Decision Vision Episode 103: Should My Company Borrow Money? – An Interview with Bill McDermott, The Profitability Coach
Bill McDermott, Profitability Coach and ex-banker, speaks with host Mike Blake on when and how business owners should borrow money for their business. Bill also breaks down how bankers assess business borrowers and make lending decisions, various types of debt, one type of business loan he considers predatory, and much more. “Decision Vision” is presented by Brady Ware & Company.
Bill McDermott, The Profitability Coach
Bill McDermott is the Founder and CEO of McDermott Financial Solutions, serving as a profitability coach to his clients. When business owners want to increase their profitability, they don’t have the expertise to know where to start or what to do. Bill leverages his knowledge and relationships from 32 years as a banker to identify the hurdles getting in the way and create a plan to deliver profitability they never thought possible.
Bill currently serves as Treasurer for the Atlanta Executive Forum and has held previous positions as a board member for the Kennesaw State University Entrepreneurship Center and Gwinnett Habitat for Humanity and Treasurer for CEO NetWeavers. Bill is a graduate of Wake Forest University and he and his wife, Martha have called Atlanta home for over 40 years. Outside of work, Bill enjoys golf, traveling, and gardening.
Connect with Bill on LinkedIn and Twitter and follow McDermott Financial Solutions on LinkedIn.
Mike Blake, Brady Ware & Company
Michael Blake is the host of the “Decision Vision” podcast series and a Director of Brady Ware & Company. Mike specializes in the valuation of intellectual property-driven firms, such as software firms, aerospace firms, and professional services firms, most frequently in the capacity as a transaction advisor, helping clients obtain great outcomes from complex transaction opportunities. He is also a specialist in the appraisal of intellectual properties as stand-alone assets, such as software, trade secrets, and patents.
Mike has been a full-time business appraiser for 13 years with public accounting firms, boutique business appraisal firms, and an owner of his own firm. Prior to that, he spent 8 years in venture capital and investment banking, including transactions in the U.S., Israel, Russia, Ukraine, and Belarus.
Brady Ware & Company
Brady Ware & Company is a regional full-service accounting and advisory firm which helps businesses and entrepreneurs make visions a reality. Brady Ware services clients nationally from its offices in Alpharetta, GA; Columbus and Dayton, OH; and Richmond, IN. The firm is growth-minded, committed to the regions in which they operate, and most importantly, they make significant investments in their people and service offerings to meet the changing financial needs of those they are privileged to serve. The firm is dedicated to providing results that make a difference for its clients.
Decision Vision Podcast Series
“Decision Vision” is a podcast covering topics and issues facing small business owners and connecting them with solutions from leading experts. This series is presented by Brady Ware & Company. If you are a decision-maker for a small business, we’d love to hear from you. Contact us at decisionvision@bradyware.com and make sure to listen to every Thursday to the “Decision Vision” podcast.
Past episodes of “Decision Vision” can be found at decisionvisionpodcast.com. “Decision Vision” is produced and broadcast by the North Fulton studio of Business RadioX®.
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TRANSCRIPT
Intro: [00:00:02] Welcome to Decision Vision, a podcast series focusing on critical business decisions. Brought to you by Brady Ware & Company. Brady Ware is a regional, full service accounting and advisory firm that helps businesses and entrepreneurs make visions a reality.
Mike Blake: [00:00:20] Welcome to Decision Vision, a podcast giving you, the listener, clear vision to make great decisions. In each episode, we discuss the process of decision making on a different topic from the business owners’ or executives’ perspective. We aren’t necessarily telling you what to do, but we can put you in a position to make an informed decision on your own and understand when you might need help along the way.
Mike Blake: [00:00:41] My name is Mike Blake, and I’m your host for today’s program. I’m a director at Brady Ware & Company, a full service accounting firm based in Dayton, Ohio, with offices in Dayton; Columbus, Ohio; Richmond, Indiana; and Alpharetta, Georgia. Brady Ware is sponsoring this podcast, which is being recorded in Atlanta per social distancing protocols. If you like this podcast, please subscribe on your favorite podcast aggregator, and please consider leaving a review of the podcast as well.
Mike Blake: [00:01:08] Today’s topic is, Should my company borrow money? And, you know, talk about borrowing and lending, it’s automatically a charged topic. And so much of our consciousness, I think, revolves around debt. And I don’t know if it’s always been that way. Certainly throughout history, people have talked about debt, usually from the dangers of debt. Of course, “neither a borrower nor a lender” attributed to Benjamin Franklin. And, of course, you know, there’s a whole ton of discussion around medical debt, student debt, the national debt. There are individuals that have made, frankly, fortunes and careers advising people against the dangers of debt, Dave Ramsey is probably the most important one, but there are several others, of course.
