Follow the Leaders
As a banker, we hear it a lot. As a borrower, you might have said it before. “My interest rate is so high. Can’t you come down on that rate a bit?” It seems like a fair question, especially given the current competitive banking environment. It always seems like banks are trying to attract your business but at the highest interest rate possible. As bankers, we do understand your concerns, especially when it seems like another bank down the road will offer you something different. But in the bigger picture, is a bank’s cost of capital really THAT high? That answer will most likely depend on the type of financing you are requesting based on the risk profile of your business.
While banks are providers of capital, they are usually the lowest risk provider in the market. For a bank, an investment is the loan that is being extended while the risk is the business’s ability to repay that debt. Just like most other investments, the higher the risk (i.e. the greater the concern for repayment of debt), the higher the return (the interest rate that will be charged).
Let’s assume you are in the process of starting a business. According to data provided by the U.S. Bureau of Labor Statistics, roughly 20% of small businesses fail within their first year while 50% fail by year five. Approximately 35% remain in operations after ten years. You have a business plan and you’ve identified human capital that will move the business forward, but you haven’t quite gotten off the ground. There is a lot of excitement and prospects for taking your idea to market. You need some form of capital, outside of what you can provide via your own personal equity, to handle projected expenses.
In the seed and startup phases, businesses often experience minimal revenues, net losses, and cash flow and working capital deficits. It is challenging for a bank to be comfortable with a new company’s ability to repay debt due to these factors and the overall statistics mentioned above. Because of this, businesses may be required to find capital sources through such things as crowd funding, angel investors, venture capital funds, and small business administration loans. Businesses that have utilized these sources of capital will tell you that this type of financing can include significant interest rates, the potential for loss of equity, and noted reporting requirements. Though needed to fund the risky startup phase, the costs are very high. The return, or the cost of that capital, will match the risk whether it is from outside financing or bank debt.
Great news! Your business made it through the startup phase and is now growing. Revenues are accelerating, net income is being realized, cash flow coverage is strengthening, but working capital needs are challenged. Your debt carrying costs continue to strain cash flow and make it harder for you to fund your business. The startup financing was vitally important, but it might be the perfect time to speak with a commercial banker about replacing your existing, costly third-party debt. You have proven that the market can and wants to absorb your products or services and there is positive cash flow. You’re now less risky because you have shown the ability to repay financing, but there is still noted risk as operating expenses fluctuate and are often unexpected as you grow. Though reduced, risk and limited positive operating results will often result in higher priced bank financing that will still reduce your overall interest expense related to expensive outside startup financing.
Finally, you’ve made it through the growth phase, and you are an established or mature business. Revenue growth is predictable while your profitability is strong and stable. Cash flows are adequate and your leverage is moderate because of your profitability. Equity in your business is strong and allows you to “weather the storm” that will inevitably come when economic conditions deteriorate. In these phases, you are most likely a great candidate for bank financing as a capital source and you should see a much lower interest burden due to your track record. In fact, you can probably even call the shots on your interest rate as every bank in town is clamoring for you. It took a while, lots of hard work, and varying capital sources, but your company has performed well. Your risk to the bank is low, and so is their return.
The truth is that banks are risk averse compared to other capital sources. Losses incurred by a bank lead to reduced capital levels and the ability to lend, and financial institutions have a fiduciary responsibility to their customers, shareholders, community, and Federal Examiners to be well capitalized. This leads stringent analysis in the underwriting phase to ensure that businesses have shown the ability to perform in a way that enables debt to be repaid. As the risk profile of your company lessens, so should your ability to find capital sources with reduced costs.
If you haven’t already done so, look for a commercial banker that will take time to discuss these areas with you, learn about your business, explore capital opportunities, and ensure that your interest rate is appropriate. Responsible bankers may also provide you with guidance around capital sources if they feel that bank financing is not available at that time. Most importantly, a strong and trusted banking relationship with open communication can provide an avenue for the bank to fully understand your business leading to financing opportunities in various company stages at lower interest rates.
Matt Paciocco is a Senior Vice President, Commercial Banker with Virginia Commonwealth Bank. Matt is passionate about working in a community bank that enables him to build strong relationships with his business customers and the surrounding communities. Matt has spent the last 15 years specializing in commercial banking and has positioned himself as a leading community banker in Richmond.
Editor’s note: Image and content provided by VCB. VCB is a Sponsor of VA Council of CEOs.