by Norm Brodsky
Mistake #3: Being unresponsive. Bankers often have questions about your financial statements, and you may not know the answers. Some people get annoyed or defensive when asked to explain their financials. Instead of having an accountant provide the necessary information, they try to talk their way out of the situation, giving lame responses that don’t add up. When the examiners come in, the banker is asked the same questions, can’t offer satisfactory answers, and gets hammered as a result. Another strike.
Mistake #4:Neglecting the relationship. When you don’t need anything from your bank, it’s easy to ignore your banker. There are always plenty of pressing matters to focus on. You figure, “Why bother with the bank? Let’s leave wel enough alone.” But by the time you do need something, it’s often too late. If you haven’t already built a good relationship, the chances are you’l go away empty-handed. That’s why it’s important to meet regularly with your banker. My partners and I always made a point of sitting down with our bankers at least once every three months.
Mistake #5: Failing to keep the bank adequately informed. Bankers don’t like big, bad surprises any more than the rest of us do. They understand that unexpected things happen in business, but many problems can be anticipated, and bankers want to have as much advance warning as possible. Bankers also need some reassurance that you’re in control of your business. That’s one reason they ask for annual forecasts.
If your projections are way off year after year, your banker wil conclude that you don’t know where your business is heading—or, worse, that you’re being dangerously optimistic.
Mistake #6:Ignoring the rules. Whenever a bank lends you money, it comes with strings attached, namely, the covenants contained in the loan agreement. A lot of people don’t understand the covenants, or forget about them, or simply ignore them. I know one guy—let’s cal him Marvin—who decided, with his partners, to have their company give them a $500,000 bonus so that they could avoid having to pay taxes twice on the money. (If they’d instead taken the money as a dividend, the company would first have had to declare the $500,000 as earnings and pay corporate taxes on it, in addition to the individual taxes that would then be owed.)
Unfortunately, they overlooked the effect that the payout would have on their debt-to-equity ratio. By reducing their equity in the company, the bonus caused the ratio to soar way beyond the limits al owed by the bank. When their banker told them the company was out of ratio and they had to correct the problem, they were outraged. The company had been a loyal customer for decades. The bank, they said, had no right to tel them what to do.
Ask Norm
Dear Norm:
I’m only twenty-two years old, but I’ve been wanting to start a business for along time. My passion is computers, and I’ve come up with a concept that has an incredible upside. I just need about $100,000 to make it ago. My father-in-law has access to that kind of money. The problem is, I have no idea how to approach him.
Brandon
Dear Brandon:
Entrepreneurs are optimistic by nature, but it’s important to look at the downside risk as wel as the upside potential, and let’s face it: there’s an inherent risk in borrowing money from in-laws. So first you need to ask yourself, What would happen if I lost al the money? If the loss would have serious personal ramifications, I’d look elsewhere. Business failure is tough enough without adding family trouble into the mix. But if losing the money would have no effect on your in-laws’ lives, if your family wouldn’t be torn apart, then it should be easy to approach your father-in-law. Just lay your cards on the table. Tel him you think your plan wil work, but if it doesn‘t, there’s a risk he’l lose al the money he’s invested.
Ask him if he’s interested and assure him that, if he isn’t, there wil be no hard feelings. And remember there are other sources of capital around if your in-laws are not an option.
—Norm
That was an example of...
Mistake #7: Arguing when you’re wrong. A lot of businesspeople think they’re entitled to the money they borrow from a bank—especial y if they’ve been good customers for a long period of time. They start to think of the bank’s money as their money, and they become incensed if the bank asks for it back. But banks have the right to get their money back when borrowers violate their loan covenants. After al , those covenants are there for a reason. A bank is also required to fol ow certain rules. If its loans don’t measure up to federal standards, it could wind up with serious regulatory problems.
Nor does it help to protest when a bank changes its lending policies, as happened in my case. Arguing won’t bring the old policy back any more than outrage wil make a bank forgive you for violating your loan covenants. On the contrary, by becoming a pain in the neck, you give the bank another reason to throw you out. That’s exactly what happened to Marvin and his partners.
Understand, none of the mistakes I’ve mentioned is fatal by itself. Even Marvin could have salvaged his banking relationship if he’d stayed calm, acted reasonably, and come up with a plan for getting his company back in ratio. It takes time to build a relationship, and it takes time to break one up. One mistake compounds another. The damage is cumulative, and often invisible. You may not know exactly where you stand until it’s too late.
One day, the letter wil arrive, or the banker wil cal , and you’l find out if you’re in group two or group three. Perhaps you’l never get that letter or cal , but if you do, let’s hope you land in group three. In business, as elsewhere, it’s a lot nicer to be shown gently to the door than to be unceremoniously given the boot.
