If you’re seeking a business loan, chances are you’re going to have some covenants written into the loan agreement.
“Covenants are basically additional terms in a loan agreement, usually to set financial guidelines for a company,” says Mike Dalton, vice president of commercial lending at National Bank and Trust. “I would expect that more than 99 percent of all loan agreements have covenants of some sort. You can pretty much count on a loan having covenants about collecting financial information.”
Smart Business spoke to Dalton about loan agreements and what business owners need to know about covenants.
What are some typical covenants?
Probably the most common are financial statements — requiring that the borrower provide annual tax returns, monthly operating statements in the form of balance sheets and income statements. A covenant that the borrower provides the lender with up-to-date financial information is very commonplace and put on virtually every loan.
Beyond that, a cash flow covenant of some sort is common. This can be measured in a number of different ways, but the covenant basically says that the company needs to maintain, whatever its debt service is, a certain percentage of that debt service over and above through profits and/or after distributions. Outside of the financials, common covenants involve current ratios and leverage ratios, whether debt to asset or debt to equity.
Are covenants solely to protect a bank’s interests, or do they provide any benefits for borrowers, as well?
It’s really mutually beneficial. From a bank’s standpoint, it is risk management, and loaning money is managing the risk of getting that money back. But covenants are certainly guidelines that are going to make a company healthier and are going to help a company potentially weather a down economy or a bad contract it took a loss on. If covenants make sure the business is maintaining appropriate liquidity ratios, they will help the company get through a bad situation. While the bank sets them, covenants are certainly a benefit to the borrower, as well. These are elements that can keep a company healthy and viable through a potential downturn.
Do business owners usually negotiate covenants, or do they use consultants?
It’s probably 50/50, depending on the size of the business. With a smaller, mom-and-pop operation, it’s likely going to be strictly a conversation between the bank and the business owners. When you get into larger companies, it’s not uncommon to have a CPA involved. Potential borrowers are always encouraged to consult with their CPAs.
Are banks dictating terms, or is there a give and take?
I would say they’re somewhat negotiated items. Ninety-plus percent of the time, it’s just a normal conversation sitting across the desk from a business owner and discussing a loan request, identifying strengths and weaknesses, and coming to a mutual agreement on rates, terms, etc., that are acceptable to both parties.
What happens if a covenant is not met?
There is some kind of penalty. It could be a one-time fee or a higher interest rate until that covenant is corrected.
Typically, it’s an interest rate bump — if a business has missed the covenant, the interest rate goes up by 1 percent, 2 percent or 3 percent until the business gets back into compliance with the covenant. If the borrower drops below its current ratio covenant, you’ve got a company that doesn’t have the appropriate amount of liquidity, so the bank’s risk goes up. Therefore, the rates are raised an appropriate amount. Loan rates, especially in commercial lending, are priced based on risk — the lower the risk, the lower the rate. Another way it’s done is a one-time fee where the bank says, ‘We’re going to measure this covenant at year-end, and if you miss it, we’re going to assess a penalty of a certain amount of dollars.’
If the interest rate can go up, is there anything a borrower can do that would lower its rate?
Anything that lessens the bank’s risk is going to lessen the rate. The borrower could provide additional collateral. If it has an acceptable current ratio now, could it ask, ‘If I increase my current ratio above this, can I get a lower rate?’ Sure.
Other than covenants, is there anything else business owners need to understand about loan agreements?
A loan note itself, other than the covenant section, is 90 percent boilerplate. The bank fills in a few blanks as far as loan amount, interest rate and payment amount, but the overwhelming percentage of a loan agreement is boilerplate legalities. They’re pretty standard; most banks use one particular software system. It’s a two-page note and the second page of the note is identical on every loan and goes over definitions of how the bank calculates interest, what makes a default and what remedies the bank has to collect on the loan in the event of a default. That’s the boilerplate section.
Mike Dalton is vice president of commercial lending at National Bank and Trust. Reach him at (937) 382-1441 or firstname.lastname@example.org.
