What Lenders Look For: A Banker's View
by John H. Robinson
"Lenders will usually lend if the purpose is legal, the loan will be repaid, and it will be remunerative." That is how an early teacher of mine explained it. While his statement does capture the lender's perspective in a nutshell, there are, of course, details law firms should be aware of when seeking financing.
Asked to lend money to a firm, a bank follows a process that includes both legal and financial due diligence on the firm and its position in the marketplace. Specifically, lenders need to feel comfortable with a number of areas before committing to a loan. They want to understand the borrower's profile, the purpose of the financing and its amount, the security behind the financing, the associated repayment profile and whether the price of the debt accurately reflects the risks associated with providing it.
If you understand what bankers need to know, both before and after a loan is granted, it will simplify the process and increase the odds that everything will run smoothly for all parties. Here's what you need to know about what banks expect from law firms that wish to borrow money.
The Canons of Lending: Types of Capital
Typically a lender's foremost concern is that the firm has the strength to meet and manage its capital needs. There are normally three types of capital in a partnership: fixed capital, current capital and working capital. It is important to understand the differences between each kind of capital, as well as the specific purposes of each.
Fixed capital. As its name indicates, this type of capital is permanent, covering the fixed and long-term asset needs of the partnership.
A prime example is the start-up costs of the business, including premises, hardware and software, furniture, transport needs, fixtures and fittings and the like. It is usually unwise to acquire long-term assets with short-term finance.
Current capital. Current capital, which takes the form of undrawn profits, should be fluid-that is, rising and falling in accord with short-term business needs. Current capital is used to balance the firm's working capital as it fluctuates.
Be very aware that profits should only be withdrawn when the firm can truly afford to pay them. Borrowing from a bank to pay out profits is not a sustainable practice. Any bank that understands professional firms will require a compelling rationale for making such a loan.
Working capital. Working capital is the amount of money needed to finance day-to-day current assets after allowing for current liabilities. The equation is: accounts receivable plus unbilled time less payables and bank debt. Working capital could be provided by undrawn profits or borrowed by the partnership on a revolving basis-within required limits, of course.
There are numerous factors in assessing working capital. On the payables side, for example, you may normally wait until month's end before paying your workforce's salaries, and most suppliers allow extended credit before they receive payments from you. However, it is also normal for firms to give credit to clients, which requires funding. That credit can run up to six months in some cases, but prudent managers always make the period as short as possible. Lawyers are not bankers and should not provide extended credit to clients. Clients have bankers of their own for that purpose.
Understandably, bankers are quite keen to see that a firm manages cash flow prudently. A benchmark is that the firm's current capital should meet any requirements in excess of prudent external borrowings.
The Partners' Stake and Other Initial Considerations
A normal lending guideline is that the partners' stake should equal the start-up costs of the business. Or, in an established firm, the stake should equal the risk capital that gives external funders-both banks and other creditors-the comfort level needed to provide funding to the business. Day-to-day costs should be met by working capital, including bank lines, supplemented by the partners' undrawn profits.
If the partners borrow their fixed capital from a bank on simple terms-unsecured, without extensive personal credit assessment, with low-interest margins and for a longish term-it will ease their cash requirements. That, in turn, will negate the need for them to use their own monies, although they will still be personally liable on their loan.
Of course, there will always be variations in the partners' stake and the finance terms. For example, the firm may need financing for a substantial capital expenditure such as freehold property or IT hardware and software. In these instances, the rules differ, often requiring only a small stake by the firm but with the asset pledged to support a long-term loan. Mortgages with a loan-to-value ratio of approximately 70 percent for property and leases for IT are popular. Normally, banks aren't attracted to lending for a term longer than the asset's expected useful life.
The bottom line is that no two partnerships finance themselves in the same way, and no two lenders demand the same terms. Nothing is set in stone.
Banks' Credit Procedures and the Firm's Profile
In addition to knowing that the firm has the strength to meet its capital needs, lenders also want to know that the partnership has a good track record, solid prospects for the future and a strong management team. This means discussing a number of areas with the firm's senior management:
- The firm's history
- Its present position
- Its medium-term plan
- Its going-forward strategy-both where it plans to go and how it will get there
Normally, the lender investigates these factors in detail, through modeling of financial information and key ratios. In addition, gauging the firm's relative market strength means carrying out public-domain research on firms similar to the borrower-meaning firms in the same size range, geographic range and type of practice. By comparing the borrower's performance against that of similar firms (over a single year and over multiple years), the bank can identify any significant variances and explore the reasons for them.
The resulting report enables the bank to assess the risks that need to be considered in providing the financing and the rewards that the bank will receive for taking those risks. Note that following approval, documentation and drawdown, the lender will continue to regularly monitor the progress and performance of the borrower.
The Key Is Restraining One's Appetite
Lending to law firms is usually good business for banks. Mostly they are profitable and the returns are generally good compared to the risks. Many law firms, especially larger ones, are very conservative and manage their cash tightly, so it is unusual for them to wish to borrow to the full amount of a bank's appetite. This is as it should be.
John H. Robinson (john.robinson@barclayscapital.com) is Director of the Professional Practices Team for Barclays Bank PLC in New York, NY. He has been with Barclays for 36 years and has specialized in law firm banking and treasury needs for the past 15 years.
"What Lenders Look for [A Banker's View]" by John H. Robinson published in the Law Practice Management, volume 30, No. 8, November/December 2004 ©2004 by the American Bar Association. Reprinted by Permission.