Debt restructuring is about how you negotiate with your bank to modify a loan
Roll the clock back to pre-Covid19. You are running a successful business, but you need more working capital to expand, so you go to your local banker. The bank agrees with your forecast of healthy growth and gives you a $500,000 revolving line of credit with a three-year maturity. The bank also asks for your personal guarantee, which you are told is just standard practice and nothing to worry about. The line of credit is secured by all assets of the company. Your business grows and prospers.
Now fast forward to January 2020. Lots of bad stuff happens that month. With the Coid19 pandemic, the economy in general begins a downward spiral. Your business does not go into a tailspin, but the numbers trend down for the next several months.
Fortunately, your business made it through, and it now looks like you might have turned a corner—numbers were up last month for the first time in almost a year. Unfortunately, the loan matures in a few months and there’s a balloon payment that will be difficult to make. And there’s that personal guarantee that has you a little worried in the back of your mind.
What do you do?
Keep the Bank in the Loop
If you are thinking of debt restructuring, remember that banks hate surprises – especially when the surprise is that a borrower may not be able to make the next loan payment. Open and prompt communication with your bank builds trust and credibility. When the time comes for your lender to decide whether or not to cut you some slack, that trust and credibility will almost literally be the equivalent of “money in the bank.”
Don’t wait until your company is in desperate straits (for example, how are we going to make payroll tomorrow?) to let the bank know about problems. Approaching the bank early on not only builds trust and credibility, it gives the bank the flexibility to make concessions that might not be possible down the road. Poor communication is the enemy. It creates mistrust, raises suspicions and pushes the bank to assume the worst and take drastic actions that may be irreversible and ultimately not in the company’s or the bank’s best interest. Keep the bank in the loop.
In Debt Restructuring Always Understand What the Bank Wants
Ultimately, to negotiate successfully with a lender to modify a loan, a borrower needs to understand how banks see the world. Typically, banks have the following three goals when dealing with loan issues:
- keep the loan in “performing” status
- continue receiving a “market” rate of interest on the loan
- have a realistic exit strategy for full repayment of the loan.
The bank will measure any proposal to modify loan terms against these three goals.
Take Responsibility for the Problem—and the Solution
Simply blaming the “bad economy” for your loan problems and throwing up your hands is guaranteed to get your banker worried. To negotiate with the bank from a position of strength and enhance your credibility, it’s essential that you identify the problem, take responsibility for it and propose a reasonable solution. This will immediately impress the bank, and it will be much more willing to make concessions on the loan.
Debt Restructuring – What Are the Options?
Here are some of the most common ways to to debt restructuring, starting with the most preferred and going to least preferred, from the bank’s point of view:
- Extend the Maturity Date. Lenders usually prefer extending the maturity date rather than making other changes to a loan because it keeps the loan in fully performing status.
- Modification of Financial Covenants. Relaxing financial covenants written into the loan, such as covenants regarding tangible net worth or coverage ratios, will allow a company more flexibility in dealing with its financial issues.
- Interest-Only Payments. Deferring principal payments for a time and making only interest payments helps the most with older loans that have a large principal component. It is of less help on newer loans.
- Defer Principal and Interest Payments. Banks don’t like this—it puts the loan in non-performing status. In certain situations they may be willing to consider this option if it is for a short period of time and the bank has good collateral that will maintain its value.
- Reduction of Interest Rate. Banks hate to do this, but they may be willing to consider it in certain severe situations.
- Forgiveness of Principal or Past-Due Interest. This is one of the least preferred changes to a loan from the bank’s perspective, but a bank may consider it when the outlook for full repayment of the loan is particularly questionable.
- Converting Debt to Equity. This is most likely an option for companies with severe but temporary problems that can demonstrate good long-term prospects, especially where the lender is not a traditional bank.
If you have built your bank relationship on transparency and credibility, your bank will often consider one or more of these options to give your company breathing space and do debt restructuring.
Mr Paul Ho, chief mortgage officer at iCompareLoan, said: “Times are still bad and a lot of small businesses are still trying to stay afloat. But business owners have to remember that this may be the best time to expand their business if they can get access to more cash. They should speak to loan specialists who can guide them in such matters.”