It’s All About the Collateral

I’m often asked if a business plan is solid enough to take to the bank for financing. I disappoint a lot of folks when I tell them that, while a solid business plan is important, getting loans is all about the collateral.

Banks are not in the business of understanding your business. They don’t know how to evaluate a broadband business plan. It’s important to understand that in a given week a bank might be offered your broadband business plan, a plan to roll-out a dozen yogurt stores, a plan to combine several farms, and a plan to start a new brewery. They can’t begin to be able to understand the nuances of the many business plans they see.

It’s very easy to become too invested in your business plan. I often hear people describing their business plan as ‘can’t fail’. I can usually demonstrate that this is not so by changing a few of their key assumptions. It’s the rare broadband business plan that can’t be worsened by lowering the customer penetration rate, slowing down the speed of sales, or increasing the interest rate on debt.

Banks understand this. Every bank has a portfolio of failed projects where the bank lost a lot of their loan investment even though a project looked solid. Banks are skeptics by nature because they deal all day with prospective borrowers who are convinced that they are bringing a no-fail project. If a loan is large enough, a bank might hire an expert like me to check the assumptions in a business plan to help to identify the most sensitive variables. However, even with expert advice, a bank is still going to assume that a business can fail.

That’s why I say that the most important thing is collateral. Collateral represents the ability of the bank to recover some of their funds should a project fail. The stronger the collateral, the easier it is for banks to make the loan.

There are various types of collateral. The best collateral is a payment guarantee that kicks in even should a project be a total bust. This is the reason why municipal bonds that are backed by tax revenues can get lower interest rates. If a city builds a fiber network, a golf course, or an arena and the expected revenues don’t materialize, a tax-backed loan requires the city to raise taxes to make the bond payments.

Many new ISPs become familiar with the idea of collateral when banks ask them for a personal guarantee, meaning a borrower must pledge their home and savings as back-up for a project. That guarantee is rarely as powerful as tax-collateral, but it improves a borrower’s chance of getting the loan.

Established ISPs also face loan guarantees. If a telco wants to undertake a large new fiber project, they generally end up pledging their entire existing company to get the new loan. Communities often wonder why existing ISPs don’t expand faster, and more often than not it’s because they’ve already used up all of their collateral on existing loans. Just like with households, every business has a natural lending cap, at which no bank will loan them more.

Banks do consider other issues other than collateral. For example, a bank might consider track record when lending to an ISP that has been successful many times in the past – and that track record might lower the needed collateral. Banks love grants, but love owner equity even more since it means the owner has skin in the game.

Occasionally I see a new fiber venture that gets funded when it probably shouldn’t. There are local banks that lend to a local fiber project because they think their community needs fiber to thrive and survive. A bank in that situation is putting themselves on the line since they see their survival tied to the survival of the community.

The bottom line is that a project without collateral is not easily bankable. Unsophisticated borrowers think the numbers in their business plan tell a bank all they need to know. The truth is that the business plan is several items down the checklist for a bank, with collateral at the top of the list.

Fiber Networks as Collateral

One of the challenges of getting a new fiber network funded is to satisfy all of the requirements of bankers in order to make them comfortable to make a loan. In my experience one of the hardest hurdles for traditional bankers to overcome is their desire to have safe collateral for every loan. Collateral is typically a hard asset that can be liquidated to pay off the loan should the borrower be unable to do so. Bankers are used to lending into businesses where there are hard assets they know are good collateral. Loans for assets like buildings or large construction equipment are considered safe since the assets can be easily resold. Unfortunately, fiber networks don’t make for good collateral.

I’ve worked with half a dozen different clients recently where the bank asked this question. The bankers want to understand the ‘value’ of an installed fiber network should the loan go into default. It doesn’t take much web research for them to find failed fiber projects where the fiber was sold for pennies on the dollar. The truthful answer to the question is that once installed, fiber has little intrinsic value as an asset.

Companies without good collateral assets have a much harder time borrowing money and this issue is not unique to fiber network. For example, firms that sell labor hours like engineers, CPAs and lawyers often encounter the same resistance with banks when trying to buy money to grow.

The right response to the collateral question is to convince the bank that they are asking the wrong question. The value in a fiber network is not in the fiber, it’s in the revenues that are generated from that fiber. Some bankers understand this and I know several fiber overbuilders who have convinced a bank to provide a cash-based line of credit. These lines of credit are typically short-term loans that can be used perpetually to build fiber. The borrower draws the funds to build fiber and repays the loan as quickly as possible as revenues are generated. Lines of credit keep renewing as the borrower pays down the balance. Over time, as the cash flows of the business grows, banks are generally willing to expand the borrowing limit, enabling the fiber builder to build faster. Eventually the loans get too large to qualify for a line of credit, but by this time the business has grown to the point where they can qualify for more traditional loans based upon their balance sheet.

