How many times have you heard the expressions “my banker is my friend” or “I have a great relationship with my banker”? These may be true, but really your banker is a vendor who sells you money—a very important vendor but a vendor nevertheless.
One must understand that almost every turnaround involves renegotiating terms and conditions of the lending arrangement with a bank or other type of lender. These negotiations can be adversarial because I usually represent the debtor. On the other hand, if they are structured properly, there can be a win-win situation allowing the company the ability to survive and the bank the ability to recover its loan.
The turnaround lesson that can be utilized in your banking arrangements is that if your loan agreements are structured properly at the time the loan is consummated, then the probability of having problems in the future is vastly diminished.
There are a number of events that may affect a bank and can have negative implications to a lender. Let’s examine each in turn.
The availability of loans and their interest rates are greatly influenced by general economic conditions at the time of the loan. If there is a great deal of liquidity in the marketplace and banks are competing for business, interest rates tend to be low and banks will take greater risks with potential clients. If the Federal Reserve tightens up the money supply, then loans are harder to get and rates are higher. Banks are subject to the laws of supply and demand, just like you are.
Over the last few years there have been numerous bank mergers, and as a result you may find yourself in the position of having a new parent bank that holds your loan. Your relationship with the bank may change due to a change in personnel. Even worse, the new bank may not like your loan or may decide to rid itself of companies in your industry even though you have not violated any conditions of the loan. This applies especially to industries that the lender may identify as high risk.
If you have had “bumps” in your relationship with the bank, for example, a late payment or two or a minor covenant violation, the bank may classify your loan as “underperforming” and express a desire that you go elsewhere. An offshoot of this is that the bank may be forced to increase its loan loss reserves in anticipation of further problems.
The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve regulate banks. Even though your bank may consider your loan as performing, the regulations may not and may force the bank to reclassify your loan.
The definition of an HLT can vary and depends on your debt-to-equity ratio. Your loan may become an HLT and be treated differently. Regulatory agencies normally mandate this definition.
Since the Enron and Tyco debacles, banks have more closely scrutinized loans and interpreted financial data more conservatively. Conservative interpretation by public accountants may also adversely change perceptions of a company’s performance, which in turn may cause violations of loan covenants.
In most lending situations bankers are seeking several criteria prior to lending. The degree to which these criteria are satisfied will affect the conditions of the loan as well as the interest rate. The criteria are:
Viability of the Business. This is determined by the historical track record of the business from a P&L standpoint and the business plan going forward.
Understandability of the Business Concept. Bankers don’t invest in businesses they don’t understand and believe will not be in existence for the term of the loan. This includes considering the competitive environment of the business.
Equity. Banks like equity investors who may be prepared to step up with capital if the business gets in trouble, hence the desire for personal guarantees, which eventually force further equity contributions. The day of very highly leveraged transactions is essentially over due to regulatory constraints.
The Character of Management. The honesty and character of the managers and owners are very important to a bank, as is stability in key positions.
The Collateral Available for the Loan. Banks want to see sufficient collateral in terms of receivables, inventories, and machinery and equipment to recover their loans in the event of default. This is especially true of asset-based lenders (ABLs), which rely heavily on this security. Again, the personal guarantee provides another level of collateral to the lender.
Communication. Last, the lender wants a schedule of reports and guaranteed communication with the company so he or she knows what’s going on.
There are several keys to taking control of your banking relationship and optimizing the conditions under which you borrow money. They are:
Get to know your banker and let him or her know the key personnel in the company (e.g., the chief financial officer).
Regularly review the operations of your company and your business plan with your banker.
Never lie to your banker.
Keep your banker informed of both favorable and unfavorable events in the business—no surprises.
Always have an alternative banking source available.
The last of these items is especially important. I stated at the beginning of this chapter that you should realize that your banker is a vendor like others. It would be foolish to have only one source for a key component of your product. Likewise it would be foolish to have a single potential lender. This means that the development of a relationship with a second bank does several things:
It keeps your current lender honest and competitive with regard to rates and conditions of your loan.
It gives you a place to go quickly if your current lending arrangement is compromised in any way.
It gives you negotiating power.
The second bank relationship may involve occasional meetings with officers of the second institution or the presence of a minor account at the second bank. But all of us know what happens if you are forced to seek new lending in a short time frame. If you are lucky enough to find a secondary lender, the borrowing rates are significantly higher and the conditions of the loan are much more severe.
A key to managing your banking arrangement is the financial projections—what is normally called your budget. The budget document and its updates are the financial document that drives your relationship. Here’s why:
Your performance is measured against it.
