Capacity: How Debt Gets Repaid

Assessing a borrower’s capacity to repay debt can be a very elaborate discussion and the subject of an entire text book. It generally varies based on lending type and term, and the effect of having guarantors always presents a wild card. Like I had mentioned in earlier articles, analysis really can’t be a one-size-fits-all approach, but nearly all credits will have some key things in common.

First we must make an assumption, and perhaps we should refer to it as one of the axioms of credit: Cash flow should be the primary source of repayment! That is a fancy way of saying the repayment of any commercial loan should come from cash generated from that commercial enterprise; therefore, you should first ignore all other factors, like collateral and guarantors, and see if the operating business makes enough money to repay the debt by itself.

How businesses generate cash varies by lending type. The process of a business producing goods and services and receiving cash is referred to as the asset conversion cycle. For example, Widget Inc. manufactures widgets. The business must first use cash to purchase raw materials to form the widgets. Then they must pay for labor to assemble and produce widgets. Once the widgets are complete, they must sell them and wait to collect payment for the sale. Once payment is received, Widget Inc. has cash again, and hopefully, more than when they started! What will they do with this cash? They will either repeat the process all over again, save it for a rainy day, or maybe pay the owners.

Say Widget Inc. gets a big order for widgets, and they use most of their cash to buy materials and pay for production. Now let’s say Widget Inc. gets a second big order before the first order is complete. Widget Inc. has a problem. They used their cash to start production of the first order, so they do not have enough cash to start the second order. Widget Inc. may need to borrow some money to start the second order. This is what we call borrowing cause.

Generally speaking, if a lender wants to give Widget Inc. a loan to fulfill the second order of widgets, then the lender should be repaid when Widget Inc. finally receives payment for selling the widgets. This is a crucial concept. The credit facility should not only match the borrowing cause, but also the timing of cash flow from the asset conversion cycle. This is necessary to increase the odds of repayment.

Where most lenders make painfully long-lived mistakes is by giving a borrower an improperly structured loan. If the loan is not structured to reflect the borrowing cause or timing of the asset conversion cycle, the borrower usually struggles to repay the debt in the long run. Either the borrower will have cash when a loan payment is not due, or a loan payment will be due when the borrower does not have cash. The loan becomes a recurring problem.

To summarize, the loan should be repaid by cash profits (cash flow) of the business. The reason for the loan should have a clearly identified borrowing cause. And, payments should coincide with the timing of cash received from asset conversion cycle. To give the customer a loan that does not coincide with the borrowing cause or asset conversion cycle results in a poorly structured loan.

Lastly, it is import to point out if the expected cash flow will be unable to meet loan payments, generally the loan will not work and should not be granted. You should not try to structure the loan around what the borrower can afford to pay, but you should only structure the loan around what the business should realistically be able to pay and when. Lowering payments to coincide with weak cash flow is referred to as troubled debt restructuring. I shouldn’t have to explain that means you are headed for problems!

How to Win at Referrals

I worked for a short while for Met Life between my first and second bank jobs after college.  I have always enjoyed talking to people and thought since I had an uncle who was an insurance agent, how hard could it be?  There, I was first exposed to the concept of getting referrals from customers to build your business.  After a presentation to a client (and hopefully a sale, which did not occur at all for me), we were to ask the following:  “If what I have presented is of benefit to you, can you give me the names and phone numbers of three people you respect, and who respect you in turn, who would also benefit from this service?” 

Since I never reached a close on a life policy sale, I never had the opportunity to ask the question.  I often wondered what to do if someone gave me the name of a deceased person.  Clearly, those survivors could use the live proceeds!  I eventually left Met Life because I was accustomed to several necessities like eating and paying rent.

Several years later, I attended a seminar on sales that was hosted by the savings and loan that I worked for.  It was there the same idea of how to generate referral business was presented.  I thought this was a great idea and that this would generate so much business, I would be as happy as a pig in a mud puddle.

So I decided to try it.  My next closing was with a couple who was buying their first house.  I strategically positioned myself at the head of the table between them and the door.  There was no way that I was not going to get three referred names from them after the closing had finished.  I would just block them in until they gave me the names.

So the closing finished and I asked my golden question to get my referrals.  I was met with silence.  The couple shifted nervously in their chairs and the Realtors looked annoyed as there was no sound except for crickets chirping.  Finally, the couple half-heartedly gave me one name and told me that was all they could think of.  Then they asked to go as their moving van was waiting for them.

I gave up on the begging for referrals soon after that.  I thought the idea was stupid and each time I asked, I was met with silence.  I don’t think I ever received one good referral from those requests at the closing table.  So I concentrated on being the best at what I could at residential and personal loans, which were the main lines of business for our savings and loan.  I became an expert at figuring out how to get the loan to the customer while still managing the risk to the S&L. 

Before long, I was receiving unsolicited referrals.  I even closed over half of the real estate transactions for the largest real estate company in my hometown.  Our branch was swamped with new business.  Yet, I never stopped to figure out why so many referrals were coming to us.  It was not clear to me until I was visiting one of my Realtor friends at his office one day.  He presented me with a new referral and said, “Now I don’t want you to get a big head but do you know why we go out of our way to send you business?  It is because you are the best banker in town who gets the deal closed.” 

It was then I learned the first great principal of referrals.  To get a referral, you need to be someone worthy of getting a referral.  Think about when you recommend a movie, auto repair shop or vacation spot.  You are not doing it because you have “give a referral for___” on your to do list.  You do it because it is something that is worthy of a referral in your estimation.  Referrals are something we do every day, whether we realize it or not.  We only recommend those we believe in. 

The second principal of referrals I learned soon after learning the first, if you have a raving fan of your product or services, you sometimes get a referral by being strategically introduced by your fan to your prospect.  This is best done when it is unsolicited by you and it will not happen unless they believe in you.  The best place to start receiving referrals is to be someone worthy of getting them.

Character, the Good, the Bad and the Ugly

Character is not credit criteria that can be normally quantified, but it is important to lending. I used to tell my students, “Your borrowers can’t pay you if they are in jail. Character matters!”

How can a lender possibly come to understand someone’s character? The obvious way is by simply getting to know him or her better. We all know what it is like when we get a gut feeling that someone is lying to us or up to something suspicious. A lender should be a “relationship manager,” and the lender should have an ongoing relationship with the borrower, so he or she has a good sense of the borrower’s character or moral compass.

Even if you have faith in the borrower’s character, the lender or underwriter should make use of public resources to discern as much about the borrower as possible. Younger generations are inclined to immediately do a Google search for the borrower’s name and check for any social media profiles. This is not a bad idea. This is a quick way to see how someone is presenting themselves to the public. If those searches turned up something questionable or objectionable, would you want to lend money to that person?

A public Internet search is only the tip of the iceberg. All lenders are familiar with pulling credit reports on individuals, and this may give you better insight into what type of customer you have. While credit scores are relevant, it is important to bear in mind, they tend to reflect only personal obligations and can easily be affected by close family members. The individual is likely not the sole source of repayment for a commercial loan. And, credit reports are limited in what they can tell you. For these reasons, credit scores are still relevant in commercial lending but to a lesser extent than when used in consumer lending. The report will probably not reflect commercial debt. Also, it will not indicate if the borrower has any criminal history.

