Surviving the Loan Underwriting Process: Part Two
RUNNING THE GAUNTLET
With that background context in mind, let’s enter the Thunderdome!
Hurdles and Gates. The best way to think of the underwriting process is as a series of stages, each with its own steps to complete and hurdles to clear before the gates open to the next stage. Regardless of the “highly-underwritten” loan product contemplated, most lenders utilize some variation of the following three-stage approach to underwriting: Discovery, Initial Analysis, and Due Diligence.
☝️ You could technically add a beginning stage called Screening and a final stage called Closing, but typically the underwriter isn't materially involved at either of these stages. The Screening stage usually consists of an inbound application and quick company website review to ensure a high-level fit, and is more a function of the lender's Sales & Marketing teams. Then, in the Closing stage, which happens once the underwriting and structuring are completed and the term sheet is signed, the underwriter usually moves on to the next deal, leaving the final legal negotiation to the relationship manager and legal counsel. It's probably fair to think of this last stage as its own separate mini-gauntlet (or circle of purgatory!), so we'll cover that in a separate post.
At the heart of this traditional gating system is a simple concept: Opportunity Cost. Not only does the lender want to efficiently allocate their limited underwriting resources to the deals with the best chance of closing, but they also appreciate that your time is finite and that, if they can’t offer you credit and win your business this time around, they’d prefer to let you know that as soon as possible so as not to waste your time, thereby increasing the chance of getting another shot at your business down the road.
☝️ There are actually two ways this should be read: (1) the deals with the strongest credit profiles and (2) the companies exhibiting the strongest intent to close. At the risk of exposing my glass-half-empty demeanor, the truth is that lenders put the gates in place to make sure that both low-credit AND low-intent companies don't make it through.
Discovery: The primary objective of this stage is to quickly determine if your company is a potential fit for the lender and their loan product offering. Or, said more bluntly, whether there are any obvious deal-killers that put you too far outside the lender’s credit box to warrant additional analysis.
☝️ My former mentor was an avid golfer and would often ask if a prospective borrower was "in the fairway" or "in the rough," meaning did it fall squarely inside the credit box or did it exhibit risks that warranted more analysis. Think of the Discovery stage as trying to determine if the deal is "out of bounds" and therefore unplayable, meaning that it's just too far out on the risk curve.
In this stage, lenders will start by reviewing your website, asking some basic questions, and requesting high-level company information and summary financial statements (see table below for more details). The intent is to get a sense of what the company sells, who it sells to, and how well it’s doing in those efforts.
☝️A lot of lenders will ask for stats like client retention, CAC, and inventory turnover, then use your self-reported numbers to start to rough out the risk of the deal. Don't be surprised if and when they ask for reporting to validate those numbers later in the Initial Analysis and Due Diligence stages.
If that information suggests you’re a potential fit, you’ll be moved to the Initial Analysis stage. Depending on the situation, the lender may provide you with some basic and informal ideas around a potential loan structure, like estimated amount and specific loan product(s). This is as much a sales tool as it is an underwriting tool, as you may be a good fit for the lender but not at the dollar amount or loan structure you’re envisioning. A good lender will be transparent as to the range of outcomes you’re likely to experience post-underwriting in order to avoid confusion or frustration later on in the process.
If the information suggests you are not a good fit, it’s usually a point-in-time issue with your financial performance (e.g., you’re currently experiencing losses or your debt-to-equity ratio is too high), in which case a good lender will (1) succinctly explain the reasons for the declination, (2) provide you with some concrete steps, actions, and timelines they’d need to see in order to take another look (e.g., a return to profitability measured over the next six months), and (3) refer you to other capital providers who are better-suited to your current situation and cash need.
☝️If you've ever been declined during the Discovery phase, it can be frustrating and maybe even a bit of an ego-hit. Keep in mind that all lenders have a wide range of risk philosophies and return objectives, so a decline typically isn't an indictment of your business plan, execution, or leadership. Lenders often have internal limits on how many deals they can do in a specific sector or geography or product type, and sometimes lenders have specific limitations on how loan proceeds can be used, for example barring acquisition financing or partner buy-out requests. As noted, most of the time the decline is not a "never" but a "not yet."