Mike Blake: [00:02:12] And I see that this mentality does bleed over into the corporate world to some extent. And there are a lot of funny things about debt, you know, one, it has a mystique to it. I think, because when debt works well, it works great. When it works badly or when the outcome is bad, the outcome is usually spectacular. And even our most recent past president – you know, there’s at least a lot of suspicion. We don’t know his full financial position – the prevailing suspicion or understanding or belief – I don’t want to use suspicion in a pejorative sense. That’s not the intent – but the belief that our own president has built an empire on debt and that he’s still very heavily leveraged. But in spite of that fact, he doesn’t appear to be financially hurting.
Mike Blake: [00:03:12] So, you know, debt can be somewhat paradoxical. And I think when debt fails, it fails badly, it fails in a lot of ways publicly. And who doesn’t love a good car crash, as long as you’re not in it. You know, I think that generates a lot of attention. And I’m not a debt expert at all. I have much more experience on the equity side than on the debt side, which is we have a guest coming up that does know what he’s talking about. But, you know, it’s understanding that debt is a power tool. And a power tool, you know, take a circular saw as a great example. If you know what you’re doing and you respect the power of the tool, the circular saw, you can build amazing things, right? You can build furniture. You can build a shelter, you know, effectively with a circular saw and a few other tools. Not that I’d ever do it. I’m incompetent. But I’ve seen people do it and this seems to be the way that it happens.
Mike Blake: [00:04:17] Conversely, if you don’t know what you’re doing, if you put your hand in the wrong place, the next thing you know, your name is Lefty or The Claw or whatever. But the saw itself isn’t bad. It’s simply a matter of the capability and the emotional intelligence of the person using it. And so, as a consequence, you know, I do think that, of course, there are companies that use debt irresponsibly. And we’ve had an interview on a podcast with Tom Rosseland of Bodker, Ramsey talking about, you know, should I enter into a workout? So, we’ve covered that part. And eventually we’ll cover bankruptcy as well. I just haven’t really found the right guest for that.
Mike Blake: [00:05:00] And we’ve talked about SBA lending in a very sort of particular finite discussion. But we haven’t had a far ranging strategic discussion about debt, how it works. You know, the world of debt is much more expansive than simply SBA lending. SBA is a great program. Don’t get me wrong. It’s one thing that I think our government actually has implemented pretty well with a lot of the desired effect. But there’s a lot more to it.
Mike Blake: [00:05:31] So, I want to give this topic, frankly, the amount of depth and breathing space that it is due. And helping us fill that breathing space is my friend Bill McDermott. Bill and I have known each other for over a decade. He is a graduate from Wake Forest University and launched a career in banking that spanned 32 years. And in spite of knowing Bill for a while, as I’ve said previously on this program, I’ll dig into some of his bio. And I learned something that I did not know. And I did not know that he first started out as the repo man for Wachovia Bank in their management training program. And he later moved to Peachtree Bank, which later became SunTrust. You all know the deal, SunTrust is something like the product of 9,000 mergers. And that’s how banking works, I guess.
Mike Blake: [00:06:22] You know, he was a great producer of both loans and deposits for the bank. Climbing the ranks to ultimately become a group vice-president for the commercial banking division. And in 2001, Bill’s group won the SunTrust Cup – the highly coveted, I imagine, SunTrust Cup – for being the highest performing commercial bank group in the company. He worked in community banking, becoming a top producer for Ironstone Bank, et cetera, et cetera. So, Bill really knows what he’s talking about. Over the last 11 years, Bill has been the profitability coach. A recovering commercial banker, he has served over 200 clients in the last year by delivering results – I don’t know if it’s last year or not. He’ll clarify it. I think it’s more than that – by delivering results oriented insights, helping them to make financial – to take them – sorry – from financial confusion to financial clarity.
Mike Blake: [00:07:15] Bill currently sits on the board of directors for Pinnacle Bank. He also hosts a monthly podcast, ProfitSense, which features stories of successful business owners and the professionals that advise them. When Bill is not working, you can find him on the golf course, gardening, spending time with his family, and leading a small group at his local church. Bill McDermott, welcome to the program.
Bill McDermott: [00:07:37] Mike, thanks so much for having me. I’m excited about talking about the topic. And, yes, the repo man spent time either collecting payments at the local furniture factory. I did move to Kinston, North Carolina, which is tobacco country. So, back in the day, I was known to collect past due car payments from some of the tobacco workers coming out of the field. I had a cash receipt book and collected those payments. Or I did have to repossess a car, too, in my day. So, back then, they thought you had to figure out a way to collect loans before you could make them. So, I did survive that, by the way, as proof of me being here, right?
