When you hear the words "Special Assets", you're past due, you broke a covenant in your loan agreement or the value of the real estate is less than your loan balance, your loan may have become a problem for the bank.
Watch out for the "good news, bad news" conversation your banker may be having with you. You might be smiling like the couple in the picture only to be told later that the bank will not be renewing your loan when it matures in the next 90 days. Here's a couple of situations that could signal that there's a problem:
From the bank's standpoint, all bets are off when your loan matures. Even though they may have renewed it several times before, loan maturity does not equal loan renewal. If you:
- lost money last year
- your real estate declined in value to the point where it's less than the loan balance
- you've had losses
- broke a covenant or
- had a material change in your financial position
the bank will use the maturity of your loan to work out these issues. If they are significant, you could get a new account officer with the Special Assets Department. Special Assets is where the bank puts all their relationships that they are trying to move out of the bank due to excessive risk.
Past due Payments
Your term loan/mortgage loan has default language that the bank can use if your payments are significantly past due. Default language can include increasing the interest rate or charging a late fee on late payments. Your payment history can play a part in your bank's willingness to renew the loan when it matures.
You broke a loan covenant
Loan covenants matter to your banker. They wouldn't be in your note, loan agreement or commitment letter. A covenant is a mutual promise that you both agree on. A condition of being able to continue to borrow money is you keeping your side of the covenants. They can be financial or non financial. A cash flow covenant or leverage covenant are the most common financial covenants. If you have losses or excessive distributions to the point where you break covenants like this, the bank has the right to declare a default. You didn't keep your promise, so they're not compelled to keep theirs. Changes in ownership or management, filing bankruptcy or legal matters like liens or judgments are examples of non-financial covenants that could trigger defaults. A covenant default (you break a covenant and the bank declares a default) is not the end of the world. It's a signal to you that the lender wants to talk about what happened and why. They may want to enforce the covenant (you have a problem) or they can waive the covenant default (a slap on the wrist, don't go it again). If they waive the covenant, be sure you get that in writing from the bank. If you don't and you get CPA reviewed or audited statements, your CPA will need it to comply with their professional standards. But you should get it in writing whether they do or not.
Your loan balance is higher than the appraised value of the real estate.
During the Great Recession, this was the demise of many banks. A lot of banks loaded up on real estate loans only to find out that the values declined faster than the amortization. This became such a problem that the regulators forced banks to order regular appraisals and mark to market their loan balances based on the appraised value. If your loan balance was $200,000 greater than the appraised value, the bank had to set aside that amount in loan loss reserve to cover the difference. While the bank makes an adjustment on their books, you still owe more than the real estate value. If you default, or at maturity, the bank could ask you for a pay down of the loan or additional collateral or a combination of both to shore up their position.
You lost money, declared bankruptcy or had a material change in your financial position
Most notes or loan agreements will have default language in them that gives the bank the right to declare a default if the borrower or guarantor declared bankruptcy, or had a material change in their financial position (had losses or took out a big loan which changed the leverage of the company). The bank gets to decide what is or isn't material. These kind of changes signal financial distress and are big red flags to the bank.
Many times, you've created a situation that triggers a default unknowingly. The bank holds you responsible/accountable for anything you signed when the loan was funded and expects you to maintain the business the same way when the loan was originally made. If external factors created the issues, it's still your responsibility to discuss the problem with your banker and seek a solution. The issues usually can be resolved by either contributing more capital to the company or pledging additional collateral to the bank.
Over the past 90 days, we've seen credit start to tighten. Credit underwriting has become stricter, interest rates and fees have started to increase and it's just harder to borrow money than earlier in 2014 and the year before.
The Quantitative Easing Program initiated by the Fed was officially terminated in October 2014. In a recent survey, about 50% of the banks believe either this will cause mortgage interest rates to rise, which will in turn curb housing growth this year, or the increase in interest rates will cause financial distress in those institutions that did refinances in a lower interest rate environment.