Your loan covenants are based on the numbers you project.
Most businesses have seasonal ups and downs, or if they are growing may have cash needs beyond that of a steady-state business. The projection you give the bank should be conservative in nature and reflect a less ebullient projection than those projections you use for the sales force or the board of directors. It should reflect your cash needs in a realistic manner and allow for contingencies. The penalties for breaking a covenant can be:
A high fee for forbearing the incident, if it is a minor covenant
An increase in the interest rate to what is called an upset rate (usually 2–3 points above the normal interest rate)
Calling the loan (i.e., forcing immediate repayment) if the violation is severe enough
Each year, just as your bank reviews its relationship with your company, you should review your relationship with the bank by asking yourself the following questions:
Is my lender meeting my company’s needs in terms of services? This can include payroll services, clearing of deposits, letters of credit, clearing of checks, and resolution of disputes.
Is my bank charging a competitive rate for my loans, or can I get better terms elsewhere?
Does the bank have overly onerous conditions in the loan document?
Can I get a loan elsewhere without a personal guarantee or with less collateral?
How easy is my banker to work with, and can he meet my borrowing needs as the company grows?
Many companies stay in less-than-optimum loans because of “comfort” with the current lender. Again, you should review your relationship with your lender annually, especially if the company has had a very good year and as a result represents a lower level of risk to the bank.
The lesson that all turnaround people know is that the loan documents and language in those documents will affect your total relationships with your lender. The more liberal your bank document, the easier it is to come to an equitable arrangement with the lender when things go awry.
Let’s examine the types and elements of loan documents that you should be aware of:
Fixed-Term Loans—. A loan for a fixed period of time with a specific payment schedule identified in the loan documents.
Revolver—. A loan of a fixed maximum amount that may be drawn down at the discretion of the borrower and remains in place for a period of time determined by the loan documents.
Asset-Based Loan (ABL)—. This loan relies on inventories, receivables, and other assets for its securitization. The loan size is normally a percentage of the value of the assets. This percentage is normally called “the advance rate.” If lending is just against receivables, the common term used is “factoring.”
The contractual conditions for most business loans vary. I go into detail here because each condition in a loan document can be negotiated depending on the strength of the company and competitive market conditions.
Rate—. The interest rate charged by the lender can be fixed for the term of the loan or can vary according to some index such as the prime rate or the London Inter-Bank Offered Rate (LIBOR). This rate can be negotiated. Rates for excellent companies are sometimes below prime, but risky loans may carry rates as high as prime plus 4 or 5 percent. When a company has been doing well, it can sometimes go back to the lender and get a lower rate.
Term—. The term or amortization period of the loan is also negotiable. Quite often, turnaround personnel reduce the cash strain on a company by renegotiating the term in order to extend out the principal payments or move some payments to the end of the loan (balloon). Also it is best not to have a prepayment penalty if the company wishes to extract itself from the loan early.
Advance Rate—. In the ABL loan, a major negotiation relates to the advance rates that are offered against assets. For example, an 80 percent advance rate against receivables that are less than 60 days old is typical. You can negotiate this rate up to as much as 90 to 95 percent depending on the quality of the receivable. Certain receivables, such as government receivables, are typically disqualified (there are other lenders for government receivables). The same idea applies to inventories (typically 50–70 percent for finished goods, 70–80 percent for current raw material, and 0–10 percent for work in process) and plant and equipment. Each of these categories can be negotiated to optimum levels. The methods for valuing the inventory become very important as part of the negotiations as well.
Default Sections—. This refers to the parts of the loan agreement that name the conditions the borrower must maintain in order to avoid a default. This can be a debt-to-equity ratio, a minimum cash requirement, a maximum negative cumulative cash flow, etc., plus the requirement for timely payment of interest and principle. If a company violates a covenant, it may be subject to a series of punishments. Another area of negotiation is the “cure period” to fix the problem. It is normally 30 to 60 days and is also negotiable. If a default occurs, the bank will usually charge an upset rate so that your woes multiply by having to pay even greater interest. The conditions of imposition of this rate plus the conditions for its removal are an important part of the loan document.
Right of Offset—. Banks like to have the right of offset, which means if you default they can reduce your debt by seizing the cash in the accounts you have with the lender. This is a good reason to have small accounts at other lenders.
