Author: Paul Muldoon
Six questions – and answers – to help you better evaluate your borrowers’ performance
According to Generally Accepted Accounting Principles, “GAAP”, any revenue from projects that span more than a calendar year are typically recorded under the “percentage of completion method” for long-term contracts. Here’s what you need to know to help you better evaluate your borrowers’ performance.
Q: What do I need to know about the percentage of completion method?
A: If a borrower enters into a long-term contract, the percentage of completion method will affect its financial statements, and the subjective use of estimates might put you at risk for financial misstatement. It’s critical that you understand the basics of percentage of completion accounting so you can make more informed, prudent lending decisions.
Q: What types of lenders typically use the method?
A: Any company entering into a long term contract. For example, homebuilders, architects, commercial developers, creative agencies or engineering firms, use this method. There are several ways to report long-term contracts, according to the AICPA’s Accounting Research Bulletin (ARB) No. 45, Long-Term, Construction-Type Contracts, and Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.
The first method is known as the “completed contract.” With this method, revenues and expenses are recorded once the contractor fulfills the terms of the contract. The “percentage of completion method,” on the other hand, ties revenue recognition to the incurrence of any job costs (or estimates of an annual completion factor). SOP 81-1 establishes a strong choice for the percentage of completion method, so long as businesses can make estimates that are “sufficiently dependable.” Many contractors use the method for income tax purposes.
Q: How does the method differ from the revenue recognition principle?
A: GAAP requires that all borrowers report revenues as earned, regardless of when the cash is received. Typically, revenues are considered as “earned” when a business delivers the products or services to the customer. The percentage of completion method deviates from the revenue recognition principle by identifying income before a job’s completion.
This method matches any revenues to costs incurred, including materials, direct labor, and overhead. Normally, borrowers use the cost comparison method in order to estimate percentage complete. And sometimes, contractors will estimate the percentage complete with an annual completion factor. Keep in mind that the IRS requires detailed documentation or certification from an engineer or architect to support annual completion factors.
Q: How does percentage of completion work?
A: This is how percentage of completion affects financial statements: Let’s look at a $1 million job that’s expected to span two years and cost somewhere around $800,000. In the first year, the contractor incurs some $400,000 in costs and then sends an invoice of $450,000 to the client.
At the end of Year 1, the percentage complete is 50% — that is, $400,000 in actual costs divided by $800,000 in expected total costs. Thus, the contractor would record some $500,000 in revenues (calculated as $1 million times 50%) to match the $400,000 in costs. So, the contractor’s net gross profit is $100,000 in Year 1.
Next, the contractor reports billings in excess (a liability) or costs in excess (an asset) on the balance sheet. Here, the borrower has billed $450,000 but has recorded $500,000 in revenues. The $50,000 difference will show up as costs in excess, a current asset account that reflects the under billings in Year 1.
Many companies run several jobs simultaneously. GAAP doesn’t allow contractors to offset (or net) assets against liabilities. So it’s possible that a contractor will report both costs and billings in excess on its balance sheet.
As you can see, percentage of completion accounting requires subjective estimates about expected costs. Further complicated by job cost allocation policies, changes in estimates and orders, and differences between book and tax accounting methods.
Freed Maxick’ s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your customers’ collateral by performing pre-loan surveys and rotational collateral monitoring field examinations.
For more information about our services for asset based lenders, contact me here, or call us at 716.847.2651.
Fraud Awareness Workshop: NYC Sept. 24-26
The Fraud Awareness Workshop is a three-day program presenting best practices in the prevention and detection of borrower fraud while also recommending fraud prevention procedures for a variety of ABL disciplines. Reinforcing each learning point through numerous case studies, the goal of the program is for participants to understand their roles in mitigating the risk of fraud within their organizations.
Michael A. Boeheim, CIA, CFE is a director in Freed Maxick's Asset Based Lending Practice. Mike joined the Firm in 1995 and has over 30 years of experience in the ABL industry. He is responsible for staff supervision, quality control and developing and maintaining lender relationships.
Mike also has experience in portfolio acquisition due diligence and forensic examination assignments of troubled loans involving fraud. He served as an instructor and developed the fraud programs for the Commercial Finance Association Fraud Awareness Workshop and the European Fraud and Audit Conference, and has been a speaker for a number of organizations on various fraud related topics. Mike's articles have been published in the Secured Lender and the ABF Journal. He has provided Grand Jury testimony and was recognized for outstanding service as an instructor to the Asset Based Financial Services Industry.
