April 3, 2024 •Oak Street Funding
Without a doubt we’re experiencing a historic economic era with dynamic rates resulting from inflation. While economic pundits attempt to predict the future, the reality is this simple: business continues. Companies with a sound cash position are taking advantage of opportunities during this economic period with owners making deals and investing in their companies.
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If you’re among the dealmakers, here are six tips to remember while you’re working with a lender’s underwriting team. Whether you need a working capital loan, funds for a buyout or cash to fuel an mergers and acquisitions strategy, the underwriting process should be a partnership.
Part of an underwriter’s job is due diligence to assess a borrower and their finances against the loan request. This is why underwriters ask a loan applicant a lot of questions about themself and their business. Underwriters review the request and current financial data through the lens of the five Cs of credit (capacity, capital, collateral, character, and conditions). With this in mind, underwriters design a framework to support business success.
It's important to understand an underwriter’s questions as the partnership develops. Here are six tips for working with an underwriting team.
1. Underwriters are partners
Sometimes business owners wonder why their request has gone to underwriting. In initial conversations with a commercial lender, ask about their underwriting process and team’s involvement. Underwriters should be involved very quickly to support creating a deal structure that works for your business strategy and goals. Being involved from the outset of a deal is a benefit. If the request isn’t going to work for any one of a myriad of reasons, it’s better to all shake hands before starting the process. And of course, if there’s a deal that’s sound, the underwriters issue a term sheet, also known as a proposal, to move forward.
2. Underwriters seek financial clarity
Credit worthiness is derived from the predictability of the future cash flow resulting from business operations. As such, underwriters ask for personal financial details, company information and review business financials to examine capital ratios. This means they’re looking for how much equity the owner has along with how much cash the owner has available to put into the business. They’ll ask about the business structure, ownership team, key employees and business partnerships, how long you’ve been in business, and future business plans. Underwriters need to understand the company’s financial strengths and weaknesses to make a loan recommendation and create a framework for client success.
3. Valuation on the book of business
Some deals require a business valuation. This requires review of a company’s financial statements and comparable transactions against industry ratios and other quantitative and qualitative information. Potentially applicable adjustments are made to align the company to an industry standard or benchmark. The result is a reasonable assessment of fair value. Owners have put time, energy, thought, and tears into building a business and often value their company through that point of view. The final valuation is derived through a set of procedures used to estimate the economic value of the business and how it plays into your ability to maintain those five Cs of credit previously mentioned above.
4. Underwriters want you to know how equity or cash requirements are derived
Underwriters want you to know how equity or cash requirements are derived
Clients often ask early in discussions about the amount of equity required for a loan. There is no specific answer. While yes, equity or cash is typically requested, we also want clients to have cash on hand if there’s a blip in business. Otherwise, is the only option to come back to the lender requesting cash? Each deal has a unique equity requirement depending on the loan request. Once the book of business and company are reviewed, an equity requirement amount is derived.
5. Underwriters want you to know your loan options
Different loan requests have different options. For example, one of the options we have when we're looking at lines of credit is a non-revolving line of credit. If a customer is in an acquisition mode with several options to purchase companies over time, we might propose this type of loan so it can be used again for the next purchase. If a client has one acquisition, we could recommend a term loan with a secondary line of credit for working capital needs.
6. Underwriters recognize rates and put them into historic context
While finance professionals are carefully watching the Fed’s decisions. It’s key to remember, rates have been higher than they are now. We're still at a fairly low level of rates, and the interest rate is not going to make a good deal, bad.
Documents requested by an underwriter
There are four main types of documents you can expect most lenders to require for a business loan. These are typically submitted with an application form that asks for business information such as address, organizational structure, and contact information for the owner and other stakeholders in the business. Having these documents well drafted helps protect you and shows the lender you are prepared and organized:
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- Financial statements for the past three years;
- Company tax returns for the past three years;
- Pro-forma financials that forecast the expected future revenue; and
- Personal financial statements that establish the financial character of stakeholders.
During this historic economic era, astute business owners are strategically focusing on growth. Keep these tips in mind when working with your lending institution’s underwriting team. Remember, it’s an underwriter’s job to analyze risks. They need to understand you and your business to derive and design a credit strategy that complements your business now and long into the future.
Disclaimer: Please note, Oak Street Funding does not provide legal or tax advice. This blog is for informational purposes only. It is not a statement of fact or recommendation, does not constitute an offer for a loan, professional or legal or tax advice or legal opinion and should not be used as a substitute for obtaining valuation services or professional, legal or tax advice.