Mike Blake: [00:08:26] Yeah. You know, otherwise, I have to say, this podcast is sponsored by Weegee. So, clearly you’re here to do it. But, you know, when we were talking off air, you told me something that I thought was fascinating that makes all the sense in the world to me. And that is, you said that before they let you lend money, you’d have to collect it.
Bill McDermott: [00:08:47] Yeah. And so, essentially as a banker, you have to know the characteristics of a good loan from a bad loan. And so, you learn the bad loans first. Unfortunately, you learn what not to do before you learn what to do. And the perspective of a banker in lending money from a banker’s point of view, everything is about risk. A lot of people don’t really understand that a bank really only makes about a 4 or a 5 percent gross margin. They’re leveraged about 10 to 1. So, they don’t really have much room to make mistakes given that margin and given that leverage position. So, it is risky to be in the money lending business. Plus, they’re not loaning their money. They’re loaning their depositor’s money. They have to be sure that they get that money back so that can take care of their depositors as well.
Mike Blake: [00:09:49] You know, I’m probably going to set a record here, I’m going to rip up the script before I even get to the first question. But that is, you know, I think what that would teach you, they talk about the C’s of borrowing. I can’t remember if it’s four or five C’s, but I recall that one of them as character. And that must teach you a lot about the character part. And I wonder if some of that is getting lost. You know, banking, like everybody else, is now in data analytics. But, you know, it’s hard to do that with character. And I’m curious if you have a view as to whether or not maybe that one of the C’s is now getting lost a little bit because, one, they’re not making people learn how to collect money and see borrowers face-to-face before they lend it. And, two, if they were so focused on analytics where, you know, maybe sometimes we go a little bit overboard.
Bill McDermott: [00:10:42] Yeah. And so, I think another point – so I think you’re spot on in what you’re saying – character, the average banker right now that is interfacing with a business owner client typically has not had any form of credit training. And I’m generalizing here, but most bankers below the age of 40 may not have had any formalized credit training. And so, they might be able to evaluate character, but they also may not. The other thing is, there was a time when the banker you met with face-to-face had the authority to approve the loan. Now, the approval process is the salesperson meets with that business owner, gets the financial information, takes it to the credit approver. Well, the credit approvers kind of like the Wizard of Oz behind the green curtain, pulling all the levers, but never himself or herself gets the opportunity to determine the character of that borrower.
Mike Blake: [00:11:53] And I mean, you know, you really can’t know it. We try to get a view of it, of course, with credit history, but that’s only one piece of the deal. But anyway, we do need to get through these questions. But, you know, I just love talking about this stuff, and I could for a long time, but we do need to get into it. So, I’d like to start at a very basic level. And that is, you know, talk about what you see currently as what is more or less a typical borrowing process. And does that vary a lot or can you generalize it fairly widely that most lending programs or lending entities, including banks, follow that?
Bill McDermott: [00:12:32] Yeah. At a high level, there are some commonalities. I think the first thing is, a business owner has to put together a loan package. That loan package is generally going to have three years worth of historical financial information. It may have the most recent interim financials. You know, we just finished January, so a January balance sheet and an income statement. It will include a personal financial statement of any owner that has more than 20 percent ownership. Because a bank looks at the people that make up the ownership of the business. Yes, they are loaning to the business. But, generally, that business is a reflection of the people that are running it.
Bill McDermott: [00:13:23] So, first part is the loan package, Mike. The second part, generally, a credit interview. Again, as I mentioned, banks are looking at everything in terms of risk. So, they will have analyzed those financials. They’re going to have some underwriting questions, what’s going on in the business. But, yeah, to your point about the C’s, there are 5C’s as they’re going through that interview. They’re going to be evaluating the character of the borrowers. They’re going to be looking at the cash flow. Does the business have the ability to pay it back? They’re going to be looking at credit score. Generally, the business owner’s personal credit score is the proxy for the business. They’re going to be looking at collateral. Do they have the ability to secure the loan?
Bill McDermott: [00:14:10] And then, the last thing has nothing to do with the business or the business owner. But they’re looking at conditions, specifically economic conditions. So, we just are, hopefully, on the tail end of a pandemic. But the economic conditions and the economic uncertainty have played a big role in bank’s willingness to loan money in the current economic environment. And so, credit has tightened because conditions of economic uncertainty have tightened. But that’s generally the process, one package, credit interview, evaluating the 5C’s. It’s really important for the business owner to have a clear request. And it’s also very important for the business owner to have a compelling case. Why should the bank loan them money? How does the company present itself in terms of risk? And if there are any risks, can those risks be mitigated to help the bank approve the loan?