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Doing business with a large bank may seem like an attractive option for a growing business. But at a large bank, a smaller business can get lost, as some banks are increasingly turning their focus to larger customers, says Kevin Ball, head of commercial lending at Lorain National Bank.
“A local bank can offer a number of unique value propositions, including experienced staff who are familiar with your industry, a flat organizational structure allowing access to decision makers and quick decision making and execution,” says Ball.
Smart Business spoke with Ball about how a local bank can tailor its services to your business’s needs.
How can partnering with a bank whose staff has decades of experience benefit a business?
That kind of experience is necessary in order to quickly understand a business and determine its needs and if the bank can meet those needs. Businesses often complain that banks take their information, then it takes forever for them to come back and make a decision.
If a bank can make a quick decision, even if the answer is no, and explain its reasoning, the relationship can be preserved, leaving the door open for future opportunities with that business. That sounds easy to do, but it is quite rare to find in the banking world.
How can industry-specific experience help a bank serve businesses?
If a bank has done a lot of business in a certain industry, its bankers have built up experience with and knowledge of that industry. Because they see different companies in the same industry and know how things are done, they can provide more than banking solutions; they can also provide insight into that industry and advise a business owner on something he or she may not have thought about.
Bankers at smaller, local banks are also more likely to sit on boards in the community. They are deeply ingrained in the communities they live in and attend functions and get to know the community’s business leaders. This can help them spot potential needs and allow them to talk with potential clients about their needs before they even walk into the bank.
What are some other pieces of the value proposition of a local bank?
A smaller, local bank doesn’t have layers of management and is more streamlined than a national or international bank. Bankers can visit a business owner and bring with them the head of credit, or the president. Those are the decision makers, and that gives them the opportunity to really get to know your business. There aren’t many large banks where you will get that kind of personalized attention.
In addition, smaller banks tend to be heavy participants in the SBA loan programs. That helps them mitigate some of the risks that might be involved in the transactions and can accelerate lending to small businesses.
How can partnering with a local bank help a business owner develop long-term relationships?
At a local bank with experienced bankers, business owners get to know their bankers. At larger banks, people are often trained by rotating them through departments, and business owners may speak with someone different every time they call the bank. Smaller banks are less likely to do that, and with an experienced staff, you are dealing with the same people every time you call, giving you the opportunity to build that relationship.
How do those relationships result in a better match of banking products?
It allows the bank to better tailor products to a business’s needs. The banker has time for work with individual businesses to find out exactly what they want and need, tailoring solutions to that, as opposed to a big bank approach, which often views smaller businesses as too small to do business with.
A lot of big banks say they’re lending, but they’re not. A business owner might find more success with a local bank, which will take the time to understand their business.
Are a local bank’s clients limited to the area?
Not necessarily. With today’s technology, the reach is broader. It’s no longer necessary for banks to have branches on every street corner. Modern treasury management provides the technology to scan items and use an Internet-based system. If you find a bank that offers great service and solutions that fit your business, its physical location isn’t as important.
How does the market for lending look going forward?
There is currently a good balance of activity and an increasing amount of optimism in the marketplace. Car dealers are having a great year so far, business is booming for some manufacturers and industrial space is starting to get tighter. Although the media tend to focus on negative stories, there are a lot of businesses that are thriving.
Kevin Ball is head of commercial lending at Lorain National Bank. Reach him at email@example.com.
Coming out of the downturn, many private companies had not been able to get venture capital funding and had to look internally or to commercial banks to get capital or leverage.
“As the economy comes back and commercial banks have more capital at their disposal, things are improving regarding the ability to get commercial loans,” says H. Jesse Garcia, senior vice president and group manager of Bridge Bank’s commercial lending office in Palo Alto, Calif.
Some companies may have stressed their banking relationship during the recession and will likely go out into the marketplace, after returning to profitability, to look to get more from a new banking relationship. Understanding what qualifying conditions commercial banks are looking for will prepare companies to work better with their commercial banks and leverage what they have to offer.
