The rules of small-business banking have changed, and that's bad news for the economy. But there are ways to cope, and there may even be a silver lining.
Now that we have been through Armageddon on Wall Street, the question is: What effect is all this turmoil going to have on the rest of us -- specifically, those of us who depend on bank loans to finance our companies' growth? My crystal ball is broken at the moment, but I do have some experience in these matters. It seems pretty clear that we are heading back to the time when banks preferred to lend money to those who didn't need it and it took a good deal of ingenuity to get any loan at all. Listen, small-business banking goes in cycles. Even before the latest meltdown, it was clear that we had moved from one cycle to another. Already, I had begun to feel nostalgic for the good old days. Not so long ago, you could still get what bankers affectionately referred to -- in private -- as an "air-ball loan." That was a loan based not so much on your assets but almost entirely on your relationship and history with the bank. Yes, the bank would glance at your company's earnings and cash flow, just to be sure you could make your payments and weren't about to go bankrupt, but the relationship mattered most.
And the terms were terrific. If you were financing your receivables through a bank, the monitoring was extremely light. Often, it was just a matter of submitting a report every other month, whereas an asset-based lender would insist that all the money you collected go into a lockbox. Or suppose you needed equipment. In my business, we kept having to buy storage racks as we grew. Leasing companies would charge us 11 percent or 12 percent interest, and we would have to pay the loan back in four or five years. Banks, on the other hand, would charge 6 percent or 7 percent, stretch the payments out over 10 years, and give us a balloon at the end. That translated into a whole lot of additional cash flow.
And banks were falling over themselves to lend us money. I would get six to eight unsolicited calls from bankers every month. Sometimes they would show up in our lobby unannounced, saying they just happened to be in the neighborhood and thought they would drop by. Now, you have to understand that our offices are at the end of a street, with only one other business anywhere near us -- a doggie day care center. Nobody "just happens" to be in our neighborhood. We welcomed the bankers anyway. You never know when an extra one might come in handy.
But those days are gone. Two encounters with banks in the past three months clearly demonstrated to me that we were in a whole new world in terms of banking. One occurred in Telluride, Colorado, where I'm building luxury homes with my partner Ernie Graham. We needed to borrow $4 million to cover the building costs, and Ernie suggested we use a local bank. He set up a luncheon with two of the bank's top people, and they indicated immediately that they were very interested in financing the project. My wife, Elaine, and I had already thought about the terms we wanted. Having just gotten rid of the personal guarantees we had had to pledge to finance our companies (see "Free at Last," September 2007), we were reluctant to pledge our own assets as collateral, and I said so. The bank president said he would need to examine my personal balance sheet, which I had brought along. He took a look at it, and we left the luncheon thinking we had a deal.
But a week later, the bank president called and said that because we weren't giving a personal guarantee, the bank would lend us the money only if we made a "substantial" deposit, by which he meant an amount equal to 50 percent of the loan. I pointed out that a deposit of that size was hardly necessary from a security standpoint. Our development company had unencumbered assets of $7 million. Once the construction was finished, the value of these assets would rise to more than $16 million. The risk to the bank was minimal. But it turned out that risk wasn't the issue. "In order for us to make loans, we need deposits," he said. "Things are very tough right now."
"In that case," I said, "I think I'd rather give you a personal guarantee." I didn't like the idea of tying up my money in a bank account.
"OK," he said. "I'll run it by the board." Another week went by, and he called me back. "The board would really like to lend you the money," he said, "but we only want to deal with people who are customers."
"Fine; we'll open an account," I said.
"You would still have to make a substantial deposit," he said.
It was June by then, and every day brought news of another troubled bank. The big issue, I realized, was the Telluride bank's solvency, not mine. "Why don't you send me the bank's balance sheet," I said.
"Sure," he said. "But why?"
"The FDIC only insures $100,000 per account," I said. "If I'm going to make the kind of deposit you're asking for, I want to know where my money's going."
When the bank's financials arrived, I showed them to my partner Sam, who has served as the point person in our company's banking relationships. "What would you do?" I asked.
"I wouldn't put more than $100,000 in any bank right now," he said.
I knew he was right. I told the Telluride bank that we weren't going to need its money after all. If necessary, we would do the financing ourselves.
The second episode was in some ways even more revealing, because it involved a large bank in New York City. We were looking to do some restructuring of our companies' debt. Specifically, we wanted a bank to take over the lower-yielding -- and safer -- senior debt, thereby freeing up cash that we could then invest in higher-yielding securities. Sam approached a banker he knew who had been courting us for years. "Do you still want to do business with us?" Sam asked.
"Yes," the banker said. "We would love to do business with you, but times have changed. We have to be very secure."
"What? No more air-ball loans?" Sam said.
The banker laughed. "There's no such thing anymore," she said. "We need to have collateral, and there has to be a substantial amount of subordinated debt and equity behind our senior debt." (In a bankruptcy, the investors of senior debt get paid first.)
This was a huge change, and there were others. In the past, we were able to borrow an amount of senior debt equal to four or five times our EBITDA (earnings before interest, taxes, depreciation, and amortization). Now the multiple is more like two and a half or three. And if we had gone looking for a $30 million loan a year or two ago, the bank would have insisted on doing the deal by itself. Sam's banker indicated that the loan would be syndicated to three or four other banks -- with each putting in $10 million or less.
So what does all this mean? I have no doubt that companies like mine will still be able to secure the bank financing we need -- mainly because we don't need it that badly. I worry about smaller companies that really do need bank financing and may have a hard time getting it. That will have ramifications throughout the economy. Yes, interest rates are still relatively low, but cheap debt does you no good if no one will lend to you.
Part of the problem, I sense, is that the bankers themselves are still trying to figure out the new rules and standards. If you are going for a bank loan, I would suggest you ask right away, "What does it take to qualify for a loan these days?" And make sure your finances are in order. Developing a relationship with a bank is still important, but you are going to need earnings and liquidity.
You might also want to look at alternative means of financing. If you are buying equipment, for example, ask the seller for help getting financing; vendors often have a relationship with leasing companies, which may now be your best option. You might also want to try to obtain receivables financing. Whether you get it will depend largely on the creditworthiness of your customers, given that that's what asset-based lenders look at. For that matter, your customers may be able to help you. If they pay you in 60 days, you might offer them a 2 percent or 3 percent discount provided they pay you in, say, 10 days.
And remember: The credit crunch isn't all bad news. Change creates opportunities. Some of your competitors could be struggling. You may want to think about acquiring the weaker ones or at least picking up some of their customers. Of course, your competitors may be thinking the same thing about you. So you would be wise to work on strengthening your customer relationships. In times like these, everybody wants to save money. You can help your customers do that by showing them how to use your products or services more efficiently. Or maybe now, with gasoline prices going down, it's time to get rid of your fuel surcharge. In any case, be sure to do it before a competitor points out that you have left the surcharge in place despite the drop in fuel costs.
Whatever you do, recognize that we have entered a new era. The credit crisis will abate sooner or later, but it will be a long time before we see another period of easy money like the one we went through in the first seven years of this decade.
Norm Brodsky is a veteran entrepreneur. His co-author is editor-at-large Bo Burlingham. Their book, The Knack, will be published by Portfolio in October.