Mike Blake: [00:15:14] So, I’m curious because you’ve talked about banks tightening lending standards. And a lot has been made around Fed policy, not just now, but really starting in 2008 when we entered the quantitative easing phase and, all of a sudden, quantitative easing entered the jargon. And as a person who’s a trained economist, that scared the living you know what out of me, because you’re not supposed to be able to do that. It turns out, at least for now, you are. But there’s a paradox that’s happened, I think, and I’d love you to comment on it, which is, things like quantitative easing, things like lowering the discount rate, i.e., the Fed rate, is supposed to make more money available for lending. But, you know, it’s one thing to make more money available. It’s another for the bank to feel comfortable. They’re going to actually get that money back, right? And those two things don’t always flow together and cooperate the way that, I think, policymakers would like.
Bill McDermott: [00:16:19] Yeah. And so, let’s go back to 2008, 2009. Quantitative easing was to make more money more available. But, frankly, banks had capital calls. They had liquidity calls. There was a huge devaluation of real estate. Banks had to actually reset their portfolios. And, frankly, Mike, there were a lot of bank failures because of that. They were undercapitalized. There were cease and desist orders. Banking is a highly regulated business to protect the depositors, of course. And so, you had to record bank failures. So, even though banks are supposed to always be healthy, the level of real estate lending caused a lot of banks to become undercapitalized. And so, the quantitative easing really didn’t help, primarily, because it was the banks that were in poor financial position at that moment, which created a huge consolidation during that phase.
Mike Blake: [00:17:25] So, I’m going to combine kind of two questions here, because I think it just flows better. And that is, you know – well, actually, let’s do it this way. So, my next question is, when you’re lending money, do banks care as to the reason – you know, are they going to ask what you want the money for? And if so, does the answer matter as long as, maybe, there’s enough collateral cash flow or whatever? And what are some good reasons to borrow money and what are some not so great reasons to borrow money?
Bill McDermott: [00:18:04] Yeah. So, that’s a great question. And the answer is, do banks care about what the money is being used for? Absolutely. Unequivocally, yes. As a matter of fact, banks have very specific lending policy that says, I will loan into these situations. I will not loan into these situations. So, for example – you know, appropriate reasons for borrowing money. And I’m going to go back to your circular saw, which I thought was a great example. Circular saw used well from a banking point of view, having a line of credit for a business eases the cash flow bumps. You know, all business owners have generally erratic cash flow. It can either be feast or famine. Having a line of credit helps those famine times by having cash available to insert into the business’s purchasing fixed assets, a business that may need equipment, may need vehicles.
Bill McDermott: [00:19:11] Fixed assets also include real estate, a lot of businesses will buy a building and lease it to their company. So, all of those things – one more, acquisition. You know, one company wants to buy another company. So, certainly those are things that banks would say yes to and are good reasons to borrow.
Bill McDermott: [00:19:34] Two things that come to mind reasons you wouldn’t want to borrow money – and banks would probably not look favorably on that – is, you don’t borrow money to fund losses. If your business is losing money, borrowing money to fund losses is like pouring gas on a fire. It’s an accelerant. The other thing is, there are business owners that like to look at their business as their own personal cookie jar. They take a lot of distributions. And so, banks are not really interested in loaning money to fund the business owner’s lifestyle. So, those would probably be two reasons why a bank wouldn’t lend money to either fund losses or fund distributions.
Bill McDermott: [00:20:23] Another thing would be, banks probably wouldn’t finance anything that they consider to be of speculative nature. And, again, coming from a very conservative point of view, based on the leverage and the gross margin that I mentioned, what I would define as speculative as an entrepreneur and what a banker defines as speculative are really two different things.
Mike Blake: [00:20:48] So, I imagine you have too, but you tell me, you do run into people that are just ideologically opposed or even borderline phobic of debt, right? And they’re proud of the fact that their balance sheet has no liabilities to it. And, you know, what do you think of that attitude? And is that a healthy attitude? Or is that attitude actually creating costs of its own?
Bill McDermott: [00:21:16] Yeah. So, I have a client who’s a professional services provider, she is totally opposed to borrowing money. As a matter of fact, now that I think of it, I have two clients. They don’t believe in using debt. If there is a capital call in the business, they’ll fund it out of their own pocket or fund it out of profits. And so, I’m not really sure. It’s kind of a choice. I would say it’s a little unhealthy and the reason is, primarily, there is a cost associated with that. All businesses need to have access to capital from time to time. And so, for a business to be opposed to debt, they’ve just taken one thing off the table in terms of having access to capital that they won’t use.