A background check can be utilized to search for criminal records and even civil litigation. There are a wide variety of companies that provide background checks, and they range greatly in price and quality. Most resources tend to focus on verifying public records and a review of criminal activity; whereas, systems that check for civil litigation are harder to come by. The federal government has a repository for federal court activity at www.pacer.gov but this will not capture cases filed in State courts.

The extent to which I have suggested investigating a customer’s background may seem invasive, but remember, commercial lending typically involves the transfer of substantially more money than a consumer lending transaction. If a $20,000 loan does not get repaid because a customer is convicted or suffers from a lawsuit, your institution will likely persist tomorrow much as it did today. If your institution loses a $2,000,000 loan because of a borrower’s criminal conviction or a civil judgment, now your executive management may be concerned with capital ratios and face increased regulatory scrutiny. In this respect, you should not feel as though you are invading privacy, because your institution simply cannot afford to suffer a large loss of funds due to character flaws.

My advice is always do a character check for all significantly large loans and cast a big net. Pull a credit report, do some internet searches, find an affordable yet effective way to check into criminal records, search for the customer’s name at www.pacer.gov, and try to check any search engines provided by your local court system. And if you do find adverse information about your customer, don’t immediately assume your customer is a terrible person to do business with. Present your findings to the borrower in a professional manner, and listen to what they have to say. Your customer may have a reasonable explanation for your findings, and if they do, then it is your responsibility to check if there is corroborating evidence supporting their explanation. --Trevor Plett

Using a Guidance Line

Early in my commercial lending career, I had a client approach me about buying a series of houses that he would fix and sell or elect to fix and hold as rental properties.  He had a couple of houses in mind immediately, and could possibly be interested in buying up to 25.  He also needed a way to close rather quickly on the properties.

My first reaction was fear.  I knew the process we had to go through to get a loan approved.  The write up and presentation alone would take several days if not a week.  Much of the information would be duplicated and would require repetitive analysis.  I hate unnecessary repetition even though the industry I am in repetitive busywork goes with the job as much as jelly goes with biscuits. 

My mentor in the business provided me with a brilliant idea, use a guidance line.  We would underwrite the entire relationship up to the maximum that was comfortable by the lender and the borrower.  An agreement would be signed that covers the whole but individual loans would be booked for each property that was closed.  This allowed for the credit write up and approval to be completed one time, then loans could be closed as long as they fit the “guidance” of the guidance line agreement.

We specified in the guidance agreement what our lien position would be on each property, how much we would advance, how much the borrower would put in, at what level an independent evaluation would be required, the interest rate, amortization and repayment.  Other overall terms like the borrower, guarantors, and the length of the guidance line was specified. 

In this case we set out the guidance line for a year, so we could do adequate review.  Individual house loans could be closed under the line with an amortization of up to 15 years and term of 3.  The maximum we would advance on any one house would be 75% of his price and we would require a drive-by appraisal for any house over $150,000.  The smaller ones we would use the county assessment or a broker’s price opinion.  We also allowed him to have no more than 5 rental properties in the line at one time. 

The structure allowed us to quickly serve the customer needs once the overall structure for the individual credits to be approved.  The overall guidance line was not booked, only the individual credits under the line.  This allowed the overall credit to be approved at one time.  This saved a lot of time and hassle for all parties involved.

Over the years, I have seen guidance lines used for major development projects like construction of condominiums to purchases of pieces of equipment to acquisition of vehicles for a company’s fleet needs.  The structure offers flexibility to the borrower and certainty knowing how each loan will be reviewed and closed.  The loan committee did not have to see the same credit come before them with a hurried attempt to rush the deal through.  I, as the lender, could avoid some stress and duplication of effort and just manage each deal under the overall agreement.

If any deal fell outside of the outline of the agreement, it would require special approval.  The line was also able to be closed if we saw a deterioration of the financial position of the borrower.  The lender remained in control. 

This lending structure may be of benefit to some of your clients, especially those who seem to be buying equipment.  We often would approve guidance lines at the annual loan review time if we knew a client had upcoming needs for the next year.  This seemed to cover most of the needs of the client, unless some event came up that required us to investigate further into the borrower. 

Don't Bring a Knife to a Gun Fight--Doing Analysis Right

Credit analysis is the process of analyzing a borrowing request and determining under what conditions, if any, money should be lent. To do this effectively, it is important to know what analytical tools to use and when.

For newcomers, this can seem overwhelming. First of all, it is intimidating to think about the large volume of money about to change hands. Second, the number of adverse situations that can arise seems endless and impossible to fully understand. Both are good reasons for concern, but proven methods have helped us conquer these problems effectively.

Our first method for dealing with a world full of infinite risk is trying to categorize all risk into 5 buckets we call the “5 Cs of Credit.” All risk can be categorized as follows:

1.  Character, which includes reputation and payment history

2.  Capacity, which includes whether the enterprise provides enough cash to repay the debt. 

3.  Collateral, which is generally an asset that could be sold to offset the debt in default. 

4.  Capital, which is an assessment of how much the borrower has at stake in the transaction. 

5.  Conditions, which is an assessment of economics, industry, and operating environment of the borrower. 

Ideally, if each category looks strong, we should have little to worry about.  Most of the time, you will find some of the categories are weak therefore exposing more risk, and the question arises whether the stronger categories can carry the weaker ones.

How these 5 Cs of Credit should be investigated is where most analysts unknowingly run into problems. There are several analytical tools which can be used in credit analysis and it is confusing to know which one applies to each specific situation.

Not understanding what is in your tool box will lead you to making mistakes. Often I have seen an attempt to use every analytical tool simply to assure no stone is left unturned, but doing so can be foolish. It is like watching someone use a screw driver to hammer a nail or like watching someone trying to eat soup with a fork.

Using the right tool means first identifying what type of problem you are trying to solve. There are actually different areas of lending that will require you to look at different metrics. For the types of loans we typically encounter, there are three broad lending types:

*  Commercial Real Estate (CRE) 

*  Commercial and Industrial operations (C&I) and  

*  Agriculture

The 5 Cs still apply to each lending area, but the how they will be investigated will differ. Each lending type will require its own unique tools, and it doesn’t always make sense to use the same tools in each situation.

For example, take Capital. For a loan to acquire an existing commercial property (CRE lending type), capital will be measured using a loan-to-value (LTV) ratio. But for C&I and Ag, capital will be measured by a debt-to-net worth ratio. Even though you will use a debt-to-net worth ratio for both C&I and Ag, a ratio of 2.00 may be considered acceptable for C&I but will be considered unacceptably high for Ag.

Another area that often causes confusion in using the right tool is the term of the request. Short term credit will have different metrics than long term credit. For example, debt service coverage ratio (DSCR) is an adequate measure of Capacity to repay long-term debt, but it is a poor way of measuring the capacity to repay short-term debt. Why? Short term debt service is often interest only payments and does not account for the need to curtail principal. Therefore, when a DSCR is used for a short-term interest only line of credit, the capacity to repay the debt is not being reflected.

Often the real challenge with analysis is not failing to account for some hidden risk, but using the proper tool. Using the right tool will help report the 5 Cs adequately so an informed decision can be made. But, if you use every tool at your disposal regardless of lending type, the result is often white noise that nobody can understand.  That is why it is important to identify the proper lending type and then only use the tools that are relevant.

In my coming articles, I will explain each of the 5 Cs in the context of different lending types and suggest the proper tools you may use for analysis.--Trevor Plett

Checking Into Your Hotel's Financials

In the Checking Into Your Hotel post, I discussed the importance of the condition of the hotel in the annual review process.  A hotel with deferred maintenance items or improvements the franchise is forcing to complete may cause a problem in cash flow, both in the expenses for the improvements and a possible drop in top line revenues. 

