by a local economic development agency offering up to $250,000; or a microloan fund of $10,000 to $50,000 available through the Michigan SmartZone network. Crothers says collaborating with other organizations helped him keep program expenses low.

Preloan and postloan assistance sets incubation apart

Commercial lending institutions often focus on the preloan stage. Advisors calculate the probability of risk and return on loans based on quantitative measures such as a company's credit history and current assets. In today's lending environment, the risk threshold is low. Most lenders require a substantial credit score, three years of business tax returns and collateral to cover the debt, which many start-ups can't provide.

"Lots of start-ups have been debt-financed in the past, but the current environment really is completely new," Reddin says. "Most start-ups' collateral comes from their house or the equity built from the house, but with the fall of the real estate market, that has dried up. Cash flow lending is unbelievably important right now."

In general, incubation programs are less risk averse than traditional lenders because incubator staff and mentors can provide preloan and postloan assistance to help clients navigate the crags and fissures start-ups typically face. "After an entrepreneur gets the loan is the riskiest time, and most banks wash their hands at that point," Wolfe says. "Incubators provide value-added assistance in real time; annual or quarterly meetings are not enough."

Regardless of an incubator's ability to mitigate risks, lending to start-ups is still a gamble, so incubator loan programs must accommodate additional programming overhead and potential losses. "A lot of businesses can recover and perform on the loan if you catch a problem early enough," Wolfe says. "But in many cases, they don't want to admit there is a problem – they bury it and it grows."

Wolfe says requiring open communication protects the incubator too. Lender liability stipulates that if you coach clients and they fail based on your guidance, you can't go after them to recover the funds.

A for-profit structure linking incubator clients with mentors and advisors who are indirectly financially invested in their success encourages clients to approach a loan committee prepared and ensures high repayment rates, says C. Dean Kring, director of research at the Services Cooperative Association in Houston. Advisors purchase a seat on the SCA Advisory Board in return for a percentage of client company royalties, and all clients must select a mentor from the advisory board.

If a mentor recommends a client receive a seed loan, the loan application is approved. The mentor determines the length of the loan and is responsible for keeping the client on track. "When a company screws up, we consider the mentor responsible – they know what's going on," Kring says. Still, the responsibility to build the business is a collaborative effort. The client must meet monthly with the advisory board and mentor; SCA invokes penalties if they don't.

"Growing companies sometimes run out of money before they have the opportunity to build the necessary banking relationships for more traditional loans," Kring says. "We started the seed fund in 1989 with $1,050, and we've made loans anywhere from $100 to $25,000." The SCA executive committee, made up of past clients, set the fees and rates at prime +2, and they have never had a reason to change them. "We have had no defaults," Kring says. "Entrepreneurs go through lots of screening to become an incubator client. People pay us back, so the fund is continually maintained."

Conducting a needs assessment to evaluate market and feasibility

Early on, an incubator should complete a needs assessment to determine if an internal loan fund is necessary. Many communities have existing funding opportunities for high-risk clients through commercial lenders or other economic development organizations. For example, the U.S. Small Business Administration collaborates with lenders to provide a variety of guaranteed loans for small businesses: the 7(a) Loan Program, Microloan Program and CDC/504 Loan Program. If lenders participate in these programs – or if they are willing to participate in these programs – an incubator can just make connections rather than administer a loan. "That analysis to determine if there is a real gap is paramount; 70 percent of the time, people just don't have access or awareness to appropriate financing," Wolfe says.

If capital resources are not available elsewhere, the incubator must decide who will administer the program, who will report to loan funders (if using state, federal or private funds), who will oversee the loan process and whether a loan committee is required. It is also critical to delineate terms of repayment, such as interest rates, loan guarantees, and minimum and maximum loan amounts.

Additionally, the incubator will need to evaluate insurance requirements. A nonprofit would require general liability insurance, while for-profit incubators would need to be a licensed lender within their state. The size of both the fund and individual loans will determine the amount of insurance necessary.

