Surviving The Loan Underwriting Process: Part Three
Detours and Sidetracks: Okay, so now you have a general idea of how the obstacle course is laid out, and what every lender is trying to figure out from a holistic perspective, regardless of the “highly-underwritten” loan product being offered. Now, how much different and/or harder is the course if you’re applying for a term loan versus a line of credit, or venture debt versus mezzanine debt?
☝️We'd recommend you take another look at the Bainbridge Field Guide to DTC Capital to remind yourself of the range of different loan products we’ll be discussing below.
First, it’s important to remember that there are three primary variables at play that distinguish different loan products and their resulting underwriting processes: (1) the expected repayment source, (2) the time horizon over which that repayment is expected to occur, and (3) the lender’s credit box. (Where your company is in its life cycle is likely to inform all three variables.)
Second, for the purpose of this section, we can set aside Non-Sponsored Bank Term Loans & Revolving Credit, as they tend to hew closely to the “standard” underwriting process detailed in the prior section. That’s because banks tend to be very conservative, such that prospective borrowers must exhibit a fair level of strength across all metrics and multiple repayment sources.
☝️Which makes sense, since the money they're lending is from the checking and savings account deposits of folks like you, me, and your grandma!
If a bank expects the loan to be repaid via the near-term conversion of inventory to cash (i.e., the primary repayment source), it’s still going to underwrite the long-term cash flow capacity of that company to ensure it has another payback option (i.e., the secondary repayment source). All bank loans are predicated on the expectation of at least two solid repayment sources, which is why bank underwriting processes tend to exhibit both depth and breadth.
On the flip side, loan products like Asset-Based Loan (ABL) facilities, Sponsor-Focused Bank Term Loans, Venture Debt, and Mezzanine Debt all tend to be more reliant (or sometimes entirely reliant) on a single repayment source, so it’s no surprise that their underwriting processes tend to go very deep on those specific sources and not so deep on the others. As such, we’ll be focusing on these “specialized” loan products below.
Asset-Based Loan (ABL) Facilities: Lenders offering this product underwrite to the following assumptions: (1) the repayment source is the sale of your on-hand inventory, (2) the timeframe for repayment (of each advance) is very short, generally less than three months, and (3) the expectation of a credit loss on any single loan is very low (though slightly above a bank’s loss appetite).
Above all else, ABL underwriters are focused on determining how much money the lender would receive if it had to take possession of the inventory and liquidate it with no assistance from the borrower. ABL underwriters need to have an in-depth understanding of the physical location of your inventory, the core systems used to oversee the management of your inventory, and any related legal or logistical obstacles that could impact their ability to step in and take control. They also need to understand your current sales channels and historical margins (including discounting) in order to develop an extremely detailed liquidation plan including how and where to sell the inventory, at what prices, over what timeframe, and at what liquidation cost.
Not surprisingly then, the ABL underwriting process differs from the “standard” approach in its focus on the following:
- Sales and Inventory reporting: Finished goods vs WIP and raw materials; SKU-level gross margins and turnover, historical sales by channel, historical discounting, etc.
- Physical inventory location: Dedicated warehouse vs third-party logistics (3PL) locations, leased vs owned, on-hand vs in-transit, etc.
- Core systems - perpetual inventory accounting, historical accuracy, critical data back-up, etc.
- Third-party reliance - Onsite inventory appraisals
☝️ABL can be tricky for DTC and eCommerce because access to inventory can be complicated by third-party logistics (3PL). Liquidation values are hard to determine and liquidation processes are hard to implement.
☝️ABL does not finance inventory that’s in progress or in transit. That means you can’t finance the deposits to your Chinese supplier or what’s on a boat on its way to your warehouse. You can only finance what is on hand.
Of note, ABL lenders may not spend as much time as a bank would underwriting your supplier relationships, A/P turnover, or overall cash flow and profitability prospects, since they aren’t reliant on your long-term sustainability in order to get repaid. There are two main reasons for this somewhat harsh reality:
☝️ABL facilities typically aren't too concerned with where you are in your life cycle, although upstart companies with unique loan products may find it hard to get compelling ABL offers given the lack of readily available market information to help value the inventory.
1. Since an ABL lender only finances inventory that it can legally and physically possess as a secured creditor and sell in a default scenario, it doesn’t really need to worry if your supplier gets repaid. Accounts payable are generally unsecured from a legal perspective, so in a bankruptcy situation suppliers are only entitled to repayment if there are excess amounts available after the secured lenders are repaid in full.