Bill McDermott: [00:22:12] And then, the other thing, I think, not having access to that capital, their ability to grow is going to be limited to how much internal cash that they can generate in order to accommodate that growth. So, yes, there is a cost to that attitude. I think it can be limiting. But as far as whether it’s healthy or not, I certainly respect people’s choices. But I think, as with anything else, choices have consequences.
Mike Blake: [00:22:40] So, a term you used earlier today that I want to make sure that we talk about, because you can’t really have a discussion about debt without it. What is the difference between a loan and a line of credit? And when is one more appropriate than the other?
Bill McDermott: [00:22:59] Yeah. So, a loan, in its purest sense, is really a sum of money that is put out there. And the structure of that loan really determines the difference between a loan and a line. So, there are actually three types of loans. The line of credit is one, you borrow, repay, reborrow. And it’s great for handling short term cash flow. The other two types, of course, there’s a term loan. Term loans you use to borrow for equipment. And then, the third is a mortgage loan, Mike, which are used primarily again to purchase real estate, which then is leased back to the company. So, loans fit into three categories really just depending on what the money is used for and then how it’s structured for, short term versus long term.
Mike Blake: [00:24:01] Okay. Now, banks aren’t the only lenders. I think, a lot of people, when they think loans, they think of banks. Or, you know, they think of the loan shark who has the big fur coat is going to break your kneecaps if you don’t pay back. But there’s a lot in between those two, isn’t there?
Bill McDermott: [00:24:22] Yeah. There really is. So, you know, if I’m going to walk down a balance sheet for a business owner, I’m always going to look at bank debt first. Because the accounts payable are a way of financing the business. But as far as actual bank financing or non-bank financing, it’s the cheapest source of capital, the interest rates are lower. But banks are basically loaning against the balance sheet and the income statement of that borrower. If they lost money last year or their balance sheet is leveraged generally more than about $3 of debt to every $1 of equity, they’re going to have a hard time. They can get a loan, but generally not beyond that.
Bill McDermott: [00:25:15] So, for somebody that lost money last year or has a leveraged balance sheet, there are asset-based lenders. Asset based lenders don’t care about the balance sheet. They don’t care about the income statement. All they care about is the collateral. And so, if you have $100,000 in accounts receivable, you should be able to loan or borrow about 75 to 80 percent of that. But it carries a high interest rate. Generally, there’s 1 to 1-1/2 percent per month service charge and then there’s money usually at about prime plus two, prime plus three on top of that. So, 1 percent a month for 12 months is 12 percent interest, prime plus three is another 6 or 6-1/2, so all of a sudden, it adds up quick. Mike, that’s an 18-1/2 percent loan you’re up to credit card rates.
Bill McDermott: [00:26:12] Also, I’m going to say there are some – what I’ll call – payday lenders. Honestly, I think they’re borderline predatory lenders. There are some people that will loan you money, but they ask you to pay a piece of it back every day. And sometimes the annual percentage rate on those loans can be in the 30s, even in the 40 percent. It’s absolutely borderline criminal, in my view. Not to say anything disparagingly about those lenders. I’m sure they serve a purpose. But at such high interest rates, it’s incredibly difficult for a business owner to sustain their business. Because a lot of times. those interest rates exceed the gross profit that the business is even generating.
Mike Blake: [00:27:02] Yeah. And, you know, payday loans and their ilk are kind of interesting. I mean, I’m generally a free market guy, but I also enjoy studying the psychology of decision making. It’s why I do this podcast. And one of the things I’ve learned about decision making in crisis – and it almost doesn’t matter if it’s a financial crisis or physical crisis or something else – I’ve seen empirical studies that show that when a person is in crisis, the average person has a functional IQ reduction of between 10 to 15 percent in the midst of that crisis.
Mike Blake: [00:27:44] So, in effect, when you’re in a crisis, most people become dumber because the nature of the crisis makes you tunnel visioned. It makes you focus on how do you solve the problem today the most painlessly, even though you’re creating a problem ten times bigger that you have to confront a week from now. But the psychology of crisis leads you into that decision. So, you know, whether that means that’s predatory, I’m not sure. And I’m not afraid to say, this in my view, it does call for some regulation because you’re selling to what is effectively an impaired market. It’s fine to say that people are free to make their own decisions, but when there’s data that shows that your market, by definition, is cognitively impaired by the very thing that’s leading it to come to you, there’s a clear conflict of interest.