About 78% of lenders believe that unstable energy prices and the housing market have the potential to create the greatest negative impact on the economy in 2015. The drop in oil prices will force energy companies to cut back on production until supply decreases or demand increases. Also, an increase in interest rates will have a negative impact on home purchasing which could cause home prices to drop or newly constructed homes to sit in inventory much longer than expected.
For the first time in the past 5 years, more lenders expect to tighten their loan structures than relax them. This seems to indicate a more cautious credit outlook than we have seen in recent years. Further, more lenders indicate that they plan to increase interest rates and fees than maintain or decrease them in 2015. The combination of tighter loan structures combined with interest rate and fee increases indicate a less attractive borrowing market for 2015. Lenders appear to be moderating their aggressive structure and pricing over the past couple of years. The question remains if they can successfully do this on their strongest credits or just limit it to marginal ones.
In an industry outlook by one of the major consulting firms in the country, banks have been positioning themselves for growth and profitability. An increase in GDP should drive greater loan originations, which will boost profitability. However, new liquidity and leverage standards for banks enforced by regulatory agencies could force banks to hold on to low yielding assets and place additional capital burdens for some assets. Even with the increased demand and more favorable interest rates, some banks may not be able to take advantage of the market due to these new regulatory requirements. It's interesting to note that loans made up 56% of the total assets mix of banking across the country. During the Great Recession with declining interest rates and more regulatory requirements, loans now total only 51% of total assets 7 years later. These circumstances will continue to create consolidation in the banking industry where banks that are marginally profitable and only moderately capitalized will merge with larger banks due to economies of scale.
C&I Lending (commercial and industrial) will be a primary driver of growth for many commercial banks. Wealth management remains an attractive line of business due to the fee income potential. Mortgage lending will be depressed due to an expected increase in interest rates and the lull created by the refinance boom when interest rates were low.
So, with the demise of Quantative Easing, banks expect a more favorable interest rate envirnoment and will expect to increase interest rates and fees. However, banks are still concerned about unstable energy prices and the potential of another housing bubble that could burst. More banks are reporting that they intend to tighten credit structures than relax them going forward. This is the reversal of a five year trend. In a favorable rate and economic environment, regulators are increasing leverage and liquidity requirements for banks, which could impact the supply of loans available in the market. It can also increase M&A activity in the banking industry for leveraged, illiquid banks to be acquired.
So, what does this mean for your business?
Unfortunately, any improvement in the rate and economic environment could be offset by increased regulatory requirements. It appears that the business owner needing to borrow money to finance his/her business, could expect a potentially tighter credit structure with higher interest rates and fees based on data from lender surveys and leading consultants in the banking industry.
Credit structure is very difficult to negotiate with a bank. The loan amount, covenants and term are all part of the credit structure. Do the best job you can to negotiate the largest loan amount you need for the most favorable term (1 year for a line of credit) with the least number of covenants, but realize when the bank delivers your commitment letter, the credit structure is pretty much cast in concrete. However, interest rate and fees are negotiable. Non-interest bearing deposits are a great negotiating tool for you. What's the best way for a bank to increase liquidity? Give them deposits. Because 90% of a bank's loan funding source is deposits, you can trade deposits for a lower interest rate and fees. Let's pretend the bank is loaning you money at 6% and they pay you 0% on your checking account of $100,000, that's a 6% spread or $6,000 a year benefit to the bank. If the bank is willing to give you credit for 1% of that 6% spread, that's a $1,000 benefit you can use to offset your interest rate or fees.
Have questions or concerns about your banking relationship or line of credit? Leave us a comment or contact us here.
You might be dissatisfied with your performance last year and want to increase revenues and profits or you want to continue to grow in the upcoming year. What are your options? Here are 5 ways to consider:
- Increase leads. You have a solid customer base, but you would like to add more customers. The best way is to increase the number of leads your sales people are calling on. Nobody likes to cold call, but have your sales people really done a good job of asking their customers for referrals? People do business with people they know. So, ask your existing customers for introductions to help add to your customer base.
