It’s the meeting no business owner wants, an adult equivalent to sitting in the principal’s office.
Only instead of a principal, the person calling you in is a banker. And instead of the dreaded “permanent record,” the folder on the desk is an agreement for a business loan, a line of credit, equipment financing or some other form of borrowed money that helps keep the company afloat.
In that agreement are clauses, called covenants, which spell out what the company has to do to stay in the bank’s good graces. One might set a minimum amount of capital or revenue that the company has to maintain. Another may be a requirement to deliver a financial statement to the bank each month or a periodic audit. Whatever they are, covenants are getting tougher to meet in a bad economy.
When a business borrower starts breaching a covenant, the banker starts getting nervous. Nervous bankers call â?¨business borrowers in for the big meeting.
“The last thing any bank wants right now is additional losses,” says Tim King, president of US Bank’s Sacramento region. “I would say it’s pretty black and white. When you enter into a credit agreement, you define the metrics. There really aren’t loose interpretations of the metrics.”
Bankers say criteria for business loans and lines of credit aren’t any tougher now than they used to be. But these days they’ll act faster if they see a business borrower start to wobble.
“What we are seeing is the banks, not surprisingly, are watching these loans much more carefully than they have in the past,” says Jeff Koewler, managing partner of law firm Downey Brand LLP in Sacramento. “As covenants are being violated, banks are immediately contacting the borrowers.”
This leads us to one of the most counterintuitive aspects of dealing with a nervous banker. The business borrower who warns the bank about upcoming trouble is the one most likely to get a break.
“The earlier the better,” says Steve Fleming, president and CEO of River City Bank. “Because I’m far more likely to stretch for somebody who I feel is being candid with me. If I start finding out things about them that they haven’t disclosed, that the risk is higher than I thought it was, they have lost all credibility.”
In fact, banks go all the way back to the original paperwork to see how good a borrower is about showing all the warts. About 95 percent of the business people who apply for loans claim their houses and commercial real estate are worth more than they really are, Fleming says. He knows because his staff goes out and checks.
“If we start seeing that they are overstating the value, we are far less likely to view them as credible,” he says. “At that point you conclude that everything [the client] tells me I have to discount.”
But if the bank staff finds out that the borrower is taking a conservative measure, the confidence level goes up.
Likewise, there’s nothing to be gained by business borrowers sugarcoating any new financial pain. If a business is on a path to encounter some bad news, it should tell the bank a couple of weeks or even a couple of months ahead of time.
“They would much rather work with you in advance of having a covenant breached,” Fleming says. “Don’t try to present it strictly as a glass-half-full thing. Be candid. Be realistic.”
One big mistake is not keeping track of the covenants. The only thing worse than not telling the bank about a breach is not realizing there has been a breach. You don’t want to get on a bank’s “watch” list by accident, Koewler says.
But in addition to knowing about a problem, bankers also want to see the company’s solution. Cutting a few employees from the payroll and outsourcing some work might soften the blow. It may help to get more aggressive with vendors or cut back on inventory. If fuel prices spike again like they did last year, how does the company plan to respond?
“It speaks volumes when a client is proactive about making these changes before we suggest making them,” King says. “I think what banks would rather see are forward-thinking, aggressive executives.”
If a borrower comes in with a solid plan, he says, banks generally will give the company a chance to make it work.
“It speaks volumes when a client is proactive about making these changes before we suggest making them.”
Tim King, president, Sacramento region, US Bank
If things look really bad, it might be time for a business owner to call in some professional help. “People like myself act as advisers to companies to help them walk through this tough environment,” says Rich Brooks, a partner in Tatum LLC. Lately he’s been working through a Tatum division called Kinetic Advisors LLC, a boutique firm for middle-market debtors in distress.
Brooks is the guy who tells business owners to take their medicine: cut back, refinance or, perhaps, consider selling some or all of the company. He also sits between the borrower and the bank and tries to help the two sides work out a deal.
“Sometimes we are hired by the company being proactive,” he says. “Probably the majority of the time the banks advise or force the client to hire us.”
Services like that are far from free. It can start at a couple of hundred dollars an hour, and if there’s enough work, it can morph into a monthly fee. Not surprisingly, Brooks calls it cheap insurance when a business owner’s equity is at stake.
