Please read the disclaimer before perusing the following article.
(written 1992, published Beef in B.C. Nov/Dec 92)
Many business people including those in farming, resent banks. Smith, in “Breaking Smith’s Quarter Horse” (by Paul St. Pierre) disliked his banker—and “a few others set in authority over him”, including the brand inspector and range officers!
Whether you like your banker or not, most of us won’t get too far in business without bank services, especially loans. Since being on the bad side of a lender is at best a miserable experience, and at worst means you’re out of business and possibly bankrupt, it is worth looking at ways to help yourself stay on the good side.
This article talks about ways to stay out of trouble. A future article will talk about things to consider if you get into trouble.
The time to start on the road to staying out of trouble is when you are about to apply for financing. Suppose you have an idea for a farm or ranch improvement or expansion, and you want to go ahead. Unless you have the capital to fund the improvement yourself, you will need to borrow money to go ahead. Budget preparation is the essential first step in deciding if you should go ahead with a project. You must be realistic, honest, and conservative in making the budget. Use historical averages, not anticipated potential. At this stage you are putting together information to decide IF you want to go ahead with the project. Unless your budget shows that the project has potential profit and acceptable risk, you should forget about it.
The budget will not only assess the financial viability of the project, but also the amount of money that you must borrow. You should work out the amount of financing that you prefer to get, and also calculate the amount of money you MUST have to make the project viable.
In the budgeting process, work in a few variables. What if your construction costs run 20% over? What if construction time is over by a third? What if interest rates go to 20%? A lender will be interested to see what “what-if” calculations you have done.
If your project is sensitive to changing interest rates, consider fixed rate financing, or financing that can be converted to fixed-rate financing if interest rates start to rise. Balance the potential extra cost of fixed-rate financing against the failure of the project if interest rates rise.
If the project is a substantial one and assuming it shows a potential profit and acceptable risk, and you know how much you need to borrow, you may wish to discuss the financing application with your professional advisors, especially an accountant. With your budget and financial statements, your professional advisors can help you put together the financing application package, and can help you assess in advance what security the lender will ask for the loan, and what security you ought to be prepared to give.
In the financing application package, you should include the following:
What you are trying to do in assembling the information for the financing application package, is to provide the lender in one fell swoop with all the material it needs to assess your proposal, your financial situation, the security that might be available and the security purposed. You look like a capable business person if the lender does not have to come back to you several times for more information on your application.
Before you set up the appointment to see your lender, you should have a good idea from your professional advises about what is sensible in terms of the security you should give for the loan. Whether or not you end up giving the lender the security it requests, you should make your own assessment about what security is reasonable. There is sometimes an opportunity to negotiate loan security with the lender. Here, as well as with a worthwhile business project, is where you can head off or limit future problems.
Guarantees deserve attention. What if any, is the limit of the guarantee? Is it in an amount that is reasonable for you to repay if things go wrong? Who all is being asked to provide a guarantee? Are they directly involved in the business? Family members who are not involved with the business should not (except in the most unusual circumstances) be guaranteeing loans. Rather than giving a spousal guarantee, sometimes having the spouse sign a document that acknowledges that any interest he or she has in the secured property ranks after the lender, will satisfy the lender so that the guarantee is not required.
Lenders sometimes seek guarantees to make sure that some essential person maintains an interest in the business. For example, an inter-generational ranch transfer that is funded with loan proceeds, may require the guarantees of the children-operators and the retired parents—although a lawyer acting for the parents will quite properly resist the parents’ guarantee.
My preference is to have the guarantee refer to the specific loan for which the guarantee is being given. Nearly all guarantees these days are for any indebtedness of the borrower to the lender, including later debt and debt of third parties which the borrower has guaranteed! If the guarantee is for the particular loan, the guarantor has the comfort of knowing that the guarantee is gone when the loan is paid off.
There are other concerns that you should negotiate with the lender during the application process. One concern is the lender’s requirements to give a partial release of the loan. For example, if you plan to sell some assets but these assets will be included in the lender’s security, you should have a clear agreement with the lender about the conditions under which the lender will release those assets, so that you can sell clear title to your buyer. Will you have to give the lender the whole sale proceeds? Part of the sale proceeds? So many dollars? Iron this out when you are getting the loan, not a couple of years later when you have sold the property and have to accept any terms the lender proposes so as to complete your deal with the buyer.
Another question to work out at the time of the loan application, is whether or not you can pay out the loan before it comes due? If you have fixed term financing you may discover that you are not entitled to pay it out before the maturity date of the loan. If you can pay it out you may find that there is a three- or six-month penalty, or an interest differential to the end of the term. You need to know what the prepayment privilege is, in case you are able to pay out the loan before it comes due, especially if an asset is sold and you must have the loan partially discharged.
Keep an eye on the lender’s reporting requirements. You might be asked for monthly, quarterly, semi-annual, or annual statements. If for example the lender wants monthly statements and you are not set up to provide them, discuss this with the lender and arrange something acceptable to the lender that is also acceptable to you.
Over the course of the loan and at each annual review, keep an eye on the security held for the loan compared with the loan balance. Perhaps if the loan is paid down substantially, the lender will release a guarantee, or part of the loan security. The aim of the exercise is to make sure that the security held is reasonable but not excessive. You certainly won’t get this concession unless you ask for it—and may not get it even if you do ask for it.
Despite the most thorough loan application, the first lender to whom you apply may turn you down. If that happens, do not assume that no lender wants you. All lenders have cycles of greater or lesser interest in lending money, and greater or lesser interest in lending money to agriculture. Various lenders are usually at different points of this cycle, so if your usual lender is not interested, try one of the others.
In a situation where your lender says that it will only lend a certain amount and you know from your budget that this amount is less than the minimum you must have to do the project, turn them down. A seasoned lender is unlikely to allow this to happen—but if you borrow less money than you know you have to have, you are in trouble right from the start. Try another lender and if you don’t get what you need, don’t do the project.