Smart Business spoke with Garcia about the lending climate and the criteria commercial banks use to qualify loans.
What do commercial banks offer to private companies without venture capital funding?
Commercial banks can offer a variety of loans, including lines of credit backed by accounts receivable, equipment financing, term loans, acquisition loans and commercial building loans where a business buys the building in which it works to facilitate its business.
Commercial banks qualify non-venture capital-funded companies on three main factors:
- Historical performance, which includes profitability, cash flow and its record of servicing loan payments;
- Secondary sources of redemption, which could include accounts receivable or inventory, but could also be fixed assets or assets that the owner pledges; and
- The business owner’s personal guarantee, including the strength of his or her personal assets.
When looking at these three criteria, a borrower generally could have a deficiency in one area and mitigate it by strengthening another to improve the chances of getting a loan.
From a lending perspective, what is the difference between closely held businesses and venture-backed companies?
Typically, closely held businesses have a much smaller group of individuals holding the company, and these individuals don’t want to sell a portion of it to bring in capital. Depending on the market, companies could be limited on sources of capital because of their narrow market share. Normally these privately owned companies need to run with a much leaner finance and strategic group, and the main focus of the owner is building the business and knowing their industry. Owners often lean on their commercial banker, CPA and other advisers for resources to grow the business. More successful private businesses have a more cohesive core of professionals around them who are extensions of their finance group.
What should these private business owners look for in a commercial bank?
They should be looking for an experienced banker and a bank that’s focused on commercial lending. Lending to privately owned businesses is a niche in banking and it takes a very keen eye. Experienced bankers can guide you through many loan products or ways to leverage the company — some more limiting than others, depending on your rate of expected growth. Being able to have a banker who understands the pitfalls of products helps owners make more appropriate choices when thinking about how to leverage their company with commercial banking debt.
Also, owners often want to work with a bank that understands the landscape of other professional service providers who can help their business. Many companies don’t have the wherewithal to bring in strategic financial consultants, so it can be helpful to be guided to the right professional service providers.
Is the old adage, ‘Banks only lend money to those companies that don’t need it,’ true?
While this might be spoken tongue-in-cheek, there are people who think this might be true. It refers to the belief that banks only lend money to companies with high profits because they have more cash on hand and, therefore, a greater ability to repay. Conversely, it implies that banks aren’t there for companies that really need the money. This has been reinforced because of the lending conditions that some have perceived to become prominent following the economic downturn. However, this really isn’t the case.
Good commercial banks work with companies through many situations, and banks have really stepped up during the downturn to provide or continue to provide loans as companies push through the difficult market. One thing that may have happened during the downturn is good banks had to look internally and see what their clients’ needs were and keep resources available for them. This means they were not as outward looking and not as aggressive in pursuing new clients. But over last two years, as the economy has turned around, there’s been more certainty in the market and banks are again looking outward.
How has the underwriting for these businesses changed during the past several years?
In the commercial lending market, the types of financials and tax returns it takes to underwrite loans has not changed too much. Commercial banks have generally needed a lot of information to examine the business’s ability to pay back debt. While this is still true today, the current market is perhaps more conducive to borrowing compared to a few years ago. Banks have increased capital reserves in the recent past and as a result are more eager to lend. They are looking to diversify lending to include more commercial loans in their portfolio. Companies with adequate cash flow are attracting a lot of attention from commercial banks. There seems to be a good market for companies to get better pricing and terms than what they had two to three years ago.
H. Jesse Garcia is senior vice president and group manager of Bridge Bank’s commercial lending office in Palo Alto, Calif. Reach him at (650) 462-8512 or firstname.lastname@example.org.
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If you run a small business that has had difficulties obtaining a loan, there is some good news. Preferred lenders can help businesses navigate through the U.S. Small Business Administration (SBA) loan programs to obtain financing needed for growth and expansion. The SBA loan process can be confusing, and small businesses may experience unknown challenges when applying, such as a collateral shortfall or not enough cash down payment to put into the transaction. However, preferred lenders, like community banks, can help small businesses with this process.