Your Inner Bank
To be sure, there are times when credit gets so tight that you can’t get a loan no matter what you do. Fortunately, you may have an alternative if you happen to have a business that bil s its customers after delivering whatever product or service it happens to sel . Unless you’ve already pledged your receivables to someone else, you have your own inner bank, and you need to start thinking like a banker.
Receivables are, in effect, loans you’ve made to your customers, and it’s always a good idea to keep an eye on the quality of your loan portfolio.
It’s especial y important when other sources of cash dry up. You need to ask, Is it taking you more time to col ect than it should? Is your average col ection time increasing and, if so, why? Do customers need to be cal ed more often? Are some of them struggling because they have problems of their own? In that case, you might need to work out new terms with them. Or are people taking advantage of you, in which case you might want to apply additional pressure—or maybe even terminate the account?
Of course, if you’re borrowing against your receivables through a bank or an asset-based lender, I suspect you already have a pretty good idea of the shape they’re in. Your lender is no doubt making sure that you track them closely. They’re the col ateral on its loan to you. If receivables go unpaid for too long, you’l stop getting the cash you need to survive. So you have a powerful incentive to find out who is paying on time and who isn’t, and to go after the latter. But even without that incentive, we should al be tracking our receivables as if we had an asset-based lender looking over our shoulders. Unfortunately, it’s easy to lose that discipline as a company grows, particularly if you have strong cash flow and money in the bank.
I discovered that danger during the due diligence process we went through when we were thinking of sel ing three of our companies in 2006.
After looking at our receivables, the would-be buyer wanted to increase our reserve against bad debt by $200,000 to $400,000, which would have reduced the purchase price by $2 mil ion to $4 mil ion. “What are you talking about?” I said. “Our receivables are al good. We have the customers’
boxes. They can’t get their records back without paying us.”
“Yeah, wel , your own records show that 40 percent of your receivables are more than 120 days old,” the auditor said. “That’s a big number. A lot more of them may be uncol ectible than you’ve made al o
wance for.”
I was shocked. Even though we do a lot of business with hospitals and government agencies—which pay reliably but slowly—it was a much bigger number than I would have guessed. We had a good system in place for tracking receivables, but I hadn’t been paying attention. It wasn’t as if we’d been having cash flow problems, after al . We were paying our bil s on time and had plenty of money left over. The thought that we might have a receivables problem never entered my mind. So monitoring col ections was not very high on my list of priorities.
But the prospect of losing $2 mil ion to $4 mil ion got my attention real fast. I assured the buyer that almost al of the 120-day receivables were col ectible, and we’d prove it. We spent the next four months doing just that.
We began by looking at the breakdown of our receivables month by month for the past three years—that is, the monthly percentage of receivables that were current, 30, 60, 90, and 120 days or more outstanding. It turned out that the 120-day number had been creeping up steadily over the entire period. The average monthly increase may have been only half a percent, but that translated into 6 percent a year. At that rate, you could start out with, say, 10 percent of your receivables in the 120-day category—the acceptable amount depends on the kind of business you’re in and the type of customers you have—and wind up with 28 percent by the end of the third year. That’s more or less what happened with us.
Part of the problem, we realized, was that the col ections department was overworked and understaffed. So we hired an additional person, not to go after the long-term nonpayers we already had, but to keep from adding to their number in the future. That’s the first step in problem solving: make sure you don’t keep repeating your mistakes going forward. (See chapter 16.) Then you can go back and deal with what happened in the past.
Accordingly, we next turned our attention to col ecting the money we were owed by customers who hadn’t paid us in more than four months.
Because we weren’t in a money crunch, we were able to avoid two common mistakes made by people desperate for cash. When you absolutely must get cash right away, you natural y go to the customers most likely to pay you quickly—namely, your best accounts, those that already pay on time. You put pressure on them to pay early or you ask for favors, neither of which helps build good relationships with the people who are most important to your company’s success. The second mistake is to have your accounting people do the col ecting. They don’t know the customer nearly as wel as other employees do, and they don’t have the personal relationships that they could use to avoid inadvertently antagonizing people who should be al ies. A salesperson, a customer service person, or an operations person who interacts regularly with the customer may know a better way to make the request or may be able to offer a favor in return for a favor.
With that in mind, we divided up the 120-day accounts among our sales, service, and ops employees and began contacting customers. What came next was a revelation. Some people blamed us for their own failure to pay for the services that we’d performed. One customer said, “Sure, we’l pay you, but why did you wait so long to cal us? You shouldn’t have let it get this far. You should have let us know a lot sooner.” It turned out the customer had a problem in its accounting department that was only discovered when we asked for our money. The people blamed us for not alerting them to the problem sooner. Who knows? Maybe they had a point. In any case, we apologized and moved on.
