Three ways commercial banks are beneficially different
Commercial banks are often considered to be similar if not almost identical to one another. In fact, this perception is so pervasive that CFOs of middle market companies often believe they are fulfilling their fiduciary responsibility to get the best loan terms for their company by soliciting term sheets from only two or three banks.
The truth is that commercial banks are different because they have different regulators, underwriting standards, policies, focuses, strategic goals, problem loans, etc. These factors influence the type of borrower lenders pursue as well as the types of terms they can offer to attract them. Below are some examples of how commercial lenders’ differences can impact not only your ability to get better terms, but your ability to even get a loan at all.
1. Acquisition EBITDA
Cash flow leverage is an important metric for lenders. It often is the gating item that determines the size of credit facility. Commercial banks often want to see loan sizes below three turns of EBITDA, which is considered “cash flow leverage”. So if your EBITDA is $1M then a commercial bank will be hesitant to lend you more than $3M.
Some banks do allow certain types of add backs to EBITDA such as various one time expenses for restructuring ,severance, and others. One of the most important add backs is related to acquisitions. Before engaging in an acquisition, a smart borrower will make sure their lender includes the acquired company’s EBITDA when determining cash flow leverage. Otherwise, the borrower would need to make sure that their company has enough cash flow to achieve a high enough loan amount to complete the acquisition and remain within the three times cash flow leverage.
2. Net worth to liabilities
Balance sheet strength or lack of strength can make or break a deal. Certain lenders will look at the ratio of net worth to liabilities and use that ratio to determine whether they can lend to the company. Levels of 5x or less are generally considered strong, but each lender will have their own view on the ratio. Some banks go the extra mile to avoid risk and look at tangible net worth instead of net worth. Tangible net worth is different from net worth because it excludes all the intangible assets such as trademarks and goodwill.
Lenders who choose to use the tangible net worth ratio are taking a conservative path compared to other commercial banks. Smart borrowers should consider this metric before they negotiate with their bank. Even if lenders do not discuss this ratio in their term sheets, you can bet they discussed it during their credit committees. Companies that have low tangible net worth should be prepared to provide additional collateral for their deal.
3. SBA loans
Many commercial banks also provide SBA loans, which are loans guaranteed by the Small Business Administration. The guarantee allows the banks to lend to companies that may not have qualified for traditional financing. The SBA has listed out a very strict set of guidelines that banks have to follow to qualify for the guarantee; however, banks choose to require more than what the SBA stipulates.
For example, the SBA allows lenders to count projected cash flows to determine credit strength, which is not typical. Normally, lenders underwrite loans based on the strength of historical cash flows. The reason lenders are so careful is because lenders view the SBA as an insurance company to the commercial bank. There is uncertainty and risk in attempting to collect on the insurance. Commercial banks then take extra precautions to reduce risk of being out of compliance with the SBA regulations.
The three reasons above are just a few of the many ways in which commercial banks view the world differently than one another. CFOs who are trying to fulfill their fiduciary responsibility of getting the best loan terms should approach 10 to 15 lenders, instead of the usual three. Though this process can be timing consuming, the benefits can be significant, including removal of personal guarantees, reductions in pricing and fees, fewer reporting covenants, and larger loan amounts.
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