Skin in the Game

What is skin in the game? That sounds horrific, doesn’t it? It sounds like somebody lost skin doing something painful, like sliding into second base. Another way to phrase this is “to share in the risk.” Someone who has “skin in the game” is someone who is “sharing in the risk” of a transaction.

Why is it important that someone share in the risk? When making a business loan, we feel someone is more motivated to operate their business successfully, if they are exposed to the risk of losing their own money. That is why we want them to have some skin in the game. If the borrower does not have their own money at stake, they do not suffer if they give up and walk away, or they may not feel as motivated to turn things around when bad times hit.

Lately, I have had to explain to a handful of lenders (across several institutions) the issues related to financing 100% of a business borrower’s purchase. In other words, the borrower has no skin in the game. This presents a great risk in business lending, even though 100% financing is common in consumer lending. Consumer loans are relatively small in dollar amount, especially when they aren’t for a home. And it should not come as a surprise that buying a home requires a down payment since it is a big purchase, and we want to make sure the borrower has skin in the game.

Financing business loans at 100% carries considerably more risk, because of both the high dollar amounts and the nature of the collateral. There are less buyers in the market for an office building or stamping machine than there are for cars and RVs. That means if we foreclose on business assets, we may have to accept a much bigger discount on the value to sell the asset. An office building might sell for 80-90% of its appraised value. And then consider, we will have a lot of legal costs in foreclosing on something that big and have to pay a large commission to a real estate agent. When all is said and done, we might get proceeds equal to 75% or less of the appraised value of the building. Why then, would we ever want to finance more than 75% of the building? Usually, we don’t.

So by now, you can see there are actually two major issues that arise when someone has no skin in the game. First, the borrower has no exposure to losses, which could affect their motivations; and second, there are no ways to offset costs related to foreclosing and selling collateral. Therefore, sharing in the risk doesn’t just keep the borrower motivated to stick with business, but their equity in a project also helps absorb some of the losses the lender faces.

On the surface, these seem like tempting transactions to do when there is significant cash flow that can easily make the loan payments. But we have to bear in mind, we are observing the best-case scenario when everything is going right. We have to ask ourselves, what could transpire in a worst-case scenario? What could happen is cash flow could no longer service the debt. And if someone has not invested any of their own money, what incentive would they have to stick with the project then?