A graduate of the State University of New York at Buffalo, Mike is a Certified Internal Auditor and Certified Fraud Examiner.
Jerry Oldham is co-founder, Chairman and CEO of 1stWEST Financial Corporation. Mr. Oldham has an extensive background investigations and corporate due diligence background and a broad senior management resume in commercial banking and corporate and real estate finance. He frequently serves as a consultant or expert witness in litigation and settlement negotiations involving complex corporate finance, real estate, banking and lending practice issues, having assisted in the settlement of hundreds of lawsuits over the years. Additionally, Mr. Oldham often acts as a consulting team leader to manage the overall due-diligence process on investment decisions for 1stWEST clients.
Mr. Oldham received his B.S. Degree in Finance and Real Estate from The Pennsylvania State University and his M.S. Degree in Banking and Finance from Colorado State University. While at Penn State he was President of the College of Business Student Council, and was awarded the Dean's Cup upon graduation. He is recognized for his banking research and publications in the areas of commercial loan pricing and profitability analysis and due-diligence.
Mr. Oldham is a graduate of the American Bankers Association's Undergraduate and Graduate level studies programs and holds the ABA's Certified Commercial Lender designation. Jerry also serves on the Board of Governors of the Education Foundation of the Commercial Finance Association and as a member of its Executive Committee and Education Committee. Mr. Oldham and/or 1stWEST are also members of the Association for Corporate Growth (ACG), the Small Business Investor Alliance (SBIA) and the College and University Professional Association for Human Resources (CUPA-HR).
Doug Bull is the Team Leader, Field Examination Services with JPMorgan Chase. In addition to serving as an instructor for the Commercial Finance Association, he was the primary author of CFA's Field Examiner School. He was named Best Newcomer Lecturer 2006 for the Asset Based Finance Association, UK. Prior to joining Dopkins in 2000, Mr. Bull gained 16 years of experience from public accounting and the private sector with a 10-year concentration in asset-based field examinations, most recently as Vice President, Collateral Examination Manager at HSBC Bank. At HSBC, he supervised an internal staff and coordinated the outsourcing of field examinations to various firms.
The program will meet at:
30 Rockefeller Plaza
New York, NY 10112
Sep 24: 8:30 a.m. – 5:00 p.m.
Sep 25: 8:30 a.m. – 5:00 p.m.
Sep 26: 8:30 a.m. – 1:00 p.m.
Continental breakfast will be served each day beginning at 8:30 a.m. The program will begin at 9:00 a.m. Lunch will also be provided each day.
Program Level: Intermediate
Recommended for: Any staff seeking to minimize their institutions' fraud risk.
Commercial Finance Association is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: www.learningmarket.org
Career Services: $298
Career Services with Textbook: $325
Member with Textbook: $770
Non-Member with Textbook: $995
As a special offer, you may purchase the industry textbook, Asset-Based Finance - Proven Disciplines For Prudent Lending at the discounted price of $25 (regularly $49.95) for CFA members, and $50 (regularly $79.95) for non-members, if you do so with your registration.
To attend, please check out the EVENT INFO HERE.
Freed Maxick ABL Services is one of the nation’s largest providers of ABL field exam outsourcing services to asset-based lending and other financial institutions that have granted loans, increased credit lines, reduced credit lines, or reduced loan loss exposure.
Read some of our ABL thought leadership on our “Summing it Up” blog.
By: John Kleiman
Commercial lenders often cross-collateralize loans in order to reduce risks. But beware: Accounting concerns and debt restructuring issues may emerge when using multiple properties to secure a loan associated with one property.
Nonaccrual status for loans
Typically, when interest payments on a loan are significantly overdue and collecting any principal is unlikely, the loan must be placed on what’s known as “nonaccrual status.” For example, if your bank experiences an increase in nonaccrual loans, it will likely be forced to bump up its reserves for loan losses, which may hurt profits in the long run.
Cross-collateralization can cause multiple loans to be placed on nonaccrual status, even if some of the loans are still performing. In the OCC’s June 2012 Bank Accounting Advisory Series (BAAS), the agency offers several examples that show the potential impact of cross-collateralization on nonaccrual status.