This post will look into the finances and look at several questions the astute commercial officer should ask.  So is there anything else that must be done once you have reviewed the financials and tested the debt service coverage?  Once that is complete and the ratio passes the minimum threshold are you finished with your analysis?

Not yet.  A good analysis of a history of income and expenses from year to year is helpful.  This may show any large, one-time expenses in a year or also any deteriorating or improving trends.  A discussion with the owner will reveal if these trends are likely to occur in the future or if they will not.  This analysis may be an early indication of a problem loan in the future, even if all seems to be fine today.

Questions on the composition of the gross revenues should be asked.  Are there any large contracts for rooms?  Here we are not talking about a group that takes a block of rooms for a weekend.  We are talking about a large number of rooms being taken for an extended period of time.  If so are these likely to continue and how are they priced compared to other room rates.  A few years ago, the Southeast Missouri State found it ran out of dorm rooms for students with the increased enrollment.  They elected to have new apartments built by a third party and then enter into a master lease with the developer for the buildings, which they in turn, rented to students. 

The apartment towers were several years away from completion and they needed spaces for students now.  The school officials contracted with several hotels to rent entire floors of hotels for student housing.  These contracts proved to be a blessing and a curse to the hotel owners.  It was a blessing with a large slice of revenues becoming more certain.  The school rents ran through the slower period of the winter months and still left the hotel open to travelers in the high occupancy summer months. 

But it also was a curse.  The block rents were below what the hotel could rent rooms for on a nightly basis.  The younger student room renters tended to be harder on the property than the average traveler.  This drove up repair expenses.  A challenge to the loan officer is to help understand when the large block revenue will end and what will happen to the hotel’s income statement.  In this case, the owner expected to have a drop in revenue by 10% without the university’s contract income.  They expected their room rates would increase overall.  Management also expected to see a substantial drop in repair expenses.

Some hotels are completely dominated by contracts from one source.  I once looked at a hotel in Kansas that had a contract to rent 80% of its rooms to the railroad.  The hotel was the only one in that small town, so it enjoyed this constant stream of revenue for years.  The only risk would be if the railroad decided they did not need the rooms or if more competing hotels were built in the area.

I always ask for the year ending Smith’s Travel Research (STR) Report.  This is offered free to the hotel owner in exchange of them submitting numbers for occupancy, rooms available to rent, and average room rates.  STR allows the hotel owner to select other hotels they view as competition in their market area and provides information of the performance of their hotel compared to the peer group. 

The STR is helpful in tracking trends in occupancy, average daily hotel room rates and also daily revenue per available room (RevPAR).  Caution should be used when looking at the peer comparisons. Since the hotel owner can select his own peer group, that selection may or may not accurately represent the competition. 

Questioning the components of the income statement further and an analysis of the STR report can be valuable tools for your annual check into your hotel loan.  These strategies may help you understand problems that will occur years before they begin.—Phil Love

Credit Unions Need to Rethink Capacity

In the past couple of weeks, I have heard from several credit unions that were interested in purchasing a construction and development (C&D) participation, but they were being mindful of the NCUA cap of 15% of net worth.  These credit unions were concerned that if they approached their 15% cap, then they would be unable to fund other C&D projects for their members.  I think it is important to be mindful of this, but it is a concern that can be mitigated by using the CUSO for leverage.

For example, assume you are a credit union that has only $1 million in C&D capacity.  It is important to understand that if you have a member who comes to you with a $2 million C&D request, you can still lend to this customer.  How?  The obvious answer is to find a participant who can fund the other $1 million of C&D.  You can then fully fund the loan, but now, you will not be able to make any more C&D loans to other members who come to you with requests.

There is also another way to do this without exhausting your capacity.  Say that same member needs a $2 million C&D loan, and you still only have $1 million in capacity.  You may participate out the loan to other credit unions; however, to do this, you only need to retain 10% of the loan.  That means, you can lead the participations with 10% of $2 million, which is $200,000, and find participants for the remaining $1.8 million.  The advantage to this approach is that you now have helped your member fund a $2 million C&D loan while only using $200,000 of your C&D capacity.  Therefore, if you have another member who needs a C&D loan, you still have $800,000 in remaining C&D capacity.

If a credit union only has $1 million in C&D capacity and is willing to participate with other credit unions, the lead credit union actually has up to $10 million in C&D loans they can originate.  That is what we call “leverage” in the financial world, and it is a common practice.  When a credit union or bank makes a loan, it actually uses a small amount of its own money to make the loan, usually around 10%.  Where does the other 90% of the money come from?  It comes from your deposits, other peoples’ deposits and businesses who deposit money at that institution.  Depository institutions leverage their own capital with deposits as their primary means of getting business done, so a credit union with $1 million in capital can use $9 million in deposits to make nearly $10 million in loans!

Leverage is one of the fundamental principles that make financial institutions work, but it will require a paradigm shift to understand leverage goes beyond simply deposits and capital.  Leverage is always about expanding capacity with limited resources.  If a credit union already leverages their capacity to make loans by using deposits, why should they be hesitant or skeptical to leverage their C&D capacity through participations?  The lead credit union can remain the face of the relationship, and most importantly, be able to retain a relationship regardless of size and internal capacity.  Again, this is the fundamental principle of leverage, which a credit union or bank uses every day.

And as a side note to C&D limits, I think it is also important to mention that by choosing C&D projects wisely, the utilization of the C&D capacity can be relatively short-lived.  When I say choosing wisely, I mean taking on projects that result in income-producing properties and are well underwritten to deal with typical construction risks.  This will result in a relatively short-lived C&D loan, which means a relatively short duration of occupying C&D capacity.  A typical construction project should be completed within 12 months, give or take 6 months.  I think it is important to consider this too when you consider to fund a C&D loan.  It may count against your C&D limits, but it should only count against your limit for about 12 months.  And the best part is, after having taken on the burden of using your C&D capacity for a short time, you should be rewarded at completion by holding onto a relatively low maintenance asset with a decent yield for years to come.--Trevor Plett

Checking Into Your Hotel Loan

It is time to ring the bell at the front desk of the hotel you now hold as collateral.  As all seasoned commercial lenders know, the work on a loan never stops when the closing is over.  The loan must be properly monitored, analyzed and new risk grades applied.  With any loan this requires obtaining updated financials on the borrower and the guarantors.  New tax returns are obtained from all parties and reviewed. 

But what else is done regarding a hotel loan?  Is there anything different that needs to be done to reveal the condition of the company?

Truth be told, there are several additional steps that should be done with the annual review process than the steps taken for a typical commercial loan.  This blog will focus on what to look for with the physical inspection of the property. 

A visit should be made to the hotel and with the owner.  Careful review should be made to the condition of the property.  Are there any deferred maintenance items such as any worn carpet, fixtures or furniture?  The finishes and items in a hotel are not designed to last forever and will require constant repair and replacement. 

Pay special attention to the common areas of the hotel since these tend to get more wear and tear.  The entrance area is also a showcase and the first experience a traveler has when he enters the property.  It is important this area is clean and attractive.  A good measure would be to ask if the property would be a desirable place for you to stay with your family.  If not, then that may raise some red flags.

