Convincing The Cash-Conscious Banker

Most large banks provide excellent information packs on how to open a new business account and how to make a loan proposal; but how and why bankers make lending decisions is rarely clear to entrepreneurs.

This article aims to shed light on these issues so that the entrepreneur can make informed decisions on whether and how to seek debt finance and present a proposal in the best possible way. The following sections describe the nature of lending; the benefits, costs and risks for both parties; and critical success factors in forging a banking relationship for a new venture.

The nature of lending

 

Few entrepreneurs understand the nature of lending. As Adam Smith noted more than 200 years ago, they tend to think banks could and should extend their credits to whatever sum might be wanted without incurring any other expense besides that of a few reams of paper.

This view enrages bankers, who typically reply: If you become successful we cannot share in your success, so why should we lose if you lose? In this long-running shouting match, both sides miss the point.

Banks make the bulk of their profits on net interest income. This is the difference between the interest they pay on money borrowed from depositors or other banks and the interest they receive on the same money lent to borrowers (such as entrepreneurs). Very little (say 5 per cent or so) of the asset base of a bank consists of shareholders funds, or equity, and they operate on very narrow net interest margins.

For example, let us assume that in the case of commercial lending fees cover expenses and the net interest margin is 3 per cent. A customer defaults on a one-year term-loan and the entire principal (amount loaned) is lost. Because the bank must repay its depositors, the loss reduces the equity portion of the banks balance sheet. Even worse, because it is allowed to lend only in proportion to its equity base, the loss reduces its ability to lend.

Yet to just make up the principal on that one bad loan, the banker must earn the full 3 per cent net interest margin on over 33 new loans of the same type. (It takes more than 33 three-hundredths to make one.) This is why bankers do not like high-risk loan proposals, why loans must be repaid and why security in support of an advance is often sought just in case.

Experience and statistics have led bankers to believe that new ventures are, on average, relatively high-risk lending propositions. However, the long-term rewards to bankers on new venture lending can also be high.

A young company that grows into a successful strong business creates an ever-increasing potential source of income to its bank from fees, loan interest, deposit interest, foreign exchange, leasing, factoring, venture capital, merchant banking, insurance, extra personal accounts for an expanding and increasingly wealthy workforce and increases in local business activity.

Bankers are well aware of this and attempts to poach star accounts in the medium-sized corporate sector are legion. However, research in several countries has indicated that entrepreneurs who have a good banking relationship are

surprisingly loyal to the banker who helped them to start up and that attempts to poach are often resisted.

No one can predict precisely which new businesses will succeed; banks may well have to accept an increased level of bad debts among their new venture accounts to capture the stars of tomorrow. The good news is that failure rates are highest early on, when the amount of debt a company carries is relatively small.

Benefits, costs and risks

Why should entrepreneurs borrow? Debt finance only makes sense if the returns on the extra business financed by the debt considerably exceed the costs and risks of borrowing. In that case, the entrepreneur can make more money with bank finance than without it and can even write off the interest against tax.

The costs of borrowing include search costs, interest costs, and fees and conditions attached to the use of the debt. These conditions can place considerable restrictions on the future management of the business and even on the private life of the entrepreneurs family.

The risks of borrowing include wasted time in shopping around to no avail, interest rate rises, unexpected charges, a new bank manager with a different perspective, a change in bank policy

and the banks reaction to a temporary downturn in the business (which might include freezing the current and deposit accounts and calling the loan in early).

Bankers are constantly asked to put up virtually all of the finance for a new venture. This suggests the real reason why so many entrepreneurs seek debt finance is their desire to minimise

their own financial investment while maximising their control, defined as share ownership (see From blueprint to reality: the quest for resources, page 2).

Bankers are well aware of this. If a banker does entertain such a proposal, the loan will have so many conditions attached to it that the banker will not just control the business but also the entrepreneur.

Critical success factors

Personal loans are routinely screened in many countries using computerised credit scoring techniques. Commercial loan decisions, in contrast, are still heavily influenced by the personal impression the entrepreneur leaves on the loan officer.

Research suggests bankers form an impression of an individual quickly and tend to stick to it. It is for this reason the entrepreneur must impress at the first meeting. The aim should be to project confident professionalism.

Entrepreneurs should dress conservatively, turn up on time, emphasise their relevant experience and management skills, be prepared to produce documentary evidence to support their argument, articulately argue the case for debt finance using the bankers language and not give in too easily.

Remember the banker needs to be sure the entrepreneur can negotiate with his or her other resource providers and overcome unforeseen obstacles to pay back the loan. Asking tough questions is one way of testing these skills. Research also shows that overblown attempts to impress can leave a negative impression.

