I got a call out of the blue from a banker last week. It was Doug Bryant, now Regional Manager and SVP of Wells Fargo Bank. Doug and I hadn’t talked for several years and I had forgotten some of his particulars.

“I remember your dad,” he said, to jog my memory. When your dad’s been dead for 30 years, that kind of statement gets your attention. “He was one of the wise men of the Credit Department at the First National Bank of Boston when I started there. He taught me a lot about the credit assessment process.”

The thrust of Doug’s call was about other things, but his remembrance got me to thinking…

My dad spent most of his 25-year career at Boston’s then-leading bank assessing the credit-worthiness of the Bank’s corporate customers. He did spreadsheets the old- fashioned way (or at least his team did), with pencil and eraser. As a result of his and others’ analysis of credit history, current operations, and future prospects, the Credit Department provided recommendations regarding each customer as guidance for the Bank’s loan officers in their lending work.

After Dad retired, the Bank recruited me to spend a summer learning the basics of the credit process in his old office prior to my stint in business school. Thirteen weeks exhausted my patience with thirteen-column journal sheets, and I left for graduate school convinced that a career involving spreadsheets was not for me. Bankers, I thought, put too much emphasis on the numbers. I needed a career with more human interaction.

Fast forward sixteen years. My first entrepreneurial venture has just gone bust. My erstwhile partner takes the easy route and declares personal bankruptcy, leaving me holding the bag for the loan that the Cambridge Trust Company had granted the two of us based on our personal guarantees. Jim Dwinell, then VP of the Bank, didn’t know my partner when he advanced us the funds, but he knew me, and he made what’s known as a “character loan.” I didn’t duck the responsibility, but it was a real test of character (and financial management) to pay it all back – my share and my partner’s – over the next ten years. I came to realize in the process, however, that my subsequent strong credit rating with Cambridge Trust was as much a function of my personal values as my financial value.

Fast forward again, to the summer of 2006. For the first time in my 23 years as a part-time CFO for multiple small companies, I walked out on a client. Just got up in the middle of the management meeting, picked up my briefcase, and left, after six months of trying to get them to acknowledge their own shortcomings. I had been referred into the company by their bank in hopes that I could validate the numbers that the bankers were receiving, and I had thought I was making progress until the president, looking at June’s low preliminary revenue numbers, said “We have to increase the billings for last month.”

“How do we do that after the fact?” I asked.

“We’ll just have to lie to them,” he replied.

On my way out the door, I let the client know that I didn’t share his values or his approach to management. I subsequently let the bank know the same thing.

Five weeks later – same bank, another shared client requesting a major increase in financing. All the signals are positive, including a favorable recommendation to the bank’s loan committee, scheduled to meet within a few days. Then, word from the staff accountant that she had made a significant mistake in inventory calculations back to the first of the year: a modest, but encouraging, year-to- date profit became a modest, but frustrating, loss.

“What are you going to tell the bank?” I asked the president.

“We have to let them know – before they vote,” he responded.

The banker – by her own admission – was almost speechless when he gave her the news. “It wasn’t that they had lost money for the first six months,” she said. “Rather, it was that he was totally forthcoming about it, when it could have killed the loan. We don’t see that kind of behavior very often. We were happy to approve the loan.”

People who put money into businesses – investors – bet on a lot of factors: the industry, the product, the market, the management team, the economic model, the timing, the competition, the deal. They weigh all of the elements, and they assess their risk: is it worth the reward?

Men and women who loan money to businesses – commercial bankers – consider all of these factors as well. But because their margins are small, they typically don’t have the resources to employ the industry analysts and retain the experienced consultants who can evaluate and help to control the risk. And for certain they don’t reap investors’ rewards, even at rates that are sometimes three or four points over prime.

So, what’s the key? Ask any banker. It’s the person you’re lending to, they’ll say. “Know your borrower” was the mantra of the First National Bank of Boston ‘way back when. It’s still a catch phrase in bank lending circles today.

Alligator Bites

In the good old days of the late ’80s, when banks were struggling along with everyone else who had put any money into real estate, a high school buddy of mine collected a lot of fees as a Boston attorney specializing in “lender liability” lawsuits. He contended, and in many cases proved, that viable companies were forced into bankruptcy by over-reactive banks who had inadequately documented their loan agreements. My friend’s legal brethren then collected even more fees from the banks themselves during the ’90s as they sought to plug every gap in the lending/borrowing process.

A selection of “Standard Terms and Conditions” for a loan to a struggling smaller business now can include the following:

1. “The Borrower may not borrow from any source or grant any security interests in its assets to any person for an amount greater than $25,000 outstanding at any time without the express written approval of [The Bank].” So much for picking up a bargain lease on that piece of used equipment you’ve been looking for.

2. “Compensation to management shall be limited to reasonable amounts for services performed. Borrower must notify [The Bank} of any change in the compensation for [The Owner]. Additionally, total compensation for management may not be increased more than 10% annually, nor will any increase cause an Income Statement loss, without the express written approval of [The Bank].” When the tide comes in, we’ll still be dragging our anchor.

3. “The Borrower will agree not to pay any debts due to officers or related parties without the express written approval of [the Bank]. All other inside creditors, lenders (excluding [The Bank]), and investors to the Borrower must enter into a Subordination and Stand-by Agreement pursuant to which their loans and investments are made specifically subordinate to the Loan.” You’re going to have to find another way of paying down that home equity line…

4. “A requirement for Key Person Term Life Insurance in the amount of $500,000.” But don’t count on it helping to offset your family’s needs…

5. “An annual loan fee of 1% of the original face amount of the promissory note will be charged on the anniversary date of the note.” Let’s call it a birthday present to the Bank.

And particularly onerous in a demand loan…

6. “The prepayment fee will be 5% of the outstanding principal balance if prepaid within one year from the Date of the Note. On each Date of Note anniversary, the prepayment fee will decrease 1%…” Where’s the incentive for the Bank to provide outstanding service? Not in this document.

Draining the Swamp

In making corporate loans, banks will often require compliance with certain covenants, some of which are tied to financial ratios. Of these, three of the most common are:

1.  Minimum Debt Service Coverage – to determine if the company is generating sufficient cash from operations to enable it to pay down its debt. The ratio typically ranges from 1.0 for strong companies to 1.25 or more.

• • Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)*

– divided by –

• • Total Debt Service (Annual Interest and Principal Payments on all debt)

( *EBITDA may be reduced by cash taxes and unfinanced capital expenses)

2.  Maximum Senior Funded Debt to EBITDA – to make sure that the borrower has not become overextended in its commitments to the senior lender (the bank in first position). The stronger the borrower, the higher the ratio, but not usually greater than 2.25x for smaller companies.

• • Total outstanding principal due on all senior debt

– divided by –

• TTM (trailing twelve months) EBITDA

3.  Minimum Working Capital – a key measure of liquidity, often expressed as a ratio between Current Assets and Current Liabilities. A ratio of 1.25x or less usually indicates pressure on cash; 2.0 or better ordinarily is healthy.