Reprinted with permission from The Journal of Corporate Renewal,
copyright Turnaround Management Association.
In Shakespeare’s Hamlet (Act 1, scene 3), Polonius offers some frequently repeated advice: “Neither a borrower nor a lender be; For loan oft loses both itself and friend…” Polonius’ logic is that hitching debt onto personal relationships can cause resentment and, in case of default, cost a lender both his money and his friend. In today’s tightening credit market, entrepreneurs and bankers find themselves in agreement less and less often about what constitutes a “bankable company.” Getting inside the head of the entrepreneur may help explain why this individual’s expectations of his “creditworthiness” don’t always match his lender’s.
The following scenario is not uncommon. Management has done everything to prepare its loan application package for the bank. Members of the management team believe approval is just a formality. After all, they are longstanding customers. They’ve had some good and bad years financially, but never have they been in default, missed a payment, or broken covenants. So they are shocked when during a meeting to go over the package, the bank responds, “Loan request denied.” How could this happen? What was wrong with the information? Were they missing something? Possibilities to consider include:
·Is their balance sheet fully leveraged, even though they are making all the payments? ·Are they tight on availability due to working capital issues? ·Are they bumping up against coverage ratios even though they aren’t in default? ·Is their industry in turmoil? ·Have major competitors popped up who are eroding their market share? ·Is new technology available that they don’t have and can’t afford? ·Have their expense ratios increased while their gross margins have decreased?
Half Full, Half Empty Management and ownership—if they are not one and the same—routinely overestimate their creditworthiness and think they can convince lenders that their business plan is foolproof. Lenders, of course, see things differently. Borrowers almost universally see the glass as half full, while lenders perpetually see every glass as half empty. The problem is exacerbated if the company is in some form of turnaround in which there is far greater risk involved in executing the business plan. The difference in expectations may lie in the notion that business owners and operators, entrepreneurs at heart, are far more comfortable operating in a risky business environment than any banker ever will be.
Entrepreneurs show up every day putting everything on the line. Many of them borrowed on their homes’ equity and credit cards to launch their businesses and then pledged assets and added a personal guaranty when they first borrowed money and again when they needed more expansion capital. Lenders, however, are on the other end of the risk spectrum. They expect to get their money back plus interest and fees—no home run returns or increased equity value, just their money back. A basic metric of lending is that most banks typically have more dollars at risk in the borrower than any shareholder does.
Seldom does the net worth of a borrower exceed the bank debt. The bank inevitably has many more dollars in the deal than are in the owners’ capital account and therefore has far more tangible cash to lose. As a result, the bank will always err on the side of caution. A borrower’s sense of its creditworthiness at times may well exceed the reality of what a lender is willing to consider. It has been said by many a lender that they “haven’t seen a set of projections they wouldn’t lend on.” Is that because borrowers are so unrealistic as to how their companies will perform in the future? Are the projections based on pure hope or the old refrain, “Don’t worry about last year’s results—we’ll work harder and smarter next year”? Does the company operate like the owner’s personal checkbook? Are there far too many “personal expenses” running through the general ledger?
Lenders may have formed their first impressions of the creditworthiness of the company and the credibility of management long before they even got into the client’s reception area. Their initial impression may be formed in the parking lot under the simple premise of “TMM”—too many Mercedes. It may be when they get inside the manufacturing facility and see a Taj Mahal, with tons of marble everywhere. Maybe they hold off until they get into the owner’s massive corner office decorated with golf trophies and mounted fish that make them wonder where the owner spends most of his time. Matchmaking Why do some companies make better borrowers than others? Why can’t some companies get a loan even if their businesses are strong? Why do some business owners give lenders the creeps, even though they have a decent business? These are the questions that can be overheard around the tables at many fancy country clubs. Business owners and high-level managers may sit and talk about their respective businesses after a round of golf. One may say, “My bank just can’t find a way to lend me the money I need to expand. My business is doing well. I show profits every year. My receivables and inventory are good. I own the equipment. But they still won’t lend me more money.” Another counters that his bank is “throwing money at him,” even though he is barely breaking even.
According to the Federal Reserve (www.federalreserve.gov), the total for all commercial and industrial loans by all commercial banks exceeded $1.3 trillion, as of August 2007. The Commercial Finance Association (www.cfa.com) reports that total asset-based loans for the year ending 2006, the most recent for which data is available, exceeded $500 billion. If total loans are slightly under $2 trillion, why can’t that first guy at the country club get his loan? Here are several common and potentially destructive myths when it comes to finding financing:
·Lenders are eager to provide money to small start-up businesses. ·A loan is approved by “talking” lenders into the deal. ·When it comes to securing a loan, the company speaks for itself. ·A bank is a bank is a bank, and all banks are cold and impersonal. ·Banks, especially large ones, do not need or want the business of small companies. Part of the answer for an owner’s failure to secure a loan may stem from the type of lender he’s talking to. Is he dealing with a bank or a privately owned and operated asset-based lender? Is it a multinational bank holding company that just acquired the local bank? Is he talking to the senior lending officer or a new-business bird dog? There may be other reasons as well. Is he asking for more money than his company could possibly be expected to repay? Is he looking for term money when he needs working capital? Matching his needs to the right lender (institution) may make the lending decision easier and the probability of success greater. Or he may simply need to realign his perceptions of his company’s creditworthiness and business prospects with those of the bank. Real or Imaginary Problems? Often a company fails to win loan approval not because of a legitimate problem in the operations of the business or its management, but because of a perceived flaw that was improperly addressed or worse, potentially misrepresented. It has been said that there is a name for people who simply walk into a bank and ask for money—bank robbers. Understanding what lenders expect and how to approach them properly can mean the difference between getting loan approval and having to scrape by without additional money.
Preparing for and thoroughly understanding the loan approval process is essential in minimizing the variables stacked against a business and to help optimize the potential of bridging the great divide between reality and creditworthiness. Corporate finance advisory firms that specialize in helping to “scrub” loan applications to improve the chances of success are useful not only in turnaround situations, but also in growing companies.