2. ABL loan structures are formulaic in nature and require intense and frequent borrower reporting post-origination, including additional third-party appraisals. As a result, the amount of any future loan advances is constantly changing based on the results of updated inventory valuations, such that the lender always has point-in-time confidence that there’s sufficient collateral cushion to ensure full repayment without the borrower’s help.
Sponsor-Focused Bank Term Loans and Venture Debt: In most respects, the underwriting of these two loan products is similar, so it makes sense to discuss them together.
☝️While the underwriting is similar, the loan structures will differ mainly on pricing, both interest rates, and warrants, to account for the fact that bank term loans are almost always senior-secured while venture debt is subordinated.
Lenders offering these products underwrite to the following assumptions: (1) the repayment source is the next equity event, (2) the timeframe for repayment is near-term, generally within the next 1-2 years, and (3) the expectation of a credit loss on any single loan is high relative to a standard bank loan.
☝️Sponsor-Focused Banks generally expect losses at twice to three-times the level of a "typical" term loan. Single deal loss expectations are much higher for venture debt providers who are generally more exposed relative to the underlying value of the borrowers.
Sponsor-focused bank and venture debt underwriters are charged with assessing the likelihood that your existing institutional investors (e.g., venture capital firms) will continue to make equity investments in order to sustain the company to either (a) a satisfactory liquidation event like an IPO or acquisition, (b) a consistent cash flow position sufficient to amortize the loan, or (c) a full or partial pay-off with company cash balances.
Underwriters need to have an in-depth understanding of the enterprise valuation of companies with similar industry and product focus, revenue size, and life stage, as well as an understanding of the VCs’ track records, KPIs for continued support, and remaining fund capacity (i.e., “dry powder”).
As a result, the sponsor-focused and venture debt underwriting process differs from the “standard” approach in its focus on the following:
- Cap table, equity raise history, and capital plan, including a concurrent equity raise
- Direct access to VC partners and board members, including review of board-approved plan and KPIs
- Existing cash runway and downside forecasts, relative to the board-approved plan and implied enterprise valuation
- Revenue composition, including total revenue under contract (e.g., SaaS recurring revenue)
Of note, sponsor-focused bank and venture debt loan structures typically offer flexible repayment terms such as interest-only periods and partial amortization, and oftentimes have loan terms that extend beyond the company’s current cash runway. This is because the lenders generally expect the “true” repayment of each loan to be refinancing with a new facility as the company hits key life cycle milestones to facilitate a new equity round.
For example, a lender may offer venture debt based on the lesser of a multiple of current annual recurring revenue (ARR), a percentage of an internal enterprise valuation, and the amount raised in the concurrent equity round. By reviewing the board-approved plan and management KPIs, which invariably will show sizable revenue growth if not reduced cash burn, the lender can estimate when the company will need to raise its next round, and what the likely debt capacity will be assuming a post-money valuation in line with the higher revenue size.
Mezzanine Debt: Lenders offering this product underwrite to the following assumptions: (1) the repayment source is cash flow from operations or a liquidity event, (2) the timeframe for repayment is generally mid-term, typically between 3-5 years, and (3) the expectation of a credit loss on any single loan is high relative to a bank term loan.
Mezz debt underwriters are focused on the company’s ability to grow and generate cash flow with or without further equity assistance. Mezz lenders typically cannot rely on collateral coverage to get out of a loan, and therefore need to have an in-depth understanding of your ability to sustain cash flow sufficient to amortize the debt and/or allow for a refinance of any principal balloon amount. The mezz underwriting process therefore differs from the “standard” approach by focusing on the following:
- Historical cash flow sufficiency, including key staffing requirements and in-depth industry analysis to understand your ability to maintain your competitive position
- Board-approved plan and downside forecasts relative to implied enterprise valuation
- Vendor relationships and agreements, including direct access
☝️Mezz debt works best for mature companies with a long-term history of solid profit margins.
Of note, mezz debt is by nature amenable to taking a subordinated position to senior-secured debt. In some cases, mezz debt providers and senior debt providers will agree to separate certain company assets. More often, the creditors will create unitranche structures blending the two facilities, thereby giving you more money at a lower overall interest rate.
Pitfalls and Rabbit Holes: At this point, you hopefully have a good understanding of what to expect regardless of the loan product you’re seeking, including some context as to the why and the when. The next step is understanding when things are likely going off the rails...
First, you can probably guess that the level of unpredictability of the underwriting process is correlated with the term of the loan product and the degree to which the lender has control over future advances. A short-term ABL facility, in which there’s a detailed borrowing formula and ongoing inventory appraisals, is likely going to have a pretty well-defined process, since the lender doesn’t need to contend with a bunch of unknowns given how tight the lending reins are out of the gate.