For instance, one example involves a real estate developer that has two loans with a bank for two separate projects. Loan A is up to date and the bank expects full repayment of interest and principal. Loan B, on the other hand, is placed on nonaccrual status.
According to the BAAS, placing one loan on nonaccrual status won’t automatically require your bank to place the other loan on the same status. The guidance stresses that the responsible party on the two loans are separate corporations and are wholly owned by the developer and that there’s no cross-collateralization or personal guarantees.
So, if the bank subsequently negotiates a cross-collateralization agreement with the developer, must loan A also be placed on nonaccrual status? According to the BAAS, when entering into a cross-collateralization agreement, the bank is simply taking steps to improve its own position relative to the borrower. The bank does not need to place loan A on nonaccrual status if cross-collateralization doesn’t change the repayment pattern of the loans or endanger loan A’s full repayment.
Yet another example shows loans A and B are related to separate real estate projects. The loans are personally guaranteed by the developer and were initially cross-collateralized. Project A has the cash flows to repay loan A in full, but no excess in order to meet a shortfall on loan B, which is already past due.
According to the OCC, if the developer has the intent and the ability to make the payments on both loans, the bank could keep both loans on accrual status. If, on the other hand, the developer lacks the ability and intent to make the payments, both loans should then be placed on nonaccrual status.
Because, in the above example, the loans are cross-collateralized, make sure that collectability is evaluated on a combined basis. The developer, as the guarantor, is the ultimate repayment source for both loans, so placing only loan B on nonaccrual status wouldn’t indicate that the collectability of the entire debt is in doubt.
Troubled debt restructurings
Under current accounting standards, if restructured loans are regarded as troubled debt restructurings (TDRs), they may result in losses on the bank’s financial statements or additional valuation allowances. Typically, a restructuring is a TDR if a bank grants a concession to a borrower that’s experiencing financial difficulties.
Some institutions use cross-collateralization in hopes of avoiding TDR status on reworked loans. They might, for example, defer loan payments or reduce the interest rate in exchange for additional collateral.
Work with an expert
Should you have any questions about the cross-collateralization strategy, contact a Freed Maxick ABL advisor here or call us at 716-847-2651.
By: Dylan Walter, Sr. Field Examiner
Clients face two types of fraud risks: 1) employees who misappropriate assets and 2) those who “cook the books” to make the company look healthier than it is. Ask borrowers if they’ve prepared such a profile that reflects both of these fraud risks. After all, managing fraud risk is instrumental, to not only your customers’ success, but also yours.
The checklist below can help you create your own customized fraud risk profile for each of your borrowers. The left side identifies some of the most common risks. The right side shows a borrower’s relative risk on a scale from 0–5. A score of 0 means there’s no risk. A score of 5, however, indicates an imminent threat of material loss or misstatement with very few controls in place to mitigate risk.
If you’re not sure about the appropriate rating for any factor, contact your customer for more information.
Fraud Risk Checklist
Potential fraud risk factor
Excessive pressure. Evaluate if conditions exist that may tempt employees to massage the numbers, such as expiring credit lines, deteriorating financial performance and performance-based compensation.
Informal attitude. Determine whether fraud risk management is a top priority or is done simply to satisfy external auditors or the board of directors. Evidence of having formal fraud risk policies that includes internal audits, computer passwords, surveillance cameras, whistleblower hotlines, formal job descriptions, and corporate codes of conduct.
Changes. Pinpoint any major changes — such as updated accounting software, a new product line, a pending merger or acquisition, insurance claims or lawsuits, or IRS audits — that could offer opportunities to conceal fraud or result in a significant monetary loss.
Volatile industries. Assign higher scores to volatile industries that have high growth and failure rates, significant competition, strict legal regulations, and imminent changes in product obsolescence and technology.
Unusual activities. Look for unusual activities that may warrant additional investigation, such as the use of complex business transactions, accounting estimates, competitive bidding, proprietary intellectual property, offshore activities, related-party transactions, and contingent assets or liabilities. Also, look beyond the footnote disclosures for clarity.