Working with local lenders

Many managers agree incubators should only make loans to clients who traditional lenders consider unbankable. To ensure success, incubation programs should establish a symbiotic relationship with other funders to maintain deal flow in both directions. Lenders can send an incubator individuals who don't meet their criteria, and an incubator can send lenders mature clients with established credit histories and strong business plans. Maintaining a mutual relationship builds security and validation because banks aspire to build successful businesses too.

Many incubator managers see gap financing as one of the best roles for an RLF. For example, if an entrepreneur needs to borrow $200,000 but only has collateral to finance $150,000, an incubator can use an RLF to help finance that $50,000 gap. Reddin calls this 'the incubator sweet spot.' "It develops the relationship with the bank; it develops the relationship with the incubator client; it's perfect economic development, so long as the business plan makes sense," she says.

Assessing your incubator's tolerance for risk

Incubators considering loan programs need to determine acceptable risk and acceptable loss, so the incubator staff and board can establish appropriate policies and procedures for the loan fund.

"Every loan program loses money – every bank loses money," Reddin says. "You need to know what your threshold [for loss] is and what is acceptable. When you set up the loan program, by setting up the procedures, you determine how to mitigate and determine the risk you are willing to take."

Incubators also will need to factor a 3 percent to 5 percent loan loss reserve into the cost/ benefit equation. A reserve is an expense on a profit and loss statement, and Reddin says that expense can be painful for an incubator. "We took a huge hit as we jumped from 3 percent to 10 percent, so as you think about setting up your program, don't forget about the loan loss reserve because it can be a big hit on your P&L,"she says.

Assessing client risk

In addition to evaluating its resources and capacity to finance and manage a loan program, incubation programs also must conduct a risk assessment for each loan application to determine feasibility of market, management and operation. Can the client generate the sales and handle the growth, product and cash flow? "You need to understand the market and evaluate if the numbers your client is presenting are realistic," Wolfe says. "You need to evaluate if their management team will be able to execute and generate those sales to operate at the projected volume. Can they do what they propose?"

Many private lenders are asset-based lenders rather than cash flow lenders, wanting to ensure they can recover their financing if a loan goes south, Wolfe says. "In most small businesses, especially in this economy, there are no assets. How do you make a loan? Contrary to asset-based lending, you do not have the benefit of liquidating a loan."

Evaluating incubator capacity

Incubators that manage loan funds need sophisticated teams to administer the programs. Experience helps staff members evaluate whether a company's strengths balance out its weaknesses. If an administrator only manages one or two deals a year, the benefit of experience deminishes and underwriting becomes more difficult. Wolfe suggests, "If you don't have the deal flow, contract it out part time. To have someone on staff full time, underwriting loans and doing it efficiently and effectively, can be expensive."

As always, the right people are a critical component of a strong program. The manager of an incubator loan fund needs both nonprofit and for-profit skill sets, strong grant writing and communication skills, and meticulous quantitative analysis experience. "You need to find someone who is neither of either but a little bit of both," Reddin says.

In Reddin's experience, traditional bankers may overlook eligible incubator loan fund clients because they are accustomed to determining loan eligibility by entering applicant criteria into a software program rather than evaluating the nuances of the applicant's potential to repay. "In this scenario, it is all gray – there is no clear line. We never get the good deals that are obvious because they would go to the bank," she says.

In addition to an adept staff, incubators managing loan funds might need a loan advisory committee to help manage expenditures and understand the distinct outcomes. At the Business Incubator Center, all loan applications go to a committee. "That committee is a board member, one certified public accountant, two bankers, a lawyer, an entrepreneur and someone who has been funded so they can speak to the value," Reddin says. "That diverse group makes a decision, then we have our board ratify it."

Creating policies and procedures

Planning and organization can help loan programs maintain efficiency and reduce errors. Designing policy and procedure materials, including spreadsheets, manuals, justification and guidelines for the application process, can decrease mistakes and facilitate the loan process – for the client and the incubator. "You have to develop policies about everything you do because there will always be some way to bend around it," Reddin says. "You have to set policies so you know exactly what you are doing."