But there are other changes that may need to be made even if everything is in good order.  Franchises often may change their required finishes, signage, and furnishings.  The new changes, along with the deferred maintenance items may show up in a Property Improvement Plan (PIP) from the franchise.  Most of these will give a required list of items that need to be changed and time frames for when the changes should be made.  If they are not made in a timely manner, the franchise may elect to not renew the franchise agreement with the hotel, a move that is especially used when the franchise agreement is coming up for renewal.  This could result in a problem with the continuance of the income stream for the property, if the hotel were to lose its franchise.

A recent example is Choice Hotel's decision to require all Comfort Inns to be at least three stories high and also to have an interior elevator and room entrances.  Many hotels that operated as a Comfort Inn were forced to correct the situation or lose the Comfort Inn flag.  In either case, fixing the deficiency or reflagging the hotel, could cost substantial amounts of money, Properties with only two stories or exterior room entrances found that the cost to rehab the structure to bring it into compliance with the new rules was unbearable. This forced them to move to a different flag.  Changing flags also is costly with complying with the finishes and signage of that property.  There will also be an upfront fee paid to the new franchise.

Most franchises inspect their hotels at least annually and also provide reports quarterly to the hotel owner.  These may be from hotel inspectors, secret shoppers, or a compilation of guest comments.  The Quality Assurance Report (QAR) also may provide some insight into upcoming PIP items that will be required of the property.  QARs may also contain items on customer satisfaction. 

Understanding what items need to be repaired or improved on the hotel, when these items need to be done and how they will be paid for is essential.  You will also find out that the best hotel owners are those who proactively make improvements to their properties before the franchise requires or it is absolutely necessary to do so.  The best hotel owners realize they are not working just on making the current hotel stay nice for the guest; they need to “wow” the guest into coming back.--Phil Love

Introducing Trevor Plett

Hello, I am Trevor Plett, the new head of the Credit function at Midwest Business Solutions. I officially started working here in the middle of June 2013 and have found this to be a great opportunity and the next logical step in my career.

I came here from the Washington DC metro area, but I am a native South Dakotan that was born and raised right here in Rapid City, SD. In fact, my career in finance even started here in South Dakota with working as a bank examiner for the State of South Dakota.

My story of how I was born in Rapid City and returned as a professional in finance is full of several twists. My parents moved our family to Pierre, SD in the 1990s to work for the State government. I graduated high school there and attended college at Iowa State University. After graduating from ISU, I joined the Peace Corps where I worked as a business educator in the former Soviet country of Ukraine, which is also where I met my wife Natasha.

When my Peace Corps service ended, we decided to move to Pierre to be with my family. Working for the State government in Pierre is how I would start my career in finance as a bank examiner. Working for the State I gained strong fundamentals in banking and my wife started her career in computer programming there as well.

My time as a bank examiner took me to the largest and smallest banks throughout South Dakota. I was primarily a safety and soundness examiner, which means most of my time was focused on evaluating management decisions and assessing loan quality. A secondary role I played was checking for compliance with federal and State banking laws. To accredit my skills, the State would send me to FDIC training schools in Washington DC. There I earned credentials to be a Certified Operations Examiner and Certified Credit Examiner.

Seeking a position with less travel and wanting to expand my expertise, I sought a job in Washington D.C. I started working as a credit analyst for United Bank, which is a regional bank there with approximately $8.5 billion in assets. While working there I gained great insight into real estate lending as well as commercial and industrial lending. I also had a unique opportunity to work on lending requests from non-profits, local governments, and build expertise in tax credit finance.

Midwest Business Solutions was able to convince me to return to South Dakota for several reasons. For one, now I greatly appreciate the higher quality of life our region provides. But, I also see the need and understand the importance of cobbling together a strong local network of capital for small businesses in our community.

In addition to helping the CUSO fulfill its unique role in the community, it is a dream job to provide custom solutions for local institutions and local entrepreneurs. I enjoy the kind of job where I never know what to expect next. Here at the CUSO, each day throws a new interesting problem at me to solve and I don’t see myself getting bored here any time soon.  Trevor

2013 Mid-Year Financing Report

The most recent edition of Commercial Investment Real Estate included a recap of commercial real estate financing for the first six months of this year.  The Mortgage Bankers Association has an optimistic forecast with commercial mortgage originations growing by 11% in 2013.  The only thing they see that could dampen the growth is a rise in interest rates.  The market today looks quite different than it did several years ago.  In addition to the opportunistic borrowers, new government regulations and a lender emphasis on limiting risk and maximizing yield dominate.  Note that this overview is on a national level and different regions of the US may fare better or worse. 

Commercial Mortgage Backed Securities (CMBS) rose by 48% last year and is expected to rise between 40-50% this year to $55 billion. CMBS have been limiting LTVs to 70-75% and have recently been focusing on a project’s debt yield.  Debt yield is the net operating income divided by the proposed loan amount.  A lender looks at this as a cash-on-cash return on money lent if the commercial property is foreclosed on day 1 of the loan.  The market is targeting an overall debt yield of 9-10%, but these numbers are beginning to drop with competition.  Debt yields will also differ depending on the type and location of the property.  The top CMBS players this year are Deutsche Bank, J.P. Morgan, Wells Fargo, Goldman Scahs, UBS and Bank of America. 

Life Insurance Companies closed 18.1% of the 2012 commercial real estate loans according to Marcus & Millichap.  They are expected to increase their CRE by 15% this year.  Typical LTV maximums are 65% and 10 year fixed pricing can be found in the 3-4% range with yield maintenance clauses.  While they are very conservative, some life companies like StanCorp, Symetra, and Ohio National are looking to pick up market share by offering smaller loan amounts.

Banks have emerged from the credit crisis, but the local and regional banks still fighting to comply with new regulations.  The rules require larger capital reserves, which may affect the amount of CRE banks choose to hold.  Regulators are also watching concentration levels in the portfolio.  National, international and regional banks funded 25.5% of CRE loans last year.  Banks still remain conservative with their underwriting and are often more eager to expand the bank relationship with sale of ancillary services than the stand alone real estate transaction. 

Government-Sponsored Enterprises impact will drop in 2013 by $6.4B to $56.9B under the Federal Housing Finance Agency’s 2013 directive.  This news may have little impact on existing GSE borrowers, and other lenders may see an opportunity to expand market share in the healthy apartment sector, especially in secondary and tertiary markets.

The Small Business Administration (SBA) is expected to remain on pace with its 2012 originations, which were only a small dip from the record year of 2011 that was marked with reduced fees, expanded loan guarantees and raised loan amounts.  The SBA 504 program offers lenders the opportunity to make a 50% leveraged loan.  The SBA makes a second mortgage between 30-40% of the project cost.  These second mortgage rates have remained below 5% for most of this year on a 20 year fixed basis.  The SBA’s 7(a) program enables lenders to provide a small business a 90% leveraged first mortgage on real estate up to $5MM with a guarantee of 75% of the loan balance.  The guarantee is important, as the guaranteed portion can be sold into the secondary market to replenish the lender capital or can be held for earnings and not counted against concentration and cap limits. 

Bridge Loans are being offered by many lenders with somewhat aggressive terms for empty buildings, unseasoned properties, discounted note payoffs, and buildings needing improvements.  Terms typically are for 2-3 years at a 65-75% LTV.  Some large Fannie Mae lenders like Wells Fargo may offer aggressive bridge loans to get the final take out financing. 