In fewer instances, the lack of fit might be due to some fundamental mismatch that permanently disqualifies you from consideration, like a prior financial crime conviction or offshore ownership that legally precludes the lender from securing your assets as collateral. Lenders try to uncover these fundamental deal-killers during the Screening phase (i.e., before the underwriter is involved), typically by asking you to disclose this information in an upfront application.
☝️More on self-reporting in the last section of this paper.
Table: Discovery Stage
Initial Analysis: As noted above, when you make it past the Discovery stage it’s because the lender thinks there’s a potential fit based on your high-level financial performance and how you plan to utilize the loan proceeds. The Initial Analysis stage is trying to confirm that you are indeed a good fit for the lender. Said another way, while the Discovery stage is set up to determine that there are no obvious reasons not to do the deal, the Initial Analysis stage is designed to confirm that there are obvious reasons to do the deal.
To get to that decision point or gate, the lender is trying to (1) uncover, categorize, and rate “all” material risks with your business and financial performance and (2) model how your company is likely to perform in the future, in order to (3) determine that your repayment sources are in fact strong and then (4) craft an appropriate loan structure (i.e., loan product(s), total amount, pricing, term) that aligns with those repayment sources. To accomplish this, the lender may start with an in-depth interview in which they ask questions based on their preliminary findings from the Discovery phase. They’ll then follow up the call with a laundry list of requested financial information that will be needed to complete their analysis.
☝️If you ask, most lenders will provide you with a complete underwriting checklist during the Discovery phase, if you're curious of the total lift and/or confident enough to want to jumpstart the gathering process. One of the ways that fintechs and tech-enabled lenders are trying to streamline the process is by requesting upfront direct access to your accounting, banking, and eCommerce platforms so they can immediately jump into the Initial Analysis and Due Diligence stages with minimal lift on your side. The obvious caveat here is that you must be confident in the lender's privacy safeguards and reputation in the market before granting access to your sensitive information.
If the underwriter gets through that process and determines that you are a good fit, then the usual output is a term sheet that describes the proposed loan structure in some level of detail. In “most” instances this is a strong indicator the lender is confident you meet their credit criteria and they can deliver on the proposed loan structure.
☝️ More on this below in the Term Sheets and Commitment Letters section.
Most lenders will require that you sign the term sheet before they’ll move you forward into the Due Diligence stage, and they may require that you provide them with some upfront money needed to finalize their analysis. Again, there’s both an opportunity cost and a real cost to the lender of engaging the underwriter’s time and any third-party agencies to complete the process, so lenders want to be confident that you’ll actually take the loan before they proceed.
☝️ This also includes understanding who are your final decision makers, as many times the lender will be dealing with a CFO or a CEO who reports to a Board or requires final sign-off by the primary business owner before proceeding.
If you don’t make it to a term sheet, it’s usually because the sum of the financial parts didn’t add up to a good fit, as opposed to any single financial metric being a deal-killer. I appreciate that this may seem borderline crazy, since you already passed the Discovery stage where the high-level financial metrics were reviewed, but there are a couple points to keep in mind:
1. The Discovery stage is typically based on yes-or-no application questions and quantifiable point-in-time financial metrics, given the limited time and information with which to make the decision.
☝️ And therein lies the rub...like every other decision-making process, underwriting is a trade-off between time and information. Technology is helping lenders to obtain (and interpret) information more quickly, but it's also introducing a new variable: data security.
In contrast, the Initial Analysis stage allows the underwriter to fully access and analyze detailed historical financial trends and strategic forecasts, then overlay and incorporate nuanced qualitative assessments of the business environment in order to assess your company’s overall odds of successfully paying back the proposed loan. It’s the synthesis of these quantitative, qualitative, and in-motion variables that ultimately separates the potential fits into the good and not-so-good fits.
☝️ It's also not uncommon that the underwriter's analysis ends up clarifying some of the information self-reported in the Discovery phase, for better or worse.
2. Lenders usually utilize some form of risk scorecard to quantify this analysis, wherein each key variable and financial metric is assigned a weighted score and the total is summed to come up with an assigned rating for each deal. The scorecard will incorporate many of the financial metrics used in the Discovery phase, but should also incorporate the trend analysis and qualitative variables uncovered in the Initial Analysis stage. A decline in the Initial Analysis stage usually means that the weight of these newly-assessed risk variables dragged down the overall score below the lender’s required minimum.