The SPARK Business Accelerator in Ann Arbor, Mich., takes that concept one step further and posts application criteria, example loan agreements and terms on its Web site, which saves administrators time by reducing unqualified applications. "Potential clients know exactly what is required before they start the process," says Skip Simms, senior vice president of the SPARK Business Accelerator.

Evaluating sustainability

As a rule of thumb, Wolfe says in 2011, loan programs need $3 million to $5 million in performing loans (generating income) to be sustainable. Current interest rates may cost an organization 4 percent, and the cost of operating a loan program could be 6 percent more. In total, incubators would need to charge 9 percent to 10 percent interest just to cover the program's operating costs.

"Everyone wants to offer 2 percent to 3 percent loans because they feel they need to support the mission of the incubator," Wolfe says. "Community-based lenders may offer low interest loans, but they can't make money, so they are unsustainable and they attract the wrong people – people looking only for cheap money."

Wolfe emphasizes that cash flow lending is consistent with incubator mission. "Businesses succeed based on cash flow, not on an interest rate," he says. "Incubators need to charge interest rates commensurate with the risk of the loan to make the loan program sustainable. Otherwise, it is impossible to make enough money to keep the program going."

Wolfe says determining the appropriate loan term goes to risk and use of funds. "A common loan term for start-up clients includes a 10- or 20-year amortization with 5-year call. This arrangement provides help with cash flow, and clients can refinance after 5 years," he says.

Reddin says the Business Incubator Center ignores prime when setting loan rates. "Prime rate is silly low," she says. "You cannot run a loan program on prime. We used to charge prime +1 or prime +2. We don't even discuss that anymore."

She says incubators should charge interest rates of 8 percent to 10 percent, sometimes 12 percent. "The idea is that these are high-risk loans, and you want to charge a rate that is commensurate with that risk," Reddin says. "It's going to be more expensive [for clients], and the idea is that they are going to pay you off faster."

Reddin emphasizes that the Business Incubator Center's loan program is not a profit-making venture – the fees and percentages just keep it self-sustaining. RLFs use spread of interest – the difference between the average borrowing rate and average lending rate – as revenue.

Offering extended loan terms rather than a lower interest rate creates low payments that clients can manage while providing necessary cash flow to fund operations. "It [higher rates with longer terms] doesn't affect their cash flow, but it helps you secure your position and accommodate the risk that you are taking on," Reddin says.

Financial and nonfinancial costs of default

When clients default on a loan, the fallout isn't all financial. Sometimes, foreclosure on a loan may be impossible because of community perception. "Incubators are based on a sense of community, and foreclosing on grandma's house does not benefit that sense of community," Wolfe says. "It is possible to put a lien on a house, and you can collect later – but it may be a long time. If you kick grandma out, you are committing potential suicide in terms of community relations."

Furthermore, there may be political ramifications to refusing a client. Wolfe says a program he advises recently denied a loan for a technology firm, and the client wrote to the governor about it. "There was no management team, no market analysis – it was not a realistic deal, but there may be political kickback for denying the loan," Wolfe says.

Finally, accepting collateral can be complicated and expensive. If an incubator is a secondary lender on property, the primary lender gets its money first. "People overestimate the value of collateral all the time," Wolfe says. If a borrower defaults, incubators may need to make mortgage payments until the property can be sold (if it can be sold), so the program may be assuming mortgage, lawn care and utility payments. "What was once an asset becomes a liability for the lender," he says.

Alternatives to individual loan programs

If it is not feasible for your incubator to operate a loan program, the best alternative is to become familiar with existing loan programs. Creating a matrix of requirements and a guide to funding sources can help you help clients identify opportunities and prepare applications. Another option Wolfe suggests is to start a statewide network, which can create capacity because deals are aggregate.

Whether you develop an internal fund, collaborate with others to create a network or help clients access outside funding sources, long-range planning is vital. "When you think about putting together a loan program, realize that it is much more than throwing a couple of thousand dollars into a loan and there you go," Wolfe says. "You need to have a structured program, with policies and procedures and staff to execute on the program to get that money out."

Sources of incubator revolving loan funds

There are several funding options incubators can use to help finance client loan programs. Because many of these funding sources are tied to federal and state budgets, these sources can and will vary over time.

