Surviving The Loan Underwriting Process: Part One
Written by Mike Luebbers. Mike was Chief Credit Officer at Bridge Bank from 2015 to 2018. He was then Chief Credit Officer at Lighter Capital from 2018 through 2020. Lighter Capital was a pioneer in creating revenue-based lending. Mike is currently a consultant. LinkedIn
This is a three-part blog post. In Part One, we will cover Sections I through IV, Part Two will cover section V, and Part Three will conclude with Sections VI and VII.
A. Fact: The underwriting process can be frustrating to navigate
B. Also Fact: It’s often worth your time and effort
A. How to determine the right loan products for you
B. How to get through due diligence while keeping your sanity intact
C. How to impress the underwriter’s boss along the way
A. Highly-underwritten debt, not programmatically underwritten debt
B. Underwriting the company, not the guarantor
IV. Topic 1: Framing The Underwriting Process
A. How to view the process from the lender’s perspective
B. How to match different lending products to your specific cash needs
C. How to pitch to lenders who don’t really care if you become a unicorn
V. Topic 2: Running the Gauntlet
A. Hurdles and Gates: What info to gather at each underwriting stage
B. Detours and Switchbacks: Additional info requests for specific loan products
C. Pitfalls and Rabbit Holes: Preparing for the inevitable follow-up requests
D. Term Sheets and Commitment Letters: Understanding the difference
VI. Topic 3: Impressing the Chief Credit Officer
A. Pre-Funding: Be Transparent, Know Your Numbers, and Have a Plan B
B. Post-Funding: Be Proactive, Be Organized, and Be Professional
If you have ever attempted to get a sizable business loan for your company, you appreciate that the experience can be opaque at best, and downright Kafka-esque at worst. The lender’s underwriting process often entails multiple conversations, additional information requests, and seemingly endless back-and-forths, and that’s before you even sniff a term sheet, let alone begin negotiating specific loan terms.
☝️More on term sheets below, and their elusive cousin the commitment letter!
Perhaps more frustrating is the fact that the process rarely unfolds the same way twice. No wonder you dread the thought of it, like trying to run an obstacle course blindfolded while also spinning plates (that is, actually running your business).
☝️Now imagine trying to manage multiple competing underwriting processes at the same time... like riding two unicycles maybe?!
Having said that, the underwriting gauntlet is often worth running, as on the other side lies the ideal loan product to supercharge your company’s revenues, profits, and valuation, typically all without sacrificing ownership or control. And by the way, speaking as a career “credit guy,” there’s usually a method to our madness, as most of us are truly seeking an optimal outcome where you the entrepreneur gets the right loan product, the right amount, and the right price given your planned use of the funds, as this ultimately helps to limit the chances of things going awry down the road (i.e., payment issues and/or covenant defaults).
☝️The "right" price is obviously subjective, but in my experience, the lenders with the most superficial underwriting processes typically offer the most expensive loans, as they figure they'll make up for the bad loan decisions by charging good borrowers more.
As the old lending adage goes, lenders can make money by the thimbleful, but can lose money by the bucketful. No wonder we (I) take our (my) time to get things right before the money horse leaves the barn!
☝️Does anyone know what a thimble is anymore...?
The good news is that there’s a way to enter the maze well-armed and well-prepared for the inevitable twists and turns. Think of this white paper as both a map and a guidebook, listing all the things you’ll need in order to make it to the other side unscathed and well-funded.
We’ll help you determine the right type of loan product that is best for you so you can focus your time and get results faster, then we’ll walk you through both the core information requests you’ll always be asked to provide, plus the specific and additional requests you’ll encounter depending on the loan product you’re seeking and where your company is in its life cycle (i.e., start-up, growth mode, or mature). And finally, just for fun, I’ll let you in on a few secrets on how to impress curmudgeonly credit folks like me during the underwriting process, and how to stay in our good graces after you receive your loan proceeds.
Note that the scope of this paper is limited to what we’ll call “highly-underwritten” business loan products, such as Venture Debt, Non-Sponsored Bank Term Loans & Revolving Credit, and Asset-Based Loans. These tend to be larger loan facilities with more customized features and, ideally, lower costs to you in return. We’ll review more “programmatically-underwritten” loan products like MCA and Revenue-Based Financing in a separate post.