It may be helpful to think of a quick and overly simplified example to illustrate the concept: Suppose the Discovery stage asks for four pieces of information: (1) prior year revenues, (2) prior year gross margins, (3) prior year profits, (4) inventory turnover. Each of these four variables meets the lender’s bare minimums, so the deal progresses to the next stage.
Now in the Initial Analysis stage, the underwriter gets access to detailed financials and sees the following: (1) sales mix has abruptly shifted in recent months, (2) monthly revenue levels have stalled, (3) repeat purchases have fallen off a cliff, (4) returns are up, (5) a key supplier went out of business and the new supplier is offering worse terms, and (5) CAC is up considerably. The underwriter takes all those recent trends, pivots, and shifts into consideration (none of which were readily evident in the Discovery metrics), and forecasts that the company is in serious jeopardy of becoming unprofitable within the next quarter. Should the lender proceed?
Usually though, there’s not such a material difference between the output in the Discovery stage and the Initial Analysis stage. If the deal barely meets multiple criteria in the Discovery stage, a good lender will inform you that there’s a real chance that they won’t get comfortable at the end of a full underwriting, at which point they may offer to limit their analysis to a small subset of additional information to determine whether to keep moving the process forward. Or, even more likely, they will determine that you’re still eligible for a loan at the end of the Initial Analysis stage, but it’s either priced more expensively or is more restrictive from a structural standpoint due to the additional risks uncovered in the second stage.
Table: Initial Analysis Stage
Due Diligence: At this point, after clearing the hurdles in the Discovery and Initial Analysis stages, you’re probably thinking “okay, I’m a good fit and I signed the term sheet…aren’t we done yet?!”. In many cases, the Due Diligence phase is in fact pretty quick and painless relative to the Initial Analysis stage, but there are a few important steps remaining. Typically after the term sheet is issued, there are still a few assumptions that the underwriter has made, based either on the analysis performed or on information self-reported by management, that need to be validated before the loan can be closed.
These generally fall into two categories: (1) the underwriter’s satisfactory review of company documents and (2) satisfactory receipt and review of third-party reports, audits, or appraisals. The former category includes items such as supplier and 3PL agreements; insurance policies; cybersecurity and financial crimes control processes; and key-person and staffing contingency plans. Examples of the latter category include collateral appraisals and onsite audits; key person background and credit checks; and reference checks.
In essence, most of the focus in the final analysis stage is on items that are crucial to the ultimate success of your business and loan repayment, but are either (1) costly to undertake until both parties are certain that they want to work together and (2) not typically so unique or controversial that the underwriter expects them to swing a deal from the “go” to “no-go” category. A good lender will give you a head’s up on these specific items early in the underwriting process, as well as clearly spell out these requirements as part of the term sheet.
Once all of the specific items have been reviewed and all key assumptions have been validated, the underwriter will take the final step of submitting a credit memo internally to get the loan formally approved. Often this approval comes in the form of a loan committee meeting of key lender personnel, usually with the Chief Credit Officer as the committee chair.
Some lenders have a distributed or tiered approval process where certain personnel have authority to approve loans within a certain size range or other parameters, but in all cases there's someone or some group that oversees and must formally approve the underwriter's final recommendations. A good lender will have a well-aligned credit policy such that there are no surprises between the underwriter’s work and the loan committee’s approval. Or, in situations where the deal is a little closer to the edge, good underwriters will build consensus with key decision makers throughout the underwriting process.
If you make it through the Due Diligence stage, you are officially through the underwriting process! Typically this is signified with a Commitment Letter, which may include additional costs to be borne by the borrower in order to cover legal documentation costs and other closing costs.
If you don’t make it through the Due Diligence process, then something has gone terribly wrong in the process! It’s very rare that a reputable lender will flat-out decline the loan opportunity once the term sheet has been issued and signed, and in the few cases where it does happen it’s usually because one of the last validation steps uncovered a material systemic weakness or fraudulent behavior. Still rare but a bit more likely is that the collateral appraisals or other third-party checks uncovered something that required a change to the final loan structure, as opposed to a complete rejection of the request.
Table: Due Diligence Stage
In Part Three, we will cover specific loan product information requests, pitfalls and rabbit holes, term sheets and letters of commitment, tips for impressing the Chief Credit Officer, and how to maximize your chances during the process to build a strong relationship post-funding.