Various grants are available through U.S. Small Business Administration programs, particularly its Program for Investment in Microentrepreneurs, which is specifically set up to provide microloans to small businesses. The total program amount varies from year to year but has always been less than $10 million, with a grant ceiling of $250,000 per grantee. The SBA also provides loan guarantees through commercial lenders and certified community development organizations.

The U.S. Department of Housing and Urban Development offers grants through the American Recovery and Reinvestment Act and other programs, notably the community development block grants program. A listing of the various HUD grant programs is here.

The U.S. Department of Agriculture offers a selection of grant and loan programs, many of which are targeted at biofuels and "green energy" programs. The USDA also offers an Intermediary Relending Program, which loans money to business development programs, but programs are obligated to repay the loans if their clients default. Details about this program are available here.

The U.S. Agency for International Development offers grants and loans for programs, projects and enterprises in many countries around the world. These are described in an annual report called the "Greenbook."

There are numerous other federal grant and loan programs, some of which may be suitable for business incubation programs seeking to establish revolving loan funds. Some of these programs are highlighted in "Potential Sources of U.S. Federal Funds for Incubator Projects," a Quick Reference document available through the NBIA Bookstore.

Likewise, state and local economic development offices may have grant or loan programs available. Many of these programs are geared toward a particular type of incubator or business supported. For example, some are aimed at bringing women into the entrepreneurial system. A good listing of these, which may also include grant-making organizations that fund other types of groups, can be found at

For international incubators, the United Nations Industrial Development Organization maintains a list of international business development granting agencies.

Sources of capital during the start-up business cycle

The valley of death refers to the period of time before a new company starts generating revenue, when raising capital may be difficult. The valley of death actually contains two distinct gaps not depicted in the above graphic – the first translates directly to stage of business development (i.e., market, management capacity and financial projections); the second translates to loan size, as many lending institutions prefer larger loan amounts (>$100,000). Loan size, business type and sources of funds used to capitalize a loan can have a significant impact on the types of loans being made.

Starting a revolving loan fund

If small businesses in a community have issues accessing conventional financing, public and/or private entities can set up a revolving loan fund. Here are some basic steps for starting an RLF.

  1. Research existing RLFs and compile samples of application forms, program guidelines and other materials.
  2. Invite lenders and potential borrowers to participate in the design process.
  3. Establish the purpose of the RLF. This should include a needs assessment.
  4. Set the eligibility requirements for borrowers.
  5. Determine the allowed uses of funds as well as prohibited uses.
  6. Determine the length of the loan term, which may vary based on the use of the loan. For example, the term for a loan to purchase equipment may be based on the life of the product while a loan for real estate may have a 15-year term.
  7. Establish an application fee, origination fee and policies regarding closing costs. Define the default and delinquency terms.
  8. Decide if the interest rate will be variable or fixed and whether the rate will vary based on the project.
  9. Develop the loan application form. Create a short preapplication form or checklist to help borrowers determine if they are eligible.
  10. Set up a committee to review loan applications.
  11. Determine the administrative duties and staffing needs associated with the program.
  12. Promote the RLF and capitalize with funds from grants and individual donations.
  13. Provide loans and technical assistance to borrowers.

Source: CDFA Spotlight: Revolving Loan Funds (RLFs). Reprinted with permission from the Council of Development Finance Agencies,, Copyright 2011. All rights reserved.

Featured Sources

Carlton Crothers, former CEO, Michigan Tech Enterprise Corp., Houghton and Hancock, Mich.

C. Dean Kring, director of research, Services Cooperative Association, Houston

Chuck Wolfe, president, Claggett Wolfe Associates, Auburn, Calif.

Chris Reddin, former executive director, Business Incubator Center, Grand Junction, Colo.

Skip Simms, senior vice president, SPARK Business Accelerator, Ann Arbor, Mich.

Keywords: Funding sources/fundraising – incubator, economic development, for-profit incubators, venture capital, In-house loan and equity financing program, Angel investors/network, capital access, staffing – incubator

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