The three S’s of debt finance
If you are contemplating borrowing money from anyone, there are three factors that the person lending needs clarity on; serviceability, security and surety. It doesn’t matter whether you are borrowing money from a friend, or a bank, the principles remain the same. These three factors will determine the terms you borrow on and they could even determine your viability as a borrower.
The legendary entertainer Bob Hope is quoted as saying “a bank is a place that will lend you money, if you can prove you don’t need it”. While it’s not quite like that, as a responsible lender, we do want to make sure the borrower can repay the principal and interest, with some measure of buffer, just in case things don’t quite go to plan. This is serviceability. There’s a ratio known as Debt Service Coverage Ratio (DSCR) and it measures net operating income as a multiple of the firm’s debt obligations due within one year. It’s a good idea to make sure your financial forecasts show a DSCR above 1.5 as an average across the loan repayment period.
Next up is security. If it all goes very wrong, what valuable asset(s) can the lender receive instead of repayment, to settle the outstanding debt. While that’s the main thrust of security, it’s also an indication of how serious the borrower is. The majority of small firms are seen by banks as an extension of the owner and as such, lending is frequently secured against the owners’ primary asset, their home. This is clearly a highly emotive situation and you don’t have to read that many stories of collapsed businesses, to realise that good people can and do get into trouble and sometimes they lose their homes as a result. With niche financing, the lender should know a great deal about a particular type of business, and this knowledge should allow them to make a judgement and take a charge over the borrowers’ business only (debenture), which is how Vertus works. A high street bank wouldn’t take that risk, preferring to have a debenture and a charge over the owner’s home.
Finally, surety is the extent to which the lender is confident that you will continue to run the business the way it has been run in the past (or as described in the business plan if a change is contemplated). Lenders want to see a firm managed prudently, as this increases their chances of getting their money back as planned. Again, lenders with limited knowledge of individual firms, will often offer loans with expensive arrangement fees, high-interest rates and pages of rules (covenants) that determine how the business will be managed. Reaching a shared understanding between borrower and lender of the firm’s business model, use of funds, risk and prudential management, goes a long way to helping a lender assess the inherent risk of lending you the money. A positive result here would be fair terms and practical covenants.
The 3 S’s are combined to determine the terms one obtains when borrowing money. It’s a good idea to talk to any borrower with these critical factors in mind. Do your business planning in advance and present a plan that has taken account of the 3 S’s, and you are likely to reduce the time it takes to raise the money and improve the terms too.