Deemed Insecure—. This is an omnibus provision that allows the lender to terminate the loan if you are “deemed insecure.” This means that if your industry begins to tank, even though you have met all your other contractual obligations, the bank can exit the loan with notice to the borrower. It’s a back door for the bank to get out of a loan. The bank usually does this by informing you that it wishes you to pay off the loan within a given period of time (90–120 days) and wishes you to seek another source of funds. It may also begin dropping its advance rates on accounts receivable and inventory.
Fees—. There are all sorts of additional fees that banks can and do charge for their services beyond interest. Audit fees, interest on the unused portion of the revolver, transaction fees, as well as legal fees are some of these. You can place limitations on or eliminate some of these fees in your negotiations.
Cross-Collateralization/Cross-Defaults—. Often the bank gains additional security in a loan by asking for cross-collateralization or cross-defaults against other companies or assets owned by the parent company. Nonpayment or default on a different corporate loan can trigger a default on the one you are seeking. This obviously should be avoided.
Change of Control—. Most loans carry a change-of-control provision that allows a bank to force immediate repayment of the loan if more than 50 percent, or a number to be negotiated, of the ownership changes and key operating personnel change. If the provision is broad enough, this is seldom a problem, except at the time of a sale.
It’s important to obtain a really good attorney to assist in the drafting of loan documents to ensure that your interests are served. Many small-company borrowers are blissfully unaware of what they are agreeing to.
The biggest problem for privately held or closely held companies is the personal guarantee. The personal guarantee usually guarantees all the assets of the owners or senior managers of a company as security for a loan. These types of guarantees are problematic for a turnaround person because they add the burden for repayment of the loan to the individual as well as the company. The temptation to get out of the loan by declaring bankruptcy is diminished by the fact that personal bankruptcy also has to occur.
Unfortunately, many loans to medium or small companies require personal guarantees. Here are some rules regarding pledging personal assets:
Avoid them if you can trade other concessions such as rate or term in place of a personal guarantee.
Limit the amount of the personal guarantee to a specific amount you can afford. It may represent only a portion of your assets.
Set conditions for the personal guarantee to be reduced or eliminated based on the performance of the loan. For example, if the company meets its budgeted profit goals for three years in a row, the guarantee is eliminated or the guarantee is reduced by one fifth for each year the loan is in place.
Identify specific personal assets that back the guarantee and allow substitution of new assets for old.
Lenders will want your spouse to sign a personal guarantee since most states have joint-ownership laws. Try to avoid this as well.
There are an almost infinite variety of ways to obtain cash for running a business. Turnaround experts are trained to seek the best of these alternatives for their clients, while keeping in mind that the lowest-price loan or source may not be the best answer depending on the loan conditions described in this chapter. Some of these alternative sources are:
ABL Lenders—. They do not rely on the traditional performance of the company but rather the salability of its assets.
Bonds and Commercial Paper—. Issuing bonds as a method of raising cash is a form of borrowing from the general public. Smaller companies often use bonds to raise funds for real estate purchases (industrial development revenue bonds) for factories and other facilities.
Venture Capital and Private Equity Funds—. There are venture capital companies or private equity funds that will provide cash in return for equity or will lend money. They often have the expectation of “cashing out” in three to five years. Usually these funds want control (over 50 percent) of the business when they make equity investments.
Private Investors—. This is similar to venture capital but represents fewer investors, either as a loan, an equity infusion, or both.
Suppliers—. Often good suppliers provide funding if they wish to own part of the business or are willing to make loans to the company.
Government Sources—. There are a variety of government entities that provide loans or grants to companies, such as the Small Business Administration (SBA).
Secondary Lenders—. There are lenders that specialize in specific industries, in distressed companies, or other specific categories. The interest rates on loans from these specialty commercial lenders tend to be much higher than on loans from commercial banks.
The last area of advice I wish to offer in dealing with lenders is what to do if your loan is in duress. You may have violated covenants or missed payments. The lender will have sent in a team to discuss the situation and sent a formal default letter to start the clock on the cure period. The company may find itself dealing with the “special assets” section of the bank if it has an underperforming loan.
The answer to all these events is to get help immediately. No company is normally equipped to handle this situation. You will need a very good lawyer plus a turnaround crisis manager to act on your behalf. There tend to be emotional issues as well as economic issues in tackling this problem, and it is best to use third parties that will negotiate on your behalf. Often companies try this themselves. It is a grave and often fatal mistake.
Finally, suppose the workout is successful and the company is able to recover from its problems. It is then time to get another bank or lender, because your original bank relationship is spoiled. The memories of the company’s failure to perform properly will linger, so it is better to start afresh with a new lender.