On the other hand, a mezz lender underwriting a five-year term loan with no sponsorship, a large balloon, and limited financial covenants will no doubt spend more time trying to capture as many what-if scenarios as possible in their analysis. In these situations, it’s much more likely that they’ll continue to dig down further and further on each material risk, past the weeds and past the dirt, until they find bedrock (or silt).
Second, the more comfortable your lender is with your industry, products, and competitors, the more likely they are to stick to a well-defined underwriting process. As noted in the first post, lenders are seeking predictable outcomes based on historical precedents, so the more unique your product or client base is to them, the more likely it is that they’ll want to dig into the downside scenarios.
The same is true for sponsor-focused banks and venture debt providers, primarily related to their familiarity with your VC sponsorship. Feel free to interview your lenders as to their knowledge with your business and investors. If they’re not familiar but eager to learn, it’s still possible you may end up getting a good deal, but just know that you’ll have to devote more time and effort walking them to the finish line.
Relative to that point, it’s been my experience that when deals get delayed it’s usually because the underwriter (or their boss) is trying to find a way to do the deal, versus trying to find a way to NOT do the deal. That is, most good lenders want to be creative and flexible, to the extent it’s allowed within the bounds of their credit box. Some are well-meaning but hopelessly inefficient. Very few are actively engaged in bait-and-switch.
The key is getting the context whenever they ask for additional information, including the likely range of outcomes based on the information you can reasonably provide. If they can’t provide good context, then they’re likely stalling due to some internal dysfunction. If they can provide context, then it’s up to you to assess whether the additional time and effort are worth it relative to whatever other capital options you have on the table.
Lastly, keep in mind that you’re an active participant in the process. The extent to which you clearly communicate the business risks as you see them, and the faster you can provide complete reporting and data that validates your assessment, directly impacts the lender’s ability to stay on track. Lenders hate surprises, so if they find something in the data that hints at a deep-seated issue you didn’t give them a heads up on, then they’ll keep digging and digging. More on this topic in the last section!
Term Sheets and Commitment Letters: One final, quick note regarding the difference between these two lender documents, which on the surface look very similar. Generally speaking, Term Sheets and Commitment Letters both provide you with basic loan terms that the lender is willing to consider. The key difference is that Term Sheets tend to be more general and selective in the information provided, are issued earlier in the underwriting process, and at a minimum are subject to formal credit approval. Commitment Letters, on the other hand, are generally more specific and comprehensive, and come at the end of the underwriting process after credit approval has been granted.
Usually, the closing conditions in a Commitment Letter are limited to executed legal documentation, collateral perfection filings, and wire instruction, whereas Term Sheets will usually have “TBD” sections in the loan structure (e.g., financial covenants) as well as several remaining underwriting requests and validation items remaining.
The reason the two documents exist are simply for managing the sales process. As noted previously, lenders want to gauge your intent before engaging in further diligence, particularly any third-party requests that cost money, so a Term Sheet (and due diligence fee) is a key signal of intent. Commitment Letters are also useful for signaling intent, and often also have a fee to cover legal documentation and collateral filing costs.
The reason it’s important to understand the difference is that lenders will attempt to differentiate themselves from competitors by issuing term sheets earlier and earlier in the process. Their hope is that you’ll love their offer so much that you’ll disengage with all other suitors. However, the obvious trade-off is that the earlier the Term Sheet is issued, the more likely it will contain a bunch of caveats, TBDs, and subject-to items, and the more likely that the final credit-approved Commitment Letter will differ in some material way. The key is to read the “conditions precedent” section VERY carefully and question your lender on how likely key terms are to move given the results of the final due diligence. Either that, or keep your options open with multiple lenders until you get to the Commitment Letter phase.
IMPRESSING THE CHIEF CREDIT OFFICER
Well, that about covers it! Hopefully you’re now feeling a bit more confident in how to navigate the underwriting process. Or, at the very least, the whole subject is a little less opaque than it was previously. In this last section, I thought it might be interesting to hear what your friendly Chief Credit Officer looks for when assessing hands-down the most qualitative of credit risk variables: management “character”. To do that, I’ll widen the scope a bit beyond just underwriting to include some traits I value in portfolio monitoring and loan relationship management.
☝️There are of course some standard methods for assessing management character, namely looking at credit reports and background checks, some of which are federally-required. But, for the purpose of this paper, I'm focusing on the harder-to-quantify but still important "relationship-building" character traits that I look for in a borrower, as I very much value the partnership aspect to making and managing debt capital investments.