Personal problems or conflicts of interest. Be wary of employees who have close relationships with suppliers, co-workers, competitors and customers — or financial interests in other companies. Also look for employees who have problems with addiction, gambling, or legal and credit problems.
Internal turnover. Consider whether the business has changed owners, managers, accountants or attorneys, or lenders in the last five years. Unreasonable demands or frequent disputes could signal that the company is in crisis.
Cash. Gauge how much cash the business has on-site and where it (and the company checkbook) is stored. Mitigate risk by performing background checks on employees who might handle cash, independent bank statement reconciliations and physical controls.
Receivables. Look for a stable relationship between sales and receivables (as well as receivables and total assets) over time. And evaluate write-offs and aging schedules.
Inventory. Evaluate controls over shipments, inventory receipts and write-offs. Consider ways a fraudster can pilfer inventory or manipulate records for their own personal gain. Ask your CPA to perform physical inventory counts annually to identify discrepancies with perpetual inventory records.
Fixed assets. Ask whether the business prepares a detailed fixed asset register and tags high-value assets, such as printers, scanners, phones and computers. Keeping a routine maintenance schedule can help the client track the whereabouts and condition of each item.
Payables. Look for payable fraud schemes, such as kickbacks and phantom vendors. Borrowers must take steps — such as confirming vendor balances and duplication of duties — to mitigate payable fraud risk.
Improper revenue recognition. Evaluate the business’s policy for recording sales. Some may prematurely book sales to either boost earnings or delay recognition to minimize taxable income. Also look for fictitious customers and excessive refunds, returns, discounts and voids.
Lax expense review. Ask the management team how they verify fees paid for services, such as rent and professional fees — because there’s no physical evidence of the expenditure, except a contract or invoice. Strong customers will also have formal expense report approval procedures.
Fraud risk profiles can help you identify your borrowers’ weaknesses, and expose which areas warrant additional due diligence. Often, lenders and borrowers will independently rate the company and then compare the results. This exercise can serve as a springboard for discussing risks, opportunities and perception gaps with your customers.
Freed Maxick’s Asset Based Lending division is one of the nation’s largest providers for field exam outsourcing services. If you have questions regarding your asset based lending issues, give our Buffalo NY office a call at 716.847.2651, or you may contact us here.
By: Mary Lindsey
Operating a business is much like taking a road trip. There are things you need to plan for; check lists have to be created, packing that needs to be done, making sure your vehicle is in working order. These are all primary steps when planning a road trip. Businesses “should” operate in much the same way- but you’d be surprised at just how many small and midsize companies don’t have a “road map” to guide them through the bumps and detours that come up along the way. Having detailed business plans can help improve the odds that your clients will arrive at their destinations on time and on budget.
Creating a business plan
Business plans offer investors and lenders an assessment of current operations, as well as a “game plan” for the future. Such plans typically include an executive summary, industry and market analysis, and business and management team descriptions; then there are the implementation plan and financials.
A small or midsize company might put up a fuss at the thought of compiling a comprehensive business plan, but they’re critical when a business is in financial trouble or needs financing for a major capital expenditure. Believe it or not, the best plans are the simple ones. For example, an executive summary can be as short as a paragraph. A long-winded plan tends to bury management’s message.
For small clients, an executive summary shouldn’t go beyond one page, and the overall length should be less than, say, 40 pages.
Exploring the executive summary
While executive summaries are often the first place a lender looks, they’re usually the last page that management should write. Instead, clients should approach a business plan like they would that road trip. Think of a destination first and then map out the best route.
In the same way, business planning should start with a long-term vision. This vision should describe where the company is now and where it wants to be in three, five or 10 years. Thus, it’s best to start with historic financial results and then identify the key benchmarks that the management team wants to achieve. These assumptions will literally drive the financials.
Reviewing budgets and projections
Lenders should take a close look when reviewing the financials section of the business plan. Management’s goals are fleshed out in its financial and budget projections.
For instance, suppose a company with $5 million in sales in 2012 expects to double over the next five years. How will the client get from Point A ($5 million in 2012) to Point B ($10 million in 2017)? There are many ways to reach the desired destination.
If the management team decides to double sales by hiring five new salespeople and acquire the assets of a bankrupt business, then this “plan” is what will help drive the balance sheet, projected income statement, and cash flow statement.