In summary, the financing outlook for the remainder of 2013 is mixed.  There is significant capital in the market for projects.  Increasing interest rates may dampen demand.  Credit is still tight for projects that are too small or weak.  Credit will be more open in areas with strong economic growth such as what we experience in the Dakotas. 

A side note:  here at Midwest Business Solutions we are pleased to have Trevor Plett on our team.  Trevor comes to us with a background as a bank examiner and was most recently in credit administration for a large regional bank out east.  Trevor will be writing articles for the Credit Union Association of the Dakota’s Memo on Friday for those of you who receive this email publication.  --Phil Love

Corn and Wheat Price Outlook

Last year, those farmers who had enough moisture to have a corn crop enjoyed some high prices as the drought gripped its hand across most of the corn producing region of the US.  In some areas of the Dakotas, corn was ground up into silage as a lack of moisture caused the crop to not mature. 

Wheat prices also increased with prices began to be tied to the performance of the corn market.  Some think the correlation in prices is from wheat being used as a substitute for corn in animal feed.  This gained some popularity last year after corn prices reached record levels. 

What a difference a year makes.  Weather forecasts are calling for cooler temperatures in the Midwest for the next few weeks.  This is during a key time for corn as the crop moves into the pollination phase.  Hot and dry conditions during pollination can lower corn yields as this is the critical time when kernel formation is determined.  There are still parts of the Midwest with a moisture deficit but increased chances of rain are on the forecast for the next two weeks.  I can attest that the fields I have seen in this area of the country are lush and green compared to the brown and dry conditions last year.  Bottom line is the cooler and wetter year increases chances for a record corn crop this year.

Corn prices are also depressed from strong increases in supply from other corn producing countries.  Argentina announced an increase of 6 million tons of corn production.  Most of the additional production is available for export, which will push down corn prices further.  Currently, large speculators and funds tend to hold net-long positions on corn futures while the small speculators are bearish on the future of corn prices.   The prices tend to favor the bearish position with prices falling from over 650 for December corn in September 2012 down to 487 where it is now.  But note, that any change in the weather conditions could cause a spike in prices as short position holders seek to cover themselves.   

Wheat is in a similar trend.  Note that September Wheat has dropped from over 900 last fall to 640 where it is today.  Now going into the fall, traders will watch with keen interest the Spring Wheat crop performance.  Average yields are expected to fall below last year’s levels due to late plantings this season.  The Wheat Quality Council in North Dakota has estimated a Spring Wheat yield at just under 45 bushels per acre. 

Wheat prices are being depressed with the strong corn crop, as many will switch back to corn instead of using wheat for animal feed.  Lower wheat prices will help US Exports but abundant global wheat supplies are sending Middle Eastern and North African buyers to purchase wheat from the Black Sea region where cash prices are the lowest among major exporters. 

The Sep/Dec Wheat spreads in Chicago and Kansas City are turning bullish, indicating that commercial buying and increased exports could be emerging.  This can add some support to prices. 

The bottom line is that both corn and wheat prices will be lower than last year.  But a careful eye will be kept on these markets for the next few weeks by traders and farmers to determine where the price level will be.

Leadership is...

Try asking people this question.  The answers you will get are as varied as the folks you are asking.  Often I will hear of someone who says, “If I only was in control or had that position, I could really make a difference.”  To these people, leadership is a position, a title, a name on the door.  They think that whoever is in that position is a leader. 

But that is not true.  In 1994, institutional investors of Saatchi & Saatchi forced the board of directors to dismiss Maurice Saatchi, the CEO.  As a result of this, several key executives left as well and many of the advertising firm’s largest clients like British Airways and Mars.  Saatchi’s influence was so great that the company’s stock fell by 50% immediately.  Even though Saatchi lost his title and position, he continued to be the leader.  Stanley Huffty quoted, “It’s not the position that makes the leader; it’s the leader that makes the position.”

Some may think that leadership is management and many books have been written that say so.  The difference is that leadership is influencing people to follow in a certain direction, while management focuses on maintaining systems and processes.  Organizations need both leaders and managers.  The best way to tell if a manager is a leader is to ask him to create positive change.  Managers can maintain a system and direction, but they cannot always create change for the better.

Some will say that an entrepreneur is a leader but that is not always the case.  Entrepreneurs are skilled at recognizing opportunities and seizing them.  But they are not always skilled at leading others to achieve the goal with them.

One answer you may have is knowledge is leadership.  That is not the case.  We all know of people who are brilliant and are considered by all to be the smartest person in the room, yet who do not have the ability to lead others.

For me the true measure of leadership is influence.  It does not matter what the title, knowledge, or skill may be.  All leadership boils down to influence.  Margaret Thatcher once said, “Being in power is like being a lady.  If you have to tell people you are, you aren’t.”  If you watch people interact with each other, you will notice some leading and others following.  This often has nothing to do with position or title. 

So why do some people emerge as leaders and others do not?  John Maxwell identified several factors that cause the leadership cream to rise to the top.  First is character, who they are.  True leadership always begins with the inner person.  Second are relationships, who they know.  Any leader has to have an understanding of facts, factors, timing and a vision for the future.  Third is intuition, what they feel.  Leadership is more than a command of the data; it demands the ability to deal with numerous intangibles.  This is often a main difference between a manager and a leader.  Fourth is experience, where they’ve been.  The greater the challenge a leader has faced in the past and has overcome the more credibility they have for the present.  Fifth is past success, what they have done.  Nothing speaks louder to followers than putting some wins under their belt.  Last is their ability, what they can do. The bottom line for a follower is what a leader is capable of doing.  People gravitate toward those who can deliver a victory. 

An incident in the life of Abraham Lincoln illustrates the influence principle well.  In 1832, Lincoln gathered together a group of men to fight in the Black Hawk War.  In those days, the person who put together the group often became the leader.  He was given the title of captain.  But Lincoln had a problem.  He did not know anything about being a soldier, had no prior military experience and did not understand military strategy.

One day, Lincoln was marching several men across a field and needed to guide them through a gate into another field.  But Lincoln could not remember the proper command words to get the company to go edgewise.  He finally shouted, “This company is dismissed for two minutes, when it will fall in again on the other side of the gate.”  Lincoln started out as a captain, but earned his rightful leadership place as a private by the end of the war. 

Lincoln had a leadership proverb, “He who thinks he leads, but has no one following, is only out for a walk.”  If you can’t influence people, they will not follow.  If people will not follow you, you are not the leader.  Leadership boils down to influence, nothing more and nothing less.

The NCUA's Construction and Development Limits

The NCUA has set standard limits on all Construction and Development (C&D) Loans at 15% of capital of a credit union.  The goal of the limits is to help manage the risk of construction lending.  It seems that the regulators attempt to treat all construction with the same level of risk with this broad stoke approach to construction lending.  The question is, “Do all construction loans have the same risk?” 

I will contend the answer is no.  My years of commercial lending have taught me that each construction project has its own unique risk.  It would be impossible to create separate regulations for each loan.  However, there are some characteristics of different types of construction lending that tend to have greater or less risk than the other.  Consider the differences among these various construction projects.

Spec Construction vs. Owner Build:  A project that is built with the intent to sell all or parts of the construction is more risky than a construction project built for the use of the owner or one that has a committed quality tenant who has the capacity to handle fulfillment of the rental agreement.  A subdivision lot development or a large condominium development where the repayment is the successful sale of the lots or units is a higher risk than the construction of a building for the use in the operation of a business.  A manufacturer building a factory, an hotelier constructing a new hotel, or a developer building a retail building that has established credit tenant support will be a lower risk than spec construction of a subdivision.

