In February 1984, my first entrepreneurial venture went bust, and I ended up owing the Cambridge Trust Company$50,000 (2005 dollars: ca. $100,000). Not a really big deal in retrospect, except that I was in the family- and career- formation stages with an at-home wife, five kids, and a big mortgage.
Fortunately, all of my eggs were not in one basket.Financial Managers Trust was up and running with five clients, so the demise of The Cambridge Express, a start-up weekly free circulation newspaper, did not put me out of work. It was humbling to admit to my investors that a tax write-off would be their only return, but after two years of losing the competitive battle with The Tab, they knew the end was near.
So I went hat-in-hand to the Bank and Jim Dwinell, my friendly neighborhood banker (truly, he was) asked me what I intended to do with the Company’s loan that I had personally guaranteed.
“Well,”I said, “it’s going to take a few months to collect the receivables and pay off the accrued payroll and taxes. Then I’ll see how much is left to pay down the loan and ask you for the best repayment deal available.”
Four months later, after several trips to small claims court, I had collected all that I was to collect and had liquidated the payroll and tax liabilities that could bite me personally, while reducing the bank debt to $40,000. Jim and I had a follow-up conversation.
“What can you afford?” he asked.
“How about ten years at prime?” I offered, trying to establish a baseline for negotiations.
“O.K.,” he said. And that was that. I never considered not repaying the obligation in full.
I thought about that process last week when one of my clients, a growing $3MM family business, asked its bank to double its line of credit to $300,000. In its analysis of the loan request, the bank noticed that the owners were having difficulty managing very high levels of personal credit card debt which was, in fact, helping to underwrite the company. Not all of this had been recorded on the company’s books, and as we explored the situation, it turned out that both expenses and liabilities had been somewhat understated as a result.
There was no intent to deceive here – my client was simply embarrassed to acknowledge that, despite profitable operations for the past year, cash was a major problem due to lengthy international receivables. The banker, having known the family and the business for a while – and respecting the integrity of the principals – agreed to advance the additional funds, contingent on the pledge of further collateral in the company’s building, owned in a separate trust.
“All they’re doing is lending us our own money. We could just take a second mortgage and put the cash into the business,”said my client, forgetting that the building was tied up in an SBA financing package that would have to be unwound first.
“No,” I explained. “The bank is really trying to accommodate you. But given the company’s up-and-down history and your off-the-books financing, they just need to protect their commitment to you. In the worst case, if you go bust, they don’t want to deal with your receivables and creditors. They want you to have an incentive to do that in order to minimize the hit on the building.”
From that first experience twenty-plus years ago and in the time since then, I have come to appreciate several things about banks and their financings:
- Banks aren’t investors; they’re not constituted to take risks.
- Bankers by nature are risk-averse; the”cowboys” in the industry get weeded out quickly.
- Their margins are pretty thin: borrowing at3.75% (fed funds rate) and lending at 6.75% (prime)means that it takes a lot of good loans to offset one $100K bad debt.
- Your personal guarantee, backed by your hard assets, gives your banker comfort that your continuing skin in the game will save his/her skin at the bank.
Starting at $600 in July, 1984, I wrote monthly checks to the Cambridge Trust, a process which changed my risk profile almost as much as did the consumption rates of my growing family. All the same, taking “the hit” early myself has given me tremendous respect for the entrepreneurial spirit which drives my clients, and several million others in the U.S., to take big risks in pursuit of what they hope will be substantial rewards. One of their constant challenges, therefore, is to work to mitigate their financial risks.They may not have a banker as friendly as Jim Dwinell.
Read on…
Alligator Bites
In the immediate aftermath of 9/11, capital equipment businesses in particular suffered. Confronted by global uncertainty, companies postponed capital investments and cancelled equipment orders, so that the sales pipeline dried up and layoffs were rampant. In this environment, a few days prior to Thanksgiving in 2001 I was referred to a $10MM capital goods company that was soon to be a $6MM company, manufacturing and marketing products in the $60-100,000 range.
The company president, an energetic young guy who had purchased the business just a few years previously, had accurately diagnosed the problem as one of trying to stay afloat through the storm, as his core business was reliable. He had begun to make the right cost-reduction moves, but he was wary of the bank, which had contributed significant funding to the acquisition financing process. In the halcyon days of the late ’90s, when capital was chasing almost any kind of deal, the bank had provided more than $2MM in loans without requiring a personal guarantee, lending strictly on the assets of the business.
As sales dropped from $800,000/mo. in June 2001 to less than half of that in October, the bank, which was regularly monitoring receivables and inventory levels, moved to high-alert status. Their collateral base was rapidly eroding, and they had no back-up security. My client, seeing the walls closing around him and lacking enough personal assets to reassure the bank, was reluctant to go back to his investors (family and friends) for more financial support. So the bank was left with little choice but to call the loan, attach the bank accounts, and force the company into Chapter 11 reorganization.
During the ensuing two years, we worked through the bankruptcy process and ultimately came out the other side as sales recovered. The company is doing nicely in the current environment, and the bank will ultimately be paid in full. Not so the other creditors, however, and certainly not so my client. The bankruptcy process cost him in excess of $500,000,arguably for want of a personal guarantee. The bank couldn’t afford to back him if he couldn’t back himself.
On an affordable retainer basis, FM serves as the part-time controller and senior financial manager for multiple clients, leading them to profitability and positivecash flow.
The goal is for the organization to outgrow Financial Manager’s services, at which time FM will take the lead in identifying and hiring the right full-time financial person for the firm, and effect a smooth transition to his or her management.
Draining the Swamp
Among the measures that lending institutions use to determine the feasibility of a corporate loan request is the Debt Service Coverage formula.
Your banker wants to know that the company’s cash flow will be sufficient to cover your anticipated repayments of interest and principal on your loans.The formula is the annualized Earnings Before Interest, Depreciation and Amortization (EBIDA) divided by the annual interest expense plus current (12 months) repayments of principal on term loans.
Assume:
| Net operating income | $ | 180,000 |
| Interest expense | $ | 30,000 |
| Depreciation | $ | 60,000 |
| Amortization | $ | 10,000 |
| EBIDA | $ | 280,000 |
| Proposed current payments, long-term debt: | ||
| Principal | $ | 100,000 |
| Interest | $ | 30,000 |
| Interest on line of credit | $ | 10,000 |
| Total Debt Service | $ | 140,000 |
| Debt Service Coverage Ratio | 2.00X | |
Two times debt service coverage is a healthy ratio and may indicate a capacity for additional borrowing, contingent on other factors. A ratio lower than 1.0 may indicate that the company lacks the resources to service its current debt, especially in the absence of significant equity.