The bankers language is the language of finance and surprisingly few entrepreneurs speak it. This means that the financially literate and articulate entrepreneur has a real competitive advantage in the market for debt finance.

In the interview, the banker will probably question key assumptions behind the numbers in the financial plan. They are well aware that projected sales figures can be derived to cover the loan instead of the other way around. Financial honesty is just as important as financial literacy.

Bankers often assess debt proposals using simple checklists.

Figure 1 shows two that are widely used.

Some banks have introduced more complex checklists that are closer to credit scoring systems. They assess the management, market, strategy and general competitive environment using a statistically determined weighted scoring system. Opinions vary as to the value of these for new venture proposals. Many bankers place more weight on their judgment of how the entrepreneur will cope in any eventuality than on their assessment of the ventures strategy.

Remoulding the proposal

The banker may suggest changes in the entrepreneurs proposal in order to reduce the banks exposure to acceptable levels. In debt/equity terms, acceptable usually means roughly equal contributions to the capital base of the business by the promoters and the bank.

Bankers need to see that the entrepreneur is putting as much as is necessary into the company. They also need to be sure the finance is actually needed in the amount and type requested. Although factoring (the sale of receivables) is not usually an option for a new venture, the leasing of some assets may be and leasing can sometimes improve cash flow and the debt/equity ratio.

Security

Security is probably the most contentious issue in the entrepreneur/banker relationship. Bankers need at least one and preferably two alternative sources of repaying the loan other than cash flow. Land, buildings, vehicles, government stocks, quoted shares, insurance policies, stocks and receivables all have security potential but only at their distress sale value. Often the only fall-back security available at start-up is a personal guarantee backed by assets, usually the family home.

The practice of requesting personal guarantees varies from country to country. Entrepreneurs hate them because they wipe out the advantages of limited liability. Bankers like them because they feel the entrepreneur will work that much harder to ensure the loan is repaid.

On the other hand, having to call on a personal guarantee in the event of a shortfall from the sale of business assets is one of the most difficult and stressful decisions a banker has to make.

Bankers tend to be sceptical of government-backed business loan guarantee schemes for situations where insufficient security is available. They infringe on their profession, may have politically-motivated conditions attached (such as a prohibition on personal guarantees in the UK scheme), carry a higher paperwork load and have a higher failure rate.

It may be smarter to portray a proposal as a regular banking proposal, in which sufficient security is available, and keep the personal guarantee option open initially in the hope of negotiating it away later.

Creative thinking about security, such as obtaining options from suppliers to repurchase assets in principle, getting revaluations on

land or buildings, or positive data on the

marketability of assets, can help meet the bankers requirements.

Separating cash flows into definite (for example, secured orders, royalty or service

payments from secured orders) and probable (future sales) may reduce the amount of

security required.

To offset the risk and security issues in a new venture proposition, the entrepreneur should ensure the banker recognises all the profit possibilities to be gained from this new account.

Negotiating hard on fees or the interest rate may not be in the entrepreneurs best interest. If the banker stands to gain say 30 per cent more interest income by charging 1 per cent more, and if that 1 per cent represents only 10 per cent of the entrepreneurs tax-deductible interest charges, then why should it stand in the way of securing the loan?

Updating banks

Lets assume that after shopping around, and several near misses, an entrepreneur has secured a loan commitment.

The bankers enjoyment of the up-front fees will soon fade and nervousness will set in. Bankers hate surprises and often assume the worst when they hear nothing. To offset this, the entrepreneur must keep up a steady stream of good news and warn the banker of possible bad news before it happens.

The banker will probably want regular (such as monthly) balance sheets, profit and loss, and cash flow accounts. The entrepreneur should also send press releases, customer endorsements, export sales leads, invitations to exhibitions, whatever good news he or she can muster.

Enquiries related to other high-margin banking products, which have some likelihood of being needed (such as large foreign exchange transactions or letters of credit, for example) will keep the banker focused on the future profitability of the account rather than on its present riskiness.

If an entrepreneur has continued to keep the bank abreast of developments, and the worst happens, the banker will at least feel informed. In addition, if the banker moves on and a new banker takes over, the file will show that progress is being made.

Often, what entrepreneurs need in a crisis is a little more time from their banker. Time is granted on trust. Keeping up that stream of information can create a small reserve of trust, which one day could save the life of the business.

Jonathan Levie is a research fellow at London Business School. His research interests focus on strategy and resource acquisition in young, growing companies. He is engaged in an eight nation study of the relationship between entrepreneurs and their bankers, sponsored by the Foundation for Entrepreneurial Management at LBS.