Credit Union Managed Construction vs. Qualified Third Party Managed:  In many cases, credit unions do not have the staff talent and experience to properly manage larger construction projects.  This poses a higher risk than a construction loan that has disbursements managed with a third party title company or attorney firm.  In general, the construction inspection process is also better with a qualified third party architect or building inspector instead of utilizing the field lender.

Construction without Permanent Financing vs. End Loans in Place: Here any construction project that has permanent financing in place at the onset of the construction is less risky than a construction loan with no end loan in place. 

Repayment from the Sale of the Development vs. Debt Servicing from Other Sources:  If the repayment of the principal of the construction loan is based upon the sale of the development or building, it is considered speculative.  This is a higher risk than construction that will eventually have the principal serviced with non-speculative sources.  These could include regular P&I payments that are supported by a lease on the property or an owner use property where the amortized payments are supported by the positive net operating income of the business. 

The spirit of the NCUA limits is to help manage the risk of construction projects.  However, as shown above, some projects pose more of a risk than others and should be subject to appropriate limits.  Using the low limits may be appropriate in limiting construction that is spec, credit union managed, and has no end loan in place.  The current low limit is not applicable for owner or tenant built, qualified third party managed, and projects that have a final loan in place that is supported from historical net operating income.  I would contend that construction loans with the latter characteristics should not be subject to the 15% limit.  Such limits hinder credit unions from supporting its membership base with lower risk construction loans, which in turn, hinders economic growth in the market area.  It also causes credit unions to turn down lower-risked construction loans that will turn into good earning assets to help the credit union’s earnings and equity grow.  But whether or not the NCUA agrees with me, it is still the lender’s responsibility to recognize the variations of construction risk and act appropriately.

The Card in My Briefcase

I keep a card in my briefcase that is a folded piece of red construction paper from my son Josh.  I think of it as one of those items that help keep me grounded.  Josh was about 7 at the time and I was working for a large regional bank.  We had a management change.   The old group that left was very seasoned in commercial lending and also excellent in developing staff.  It was under their tutelage that I began to grow my commercial skills with both experience of working on over $100MM in credits and the classroom knowledge of obtaining my graduate degree from the Graduate School of Banking at University of Wisconsin.  They were also very good at developing relationships with people. 

At this time, several of these key leaders left and began working at other banks.  We had new leaders come in.  This group was not interested in establishing relationships and did not accept the lengthy sales cycle in commercial lending.  They only focused on the bottom line results from what they saw each month in the bank.  They were only interested in immediate good results to impress their next level of management.  This was often done while sacrificing the best for the bank on the altar of quarterly results.

Our entire team groaned under the new leadership.  It was at this time, when struggling to keep my job and hating every minute under the oppressive thumb of the new team, that Josh handed me the handmade card one day after work.  The outside reads:

I love you

From:  Josh

To: Dad

It continues on the inside:

Daddy I hope that those people at the bank gets nice to you

The back cover has a hand drawn heart.  It choked me up and gave me hope realizing that no matter what happened my family and I were going to be OK.  Nine years have passed and I still have the card in my briefcase.  I believe the card has valuable lessons for today.

1.  People are more important than quarterly profits.  At the end of your life, if the only thing you are proud of is how many consecutive quarters of profitable ROE you produced at your job, you have lived an incredibly empty life.  Yet this is the focus of many in the banking world, especially managers who could not keep a customer relationship if it was handed to them.

In the credit union world, we speak of our clients as “members”.  A member is not just another account measured on a spreadsheet for its profit or loss to the institution.  These are real people that have real hopes, dreams, fears, and goals.  They each have a past, present, and a future.  They each also choose to work with you because they trust you.

2.  Good long-term relationships will grow your shop better than flashy short-term achievements.  Those who love to “stack-rank” the spreadsheet results deny this principle.  Yet it is true.  The goal each of us should have is to be a trusted financial advisor to our members.  This means they will come to you because they believe your counsel is valuable and that you have their best interest in mind.  I have often said you know when you win at the relationship battle when a client comes to you for strategic financial advice that does not involve the immediate need for a loan. 

When you get to that point, if you are lucky enough, you have made a true business friend.  Your member will also begin to introduce you as his “banker”.  This is a term that is not politically correct on the credit union side of the fence.  But if someone calls you his banker, you have won the relationship war. 

I was once at a bank where the spreadsheet geniuses came up with this new “streamlined line of credit” for business customers.  This was an business unsecured line of credit that was only credit scored in its underwriting.  This product was pushed out to the front line customer service reps who had no knowledge of business lending.  The leadership in our local market did not use the product as most of the rest of the branches pushed the product on customers like a drug dealer does to a heroin addict. 

Our market never achieved the applause of senior management during that two year stretch for selling the product.  We did continue to develop relationships and put good loans on the books in that period.  We also did not experience any of the $4MM of losses the program had with fraud and unsecured lending; things that could have been stopped with proper underwriting.

3.  At the end of the day, remember what is important.  No matter how long and hard you work, you always need to remember what is most important.  Relationships and not results always trump, especially those relationships with our friends, family and Creator.  These will outlast any position you hold, any achievements you reach, or any failures you earn. 

Each time when I come across the handmade card, I thank God for the wisdom shown to me by a little 7 year old boy.

Independence Day

I have always been fascinated with U.S. history and minored in it at college.  Of all the periods that intrigue me, perhaps the one that fascinates me the most is the period of the American Revolution.  It is amazing the character and fortitude of the men and women who founded our country and fought against the world superpower of their day.  As we come upon the fourth of July, we often will have a day filled with family, BBQ and fireworks.  I have plans that involve each of those items on that day and will begin marinating the pork shoulder for the smoker on Tuesday evening.  I do think it is valuable to pause, and take time to reflect on the significance of the day.

This year, I took some time to reread the Declaration of Independence.  Some today will scoff at the Declaration or the Constitution, saying that these are overly simplistic frameworks for government in such a complex society that we have today.  I strongly disagree.  Our founders realized certain truths that are built inside of all people, regardless if they live in the horse-and-buggy or the space shuttle era.  They considered these truths to be “self-evident”, meaning that they did not require a lawyer or philosopher to argue their merit. 

“…all men are created equal…” This flew into the face of a society that was based on a hierarchical structure of a royal, ruling class and the rest of us.  Everyone is equal under the sun.  In the credit union world, we count every member the same.  It does not matter if it is a struggling college student or the successful, wealthy business owner.  All are members and are entitled to the same representation.

“…that they are endowed by their Creator with certain unalienable Rights, that among these are Life…”  The founders acknowledge everyone has the same right to live: the young and the old, the sick and the healthy, the rich and the poor, those who have made their mark in the world and those who are anonymous.

“…Liberty…”  All people are born to be free.  Our founders threw off the oppressive government of Great Britain.  This was not an easy decision, for they had to give up the security of being under the world’s most powerful nation to being on their own.  This is a struggle we see today with some wanting to live in the safety of a strong government.  Benjamin Franklin saw it different when he said, “Those who would give up essential Liberty to purchase a little Temporary Safety, deserve neither Liberty nor Safety.”  Thomas Jefferson, the writer of the Declaration said, “A government big enough to give you everything you want, is a government big enough to take away everything that you have.”