Bill McDermott: [00:28:43] Yeah. And I think at that point, the business owner in crisis has ultimately a concern that his or her business is no longer viable. And so, they will go to almost any length in order to make sure that their business stays viable. And so, I’m a big believer in the good, fast, cheap – pick any two. If it’s good and if it’s fast, there is no way it’s going to be cheap. But I do think predatory lending goes to the end extreme. It’s not really good, it is fast, but you’re paying exorbitant interest rates for that speed.
Mike Blake: [00:29:29] Yeah. And, frankly, in that kind of scenario, you really should be looking at equity, right? And you talked about funding losses. It’s not as if there isn’t a financial vehicle out there to help you. It’s just that debt is the wrong tool. If we take the circular saw, if you’re in crisis, you’re basically trying to cut a ham sandwich with a circular saw. And all you’re going to do is get a messy kitchen if you try to do that. But on the other hand, if you’re using equity, you’re using a nice little Wusthof knife to cut that sandwich, yeah, it’s going to be more expensive, but it’s the right tool for the right job.
Bill McDermott: [00:30:09] Yeah. No question. So, the nice thing about debt, debt magnifies gains, but the downside is debt also magnifies losses. So, people that use debt are able to grow quicker. But people who use debt when they’re funding losses, it magnifies those losses as well, because you’re basically borrowing money that you can’t pay back and the interest expense pushes your breakeven point even higher. So, you’re, in effect, borrowing into your future when your future is actually trending negatively.
Mike Blake: [00:30:48] So, you know, there are nonbank lenders out there, and not just the asset based lenders, but there are mezzanine lenders. And maybe you’re talking about the same thing – if you are, feel free to correct me. But, you know, lenders for subprime borrowers, I think, if I’m not mistaken, there’s a group out there that they’re not payday lender types, but they’re also are credit that’s available at a higher interest rate that is not bankable from a banking standpoint. Right? So, you know, what are those groups like? And, you know, are they legit? Is interfacing with them similar or different from that with a bank? What does that world kind of look like?
Bill McDermott: [00:31:38] Well, necessity is the mother of invention. Access to capital for business owners has been critical. We went through a period of time where banks were somewhat unhealthy. I think banks are healthy now. But over the last ten years, quite a few nonbanks have entered the market. Possibly the benefit is, they don’t necessarily have to chin to the same regulatory environment that banks do. And so, yeah, I think there are some viable entities out there that can provide capital. They actually require sources of funding. They probably go to the public markets, borrow that money, and then loan it back out on a spread. But, no, I think there are viable options out there that nonbank lenders provide and have kind of helped give business owners access to capital that banks either can or can’t provide, given whatever the prevailing economic factors are.
Mike Blake: [00:32:51] So, once you get into the lending world and all the financial world at all, you’ll start to hear terms like senior debt, junior debt, subordinated debt, can you quickly give us a vocabulary lesson. What do those things mean relative to one another?
Bill McDermott: [00:33:05] Yeah. So, first, senior debt is in the senior position, so it’s the highest of the debt positions. Typically, senior debt is predominantly bank debt. There are a lot of growth companies out there that have lending requirements behind that. Then, generally, junior debt means that it is subordinate to the senior debt. That junior debt is also mixing terms here. But subordinated debt, it’s actually debt that exists under the senior debt. It accomplishes some great things. First, for that growth company, they get access to capital. The senior debt looking at that junior subordinated debt underwrites that debt as if it were equity.
Bill McDermott: [00:33:59] And so, for a senior lender’s point of view, that junior debt gives them extra comfort that there’s cash behind their debt that is also capitalizing the business. From the junior subordinated debt, they provide a very viable access to capital that the senior debt holder is unwilling to provide. But, yeah, all you’re really doing is looking at banks in the senior position. Junior debt and subordinated debt are those institutions that provide capital subordinate to that senior position.
Mike Blake: [00:34:42] So, I wonder if this is true or I’m speculating here, is there also kind of an emotional comfort component that if you’re a senior lender and you know that somebody who’s willing to come in and be a junior lender, that it just sort of validates your judgment?
Bill McDermott: [00:35:00] Yeah. Absolutely.
Mike Blake: [00:35:01] It’s not out there on a limb, right?
Bill McDermott: [00:35:03] Yeah. And the the other thing is, if for one reason or another, that senior debt holder decides that maybe they’re wanting to exit that credit, there is a junior position behind them who may be willing to take them out if they decide to exit. So, it really gives the senior debt holder an opportunity to be taken out, if needed, from the junior subordinate. It gives them the opportunity, potentially, by taking that out, they become the senior debt holder and then that allows other juniors to come in under them.