Pre-Funding: In my experience, good borrowers exhibit each of the following three characteristics: (1) they know their numbers inside-out, (2) they’re transparent and frank in discussing both risks and opportunities, and (3) they always have back-up plans at the ready. In fact, I think I’d have a pretty good success rate if I could only ask the following questions of both the CEO and CFO (and then compare their answers to their financials):
- What are the key performance indicators you track and why?
- What keeps you up at night?
- What would you do if the risks in #2 started to happen, and when?
Let’s discuss in more detail…
Know Your Numbers: By asking the first question, I’m trying to get a beat on how in-tune management is with their financial numbers, not just at the superficial level (yes, revenue growth is good and revenue decline is bad), but also in how they view those KPIs in concert with one another and how they interpret the changes in those ratios relative to their impact on both company results and underlying business inputs.
☝️Most KPIs are a function of multiple variables, so at a minimum, good managers will understand that a shift in one stat should drive a review of those underlying variables in order to understand root causes. A strong manager will be able to tell you that the projected improvement in one stat is being driven by an expected change in specific drivers, each of which in turn is being influenced by specific management initiatives.
I’m a numbers guy by nature and by training, so it’s probably not surprising that I value someone who values stats and ratios. But, keep in mind, EVERY lender is a numbers person. Sure, if you’ve built a business on the strength of your passion and personality you’ll attract loyal customers, employees, and investors, but we’ve already noted that credit folks seek out downside protection, not upside potential. So, right or wrong, we’re going to be more impressed with someone who knows exactly which ratios to track and why.
Also, I’m asking both the CEO and the CFO the same question, because I want to understand if there’s alignment at the key management level. If I’m talking to the investors or board members, I’m asking them the same question. The level of alignment (or lack of alignment) is very telling. Often, the CFO may have a good answer on why they track KPIs, but then the CEO is focused on something entirely different or, even worse, something actively at odds with what the CFO values.
Be Transparent: By asking the second question, I’m trying to gauge how willing the CEO and CFO are to share both good news and bad news. I’ve had dozens of CEOs tell me over the years that nothing keeps them up at night, as if that will give me some warm and fuzzy feeling that their company is rock-solid. On the contrary, it tells me that they’re either not critical enough or not willing to point out where the fault lines are, or both. When we talk earlier about digging deeper and deeper in our underwriting process until we hit bedrock, it’s usually because we’ve both had CEOs tell us there’s nothing to fear and then found those cracks in our initial financial analysis.
☝️Another of my old mentor's favorite questions was "where are the easter eggs?" meaning where are the hidden risks in the deal.
I’m also trying to assess how well the KPIs they listed in response to the first question align with the risks they self-identified in answer to the second question. If they don’t, but management acknowledges there’s a disconnect that needs to be remedied, then I’ll likely give them a pass. If they don’t get that there’s a gap there, then that tells me they’re either not looking closely enough or they don’t really rely on the KPIs other than in some quarterly board deck.
Lastly, by being transparent, I don’t just mean the willingness to be frank about current and future risks to the success of the company (and repayment of the loan), but also any historical events or issues that could be seen as red flags, such as prior lawsuits or company failures. I know some of these items can be very sensitive, and maybe even irrelevant to the future repayment of the debt, but if you know that the lender is eventually going to run a personal credit check and see that former bankruptcy, why not disclose that upfront to avoid any perception of opacity?
To be honest, I’m much more likely to want to go with a company that has B- performance and A+ management than the other way around. That’s how important transparency is to me, for the simple reason that the good times are usually a combination of both skill and luck, whereas successfully managing through the bad times is and will always be more heavily influenced by skill.
Have Back-Up Plans: The last question is really the key one, as it tells me that the CEO and CFO are setting and analyzing KPIs for a reason, that they understand how changes to the underlying business inputs drive those KPIs, and that they appreciate that downside risk mitigation is a critical component of leadership. Bad news or less-than-stellar results aren’t always deal-killers, but a lack of planning will be. Again, credit folks are downside-focused, so when we spot managers with at least an appreciation for that worldview, we’re much more confident that we’re not going to be left high-and-dry when the drought rolls in.
As important to having a back-up plan is knowing when to put that plan into play. For much of my career, I’ve underwritten pre-profit tech companies that by nature are constantly running short on cash. I’ve seen a wide range of responses from management when they fall materially off-plan, including the hope-and-pray approach, the double-down approach, and unfortunately, the cut-and-run approach.