- Improve your close rate. If you see 10 leads and make 3 proposals and get 1 client out of those, you're batting average on proposals is .333. What if you could increase the number of proposals to 5 and get 2 clients? You've just increased your batting average to .400. Most of the time, you can improve your close rate by asking good questions, listening well and seeing the benefit of doing business together from your customer's point of view. Always be sure you're dealing with the decision maker and you understand the customer's decision making process.
- Expand your relationship with each customer. If you have other products that your customer may use, be sure he/she knows about them. Also, your customer may be using one of your competitors and you don't have all their business. If you don't ask for that business, you definitely won't get it. So, ask for additional business from your customers. If you have 5 customers doing $100,000 each and you increase each customers volume to $200,000, you've just doubled your revenue from that customer base.
- Increase your average $ sale. If you feel your business is close to capacity, it may be time to look at the bottom 20% of your customer base. Remember the 80-20 rule. 80% of your business comes from 20% of your customers typically. That means that 80% of your customers only comprise 20% of your revenues. To create capacity, look at which customers generate only small orders and look for ways to replace them with customers that make high dollar orders. This takes some courage, but the benefits outweigh the risk.
- Increase margin. When's the last time you had a price increase? Also, are your vendors increasing prices and you're absorbing those increases without passing them on to your customers for fear of losing their business? If you're not losing a few orders because of price, then it's likely your prices are low and you need to consider an increase.
How do you boost revenues and profits? For additional articles on related topics, these posts may be helpful. I wish you a prosperous New Year!
In case you missed it here's Part 1: What To Do When the Bank Says "No" and
Part 2: What Are Your Options When the Bank Says "No"
You've been turned down by your bank for a line of credit. You've evaluated your options. Now how do you decide which alternative is best?
I have a client that wasn't turned by their bank, they just weren't given all they asked for. The bank gave two lines of credit, one was for $75,000 and one was an SBA line secured by specific accounts receivable for one of their clients. They still had accounts receivable available to pledge to another lender.
Their choices could be an asset based lender, a factoring company or taking on a partner. They looked at it from this point of view:
- The capital needed to be available quickly. So, speed was important to them.
- While the cost for an asset based lender or factor was high, they decided to go with the factor because it was invoice specific.
- The company had struggled with cash flow the first half of the year. So, any valuation for equity would have come at a significant discount off the true value. Plus, taking on a partner can easily take up to 3-6 months to arrive at any deal and they really didn't want a third partner.
Management is hopeful they can consolidate their factoring arrangement in to a line of credit increase with their bank and reduce their overall cost of capital. This would alleviate the need for an additional lender in their collateral pool with less paperwork. Ultimately, in making a decision like this you have to weigh the costs against the benefits. Speed of access was also important here.
You've heard the expression that "time is money." Sometimes you have to pay up for access to capital until you can reach a better long term solution. Ideally, I think all borrowers would prefer to have access to capital with a quick turnaround time at the least expensive cost.
In case, you missed it here's Part 1: What To Do When the Bank Says "No"
You've just been turned down by your bank for a line of credit. What are your options?
I have a client who was unable to get a line of credit because his company was unprofitable last year and the bank wasn't comfortable with his cash flow. You should go back to the 5 C's of credit and determine why you were turned down.
- Cash flow
Depending on which C was the culprit will determine what your options are.
If character, credit or cash flow were the issue(s), asset based lending may be an option. Asset based lending is where the lender is looking at the quality of the collateral (typically accounts receivable and inventory) as the basis for their loan versus these other factors.
There are two options:
First, is a company that factors your accounts receivable. With factoring, the lender doesn't loan, they purchase your account(s) receivable at a discount and include service charges and fees that increase their yield.
The second is a lender that loans you money against your accounts receivable, typically at a margin between 75-85%. They also charge interest, services charges and fees that increase the cost of money. Usually, this type of lender will charge an interest rate (when you include the service charges and fees that could be anywhere from 18%-30%. This is expensive financing and should be considered carefully.