“…the Pursuit of Happiness.”  The founders state here that people are allowed to follow their dreams.  This is one of the principles that has made our country achieve more than any other country in history.  Think of the things we have each day because people have refused to accept the normal status quo and have achieved their dreams.  We take for granted things like the light bulb, computers, cars, air conditioning, baseball and good BBQ.   All these came because people followed their dreams.

The Declaration ends stating the signers were pledging their “lives, fortunes and sacred honor”.  Many of them and countless others have sacrificed so much in order for us to be free.  So on this Independence Day, before you take time to light fireworks or sink your teeth into the smoked pulled pork, take some time to reflect and be thankful for our country and those who have sacrificed so much for it.

Is EBIDTA the Holy Grail of Understanding a Company?

I remember the first time I was in a classroom at the bank I worked for in Jefferson City, Missouri.  I was a seasoned banker, but quite a young pup when it came to the commercial and agriculture side.  One of my banking mentors taught a short class on how to figure the Debt Service Coverage Ratio (DSCR).  This is figured by taking EBIDTA (Earnings Before Interest Depreciation Taxes and Amortization) divided by the annual debt service requirements for the firm. 

I was amazed.  I was looking for the holy grail, the excalibur that I could use to dissect the financials of a farmer or a business and gain clarity of whether the company could manage the proposed debt requirements for the loan request.  I thought I had just conquered commercial lending.

EBIDTA or another similar term, Net Operating Income, is not only used in calculating the DSCR but is also used in figuring value by using Cap Rates.  So now I was even more excited that I could not only see if the company could service its debt, but I could get a value of the company or the collateral as well.  Now the conquering of commercial lending turned into a mastery of the subject.   High fives all around.

My mom always warned me about getting "too big for my britches”.  That is good advice, as life is a constant learning experience, and just when you think you are really solid, get ready for a fall.  This was the case with my supposed mastery of the subject.  I quickly learned there is no holy grail, only road signs to help you determine the health of a firm.

It all came clear with a manufacturing company who wanted to acquire a new machine.  I did all the due diligence and determined that the customer could historically service his existing and proposed debt based upon my EBIDTA and DSCR calculations.   I completed my write-up and sent it to my boss.  The wise sage requested to see a detailed depreciation schedule.  I wondered why, since you could get the whole depreciation figure from the income statement without looking at the schedule. 

The sage called me in the next day and said, "Young grasshopper, the company has three pieces of machinery that will need to be replaced next year according to their history and depreciation schedule.  Where will the capital come from for the machinery?"  The manufacturer had equipment or parts that went on larger pieces of equipment which would wear out every two years and need to be replaced.  Since the replacement would be completed and benefit the company beyond this fiscal year, they capitalized and depreciated the asset instead of expensing it as a repair item. 

So, I had failed to account for that planned expense.  Calculating it in took my slam dunk deal into questionable territory or maybe a denial.  I trudged back to the company's CFO to get more answers. 

An important factor in analyzing a company is to look at required and necessary capital expenses that will be required to maintain the current level of production.  For my firm, the $150K for machinery press and drill parts was necessary for keeping three key machines running to continue production of granite countertops; otherwise, the company could not machine cut the countertops and would have to cut all by hand.  This would either require more staff or less production, either of which would drop the NOI substantially.  We had to uncover how those items would be paid for.  In this case, the company had set aside most of the money and was planning to pay for the last 1/4 with cash from several large sales they were to get in the next two months. 

This was a case in which only looking at the EBIDTA or NOI to figure the DSCR was not enough.  It required a further look into the planned capital expenses to determine the adequacy of cash in the company.

It is possible that the EBIDTA number can be understated.  I have banked with some hotel operators, who will expense any repair or improvement item for the hotel:  light bulbs, replacing broken furniture, new carpet, or repaving the parking lot.  All of these have different treatment accounting-wise.  The light bulb is a consumable item that should be run through the repair expense.  Replacing broken furniture can either have an expense for the broken piece depreciated out and the new one capitalized, or one could just expense the new one in the repair line.  The carpet should be depreciated over the expected life of the carpet.  In the case of this hotel, it was around 5 years.  The parking lot had an expected life of 15 years. 

If all of these items were in the repair expense, it would be counting repair items that would not necessarily be occurring every year.  Perhaps you may want to do that if you have a property that is requiring large amounts of ongoing capital investment year after year.  But in most cases, the one-time expenses should be pulled out, and a capital expense allowance can be used.  This is an estimate that on an average given year, some percent of gross income (usually 3-5%) will be spent on capital improvements for the property.  Using this method will help average out the EBIDTA in years when improvements are made and expensed, and in those years when no additions are done.

The Commandments of Borrowing

1.  Asking “How?” and “What are the proceeds used for?” is just as important as asking “How much?”  In the majority of borrowing situations, the business owner focuses only on how much money they need as their primary concern.  But understanding what the proceeds will be used for and how the loan will be repaid is equally important, because ignoring these issues could lead to borrowing wrong.

“Is borrowing wrong even possible?” you may ask.  It is not only possible, but it is probably likely, unless both the debtor and the lender approach each borrowing situation armed with a firm understanding of the basic financing patterns and the lending requirements for the correct structuring of liabilities.  Improper financing can be the death to a business. 

2.  Growing businesses and farms will often require an increased investment in both current and fixed assets.  It is incorrect to assume that growth in revenues will occur without any required growth in assets.  The only case where this is not true is if there is gap of unused capacity within the growing company and an increase in efficiency where the result is an increase in sales. But in most cases, if your borrower expects to double his sales, it will require an increase in resources to accomplish that.

3.  Fluctuating current assets should be financed by cash or short-term debt and paid off by cash flow.  Recently, I saw a financial statement from a company that had a large debt to a supplier that was over six years old!  This is a situation where the borrowing was improper.  If you borrow money from a lender or a vendor to get supplies that you need to manufacture your product, that debt should be paid off when you sell the product and are paid.  It should not be paid off from net profits after all other operating expenses are taken care of. 

Lenders can help manage this structure with using borrowing bases and other controls to force the business to pay back the operating lines in a timely manner.  This also requires understanding how and when cash flows through the business for proper structuring.  Lines should be reviewed at least annually and should be monitored at least monthly.

4.  Permanent current assets are financed by equity, permanent current liabilities or intermediate term debt and are paid off by net profits.  Any seasoned lender has been in a place where a line of credit becomes “evergreen,” in that it does not get paid off or reduced in outstanding balance.  This is a clue that the line is improperly structured.  These debts should be placed on an amortized payment and paid off by the net profits of the business over a reasonable period of time, perhaps up to 5-7 years.  The struggle here for the lender is how to properly collateralize this loan, since assets such as real estate, buildings and equipment may already be pledged.  Use of a government guarantee like the SBA may be a nice alternative to mitigate the risk. 

Permanent current assets are the base levels of cash, accounts receivable and inventory that these items never drop below.  If a company has an accounts receivable level of $50,000 and inventory of $50,000 with sales of $1MM, then it is expected that the company would need to have receivables of $100,000 and inventory of $100,000 to reach sales of $2MM.  This is assuming the accounts and inventory receivable turnover ratios remain constant. 

Of all the needs for lending, the most difficult may be the permanent current asset financing.  When a company has real growth, as opposed to a seasonal fluctuation, that represents a permanent increase in current assets, these will behave like a fixed asset.  This should be financed with equity, permanent current liabilities, expanded terms from suppliers, or intermediate term debt. 