I always try to look at a loan from the banker’s perspective. Building fiber sounds risky. It’s not hard for a banker to go to Google and find numerous fiber projects that didn’t pan out as promised (starting with Google Fiber!). The are no immediate revenues from that fiber until it’s completed and even after that there is no guarantee that any given fiber build will generate enough revenue to cover the debt payments. A banker has little choice but to consider building fiber to be a high-risk undertaking.

The way to overcome the perceived risk of fiber is to package the loan request in a form that bankers will understand. Bankers understand cash more than anything else, and so the best way I’ve found to avoid the collateral discussion is to focus the whole loan discussion on cash flows. The best way to make a banker feel safe about revenues is to pre-sell to customers. It’s a lot easier to ask for money for a specific fiber project if the bank can see a guaranteed revenue stream.

It’s important to remember that bankers don’t understand the fiber business. During the course of a given month they might consider loans from a dozen different industries and they can’t possibly understand the nuances of each one. I have clients who can’t understand why bankers aren’t wowed by their business plan projections – the simple reason is that they have no basis for knowing if the assumptions made in the projections are good or bad. When companies borrow from an industry-friendly place like CoBank their loan application is reviewed by somebody who understands our industry – but a local bank can’t be expected to ever understand enough about the broadband business to trust a projection.

This means that a borrower needs to package a loan request in terms that a banker will understand. All banks understand cash flows and they will be most impressed by a demonstration of sufficient revenues to make loan payments. A loan application that is boiled down to such simple terms has a much higher likelihood of being considered. If you instead let the loan discussion go down the rabbit hole and concentrate on collateral than you are likely not going to get the loan – because fiber networks make lousy collateral. You’ll be more successful by concentrating on things bankers understand, like cash flow, than you will be in trying to convince them to agree with your awesome business plan. Bankers hear all day about can’t-fail opportunities and they know many of them fail.

How to Talk to Bankers

I spend a lot of time assisting clients in finding financing and in doing do I’ve learned a lot about what bankers are looking for from any prospective borrower. Here are some of the key takeaways I’ve learned over the years from talking to bankers:

Be Ready with a Worst Case Scenario. Borrowers invariably create a rosy best-look business plan to demonstrate how well they will perform with the borrowed money. But bankers have learned from hard experience that things often don’t go as well as planned. While bankers certainly want to see the optimistic business projection they are more interested in your worst case scenario, so a smart borrowers will prepare a worst case scenario along with the best case one.

The bankers wants to hear about everything that might go wrong with your plan – project delays, slow sales, higher than expected cost of construction – and then to understand how the borrower plans to cope with each potential snag. They want to be shown that the borrower will be able to repay the loan even if things go wrong. A banker is going to be far more impressed to see ta plan that considers the challenges and has a solution for every contingency. I’ve seen bank loan applications fail when the borrower was unable to answer simple questions about how their plan might fail.

Don’t Talk in Acronyms. Telecom borrowers are invariably highly technical people who understand the nuances of building and operating complex networks. The banker can understand this by looking at your credentials, experience and references. Most bankers don’t want to hear about the detailed nuts and bolts about how the technology works, and they are going to care a lot more about the products to be sold on the network and the plan to effectuate those sales.

I’ve sat on meetings and calls between borrowers and bankers where the response to a simple technical question elicits a fifteen minute spiel on the nuances of the technology. Bankers are not impressed with this, and in fact it can be worrisome if it they perceive the borrower as somebody who can’t explain their business in plain English – because the banker will know that’s what customers are going to want to hear. My advice is to tone down the technology unless the banker specifically wants to hear the details.

Understand the Market. I’ve had numerous clients over the years who have had the philosophy of “build it and they will come,” meaning that they were so positive of the superiority of their proposed network that they just assumed that people will buy their products. The vast majority of the business failures I’ve seen over the years were due to this blindness of the market.

Bankers are going to want to see evidence that people are ready to buy from the new network. In larger markets that might mean a statistically valid survey. In smaller ventures that is going to mean pre-sales and having a list of customers who are ready to buy service. Bankers also want to see a comparison of proposed prices and the prices of the competition  – I am often surprised by proposed new ventures that haven’t taken the time to look at actual customer bills in their proposed market. Do the homework and make the effort to understand the market before asking for funding.