In addition, this paper assumes that your company is the one being underwritten and relied upon for repayment, not your rich uncle who’s willing to guarantee the loan and put up the family yacht as collateral. As you might expect, the stronger the personal guarantee and the pledged collateral, the more the process begins to resemble a personal loan application and not a business loan. The underwriting of “sponsor-backed” companies (i.e., companies with institutional investors like VCs and PE firms) represents an interesting gray area that we’ll explore a bit below, but since there is rarely a financial guarantee or collateral pledge from those investors, the lenders still “mostly” underwrite the company’s prospects to repay the loan in full and on time.
TOPIC 1: FRAMING THE UNDERWRITING PROCESS
Before we leap into the fire and examine the specific twists and turns to get from application to term sheet, let’s start with some warm-up stretches so you don’t trip up coming out of the gate…
How to view the process from the lender’s perspective. While every lender is different, they all focus on the same three steps: (1) source deal flow, (2) underwrite to a fund/no-fund decision, then (3) manage their funded deals.
☝️That is, both monitor existing loan repayment and consider future funding opportunities.
As you can imagine, lenders typically staff these three functions with different types of people. Understanding how these roles interact and influence the final underwriting decision can be helpful when managing your time and focusing your efforts between various term sheets.
Sales. No surprise here, but the salesperson’s job is to generate revenue by bringing in new deals. They are directly compensated for closed deals, typically calculated based either on the committed loan amount or the estimated deal profit (i.e., the expected interest and fees less the cost of funds). As such, they’re incentivized to maximize your interest in moving through the first stages of the underwriting process. However, salespeople are also motivated to bring in the right types of deals, i.e., companies that have strong financial performance and stand the best chance of successfully making it to the end of the process.
☝️In an effort to further align sales incentives and credit risk, some lenders will even hold back a portion of the salesperson's commission until the loan performs satisfactorily for a certain period of time.
Good salespeople tend to have a solid understanding of the lender’s desired credit risk profile (more on this below) and will want to gather enough upfront information to make sure your company is a good fit, since that will help ensure they’re not wasting your time, their time, or the underwriter’s time.
On the opposite end are lenders with either unfocused or inconsistently-applied credit risk policies, or with inexperienced and/or unskilled sales staff who don’t fully understand their risk tolerance, such that the process often devolves into a disorganized, spaghetti-on-the-wall approach. These lenders and salespeople tend to over-promise, under-deliver, and in general, exhaust your valuable time.
Underwriting (aka Credit). Once the salesperson shepherds the deal through the initial client fit stage, the underwriter jumps into the fray. Underwriters are ultimately responsible for assessing the risk of the deal, recommending whether to proceed with the transaction, and if so, under what specific loan structure (e.g., loan product, amount, term, and risk-adjusted pricing). Whereas the salesperson is charged with making money for the lender, the underwriter is trying to ensure that the lender doesn’t lose money (see thimble-and-bucket comment above). This fundamental checks-and-balances approach to lending leads to what a mentor of mine called “healthy tension” between the Sales and Credit teams, where effective salespeople act as champions for their prospective clients and effective underwriters seek prudent lending decisions that match up clients’ intended use of funds with their prospective sources of repayment.
The Credit team is typically led by the Chief Credit Officer (CCO), who helps ensure the lender stays within its desired aggregate risk appetite. CCOs do this by establishing, maintaining, and enforcing a complete set of credit policies and procedures, including a matrix of acceptable borrower risk metrics and loan structure parameters commonly referred to as the “credit box.”
☝️Although lenders' credit box definitions will vary widely, a simple setup might require that a prospective client clear minimum cash flow, liquidity, and collateral hurdles in order to qualify for a loan, with the resulting risk score driving the max loan amount and min interest rate.
The CCO’s key challenge is balancing these policies and procedures with the lender’s sales goals, since if they’re too draconian and/or restrictive, prospective clients will abandon the process and/or reject the resulting offers in favor of a more amenable lending partner. Good CCOs generally foster and facilitate strong internal lines of communication between Sales and Credit to make sure that the structural tension is in fact healthy and not destructive, either because Sales is pushing deals way outside the credit box or because Credit is interpreting credit policies and procedures too strictly.
Loan Servicing and Portfolio Management. From the entrepreneur’s perspective, it’s completely understandable to think of the loan funding as the end of the process, but from the lender’s perspective, the journey has only just begun. Until the last dollar of the loan principal is repaid, the CCO and Credit team stay involved in the deal in some capacity. This function can range from simply processing loan payments, to passively monitoring ongoing compliance via receipt and review of updated financial information, to actively managing the relationship through real-time updates to borrowing base availability.