When projecting the income statement, management should make assumptions about its fixed and variable costs. Direct materials are usually considered variable. Rent and salaries are generally fixed. But there are many fixed costs that can be variable over the long term. Consider rent, for example. Once a lease expires, management can then relocate to a different facility to accommodate changes in size.
A client’s balance sheet items — inventory, receivables, payables and so forth — are typically expected to grow in tandem with revenues. Management will make assumptions about its minimum cash balance and then debt will increase or decrease to keep the balance sheet balanced. In other words, your institution will be expected to fund any cash shortfalls that might take place as the company grows.
The financials provide an outline of how much financing the borrower will need, how it will use those funds and when the client expects to repay its loans. It’s your job, as the lender, to assess whether the client’s plan is realistic.
Understanding the internal and external environment
The rest of the business plan describes your borrower’s external and internal environment. It can be highly informative reading material, even if you think you already know your existing borrower. These sections indicate that the management team has done its market research and performed a risk analysis — and that they truly understand the marketplace.
Bring in an expert
No one should drive cross-country without a GPS or a map. Drivers need to know exactly where they are, and how close they are to their destination.
When clients are proactive, rather than reactive, they’re more likely to reach their destination. Business plans can play a huge role for lenders who want to understand their borrowers’ goals and financing needs.
A CPA can’t demand a business plan from a client, and unless the client initiates the plan, it will likely fail. But working with an experienced outside advisor can help the client’s management team crunch the numbers, stay focused, and serve as devil’s advocate when preparing the plan.
Sidebar: Evaluating a company’s management team
Typically, lenders will go right to the executive summary and financials. But, in reality, the most important section from a lender’s perspective is the management team description. Get to know every member on the company’s management team and how each one fits into the mix.
Be sure to identify people that would likely be hard to replace, and then discuss ways to make the borrower less dependent on these “key” people. It’s also critical to be realistic about how far entrepreneurs can stretch. At some point, many borrowers will outgrow their founders and require a professional management team.
Freed Maxick’s Asset Based Lending division is one of the nation’s largest providers. Contact us for more information about our services and how we can assist you.
Three Borrower Traits Asset Based Lenders Need to Recognize in their Loan Portfolio
Author: Ashley Trexler, Supervising Field Examiner
If a borrower possesses significant fixed assets, owns its real estate, or operates several lines of business, you may be exposing your bank to unnecessary risk. To avoid that situation, be sure you review your loan portfolio for clients with certain traits.
Commercial property ownership can be quite risky, especially for retailers. Why? Because the store’s owner can be held liable for crimes or accidents that occur on the site if a victim proves there’s inadequate security.
Liability insurance can help mitigate losses. But many policies may be based on outdated business appraisals, and damages might exceed the borrower’s coverage.
For an added layer of protection, borrowers may want to create a separate legal entity for their real estate ventures. That way they can lease the property to the operating business at a fair market value. The same will hold true for businesses with significant fixed assets.
Doing so will protect the operating business entity from property liability claims. The real estate venture can still be pledged as collateral for loans to the operating entity.
Suppose a dry cleaning establishment diversifies and explores the health food market. If the experiment doesn’t work, it will drag down the dry cleaning business (or vice versa). If the borrower sets up a separate legal entity for each business segment, however, the borrower will not only limit its “spillover liability,” but it will also allow for more flexibility in the ownership structure. Keeping things separate from the get-go — with separate bank accounts and balance sheets — can be quite helpful if the owners subsequently decide to sell or seek additional financing.
If a family business wants to transfer wealth to subsequent generations, the company will likely benefit from establishing separate legal entities. For example, suppose an operating business carves out its real estate into an LLC or a trust. Those who are active in the operating business are “gifted” interests in the company. Passive heirs are then given pieces of the real estate venture.
This setup serves several goals beyond limiting liability. First, the parents can use the annual gift tax exclusion ($14,000 in 2013) and the lifetime unified credit ($5.25 million in 2013) to gradually lower their taxable estate. Gifts are typically discounted for marketability and lack of control.
Second, those who are active in the business will get a stake in something they can directly impact — the value of the operating business. Passive investors will have access to a steady income stream. Plus, the family will be able to minimize its overall tax liability if the children are in a lower tax bracket.