“We’re likely experiencing the lowest interest rates in history,” says Edward L. Wood, CTP, regional vice president of commercial lending for National Bank & Trust. “The ability to lock those rates in for a longer period makes today a compelling time to get an SBA loan.”
Smart Business spoke with Wood about SBA loans and how obtaining one could benefit your business.
What types of businesses can benefit from an SBA loan?
Typically, the SBA’s goal is assist small businesses with their growth and lending needs, rather than large corporations that do more than $100 million annually in sales. However, there are a variety of SBA rules that companies must abide by to qualify for an SBA loan. It is always recommended that the borrower find an experienced SBA lender who participates in the Preferred Lender Program (PLP) and can help you navigate the SBA requirements.
How do SBA loans differ from other loan products?
There are many advantages to SBA loans, including a lower down payment, sometimes as little as 10 percent, which is typical of two SBA programs known as 504 loans and 7A loans. You also can get extended payment terms with these loans. For example, lenders with working capital loans prefer to keep amortizations between 36 to 48 months. Under the SBA 7A guaranteed loan program, many lenders allow longer amortization periods, usually up to seven years, which provides an even greater benefit to the borrower.
Also with a SBA 7A loan, the bank is lending all of the funds for the project and the SBA provides the lender with a guarantee, generally around 75 percent of the total loan amount. These loans offer working capital to fund growth, accounts receivable and inventory.
The SBA 504 loan is geared toward equipment financing and/or owner-occupied real estate. With this type of transaction, the borrower has two loans — one with the SBA who finances 40 percent and the second with the lender who finances 50 percent. The borrower is only required to provide 10 percent equity in the project. Under the 504 program the lender maintains a first mortgage on the collateral while the SBA takes a second position. Additionally, with the SBA 504 loan, the borrower should be aware there are prepayment penalties within the first 10 years.
The effective rate for the SBA portion of the 504 loan in August 2012 was a fixed rate of 4.45 percent. The lender portion is usually handled with a five-year adjustable rate.
What is the process to obtain an SBA loan?
The process starts when a borrower contacts his or her preferred lender. The lender will assist him or her through every step of the process. The lender drives SBA 7A loans and capital lines of credit from start to finish and submits the transaction to the SBA for approval. For SBA 504 loans, the lender will also work with a third-party non-profit entity that will underwrite and submit the transaction to the SBA for approval.
To apply, simply provide the same information you would for any other type of loan. Lenders are looking for the last three years of business and personal tax returns of the guarantors and accountant-prepared financial statements covering the three previous years. A personal financial statement from each year and an aging of the business accounts receivable and payables are also needed.
Why is now a good time to apply for an SBA loan?
The uncertainty in the interest rate market makes today a compelling time to apply. Because of this uncertainty, the SBA loan becomes an incredibly viable product that could allow you to fix part of your total debt service for up to 20 years. Getting longer amortizations on working capital loans are compelling because it allows the borrower to stretch payments out over a longer period of time, thus reducing your debt service requirements.
There is also uncertainty in the market, not only in terms of where interest rates will head but also where inflation will be and the debt level the U.S. has taken on. While interest rates will rise no one can be sure when that will happen, so it is to a company’s benefit to act now.
How can working with a community bank to obtain an SBA loan be beneficial?
A community bank has the ability to better execute an approval. There are fewer people at the top involved in the approval process than at a larger bank.
Depending on the type of transaction, it could take three weeks to get an approval once the lender receives all necessary information. Community banks are well suited to obtain all the necessary information upfront, which can help avoid delays.
Edward L. Wood, CTP, is regional vice president of commercial lending and the HCDC (Hamilton County Development Corporation) 2011 lender of the year. Reach him at (800) 837-3011 or email@example.com.
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It’s not unusual for borrowers to sign a loan agreement without understanding all of its provisions. Now, those hasty decisions are coming back to roost as business owners struggle to turn a profit in a tepid economy and comply with a host of pre-existing debt covenants. To make matters worse, business owners often commit another faux pas by failing to notify their banker before a violation occurs and end up facing rising interest rates, increased collateral requirements or limited cash advances.