5. Fixed assets are financed by equity and long-term debt and are paid by net profits of the business.  Most of these assets are capitalized and depreciated.  Fixed assets usually relate to fixed costs, those that do not change relative to sales over a reasonable range.  Increases in fixed assets should lead to greater capacity for the business to increase revenues. 

These are generally the easiest to finance.  The amortization term should not exceed the useful life of the asset.  Proper LTV, LTC, and terms are usually spelled out in your loan policy. 

6.  Ignoring these principles will lead to friction between the borrower and the lender.  It could lead to a business that fails and a lack of sleep as the loan officer worries about the customer.   Proper adherence to these ideas will give the business or farmer the best chances for success and also grant adequate cash flow to sustain the business.

A Company Gone Under

The last stage of company growth after Wonder, Blunder, and Thunder, is the Under stage.  This is the time when the company’s effectiveness wanes and many firms just go out of business completely.  A company can fail for many reasons.  It can fail to recognize new trends that make their product irrelevant.  It can fail due to poor financial management.  Its leadership can also fail to plan for the future.  Consequently, many companies die and are buried each year.

When dealing with this stage, it is important to realize that sometimes it is healthy for a company to be allowed to die; in some cases it is planned.  A case may be a small one-accountant CPA firm with no future succession plan.  In that case, it would be wise to sell the business and close shop when possible.  Some companies may exist to complete a particular task, and when the job is done, the company needs to end.  In each of these cases, it is important to make adequate plans to close the business.

Some companies do not adapt to changes in the world around them.  Just think of the changes in how music is delivered.  When I was born, records were the rage.  Then came the 8-track tape.  This was improved with the cassette tape.  The first stereo I bought could play records, 8-tracks, and cassettes.  I thought that I would never need another system as long as I lived. 

But then came the CD.  The sound quality was so much better and I thought that this was where all music was going.  Now we have iPods and downloadable music that is more convenient and sounds better than any other in the past.  Music can be downloaded any time from multiple sources on the Internet, and trips to the record store are obsolete.  My kids have more music on their devices today than I ever dreamed could be possible. 

If you had a company that just made records or just made cassette tapes and never adapted to new ways to deliver music, you would already have closed your doors by now.  Avoiding the “under” stage requires vision and foresight to keep the company out of the graveyard. 

Avoiding this stage also requires the company to have some of the characteristics of the other three stages.  The firm needs the excitement of the wonder stage and the desire to understand the world around it.   They also need to be willing to take the chances and overcome the failures evident in the blunder stage.  The company must also capitalize on the victories and make a real difference in their market area. 

With proper planning and work, a company can maintain its status as live and vibrant instead of being six feet under and pushing up daisies.

The Thunder Stage - Making Real Noise in the World

If a business is able to grow beyond the Wonder and Blunder stages in its life-cycle, it will next come to the Thunder stage.  The impact companies have in this stage is similar to a Midwestern thunderstorm, with its flashes, crashes, wind, and rain.  The impact may be felt worldwide or may be on a local basis.  No matter what the scope of the market area is, the company does make a difference, and cannot be ignored.

Many of these companies are ones that are studied, benchmarked, and copied by others.  Larger ones may become household names like Apple, Microsoft, Toyota, Lowes, or Exxon. Large or small, the businesses make a lasting impact in the world around them.  They may even change how people live and the products they demand.  The explosion of personal computers, tablets, and smartphones are good examples of this. 

Companies in this stage are defined with a strong culture.  They have strong demand for their product and can command a good price for it.  They may be able to determine what customers they want to work with.  They also may be able to make a difference for the long-term and become a wonderful place to work for their employees.

The challenge to a company in this stage is how do they remain a “Thunder” force?  Just like a thunderstorm will dissipate when the conditions are not conducive, companies or products can also fade away.  In the past three years consider some of the large companies that have gone out of business:  Hollywood Video, Circuit City, Borders Book Stores, Ultimate Electronics, Fashion Bug, and Hostess.  These are all companies that we all assumed would always be there. 

Navigation in the Thunder stage is just as important as it is in any other business growth stage.  There is a tendency to become complacent in this stage since the company has “arrived;” however, that is just the recipe for failure.  The best companies that stay a Thunder force will spend a lot of resources improving existing products or delivery service methods, or expanding into new ones that fit their business model.  A good example is the constant improvement Apple makes with its products.  We have watched a company once irrelevant, and noted for its school computers; expand its reach into a high quality product that competes with personal computers in many homes.  They have begun the use of Apps instead of programs and have established the tablet and smartphone benchmarks with their iPad and iPhone.  Now, Apple is setting its sights on TV and changing the way you receive your cable or satellite channels. 

Succession planning of key personnel and products is also important.  A law firm may be one of the best in its area, but if they have key attorneys who leave or pass away, it can devastate a firm who has not properly planned.  If a manufacturer like Hostess does not place its company on firm financial footing, it may not have the resources to continue in the future.  If a company, who may be at the top of their class, fails to recognize a trend that is moving away from the industry, they will not remain a force for long.  Note how many blacksmiths and buggy whip manufacturers are around today.  Long-term vision is important to remaining in this stage.

It takes proper navigation, succession planning, and continual development for a company to continue to make a lot of thunder for the long-term.

The Blunder Stage—Going from Mistake to Mistake with Great Enthusiasm

The second stage of a four-stage business life-cycle is the blunder stage.  This stage is marked with flashes of brilliance among a sea of blunders, much like one will find in adolescence.  In this stage, the wonder of the early stages of the business has worn off and actual executable plans find mixed results of successes and failures. 

The challenge here is to not make mistakes serious enough to kill the business and also, to not get so discouraged that the business owner gives up.  Endurance and persistence are keys for a business to get through this stage. 

Winston Churchill said, “Success consists of going from failure to failure without loss of enthusiasm.”  Clearly these words must have rung in the ears of Englishmen while they endured some of the darkest days of WWII.  Churchill also realized that the journey is more important than success or failure when he said, “Success is not final, failure is not fatal; it is the courage to continue that counts.” 

The business leaders in this stage should remember the early wonder years of the company.  Why did you get into business to begin with?  What opportunities were you hoping to capture?  What was your business plan?  When you are in the thick of long work days, unending deadlines and a string of mistakes, it is easy to call it quits.   That is why it is important to review the vision and mission of the firm and relive why you started.

Not only is it helpful to remember the wonder years, it is helpful to look forward to the future to the next business stage, the thunder years.  These are the times when the company really becomes profitable and effective in its mission.  The mistaken laden times the business owner is in now will eventually pass.  Failure is not fatal, it is important to learn to fail forward. 

Some of the most successful businesses came from failing forward.  Henry Ford went bankrupt seven times before he landed on the Model T.  Dave Anderson bounced from job to job and city to city as a travelling salesman.  When he failed at that business, he opened up Famous Dave’s BBQ, his real love and passion, and became a millionaire.  Fred Astaire had his first rejection letter hung above his fireplace.  The director who turned him down for a part said he could not act, was a bad singer and was even worse as a dancer.  Astaire went on to become a household name with his dancing and acting with Ginger Rogers.

Flexibility and wisdom are important in this stage.  Leaders need to be flexible enough to change direction, abandon a product, or revise a strategy when necessary.  But they also need the wisdom and insight necessary to know when to stay the course and push through the failures, knowing they are on the right path.

Unfortunately, some businesses never move out of this stage, just like some people never seem to grow up.   But for the ones that push through, the glory years are just ahead.