Insight and Guidance on the Legal Theory of “Deepening Insolvency”
Author: Emmon Khan, Senior Field Examiner
Suppose a borrower is experiencing financial trouble. His company is trying a turnaround and has asked you to continue to advance him funds under its working capital line. What should you do? As you apply professional criteria in regard to the customer’s request, keep this in mind: Your financial institution might be held accountable by your customer’s creditors under the legal theory of “deepening insolvency” if the customer chooses bankruptcy protection.
Defining deepening insolvency
Balance sheet insolvency occurs when a company’s assets no longer exceed its liabilities, thus preventing the business from repaying its debt. One court defined it as the “fraudulent prolongation of a corporation’s life beyond insolvency, resulting in damage to the corporation caused by increased debt.” Misrepresentations, mismanagement, and fraud can cause and even hasten insolvency.
Deepening insolvency has come forth in some jurisdictions as a creative remedy for creditors who assert a company delayed filing for bankruptcy and, instead, unnecessarily prolonged its corporate life by obtaining loans while already insolvent. By taking on additional equity financing or debt, a business compounds its insolvency and greatly impairs its ability to repay creditors.
Ever since deepening insolvency emerged in the 1980s, it’s been alleged against officers and directors who breach their fiduciary obligations. It’s also been alleged against professional advisors as well as secured creditors who help conceal the extent of financial turmoil, exert undue control over distressed customers and support unrealistic workouts.
The legal history
The first case that suggested secured lenders may contribute to customers’ insolvency was In re Exide Technologies, Inc. In this Bankruptcy Court case, a banking syndicate lent substantial funds to Exide Technologies in spite of the fact that the company had reported significant losses and an insolvent balance sheet. Exide used these funds to help support its faltering operations and acquire a competitor.
As the company’s financial condition continued to crumble after the acquisition, the syndicate received credit enhancements — including additional collateral and guarantees — in exchange for continuing financial support. Moreover, the lenders leading the syndicate acted as advisors and received investment banking fees from the acquisition. Over time, bankruptcy became inevitable, and the creditors’ committee filed suits against the lenders alleging, among other charges, deepening insolvency.
When the court refused the lenders’ request to dismiss the claim, it opened the door for deepening insolvency claims against secured creditors who make risky loans to insolvent borrowers to the detriment of other creditors.
Deepening insolvency claims have had mixed results in courtrooms. For example, courts in several cases, such as Trenwick America Litigation Trust v. Ernst & Young and In re Global Service Group, have narrowed or rejected the scope of claims based on the theory of deepening insolvency. Until the legal community can clearly define and consistently apply the concept of deepening insolvency, this issue will remain a wild card in bankruptcy litigation.
A properly managed turnaround can increase creditor recoveries and even help avert formal bankruptcy proceedings, thereby allowing borrowers to regain profitability. Fiduciaries of an insolvent business might conclude that the business should continue to operate to maximize its long-term wealth-creating capacity — that is, its “enterprise value.” There’s no absolute duty to shut down and liquidate an insolvent corporation. So, as long as the loan is made without violating the business judgment rule, a court should not impose liability.
However, it’s important to carefully review a client’s workout plan for errors, omissions and unrealistic assumptions. In many cases, bankruptcy may provide a better alternative — then you can lend funds to a debtor-in-possession under the court’s supervision.
A lender might find itself on either side of an insolvency claim. In addition to being charged with contributing to a borrower’s financial distress, a bank may initiate similar charges against directors, owners, or insolvency professionals to recoup any outstanding loans upon the borrower’s insolvency.
That’s why it’s critical to bring in independent financial advisors to help substantiate or refute deepening insolvency claims, including unraveling complex transactions, investigating fraud allegations, tracing assets or funds, and calculating economic damages. They also can objectively determine whether a company’s turnaround plans are reasonable or, alternatively, whether bankruptcy is imminent.
Pulling the plug
It can be quite difficult to deny financing to a loyal customer who is in financial distress. But if your client’s financial health adds up to deepening insolvency, you may need to pull the plug.
Be Wary: Not All Startups are Worth the Risk
Author: Eric Adornetto, Supervising Field Examiner
While entrepreneurship is the pinnacle of free enterprise in the United States, almost all banks tend to shy away from startups. Truth is, companies in this segment are much more likely to fail than not, at least according to the Small Business Administration. But there are some bright spots that offer lucrative lending opportunities for diligent, adventurous lenders.