“In better times, bankers were often willing to overlook minor covenant violations,” says Jonathan Sigal, first vice president of loan review and senior portfolio officer for Wilshire State Bank. “Now, bankers are worried about a borrower’s financial ability to make their loan payments, so a covenant violation is serious stuff.”
Smart Business spoke with Sigal about common loan covenants and how executives can take steps to avoid a violation.
What do debt covenants typically cover or require?
Bankers use covenants to set parameters that business owners need to take into consideration when making decisions that could jeopardize their ability to fulfill their loan obligations and to ensure that the loan’s provisions are consistent with the borrower’s risk profile. They tailor the covenants to mitigate each loan’s specific risks by imposing a series of financial and reporting requirements. For example, the covenants may mandate a certain cash flow or asset-to-loan ratio, so a company doesn’t become overleveraged and borrowers can liquidate assets to make their loan payments in a pinch. Bankers may require landlords to submit a quarterly rent roll or notify their loan officer if certain situations occur. Business owners need to understand the covenants and how to comply, because violations are no longer considered a minor inconvenience, and regulators insist that bankers strictly adhere to the loan’s provisions.
What’s the best way to avoid a covenant violation?
Business owners should read the loan document and understand the covenants before signing on the dotted line, because education and awareness are paramount to avoiding a violation. Next, assess the feasibility and long-term impact of the covenants by authoring a business plan and financial forecast. It’s better to know up front if you need to boost margins or postpone additional investments in order to meet the covenants over the life of the loan. Finally, create a spreadsheet and proactively compare your monthly results against the covenant requirements so you can change course or make adjustments before a violation occurs. Since reporting usually takes place on a quarterly or semiannual basis, continuously monitoring the company’s position gives executives the opportunity to head off violations at the pass.
What should executives do if a violation is imminent or unavoidable?
Don’t wait until a violation occurs to schedule a meeting or pick up the phone. Alert your banker right away and be ready to outline what you’re doing to change the situation. Bankers have to protect their interests, so once a violation occurs, they become enforcers and often have to initiate disciplinary action. But if you lay out the problem in a letter or e-mail, and offer a viable resolution and a timeline, your banker may become your supporter and even propose ideas or possible solutions. Remember, your banker must have confidence in your managerial abilities and know that you’re on top of the situation. Finally, always document your discussions in writing and create a paper trail, since there’s no such thing as a verbal agreement in the banking world.
Is it possible to get a waiver or reduction in covenant requirements?
If a covenant is redundant or the reporting requirements prove to be too burdensome, it’s possible to have it eliminated or modified as long as both parties agree. It’s also possible to get a waiver if you can show that an adverse situation is temporary. For example, perhaps a large customer has impacted your cash flow, but they’ve recently agreed to pay invoices every two weeks, or your company has incurred nonrecurring expenses or one-time losses that are reflected in your financials. If your request to modify a covenant increases the bank’s risk, be prepared to offer something in return like transferring accounts from another financial institution or providing additional collateral, such as a deed to a second property. Bear in mind that the bank may charge a fee for modifying covenants, but in general, bankers will acquiesce without changing any terms if a covenant waiver makes sense and doesn’t impose a lot of additional work or extra risk.
Do you have any other advice for executives?
Chief financial officers and accountants are usually familiar with debt covenants, but business owners also need to understand the commitments and responsibilities, because a violation can lead to severe restrictions or even foreclosure. Ask questions during the loan documentation and drafting phase, so you can create a realistic forecast using a variety of assumptions and contemplate the business impact of fulfilling the requirements. How does the covenant define cash flow when calculating ratios and is it possible to exclude certain expenses from the calculations? Remember, a bank can re-price your debt if your company undergoes significant changes to its financial position or operating results, and how you handle a violation may factor into their decision.
