A common mistake is to make security the cornerstone of a bank borrowing request. Entrepreneurs often expect banks to wave through deals with decent assets at comfortable loan to value ratios and are amazed when they’re rejected or asked difficult questions about the underlying transactions. But this is to confuse banks with pawnbrokers and to misunderstand how banks view security.
Serviceability
Your ability to meet - or in bankspeak, service - loan repayments is the credit analyst’s primary concern. If your proposal cannot convince a bank that there’ll be sufficient profit to repay the loan then security details are immaterial and won’t even be looked at. Frustrating though it is, banks only analyse security once they’ve satisfied themselves that it probably won’t be needed.
But why do banks care if their risk is covered by the security? Because they really don’t like calling in security. It’s expensive in terms of admin, human resources and the capital they have to set aside as provisions against expected loss. Also, the process might be contested in court, their bad loan profile (a key metric for both shareholders and regulators) is adversely affected there may be public relations issues to contend with.
What Makes Good or Bad Security?
Assuming the underlying transaction has passed muster, the bank turns its attention to security. The first boxes to tick are that it is both easy to enforce and easy to realise.
Enforcement is essentially taking possession of your security. If an asset has a complicated ownership structure, will be charged to more than one lender, is located in a different legal jurisdiction or able to fly off or sail away then it presents challenges to a bank. There may also be reputational damage in enforcing certain assets, so an in-use dialysis machine or a rescue home for fluffy kittens would make bad bank security.
Realising the security is simply converting the asset back into cash. There’s a smaller market for commercial properties than residential, so banks almost universally lend a lower percentage against them. Most lenders will be out of their comfort zone selling specialist items such as rare books or modern art and will place a zero value against them, even where there is an established market price.
With the rise of technology-led firms, banks are getting better at recognising intangibles such as intellectual property or software. However, the general rule is that banks only value something if it hurts your toe when you drop it.
Time is also a factor. Perishable goods make bad security, as do technological items that can become obsolete very quickly or clothes that could go out of fashion (which is why plain t-shirts are potential security, but printed t-shirts are usually not).
The Personal Guarantee
For obvious reasons the PG is the most bitterly contested form of security. It will either be supported (by another asset - most often property) or unsupported.
Borrowers will often ask why a PG is required at all if the business transaction is considered sound and rightly wonder what the point of an unsupported guarantee is. In both cases the bank simply wants to ensure that the balance of risk is shared by you as well as them, and to make it financially and psychologically more difficult for you to walk away from a business if it hits problems.
That said, banks do have a habit of reflexively asking for PGs whether they are justified or not. It is reasonable - if the bank’s lending policy allows, the transaction is straightforward and the risk is moderate - to try to lower the guarantee amount or negotiate it away altogether. This can either be achieved at the start or when a certain amount of time has passed or performance milestones have been reached. Insist that any such agreement is documented in the original facility terms rather than as an informal agreement to review at a later date: the bank manager or credit policy might have changed by then.
Prepare
Before you approach a bank, understand how (or even if) it values the assets in your project or business. If there is any complication to your intended security such joint ownership or jurisdiction, thrash this out first rather than waste time submitting a lengthy proposal. Can you make your security more attractive, e.g. by asking for additional finance to clear away existing charges or adapting your invoicing to make it assignable?
Ask about the lender’s credit policy on personal guarantees - are they a sine non qua or a nice-to-have? Decide in advance whether you’re prepared to provide one rather than feeling pressured closer to the finishing line when you’ve already invested time and effort.
Most importantly, does the level of security feel right to you? If you suspect the bank is being overly cautious - or even greedy - then you need to shop around. Be comfortable with security arrangements before you sign up to a deal because giving a bank security is a lot easier than getting it back again.
For any and all help with bank finance, feel free to contact Alex Lynford, Director of Flare Path Financial Services on 07950 787690 / 020 8974 9344 / al@flarepath.co.uk