Let's say you have all the C's covered except cash flow. Many times SBA lending programs provide an option due to the terms provided. SBA allows working capital to be repaid over 10 years, same with business acquisitions. The longer term calls for a lower payment which may help improve your cash flow. You pay more interest expense because it's over a longer period of time, but this option may be attractive.
Maybe you're short on collateral in your business? To make a collateral shortfall work, you may pledge personal assets to secure your loan, real estate, cash value life insurance, listed securities (non-retirement accounts).
If these options don't work, then you may not be a candidate for a loan right now. You can either put in the equity yourself or take on a partner.
If you're a credit card merchant, the credit card company you deal with may be willing to give you a cash advance on the merchant credit card volume you generate. But be careful, because you are mortgaging your future for the present and this program is expensive just like asset based lending.
In any situation, consider the cost of capital in your financing decision. The more expensive the financing option, the more impact it has on your profitability. Don't let financing costs eat up all your profits.
What options have you pursued? Which ones have you found work best for you? Please share your successes.
When the bank says "no" to your line of credit that could be the initial signal to you that your business may have a problem borrowing money.
I have a client who is experiencing cash flow issues. She doesn't have a revenue problem, she has an expense problem. We are in the process of correcting it, but the company will show a loss for the year unless some really big revenues hit between now and year end. If you approach a bank while you're losing money, the bank will tell you that they want to see a full year of profitability before they issue a line of credit. Banks don't want to fund operating losses with their line of credit. They want you to take that risk.
If the bank says no, it's likely that one or several of the "5 C's of Credit" are the culprit:
- Cash Flow- The bank is looking for cash flow (net income + plus interest and depreciation expense) to cover loan payments with a 30% cushion. This means that $130,000 of cash flow is needed to cover $100,000 of loan payments. If you have losses or your cushion is significantly less than 30% the bank will not approve your request.
- Character- For whatever reason, the banker didn't feel confident in your ability to run the business. You could have said something that caused the bank to lose confidence in you. Banks want to loan to people of good character.
- Collateral- Banks want the loan to be 100% secured with margined collateral. The collateral can be business or personal assets. They will not loan dollar for dollar. They will assign a margin requirement in the event of liquidation. 75-80% of eligible accounts receivable for example. If you don't have enough collateral to support your loan request, they will not approve it.
- Credit- Your personal credit score is the bank's indicator for how you will repay your loan. They believe you will handle your business credit the same way you handle your personal credit.
- Conditions (primarily, industry or economic) If you're in an industry that is declining or if economic conditions (GDP and job growth, consumer spending) are trending negatively, the bank may choose not to loan to your company. This one is especially tough because it may have nothing to do with you and your company.
Sometimes the problem is not you and your company. The bank may be the issue. If a bank is having capital adequacy or liquidity issues, they may have turned down the lending faucet temporarily. Another reason could be they may have too much of the loan type you're asking for on their books already (investment real estate for example).
However, if the bank says no, it's time for some self awareness and reflection to determine the reason(s) why.
Ever heard of structuring? Some have, some haven't.
My first job as a bank management trainee, was to run a teller window for three months. You wouldn't believe the things you see as a teller. Possibly, the most curious question I got was, "How much can I deposit without having to file a currency transaction report?" which goes to the IRS.
Little did they know that they were asking me to help them "structure" a transaction. Structuring is executing financial transactions in such a way to avoid the creation of certain records or reports as required by law such as the Bank Secrecy Act or the IRS code.
Structuring is often included in indictments related to money laundering, fraud and other financial crimes. Under the Bank Secrecy Act, when a bank receives a deposit of more than $10,000, the bank is required to have the customer complete and sign a Currency Transaction Report (CTR).
Further, if the bank suspects that a person is structuring transactions for the purposes of avoiding the law, they must file a Suspicious Activity Report (SAR). If a bank employee is complicit in assisting to structure transactions they could be subject to a fine and up to 5 years in prison.
A New York Times article recently reported that many businesses make small cash deposits and are not structuring. Their intent is merely to deposit the daily cash receipts of their business with no intent to avoid the law. However, if they're suspected of structuring, the IRS can seize their funds and begin an investigation. A bank employee who is concerned about assisting in structuring would file a SAR on the business which could trigger an investigation.