Mike Blake: [00:35:47] I want to switch gears here, you know, I’d like to talk about the intersection and interdependence, if there is any, on personal credit versus corporate credit. I mean, there must be at some point, I guess, but you tell me where it is. You know, where is the point where lenders make a distinction or stop making a distinction – maybe that’s easier – between the company as a borrower and the owner as a borrower? You know, is there a separation between the two? Or as far as lenders are concerned, are the buyer and the company the same thing? And so, you know, does the credit score of one impact the other? How are those two things linked, if at all?
Bill McDermott: [00:36:40] That’s another great question. So, generally speaking, a closely held business where the ownership is closely held, usually concentrated in anywhere from, maybe, one to three or four partners, the personal credit score of either that individual or individuals, in effect, is the business credit score by proxy. And so, the credit worthiness of that business is, frankly, dependent on the credit score of those individuals. When you get to businesses that aren’t closely held, the ownership is widely dispersed. Publicly held companies, for example, where the ownership is widely dispersed, they have access to sources of capital outside the market. Those businesses usually have their own credit score. If they’re publicly traded, they’re going to have a rating by S&P or Moody’s. They may have a rating by Dun and Bradstreet. So, in those cases, those businesses have developed their own credit score, no longer relying on the ownership because it’s so widely distributed. So, the intersection is, once a closely held business becomes publicly held, the owner’s credit score is no longer.
Mike Blake: [00:38:07] So, sometimes I hear from borrowers that they’ll say, “Well, you know, the bank wouldn’t lend me money if they didn’t think I can repay.” And, to me, that sounds like a little bit of a dangerous statement, because I think you’re kind of offloading too much responsibility to the bank to make the right decision for you. But I like you to respond to that. I mean, can you take some comfort even if you, yourself, have, maybe, misgivings? And maybe we’ll take that person that’s kind of debt-phobic as a good example. Is the very fact that a bank is willing to lend money to you, is that somehow self-validating for the company?
Bill McDermott: [00:38:48] Yeah. So, when I was in banking, the knock on bankers to your point was, “Oh, gosh. Banks just loaned money to businesses that don’t need it.” And so, that is a prevailing thought out there. However, the reality is 80 percent of a bank’s income comes from lending money, Mike. So, if banks don’t loan, they can’t. So, bottom line, I think someone who says that could be maybe that person that got declined, primarily because there was a factor within those 5C’s. You know, maybe they didn’t have sufficient cash flow. Maybe their balance sheet was a little too leveraged. Maybe they were wanting to borrow the money for a speculative purpose. And it just made the sum total of those things unbankable.
Bill McDermott: [00:39:53] Also, I will say, because of COVID, there are a lot of good businesses in a good economic environment were able to borrow money, but not able to borrow money in a COVID type environment. So, the economic conditions also play big into that decision.
Mike Blake: [00:40:15] I want to go back to kind of the personal versus company kind of debt profile, if you will. How do personal guarantees work? Are most business loans to a small business going to require personal guarantee? Can you talk a little bit about how they work? And if I’m a borrower, should I be expected to provide a personal guarantee and what that looks like?
Bill McDermott: [00:40:42] Yeah. So, I got to take you back to my Peachtree bank days. So, I graduated from being the repo man, just beginning to do small business lending. And so, my boss, because the subject to personal guarantees came up, his comment to me was, Mike – and it really resonated to me – he said, “Bill, if a business owner isn’t willing to stand behind his or her business, why should I?” And so, part of that personal guarantee is, yes, a closely held business, 9.9 times out of 10, it’s going to require a personal guarantee for that very reason. If the business owner won’t stand behind their business, then why should the bank stand behind it?
Bill McDermott: [00:41:38] Interestingly, though, just yesterday, I had an email from an owner that I worked with. So, he was offered a six figure line of credit. It was at four percent. There was a 2-1/2 percent origination fee, but it was unsecured and unguaranteed. Now, it was not a bank. It was a nonbank, but the rate was attractive, the fee was high, but unguaranteed. I mean, that really kind of caught me off guard. So, I guess it is out there, but I have not seen it at a bank.
Mike Blake: [00:42:23] So, bottom line, be pleasantly surprised if you’re not asked for a personal guarantee. And maybe a question to think about before you even start the borrowing process is, be prepared for that question, right? And if you’re not prepared to make that personal guarantee, it may not be a good use of your time or the banks to even pursue the discussion.
Bill McDermott: [00:42:43] Precisely. You’re spot on.
Mike Blake: [00:42:45] Okay. So, how can borrowers evaluate their own attractiveness to potential lenders? Are there any kind of self-assessment tool that the borrowers can use to understand where they might lie and maybe try to improve their profile or their attractiveness before they start this process?