With other customers, we found that we had to modify our bil ing procedures. One hospital group, for example, had a purchase order system that we weren’t fitting into. Without knowing it, we were forcing the group’s accounting people to adapt to our system, rather than making our bil ing process work with their payment process. When we asked how we could get paid more quickly, they showed us what information they needed from us and in what form. We made the appropriate changes.
Then there were the instances of our bil s not reaching the right people. We discovered, among other things, that we weren’t updating our contact information often enough. We’d get the initial information and then check it again when the contract came up for renewal in five years. In the meantime, there could have been changes in personnel, in departments, in procedures, even in the company’s name and location, and we wouldn’t know about them. Or maybe our col ectors knew about the change, but our bil ing people didn’t, because—for security reasons—we don’t al ow anyone who handles money to make changes in our system. So we developed new procedures for coordinating the exchange of information and making sure the bil s wound up where they were supposed to go.
We also came across some customers we didn’t want. They were mainly smal customers who had already heard from our col ectors—
repeatedly. We had to hound them constantly for payment. It would take six months to a year for us to col ect from them, and then they would pay only because they needed to retrieve a box.
That type of customer literal y takes money out of your pocket. To begin with, you don’t have the use of the money that the customer owes you and promised to give you when you signed him up. Let’s say his outstanding bil is for $ 1,000. If he doesn’t pay on time, you have to borrow an extra $1,000 from the bank. Suppose you’re paying 9 percent annual interest on your loans. That’s $90 per year. So your $1,000 is real y just $910.
Meanwhile, your accounting person is spending half an hour each month cal ing this guy and listening to his lame excuses and false promises.
That’s six hours per year. If you pay the accountant $25 an hour, with benefits figured in, the slow payer costs you an additional $150 annual y, meaning that the $1,000 is now down to $760.
Look at what that does to your gross margins. Normal y, I would expect an account that smal to have a gross margin of at least 40 percent. It wouldn’t be worth accepting the business for less, even if the guy paid on time. So, on $1,000, you should be earning a gross profit of $400. But because he takes a year to pay—and makes you spend $260 on interest and labor that you wouldn’t have to spend otherwise—your gross profit is $140. That’s a 14 percent gross margin. I don’t know about you, but if we had too many accounts like that, we’d be out of business! I don’t want or need that kind of customer, and so we made those accounts pay up or leave.
In the end, we were able to reduce by more than 50 percent the share of our receivables that hadn’t been paid for 120 days or more. The would-be buyers could hardly believe it. They insisted on sending in their auditors again, who confirmed that we had, in fact, shrunk the number by that amount. Not only did we address the immediate problem, but we implemented new procedures that wil keep it from arising in the future. Although we didn’t end up sel ing the company to those people, I owe them a debt of gratitude for pointing out our receivables problems and forcing us to become better bankers.
The Bottom Line
Point One: Before you ask people for money, make sure you know how much they like to invest and what they’re looking for.
Point Two: Start early to build a relationship with a commercial banker and use an asset-based lender only if you can’t get the money you need from a commercial bank.
Point Three: Bankers are businesspeople, too. Treat them the way you would like your customers to treat you.
Point Four: Your receivables are loans to your customers. Make sure your portfolio is in good shape.
CHAPTER FIVE
Magic Numbers
Here’s the best piece of advice I can give to anyone starting a business: from day one, keep track of your monthly sales and gross margins by hand. Don’t use a computer. Write down the numbers, broken out by product category or service type and by customer, and do the math yourself, using nothing more sophisticated than a calculator.
That’s what I insisted on with Bobby and Helene Stone (see chapter 1) and what I myself do when I start a business. You can save yourself al kinds of grief—and greatly improve your chances of success—if you do the same. After al , to be successful in any business,
you need to develop a feel for the numbers. You need to get a sense of the relationships between them, see the connections, figure out which ones are especial y critical and have to be monitored accordingly. Numbers run businesses. They tel you how you can make the most money in the least time and with the least effort—which is, or should be, the goal of every entrepreneur. What you choose to do with the money after you’ve made it is another matter.
You can give it al away if you want to. But first you have to earn it, and the numbers can tel you how to do that as efficiently as possible, provided you understand their language.
Tracking the numbers by hand is the best way I know of to learn that language, at least as it applies to your particular business. You can switch to computer tracking once you’ve mastered it, but if you let a computer do the work in the beginning, you lose something. You don’t develop the same intimate connection with the numbers that you get when you track them manual y. In fact, your business may never even reach viability if you don’t start tracking your numbers early on.
Consider the case of Anisa Telwar, who started her business—now cal ed Anisa International—in 1992. The business was stil struggling when she contacted me four years later. She said that she had taken her cosmetics accessories business from zero to $1.5 mil ion in sales, “... and I have nothing to show for that growth at this time.” She thought what she needed were better promotional materials. I suspected her problems lay elsewhere. In any case, I agreed to meet with her.