Jonathan Sigal is first vice president of loan review and senior portfolio officer for Wilshire State Bank. Reach him at (213) 427-7921 or firstname.lastname@example.org.
As the world slowly moves out of the great recession, banks are starting to lend more, but they’re still cautious. The best way to ensure the financing your business needs is to work with your accountant to make your organization more attractive to lenders, which starts with good business planning.
“All organizations should have a business plan — their road map of what they’re going to be doing in the future, especially a new business or an immature business,” says Carol Scott, vice president of business, industry and government for the American Institute of Certified Public Accountants.
Having a plan is critical to convincing someone to loan you money, whether it’s a bank or a venture capitalist.
“If you’re looking for financing, you have to make the business case that, ‘I have a good plan for running this business, and I have a good plan for repaying you,’” Scott says.
Planning also makes you look more put-together. Steve Christian, the managing director of Kreischer Miller in Philadelphia, says lenders don’t like surprises.
“Know your needs in advance,” Christian says. “Don’t call your lender a week before you need something, because it’s just evidence that you’re not the greatest planner in the world.”
Christian says to also be upfront with your accountant and lender about both the good and bad in your business.
“A lot of owners aren’t engaged in communicating bad information to the lenders for fear of the unknown, but actually it increases your credibility with the lender,” Christian says.
In addition to planning, demonstrating control is critical for impressing lenders, according to Mike Dubin, Philadelphia office managing partner for McGladrey & Pullen LLP.
“The last thing a banker wants to see is that the stewards of the business — and that could be the president, owner, CFO or COO — don’t have control and don’t have understanding,” Dubin says. “The minute there is a suspicion that there is a lack of control or lack of understanding what’s going on or a lack of full knowledge to exactly what’s taking place in the business, that’s the first thing that will turn off the banker.”
Dubin suggests setting up Sarbanes-Oxley-type controls for your organization, even if you’re private. For example, having segregation of duties decreases the likelihood of fraud in the business, and lenders notice those things.
“What makes lenders feel good is making sure that the control environment works properly, and accountants certainly have the skill set to be able to help owners do that,” Dubin says.
Another way to increase your chances of getting funding approval is to have accurate, professional financial statements.
“What turns off a banker immediately is when there’s a company that has internal financial statements that appear to be not professionally produced or appear to not be correct or may not be complete,” Dubin says.
This is where a reputable accounting firm can help you look more attractive to lenders.
“Dealing with the right accounting firm adds credibility to the financial statements and to ‘the ask’ — whatever it is you’re asking for,” Christian says. “It’s incredibly important to engage a reputable, well-respected accounting firm because they can assist in better terms, better conditions, and it adds credibility.”
Donny Woods, president of the National Society of Accountants, agrees but says, like with approaching lenders, to give your accountant a few weeks’ notice to prepare financial statements.
“You can’t just walk in and say, ‘We need these financial statements tomorrow,’” he says. “We have clients who will do that and think all we have to do is push a button and print report, and it’s just not quite that easy. … When you are doing financial statements, you don’t need to be rushed. You need to be able to have time to consult with the client to make sure that the information you are including is correct and there’s some analysis that has to be done, and it can be time consuming.”
Beyond these things, your history is important when it comes to getting financing, as well.
“They need to watch their cash flow and make sure they pay their bills on time,” Woods says. “They need to have a good payment track record. Those are the things that lending institutions are looking at.”
Scott says you also have to demonstrate the strength of your customers to lenders if you want to get financing.
“You have to have strong customers to have a strong business,” she says. “You could sell product all day long, but if your customers that are buying the product are not in a good position, you’re not going to collect your money.”
How to reach: American Institute of Certified Public Accountants, (888) 777-7077 or www.aicpa.org; Kreischer Miller, (215) 441-4600 or www.kmco.com; McGladrey & Pullen LLP, (215) 641-8600 or www.mcgladrey.com; National Society of Accountants, (800) 966-6679 or www.nsacct.org
Even the owner of a successful business can encounter an occasional financial setback and cash-flow problems, which prevent them from making the scheduled payments on their commercial property loan. But unless they take immediate action at the first sign of distress, they could end up jeopardizing the future of their business and forgoing the equity in their property.