If you didn't know about structuring before this article, now you know a little. Money laundering, fraud and financial crimes have been estimated in the billions of dollars annually and in 1996 were estimated at between 2 and 5 percent of the world economy according to the International Monetary Fund. Because banks ultimately could become the recipients of laundered money, the government has setup guidelines and procedures for reporting large cash deposits at banks thru the Bank Secrecy Act and the IRS code.
The best way to avoid having your bank file a Suspicious Activity Report (SAR) is to remove the suspicion. Introduce yourself to someone in management at your branch and tell them about your business. Explain to them that you have a cash business and make daily deposits of your receipts. Your intent is not to avoid any reporting requirements the bank may have, this is just ordinary course of operations for your business. You know the expression "an ounce of prevention is worth a pound of cure"? That's probably very applicable here.
Baby boomers preparing for retirement are driving the sale of small businesses like never before. As a business owner, no matter what size or stage your business is at, you must plan and implement a strategy to have your business ready for sale. Here are 5 tips for your to consider when selling your business. I have several clients that are at various stages in this process. For some, the time horizon is less than a year away and another is looking at 10 years from now.
- You've got to have a plan. Most people don't think about this until they are approaching retirement. By then, it may be too late. What amount of money in after tax dollars do you need to have financial independence and how many years do you have to get there? In addition, preparing includes having a succession plan for your departure. Preparing your business for sale won't happen overnight. It takes time.
- Having complete and accurate financial records is critical to give any buyer confidence in purchasing your company and negotiating a higher price for you. This starts with detailed annual budgets. In addition, company prepared financials for the past three years and tax returns will be requested during due diligence. Any inconsistencies in those records gives the buyer leverage to reduce the purchase price. You should establish a cutoff for monthly financial reporting and then prepare balance sheets and income statements monthly to track your progress against budget. Accurate historical budgets gives credence to your company's projected profit.
- Schedule regular board or internal review meetings. Buyers want to see records showing good governance (including minutes of meetings) and accurate financial information. This information reduces the risk taken on when purchasing the business.
- Buyers value businesses with long term leases for key locations, protecting intellectual property with patents/trademarks and having employment agreements for key employees. This also reduces the risk associated with purchasing the business.
- To the extent you can, enter in to long term contracts, such as supply and distributions agreements, with important customers and suppliers. Make sure those agreements are assignable to a potential purchaser.
There are many other areas to consider when selling your business. But, these are a critical portion of obtaining the maximum value for your business when you sell it.
The SBA hosts guest bloggers on the website from time to time. There was a recent article on their website discussing this issue:
"Due to the growing difficulty in obtaining traditional business lines of credit from banks, many business owners are turning to credit cards for small businesses as their primary unsecured business lines of credit."
I had a client recently who was in the process of obtaining a debt consolidation loan which would've paid off several business loans and credit cards. However, one of the credit card providers reported his business payment history to his personal credit bureau report. This dramatically reduced his credit score and may prevent him from successfully completing his refinance. Here's why:
Business owners are turning to credit cards as their primary source of unsecured working capital credit. The unintended consequences of that decision is that they end up putting their personal credit on the line and their business credit cards show up on their personal credit report.
Any time you use a business credit card your personal debt/credit ratios are affected. Many financial institutions offerring business credit cards report to your personal credit which can negatively impact your scores.
So, before you apply, ask the lender if they report your business credit card to your personal credit report. If so, continue the search for a business credit card that doesn't. If you're having a hard time locating a business credit card issuer that only reports to a business credit bureau, then call the bureau and ask them which credit card issuers report to them. If that's not practical, then conduct your own search, but that will probably take you longer.
Business credit cards have been around for a long time. They are great cash flow tools and usually carry interest rates competitive with other unsecured business credit sources. Just do your research before you apply. Some additional due diligence can save you potential negative impact on your personal credit report.
Happy Friday! Enjoy some banking humor to kick off your weekend!