Defining a “startup”
Startups are mostly small businesses that have a limited operating history. They often start as an idea that’s fleshed out via research and development. The business model is then formulated and the owner or owners start selling. At this point, the startups are funded by the owner’s personal resources, including savings, retirement accounts, credit cards and home equity loans.
Most lenders classify a business as a startup when it has operated for at least five years. But somewhere around the two-year mark, lenders might consider underwriting a loan. Community banks have long been a go-to source for entrepreneurs. But some big banks — including Wells Fargo and Bank of America — are starting to loosen up their purse strings to startups.
Evaluating the business
So, what do underwriters want the most from startups? For starters, the business plan should show that management has thought about potential risks and threats, such as hidden costs and seasonal cash flow shortages. But the real proof is in the startup’s actual results. If they can offer two or three years of CPA-prepared financial statements, the underwriters will have significantly greater peace of mind than with just a business plan.
Lenders also need to evaluate the startup’s concept. Ask yourself this question … would you buy it? How is this product/service different from that of the rest of the competition? It’s true … many entrepreneurs are blinded by love for their concept. So, it’s up to the lender to stay grounded and play the devil’s advocate. A startup’s growth projections should jibe with industry trends and historic results.
Franchised startups tend to bear a lower risk than nonfranchised ventures. For example, large publicly traded franchisors (such as Toyota or McDonald’s) typically provide a proven business model and marketing support for its franchisees, particularly during the startup phase.
Management quality is key
What’s even more important than the startup’s concept is the quality of its management. In the wrong hands, even the best idea can be doomed to failure. So, when you start evaluating the people behind the idea, make sure you look at their areas of expertise, employment history, credit scores and personal balance sheets. Key person insurance policies, personal guarantees, personal asset pledges, and co-signing are commonplace when lending to startup companies.
Take, for instance, a single-owner business that’s run by a technical expert (such as a former operations or R&D manager). Who will handle the administrative tasks (such as financial reporting and HR) as the business grows? Look for owners who can admit to their shortcomings and hire employees to help supplement tasks outside their areas of expertise.
Beating the odds
In the long run, lenders want assurance that a startup will be able to repay its debt, either from personal resources or operating cash flows. If your underwriters are sitting on the fence regarding a startup prospect, offer a little extra handholding in order to get the loan approved.
You’ll first need to educate the startup’s management team about what your bank is seeking. Typically, that will require a solid business plan, some two to three years of audited financial statements, and last, operating results that are above specific profitability, turnover, leverage and liquidity levels. As you can imagine, specific financial benchmarks will vary from industry to industry.
If at all possible, arrange for the entrepreneur(s) to pitch the business’s request directly to the underwriting committee and then field any questions. Transparency on both ends of the lending decision can, indeed, help push the deal through.
In addition, recommend Small Business Administration (SBA) loans to any “fence-sitters.” Companies that have less than $7 million in tangible net worth and $2.5 million in net income should investigate SBA 7(a) operating loans and 504 equipment loans, as they provide partial guarantees from the federal government in case of default. If your bank participates in such programs, an SBA-backed loan might be the final push that turns a “maybe” into a “yes.”
Worth the legwork
While lending to startups won’t be easy, it’s often worth the extra legwork. Why? Because, in addition to reaping higher interest rates for their incremental risk, most startup loans will reward diligent lenders with the satisfaction of helping struggling business owners make their dreams a reality. The bonus is that your bank might gain new long-term customers. With solid business planning and transparent communications, startup loans can be a win-win for both borrower and lender.
If you have any questions about lending to startups or any other asset based lending issue, give us a call at 716.847.2651, or you may contact us here.
4 Tips for Protecting Your Lending Portfolio
Author: Phil Pence, Field Exam ManagerAs you know, finding new borrowers for your asset based lending institution can be a very time-consuming and expensive venture. As a rule of thumb, the costs of wooing new customers can be six to seven times more than the costs of retaining existing ones, according to marketing firm Flowtown.
With today’s competitive lending market, your bank risks losing borrowers to more assertive lenders who promise higher credit lines, lower interest rates, and faster closing dates. And as you know, high customer turnover can make you look bad to senior bank executives. So, how can you protect your portfolio? Here are some tips.