Fortunately, committed owners with a viable business model may qualify for a loan modification, which gives them a chance to regroup or wait out an economic downturn by temporarily lowering their loan payments. However, owners need to do their homework and research their options before reaching a decision.
“Modifications are a great tool, but they’re designed to relieve a temporary situation,” says Seung Hoon Kang, senior vice president and chief credit officer for Wilshire State Bank. “If things don’t improve and owners fail to make the modified payments, then banks have the right to foreclose on the property or force a short sale.”
Smart Business spoke with Kang about the options for commercial borrowers who undergo a financial setback and the best way to approach a lender about a loan modification.
When should borrowers consider a loan modification?
Borrowers who run short of cash because of the poor economy or a prolonged seasonal downturn may qualify for a temporary reduction in their mortgage payments by requesting a modification. Businesses and individuals who own commercial properties such as strip malls, gas stations, car washes, hotels, motels, apartments or office buildings will be considered. But remember that borrowers are required to pass along any reductions to tenants, so everyone has the opportunity to recover. If a loan officer grants your request, your payments may be reduced for up to six months so you can continue operations. However, you’ll be required to repay the concessions once the economy improves, which is why a modification is only an interim solution.
How does a loan modification differ from a short sale or foreclosure?
A loan modification is appropriate when an owner wants to continue the business and preserve any equity in the property. If the borrower owes more than the property is worth, or doesn’t want to revive the business, then a short sale or foreclosure may be the best option. A short sale requires the lender’s approval, and allows the owner to sell the property for an agreed upon amount that is usually less than what is owed. If the bank forecloses, it assumes the property and the borrower will be forced to vacate and concede any equity. In some cases, banks may be willing to permanently modify a commercial loan by extending the length of the note or reducing the interest rate, which is the best solution for situations that are expected to exceed six months.
What should property owners know about the modification process?
Be sure to contact your lender at the first sign of trouble, because the approval process takes about four weeks. Realistically assess your situation and your options, since you’ll have to substantiate your inability to make your payments and the reasons why your business will thrive once the economy improves. Remember that lenders will consider your ambition and sincerity as well as your business plan, because it’s hard to revive a struggling business and long-term survival requires a committed and enthusiastic owner.
What’s the best way to approach a lender about a loan modification?
Make an appointment to meet with your lender and be ready to present your case by bringing a copy of your business plan, P&L and your latest rent roll, if the property is tenant-occupied. You’ll also need to provide a hardship letter that explains your situation and the reasons you can’t make your payments. In many respects, requesting a modification is like applying for a loan, because lenders will be evaluating your business strategy and the competition and assessing your ability to run the business as well as the feasibility of your model.
Why do so many modifications fail and how can business owners avoid a similar fate?
Borrowers frequently overestimate their ability to bounce back from a downturn and what will happen if they fail to make the modified payments. At that point, they lose the ability to control their own destiny, because the bank has the right to immediately foreclose on the property or force a short sale. Sometimes the situation requires more than a short-term fix, in which case the owner should consider other options and attempt to refinance the loan or negotiate a permanent modification.
Do you have any other advice for commercial property owners?
Do your homework and beware of advertisements from firms offering loan modification assistance, because they may paint an unrealistic picture of your chances or provide misinformation just to earn a fee. Listen to your loan officer, because he or she will know the best course of action after assessing your situation. Ask how each option will affect your credit and consider the long-term implications when making your decision. Finally, don’t ignore a financial setback or letters from your lender, because the situation will not go away and ignoring communications gives your lender the false impression that you simply don’t care.
Seung Hoon Kang is a senior vice president and chief credit officer for Wilshire State Bank. Reach him at email@example.com.
We've all heard the adage, “Banks only want to lend to those who don't need the money.”