Obviously, the preferred response from a credit perspective is what I’d call the preserve-and-pursue approach, where actions are taken to extend the runway while also keeping as many future options open as possible. Often this means pursuing multiple paths at the same time, like selling the business, seeking an equity partner, and seeking higher-cost debt financing. The good managers realize that they have to constantly iterate their backup plans and at each node, objectively identify which options must be eliminated in order to cover costs, including debt payments.
Post-Funding: Most of the “highly-underwritten” loans we’ve discussed in this paper are based on an assumption that there’s an ongoing business relationship to maintain versus a view of the loan as a one-off transaction. In other words, most good managers and lenders want to see a win-win outcome and preserve the opportunity for future loans and an expanded relationship. As a result, I think it’s important to share a few tips on which types of managers tend to fare better with regards to post-funding reporting.
It comes as no surprise that all of the traits noted in the Pre-Funding section apply here as well. Managers that are on top of their numbers and are transparent and communicative tend to fare well. To frame it in a bit more detail, strong borrowers tend to exhibit the following characteristics: (1) They are organized and consistent; (2) They are timely in providing required financial information; (3) They are proactive in sharing news, both good and bad; and (4) They are always professional.
At a bare minimum, good managers know and appreciate the post-funding reporting requirements when they sign up for a loan. A highly-underwritten business loan is not a home mortgage. Lenders require updated financial reporting and financial covenants for a reason, namely that the simple act of making your current loan payments is not sufficient for the lender to assess your ongoing financial situation.
Not to sound doom-and-gloom, but it’s worth remembering that the failure to adhere to ANY term in your business loan agreement qualifies as a default, which entitles the lender to take any legal action at its disposal, including implementing a default rate of interest, demanding payment in full, and/or foreclosing on your business. Granted, that nuclear option typically doesn’t happen based on simple reporting lapses, but covenant breaches can lead to severe consequences if not remedied, and poor overall communication can cause certain lenders to pursue serious legal remedies that at a minimum will cost time and divert attention from your business.
But, if we frame it more opportunistically, from your perspective versus from the lender’s view, keep in mind that the day may come where you need help from your lender or you want a new loan at a better rate. You are more likely to get that help if you have been a model borrower. Put yourself in the lender’s shoes. If you have been late, sloppy, difficult to communicate with, reactive as opposed to proactive about potential issues, do you think they will want to help or do another deal? Not likely, especially if they have plenty of other borrowers who are managing the relationship the right way.
Congratulations, you’re now fully-equipped to run the underwriting gauntlet and make some friends with Credit folks along the way! Here are a few key takeaways:
- Viewing the process from the lender’s perspective is helpful when assessing the likely steps and timing. Lenders typically employ specialized staff to focus on the sales function, the underwriting function, and the portfolio management function. As you embark on the process, ask your lender how they manage their underwriting process.
- Understand how to match different lending products to your specific cash needs. The Bainbridge Field Guide to DTC Capital is a key resource to help you evaluate different options and efficiently spend your valuable time when seeking capital to jumpstart your business.
- Lenders aren’t like investors, so when you’re pitching to them be sure to focus on the downside protection as much as your upside potential.
- Most lenders utilize a three-stage underwriting approach. Review the grid to understand what information is likely to be requested regardless of the loan you’re seeking, as well as when in the process that info will be required.
- Each underwriting process differs based on your likely repayment source, the timing of that repayment, and the size of the lender’s credit box, i.e., its risk appetite. Be sure to review the section detailing specific info requests for ABL Loans, Sponsor-Focused Bank Term Loans, Venture Debt, and Mezz Debt.
- Regardless of the loan being underwritten, the potential for the underwriting process to go off the rails is correlated with the term of the loan and the level of controls the lender has post-funding, as well as the lender’s familiarity with your specific industry niche and investor support (if seeking venture debt). Keep this in mind as you map out the time needed to get to a term sheet.
- Term Sheets and Commitment Letters are not binding documents and differ in terms of when they’re issued during the underwriting process. Term Sheets can be very broad with plenty of built-in outs for the lender, so be aware if/when choosing a specific path to head down.
- Lastly, Chief Credit Officers are people too! You’re more likely to build a good relationship with your lender if you’re on top of your numbers, if you’re transparent, and if you’re prepared with back-up financial plans. That extends beyond the initial underwriting process all the way through repayment of the loan!
🏅If you are struggling to answer the tough questions about your business, Bainbridge can help. Our platform is a finance and data team in a box that aggregates your data and provides the tools and expert help needed for you to get the best capital, understand profitable customer acquisition, understand your retention, and maximize profitability. Our tools are used by founders and team leaders at fast growing DTC brands and we’d love to learn more about your business and challenges. Please book time with us!