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Lenders lend money expecting to make an economic return consistent with the level of risk they are taking.
The nature of the risk is very different than when making an equity investment in a business. Equity has upside. Loans don’t — there is no upside in the next loan to recover losses.
So, lenders get (understandably) upset when the economics of the loan sour.
That is why loans have covenants — they provide the lender with protection and an early warning system
that the deal may not be what they bargained for.
There are lots of ways to make your lender antsy, even angry.
But these four are sure to get the job done:
- Make them worried that you can't pay back the loan.
- Make them worried the collateral that secures the loan is not worth the loan amount.
- Use a different lender or provider for certain services, rather than the lender or group of lenders that you agreed to in the loan documents. (The lender's profitability of your loan is based on your use of those services.)
- Destroy your integrity, so the lender doesn't trust you. (This one is the biggest cause for concern.)
As to how best to cause one (or more) of these reactions, the list is quite long. With that in mind,
today’s newsletter shares some specific examples — all actual experiences I’ve encountered with past clients — of what
not
to do.
Keep in mind, by the way, that while “really bad things” may not have happened yet, if the lender believes they soon will (or the odds that they might are now considerably higher), in the lender’s eyes, the economics of the loan, particularly the level of risk, have changed.
#1. Fudge the reporting to the bank (particularly the borrowing base).
Borrowers are often tempted to do this when their company "needs the money."
Unfortunately, this amounts to fraud and, once caught, your credibility is shot. And not just with the current lender —
any
future lender will likely find the misstatement during the due diligence process.
For example, a former client of mine would "refresh" the invoice date of old, large invoices so they would be current and eligible to borrow on. Yes, doing so allowed them to live another day, but not many. I came in after the fraud was discovered, but the ramifications continued. The prospective "take out" lender found the fraud in its due diligence and walked away. Ultimately, the company was liquidated in bankruptcy.
Remember that
once fraud is discovered,
everyone
in the company is suspect and trust is gone for all.
That makes it hard to fund a true sale process that maximizes recovery to creditors and minimizes personal liability of owners and officers. Besides losing trust, the lender’s collateral is now less than they thought.
#2. Provide late or questionable financial reports.
When lenders can't see the numbers, they don't know how your business is doing.
Given their past experiences, they usually assume the worst. Moreover, they are concerned
you
might not know where your business is headed either (a real problem). Delays in reporting usually mean the accounting function is understaffed, something which will make a lender assume there are weak controls in place.
A related issue is saying you will have your financial statements audited but then providing a review or, even worse, a compilation.
Once promised an audit, the lender is counting on a strong form of assurance
and will be unsatisfied with something substantially less.
Moving from a public accounting firm the lender knows and trusts to a firm no one has ever heard of (perhaps the single-shingle CPA) also contributes to lender worry. So
make sure the firm you use is appropriate for your loan size.
If the lenders are national (or simply lenders who are not local), a national name for the auditing firm helps. As you step up in loan size and complexity, one of the Big Four
may be worth the money
.
Particularly important are controls and processes to account for inventory when it is a significant asset. Lenders often take their own inventory count and valuation. If they discover they have advanced more funds than the collateral value, there will be an immediate liquidity squeeze as the lender reduces borrowings.
#3. Take on new debt.
This is a concern for a number of reasons. First,
new debt means there are fewer dollars to service the older debt.
So default is more likely.
Second, if the new debt is not subordinated,
now the lender may have to share the proceeds with the new lender from any liquidation,
reducing their recovery and further increasing the odds of default. Yes, debt service covenants may
allow
the additional debt, but that doesn't mean the lender's anxiety level won't rise.
#4. Use the loan proceeds for non-business purposes or purposes other than agreed to in the loan document.
A client of mine in the scrap metal business borrowed from the bank and took cash to buy antique cars. He was a collector and tried to argue that antique cars were “scrap.” I have also seen companies buy equipment for other businesses and other interests, all outside of what was agreed upon.
In terms of how to
reduce
anxiety on the lender side, here are a few suggestions…
Invest in your accounting function
. Make sure you have adequate controls and systems in place and are properly staffed to close the books and report in a timely fashion.
Don’t materially miss forecasts and projections
sent to the lender. If you don't know where you are going, financially speaking, how can the lender be assured you can pay him/her back?
Read the loan document
(and do what it says).
Re-read it before doing something new.
Make sure you
understand the relationships between the lenders
. Which are secured (have liens on property) and which are not? Are there any inter-creditor agreements between the lenders? If your loan is large enough to have an agent, respect the agent’s role and relationship with the other lenders.
Guard your integrity.
This means everything to your lender. Once lost you may never gain their trust again.
There are many ways to annoy and worry your lender. The four listed at the start of this article are not the only ones, just the most reliable in this regard. Am I suggesting you do whatever is necessary to keep your lenders happy? No.
But don't mistakenly alarm them either by your actions or lack thereof.
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