“Not so!” says Lloyd Bell Jr., senior vice president of Western Reserve Bank. “Banks can only flourish by making loans. Interest is their main revenue source, without which they can't survive. Simply put, all a bank wants for a commercial loan is a borrower who has a successful business, a logical reason for borrowing and the demonstrated capacity to repay the loan.”
How then can one best navigate the process of getting a commercial loan?
“The best approach is through effective communication accompanied by relevant and accurate information,” he says.
Smart Business learned more from Bell about how businesses can successfully obtain a loan from their bank.
How should a business prepare before approaching its bank?
The starting point is to think the need through, as you would for a personal car loan or mortgage. How much do you think you need to borrow? And, based on what you know about your cash flow generating capability, can you pay it back?
Then, approach a community banker and tell your story. How long have you been in business? What is your product or service? Who are your competitors? Who makes up your management team? What are the positives and negatives in your business? And where do you think your business is headed?
Are you looking for a loan for a bona fide business purpose, such as buying a plant or equipment, or for more working capital to support a growing volume of business? Speculation is considered an inappropriate reason for a loan. For example, say you use copper as a raw material in your business, and you believe the price will be going up soon. You want to buy now and make a buck when the price rises. You may end up being correct about the price, but speculation is not something the bank is going to want to finance.
Another point to keep in mind is that banks are not venture capitalists; they are not positioned to fund visions or start-ups. They are providers of debt capital, focused on providing funds to existing enterprises. You may have a great idea for a prospective business, but a bank is not the place to go for seed money. Your need some track record of successful operation, usually at least a couple of years.
What else does the bank look for?
The next step is to think carefully about when can you pay the loan back, bearing in mind that the bank is going to want to see a demonstrated capacity to generate the wherewithal to repay the debt, i.e. adequate cash flow. Saying ‘I think I can crank volume up substantially next year.’ with the thought that you can only pay the loan back if something extraordinary occurs is not a realistic way to look at your capacity to repay.
The bank lender will look at the cash flow your business seems capable of producing and match that with all of your debt payments, existing and proposed. Typically, the bank likes to see a cash flow to required payments ratio of 1.2 to 1, meaning that the cash flow — defined as net income plus non-cash charges such as depreciation, plus interest — covers all of your debt payments with an extra 20 percent cushion.
If the servicing requirement on the prospective borrowing is just way beyond your demonstrated capacity to repay, the bank, naturally, is going to decline the request.
What kind of information does a business need to provide to its bank?
Make sure your accounting records are in order, meaning that they are maintained in a timely fashion, are accurate, and give you the capability to produce statements, like balance sheets and operating statements, quickly. This is important not just for the loan application process, but, looking ahead, for the provision of statements to the bank on an ongoing basis.
In assessing your capacity to repay a loan, the bank will want to see several years of financial statements and tax returns, plus a personal financial statement and several years of personal tax returns.
Finally, think about what sort of collateral you have to secure your loan. Is it the plant or equipment you're acquiring or working capital assets such as accounts receivable or inventories? Bear in mind that the bank will want a margin of protection, meaning that they will loan less than 100 percent of the value of the assets serving as collateral — for example, 80 percent advance on real estate, 75 percent to 80 percent on receivables, 50 percent on inventory.
And don't forget your personal credit score. Check it, and if it is below 650 — 700 for some lenders — make sure there are good reasons for it not being higher. The score is not so much a measure of capacity as it is a gauge of reliability and whether you honor your obligations.
What should a business do after it is granted a loan?
Once get the loan you need to maintain ongoing communication with the bank, letting them know how the business is doing. Keep the bank supplied with interim and annual financial statements, produced in a timely manner and communicate significant developments.
This should seem intuitive, but, surprisingly, a lot of owner operators are so focused on the selling or production end of their business that they are not always tuned in to the need for good financial reporting and communications. For those who are, life can be easier: a smooth relationship ensues, and when you need additional credit, the bank is in a better position to deal with your needs routinely and quickly.
Lloyd Bell Jr. is senior vice president of Western Reserve Bank. Reach him at (440) 746-6100 or firstname.lastname@example.org.