As a third party, he can come across as a more objective voice when presenting forecasts and urging the bank to stand by the borrower. But by the time Brooks shows up, the borrower is usually already in deep trouble.
“What generally happens is the owners wait too long,” Brooks says. “They are very confident in their abilities because they built the business. But there is also a tendency to wait for a Hail Mary pass. In the old days of maybe a year ago, that may have worked. Now there is so little capital, especially given the decreased value of property, there are very few levers left to help companies that wait too long.”
As companies get more distressed, their owners tend to try riskier measures and might even be tempted into fraudulent behavior.
By the time the borrower and banker come together for the covenant meeting, emotions are typically running high. Consultants such as Brooks can help cool things down.
“What tends to happen is the owner gets frustrated and the bank gets frustrated,” Brooks says. “We use the term that the bank gets fatigued. They don’t see management doing things to get the company right-sized for the loan.”
In some cases the client company is dealing with several lenders at once, and Brooks acts as a kind of ringmaster. There may be a big bank on the hook for $15 million, plus three or four smaller banks splitting another $15 million.
“Sometimes it can get a little testy because you may have six banks in there, and one little bank may be fighting for more,” Brooks says.
Not all bankers are keen on consultants. Fleming at River City Bank acknowledges that they can be a big help when a business owner needs to frame the situation for the banker. But Fleming would rather hear it from the client.
“If he has trouble describing a compelling business case on his own, I start scratching my head, wondering if he is a guy I should be backing,” Fleming says. “I expect them to know their business and have a management team that supports them.”
If a borrower comes away from the covenant meeting convinced that the bank is getting overzealous, it may be time to scout for a new lender. “I don’t think there is any downside in seeing what the market will bear,” King says. “It’s always good to be in touch with other sources.”
Others agree. While most banks tend to have the same concerns about a company’s ability to pay back a loan, the covenants can vary from bank to bank. Of course, that also means they might be more onerous elsewhere. “It may be that the loan will look exactly the same,” Koewler says. “It could be that maybe other covenants will be tightened up.”
The bad news is that loans and credit are getting more expensive. A couple of years ago a revolving line of credit might have been priced at “Libor 150,” meaning interest is pegged at the London Interbank Offered Rate plus a premium of 150 basis points. Today the same line might be priced at Libor 300, King says.
Also, the new bank will wonder why the company left the old bank, Brooks says.
Banks aren’t the only source of money. Brooks sometimes helps clients find other types of lenders willing to take on more risk.
“Wells Fargo and Bank of America may not want to take them,” he says. “We might find a private investor or fund that loans to companies to step in at that moment.” That can give a company a year of breathing room to rebuild its credit.
It can be expensive money, though, with interest rates as high as 20 percent, Brooks says. Without a solid recovery plan, the new money might be more of a hindrance than a help.
“If you are forced by your bank to move on and you aren’t healthy enough and you take on more expensive debt to survive, it may be a death spiral,” Brooks says. “The devil you know might be better than the devil you don’t know.”
Among the new ways banks send advice to business borrowers is YouTube. River City Bank has been posting a series in which CEO Steve Fleming covers various topics, including how business borrowers can stay friends with a bank. A few highlights:
• Your bank should be trying to support your business objectives, solidify its relationship with you and, of course, protect its shareholders.
• Banks are under increasing pressure to maintain the quality of their loan portfolios. With that in mind, don’t expect the bank to be excited about financing your operating losses. It’s not unusual for a business to lose money in this environment. Your banker, however, will be expecting you to finance those losses with equity injections into the business.
• Most bankers will want to know that you have multiple sources available to repay the loan. The primary source might be cash flow from the business. A secondary source of repayment might be cash or marketable securities held by a guarantor.
• Don’t assume your banker is a knucklehead if he or she won’t give you the credit you want. Of course, your banker might be a knucklehead. But then again, maybe you should listen to his or her concerns.
• Most banks will work with you and give you more time if you inject equity into the business, make a sizable dent in the loan balance and have a viable plan to repay the rest of the loan in a reasonable period of time.
Banks are running up against some odd new competitors these days. Big box retailer Costco is advertising mortgages. Wal-Mart has issued its own debit card. Amazon is offering loans to merchants in its online marketplace.
On a morning in April, eight representatives of local banks and credit unions walked into the Sacramento Metro Chamber headquarters to discuss the region’s lousy credit situation.