Bill McDermott: [00:43:10] Yeah. Such a great question. So, a lot of times, I talk to my clients that I’m working with about what it means to be bankable. And so, the quick answer is, if you lost money last year, you’re going to have a hard time borrowing money this year, because banks believe the best indicator of the future is the past. And if you lost money last year, you’re going to lose money this year. They won’t believe you until you’ve gone through a full year and made a profit. So, self-assessment, profitability. Absolutely.
Bill McDermott: [00:43:47] The second thing is leverage. How much skin in the game do you have in your business versus how much skin in the game your creditors have? If you have more than $3 of debt to every dollar of equity, a bank will consider you highly leveraged and that could cause an issue with your ability to borrow.
Bill McDermott: [00:44:11] So, probably the other things in a different profitability and leverage, if you consistently have low liquidity, not much cash on hand, the bank is going to have some concerns. The other thing is, if you’re not good at collecting your receivables and, frankly, you’re borrowing money to replace receivables that you’re either unwilling or unable to collect, banks are going to have a hard time doing that.
Bill McDermott: [00:44:41] So, I have a little acronym that I call PALL, Profitability, Asset Quality, which is how are you turning your receivables in your inventory, Liquidity, and Leverage. And so, a self-assessment going through PALL, which I do for my clients, I provide a business financial checkup. You know, each one of us gets a physical every year, but often business owners don’t put their business through one. So, we provide that as a service so that they know once a year what’s going on in their business. And it also helps them understand whether they’re bankable or not.
Mike Blake: [00:45:20] We’re talking with Bill McDermott, the profitability coach. And the subject is, Should I borrow money for my company? And, Bill, I just had a couple more questions before we let you go. But a question I do want to get to is, you know, so much of the economy now is a service firm, which means that they’re unlikely to have the kind of collateral that a manufacturing firm has. And I think it’s something that the banking industry is really wrestling with quite a bit. Can service firms borrow money or are there certain conditions under which they can or can’t?
Bill McDermott: [00:45:56] Yeah. And I think that is something that, maybe, has evolved over time. Mike, historically, service firms versus firms that deliver a product, it is a little more nebulous to understand the delivery of a service versus a delivery of a product. You can actually determine when that product has been delivered versus service. I think that has changed over time. I worked with a lot of professional services firms, architects, engineers, I have an interior designer, I have a psychology practice. All of those are providing services, but yet banks are willing and able to loan them money. So, the risk from the bank’s point of view is it’s easier to determine delivery of a product than it is delivery of a service. But I do think the banking industry has gotten comfortable with loaning money to service firms over the years.
Mike Blake: [00:47:00] Are there times when you work with clients that are thinking about borrowing and you tell them, “You know what? Skip it. Just put it on a credit card.” And if so, what does those look like?
Bill McDermott: [00:47:11] Yeah. You know, I would say for a newer business, just getting started, there’s really no credit history. General rule of thumb is to get a bank line of credit. They like to see at least three years of history to loan money. So, yeah, for somebody who’s just getting started, I would suggest get a business credit card. I know when I started, I got a company card through American Express. I do think it’s a great idea. Don’t do it on a personal card, primarily, because when it comes to borrowing money, you want a clear audit trail as far as loaning money for your business versus – excuse me – borrowing money for your business versus borrowing money personally.
Mike Blake: [00:48:06] Bill, this has been a great conversation. There are more questions I could ask, but we have limited time. Would you be willing to answer questions of people that may have a question that we didn’t get a chance to cover here? And if so, what’s the best way for them to contact you?
Bill McDermott: [00:48:24] Sure. And I would love to. Probably the best way to do that is go to theprofitabilitycoach.net. There is a prompt in there if they want to contact me. The other way is phone number, 770-597-3136. I always pick up the phone and answer unless I’m in front of a client. But, Mike, I launched this business with the goal of helping business owners become better financial managers. And so, first, I want to applaud you for even bringing up the topic. There is a lot of mystique around it. But the goal is, I want to give business owners financial clarity out of all of the chaos of what the options are and which is best. So, I’m always happy to help any business owner that wants to contact me.
Mike Blake: [00:49:24] Well, thank you. That’s going to wrap it up for today’s program. I’d like to thank Bill McDermott so much for joining us and sharing his expertise with us.
Mike Blake: [00:49:32] We’ll be exploring a new topic each week, so please tune in so that when you’re faced with your next business decision, you have clear vision when making it. If you enjoy these podcasts, please consider leaving a review of your favorite podcast aggregator. It helps people find us that we can help them. Once again, this is Mike Blake. Our sponsor is Brady Ware & Company. And this has been the Decision Vision podcast.