Loan Servicing tends to act as the operational arm of a lender and is generally concerned with routine procedural tasks such as calculating and collecting monthly loan payments, as well as generating loan statements. Portfolio Management is involved with tracking the ongoing financial performance of the borrowers, beyond simple payment compliance, by way of collecting and analyzing updated financial statements, agings, inventory reports, and other required reporting items.
Although Portfolio Management usually rolls up to the CCO as a credit risk management function, good lenders will also utilize this area to proactively identify strong financial results potentially warranting better terms and/or additional financing. In the last section of this white paper, we discuss this important and often overlooked part of the process in more detail.
How to match different lending products to your specific cash needs. You have a finite amount of time, so you want to focus your time on the types of products and the lenders that are going to be the best fit. The first step in this process is to really understand your capital needs. ‘I just need $2 million’ isn’t a good enough answer. In which future months do you need the money? Do you need the money to finance one big immediate cash need or a series of smaller cash needs spread out over several months? What is the incremental cash flow that this cash need is expected to generate, and how long until you see that cash flow?
The Bainbridge Field Guide to DTC Capital is required reading at this stage. Have a good model of your future cash needs and read the Field Guide so you can target the right products and providers.
☝️Hint: The right product fit is not just about the dollar amount and the interest rate!
How to pitch to lenders who don’t really care if you become a unicorn. It’s common knowledge that most VCs and other equity investors lose money on the majority of their portfolio investments, and rely on a few stellar companies with huge market exits to offset those losses and provide for an acceptable total portfolio return. That’s why investors prioritize upside drivers in their analysis, such as the size of the total addressable market (TAM), client acquisition, top-line growth, and scalable operations.
Most lenders, on the other hand, don’t benefit from that kind of upside return on individual deals, since they rely on interest and fee income and rarely take a meaningful ownership percentage as part of their deal structure. Since the upside potential is limited on all deals, underwriters need to make sure they also limit the principal loss potential on every deal. That’s why lenders prioritize downside protection in their analysis, such as defensible market position, client retention, supply-chain stability, and liquidity cushion.
As a result of this fundamental difference in the “return spectrum” between equity and debt, loan underwriters really only have two tools at their disposal to limit losses: (1) underwrite to the downside scenario and/or (2) structure more conservatively. Since the former limits the pool of available loans a lender wants to win and the latter limits the number of loans a lender will actually win, most underwriters choose to focus on more deeply understanding the risk that prospective companies will default on their loans.
☝️For example, offer less principal, faster amortization, and/or tighter financial covenants and controls.
For example, let’s pretend there are two companies selling similar consumer products:
- Company A targets its products to a small, slow-growing market that is fiercely loyal. It currently averages $1 million per month in sales. It buys inventory from small suppliers and sells at a decent mark-up. It enjoys stable profits. Ownership loves managing the business and has no plans to deviate from the status quo.
- Company B targets its products to a huge, fast-growing market of price-sensitive end users. It also currently averages $1 million per month in sales. It buys inventory from large suppliers and sells at razor-thin margins. Profitability has been spotty due to ramped-up sales & marketing expenses to drive future revenue growth. Ownership intends to go public within the next two years.
Now, based on your hunch of the upside and downside potential of both companies, which one do you think has the wider range of outcomes? If you were a VC or PE firm, which company would you prefer to finance? Would your answer be the same if you were a debt provider offering three-year money at 12%?
The moral of the story is that it’s important to understand your audience when making a capital request, whether equity or debt. It’s always completely appropriate to lay out the upside potential of your company, including how the requested capital will accelerate your growth story and increase your odds of successfully executing on your strategy. However, when pitching lenders in particular, don’t forget to also highlight the downside protections you’ve built into your business structure!
Quick aside: There are an increasing number of fintechs and boutique lenders who like to position themselves as a hybrid between investor and lender. They focus on unique and flexible loan products that don’t dilute ownership but do offer higher potential yields by tying repayment to a percentage of your future revenues. In other words, the better you do, the better they do, since they get their principal and profit returned more quickly.
As a prior CCO at one of these firms, I love the win-win potential they offer, but the reality is that the upside potential of these loan products is still capped by the maximum documented return multiple (e.g., up to X% of the initial principal balance), which is almost always well below the maximum loss potential (i.e., the principal itself). In other words, these lenders still have to worry about the loss potential of every single deal they do.
In Part Two we will cover how to run the gauntlet of information requests.