TIP 1: Approach potential borrowers first
You simply can’t wait for customers to come to you about refinancing options or more borrowing opportunities. After all, interest rates are at all-time lows, and there’s ample credit supply for customers who sport strong credit scores. If you don’t act quickly, proactive borrowers might seek greener pastures.
You can’t let a competitor beat you to the punch. So make sure you review your customers’ financial statements. Go for those with strong credit, high growth and high interest rates. These will be your best prospects for refinancing or add-ons. A borrower might not even look into what your competitors are offering — so long as you contact them first, make a fair offer and maintain a long-term relationship.
TIP 2: Make sure you’re responsive and approachable
Touch base with your customers on a regular basis. Consider visiting their businesses and take them out to lunch or for coffee. Many prospects will be happy to give you a tour of their facilities. Do it. And above all, make sure you return their calls and process paperwork promptly. The top frustrations that borrowers experience when refinancing or applying for a credit line increase is the amount of time it takes for lenders to simply process the paperwork.
In fact, one borrower actually switched banks because his application with its existing lender was delayed for months over a missing 2011 tax return. A quick phone call might have remedied the omission and possibly retained the customer. But instead, the application just sat in a junior lender’s inbox — and a rival bank got the borrower’s business.
Don’t be afraid to seek feedback from your customers. Make it a point to talk to every decision maker in the business. You might find that the CFO is your best contact rather than the owner. Finally, learn what they like and dislike about your bank via written or phone surveys.
TIP 3: Offer to become a referral source
As the old saying goes, it’s not what you know but whom you know that counts in business. The best way for a professional services provider to gain customer loyalty is to become a referral source for value-added services. Work to become the go-to person in your business community. Encourage borrowers to come to you for accounting, legal or even advertising referrals. And make sure you forward borrowers any relevant e-mails or trade journal articles.
Networking can turn lenders from pesky outsiders to members of the customer’s “team.” This will help keep you in the loop when they face key changes. Plus, it will help you become irreplaceable. You might very well find that happy, loyal borrowers will be more likely to return the favor and refer some business back to you.
TIP 4: Make ’em happy
The best way to make borrowers happy is to avoid treating new and old applicants in the same manner. After all, a long-standing business relationship and a handshake should be something special in today’s business world.
Bottom line? If a client has a strong credit score and proven track record of timely debt service, make sure you streamline the refinance and application processes as much as possible.
If you have any questions about retaining borrowers or any other asset based lending issue, give us a call at 716.847.2651, or you may contact us here.
Best Practices in the Prevention and Detection of Borrower Fraud!
Mike Boeheim, CIA, CFE and Director at Freed Maxick ABL Services will take part in the upcoming Fraud Awareness Workshop presented by the CFA on April 17th-19th.
The event is a three-day program presenting best practices in the prevention and detection of borrower fraud while also recommending fraud prevention procedures for a variety of ABL disciplines. Reinforcing each learning point through numerous case studies, the goal of the program is for participants to understand their roles in mitigating the risk of fraud within their organizations.
This is a must attend for any staff member seeking to minimize their institutions' fraud risk.
Wednesday, April 17: 8:30 a.m. - 5:00 p.m.
Thursday, April 18: 8:30 a.m. - 5:00 p.m.
Friday, April 19: 8:30 a.m. - 1:00 p.m.
Continental breakfast will be served each day beginning at 8:30 a.m. The program will begin at 9:00 a.m. Lunch will also be provided each day.
Program Level: Intermediate
April 17 - 19, 2013
Event Start Time: 8:30 a.m.
Troutman Sanders, LLP
The Chrysler Building
405 Lexington Avenue
New York, NY 10174
To gain more insight into fraud and Asset Based Lending issues, check out related blog posts on our "Summing it Up" blog. You can also get a free copy of the keynote presentation delivered at the Commercial Finance Association Fraud Awareness Program Workshop.
We’re pleased to offer a complimentary copy of this valuable resource.
11 common fraud schemes
Critical management pressure points that lead to fraud
6 red flags that every asset based lender needs to be on the lookout
Recognizing irregularities in source documents, accounts payables and financial statements
9 common inventory fraud schemes and deterrents
For information about our ABL Services team and related services,
check us out on the web.