Understand What Bankers are Looking For. Every lender is different and early in the process you need to ask them how they will judge your loan application. I recommend a two-stage process for getting a loan. The first meeting should be to understand what the bank is looking for. Have the banker describe the borrowing process and then use a second meeting to make a formal presentation of the business plan in a way that meets their requirements.

If the bank is interested primarily in collateral, then walk into the presentation ready to talk about that. If they are more focused in seeing a business plan that meets some set of financial metrics like debt service coverage ratio, then walk into the presentation ready to answer those questions.

Bankers talk in lingo just like our industry, and it’s vital to make sure that you understand what they want from you. I’ve seen many borrowers who don’t understand a bank’s requirements and who then never answer the basic questions the bank asks of them. It’s not uncommon for a borrower to be intimidated by the banking process and to be afraid to show that they don’t understand the banking lingo. In the end, if you don’t understand what your banker wants, then it’s likely you won’t be making the right proposal and the chance of getting a loan are greatly diminished.

Banking Challenges for Fiber Builders

I’ve often mentioned in this blog that it’s gotten harder to finance fiber infrastructure. Today I want to discuss a few of the specific issues that fiber builders face when trying to find bank financing. There are two traditional sources of funding for the industry – the Rural Utility Service (RUS) and CoBank.  However, many fiber builders don’t qualify for this funding since both institutions favor established mature companies. Any company that doesn’t fit the profile of these two lenders must turn to the only other source of funding – local and regional banks. Following are some of the issues I see when trying to borrow from banks.

Familiarity with the Industry. Local banks often are leery about lending to telecom companies because they are not familiar with the business and they fear lending into an unknown industry. Local banks are much more comfortable lending to businesses they understand and make loans to car dealers, retail stores and the other kinds of local businesses that have been their long-term core borrowers.

Amount of Borrowing. Every bank has some pre-determined maximum amount they are willing to lend to any one borrower and it’s easy for a fiber overbuilder to quickly hit this limit. I’ve rarely met a fiber overbuilder who doesn’t see endless opportunities for expansion and it’s not hard to hit a bank’s maximum lending limit.

Loan Terms. Local banks are often uncomfortable with the longer-term loans needed to finance fiber.  Banks prefer to make loans for relatively short periods of time, with their preference being short loans of 2 – 5 years. Fiber builders are often forced to only chase projects that fit the short loan terms – which means cherry picking only the best opportunities. In doing so they will be passing up opportunities that would thrive and produce good returns with a longer loan terms of 5 – 15 years.

Collateral. Banks are often uncomfortable with a fiber network as collateral. It’s not hard to blame them for this. A fiber network, once in the ground or on the pole does not automatically have a liquidation valley equal to the cost of the construction. The real value of a fiber network is the revenues from customers who are added to the network – and banks have a hard time accepting this concept. A little research will show bankers that failed fiber ventures have often liquidated the physical fiber network for pennies on the dollar, and that rightfully frightens them.

Quantifying Risk. It can be difficult for a bank to understand the downside risks of building a fiber project. One of the key steps to making a loan is to understand the likelihood of the borrower not meeting the proposed business plan, and bankers have a hard time quantifying and getting comfortable with the potential downsides of the proposed business.

Meeting Metrics. Many banks are driven by metrics – meaning that they look for key financial performance metrics from a borrower. It’s hard to meet the typical metrics for a new fiber network. When a network is first built it boosts the balance sheet – but revenues then lag a few years behind until the new network has enough customers to meet expected metrics. This cycle of early losses followed by eventual gains does not fit easily into the expectations of a metric-driven bank.

Unfortunately, any one of these issues can convince a bank that the fiber loan is too risky or doesn’t fit their comfort zone. Many banks are comfortable with infrastructure loans, but there are infrastructure loans that better meet their expectations. Consider a loan to build an apartment complex. There is the same period of zero revenues while the buildings are constructed, but the expectation is that the borrower will then quickly reach full revenues within a relatively short period after the end of construction. An apartment building also provides comfortable collateral because there is an established market for selling repossessed buildings. Bankers in general understand the apartment complex operating model and are comfortable with the variables of operating an apartment building.

Fiber overbuilders need to be prepared to tell a story that can get a banker comfortable with each one of these concerns. I always advise fiber builders that they must put themselves into the banker’s shoes and look at their own business plan as a skeptic. I’ve often seen fiber builders who point to a business plan that eventually makes a lot of money and who can’t understand why a banker doesn’t see their plan the same way they do. Many of the misgivings that a banker might have about funding a fiber project are legitimate and the borrower must convince the banker that the overall level of risk is small – a tall task.