Where’s YOUR bailout?

Good question!! Apparently your business isn’t “too big to fail.” Well, neither is mine. Federal assistance really IS available for businesses like yours and mine. You don’t need to be a minority, and it’s not charity. It’s simply the tried and true federal Small Business Administration (SBA) loan guarantee program designed to improve availability and attractiveness of debt financing and refinancing for small U.S. companies.

It’s not a money grab, but it may be the closest thing you’ll find to “a little help from Uncle Sam.” No, the paperwork is not prohibitive, but it is detailed. Yes, the program still exists and the federal dollars are in place to make these loans happen.

Banks are conservative by nature, but this economy has made them extra-cautious. SBA loan guarantees reduce the risk to banks so they can say ‘yes,’“ commented SBA loan expert David H. Laughrey, president of The Laughrey Company. “Consolidating and terming out loans can reduce fixed obligations by 40 and 50 percent,” he continued. “It can be a real cash flow godsend for business owners.”

Many business owners collect loans over time — a real estate loan, an equipment loan or two, a working capital line of credit. Rolling them together and refinancing them over a longer amortization schedule can provide meaningful cash flow relief during slower economic times.

Skeptical?

Find out for yourself. Call your banker or email David Laughrey. SBA also has a good website that gives general information about its programs and services at www.sba.gov.

Click on Chart Below to view a larger image.

• Check state laws. Some states prohibit or restrict companies from loaning to their owners, officers and directors.
• Formally execute a promissory note and provide for loan repayment dates and an interest rate.
• Make the interest rate a fair market rate, preferably what your company pays to its lenders.
• Include in the terms some collateral.
• Have the company’s board of directors approve any loan in a corporate resolution. The resolution should specifically define the transaction as a loan. If possible, abstain from voting. You are a party to the transaction and, if you vote, the IRS could question it.
• If there are minority owners in the business and the loan from the company is substantial, obtain their approval.
• Record the loan on the company’s books (financial statements).

In general, the loan should be made on an arm’s-length basis, as if an outsider were borrowing from or lending to the company. Discuss any loan with your tax advisor and attorney. Ask about IRS rules on thinly capitalized businesses and any potential IRS issues related to unreasonable compensation or excess accumulated earnings.

Are you laboring to salvage a past investment? Letting a large, failed investment influence your current decisions?

No matter the amount of time and money you or your business have invested in something or someone, current decisions should be based solely on a sober estimate of present value of future returns. That is, time and money previously invested should not enter into the equation you use to assess which course of action will provide the highest future yield. This is the principle of sunk costs — a well-established and widely accepted principle of rational investing and sound decision-making.

For example, your decision whether to sell an automobile should be based solely on the value you place on owning it relative to the price at which it can now be sold. The amount you have invested in it should have no bearing whatsoever on your decision.

Accepted methodology in the field of appraisal, aka valuation, imbues the microeconomic theory of sunk costs. Value is derived from two main sources: cash flow (“income approach”) and the price at which the asset could be sold (“market approach,” aka the comparable sales approach). The amount of money invested in the asset or business is not an input in the value equation. Why? Buyers don’t care about how much was originally invested. Buyers care only about — and will pay for — value that can be derived from the asset going forward.

Trained appraisers know this. The value of a piece of land, for example, has nothing to do with what the owner paid for the land. Since raw land rarely throws off any cash flow, the value is derived using the market approach, i.e., by attempting to find comparable sales and comparing them to the subject asset.

Are you letting sunk costs impede your decisions?

The odds are very good that you are. It’s human nature. It’s not logical, but humans are not always logical. After all, to err is human.

Overly Optimistic Probability Bias: Studies have shown¹ that investors, once they make an investment, tend to overestimate the likelihood of a favorable return. Such leads investors to irrationally stick with failed investments and impedes their pursuit of more promising investments.

Loss Aversion: People tend to place greater importance on avoiding loss than acquiring gains. Such has been proven in numerous studies, such as one conducted by Kahneman and Tversky, the results of which were published in a 1991 article² in the Quarterly Journal of Economics. Loss aversion causes people to irrationally hold on to failed investments, even when more promising investment

opportunities are available. This fallacy plays out in investors who sell winning stocks and hold on to losers, often cutting gains short but staying in underperformers long enough to suffer large losses.

This mistake is sometimes called “chasing losers.”

Throwing Good Money After Bad: In an attempt to salvage a failing investment, many will “double down” on their prior commitment. There is nothing innately “wrong” with doing so, so long as the decision was based on an objective evaluation of the available opportunities. If, ignoring the monies already invested, the highest-yield opportunity for the remaining available investable funds is “doubling down on the prior failing or underperforming investment,” then the choice is a rational one. But if a higher return can be achieved elsewhere, the rational decision is to walk away from the prior investment. Unfortunately, investors tend to place a higher value on “proving myself right” or “salvaging my investment.” The result is commonly referred to as “throwing good money after bad.”

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Life’s short. Your time and money are valuable. Are you making rational choices about where you spend your time and money? That is, allocating your scarce time and money toward investments that objectively offer the highest return? Or are you getting stuck in a rut? Are you making the entirely human mistake of letting sunk costs influence your decisions? Letting sunk costs block you from pursuing more promising endeavors?

¹ Knox, R.E. & Inkster, J.A. (1968). Postdecision dissonance at post time. Journal of Personality and Social Psychology, 8 (4), 319–323

² Amos, T. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. The Quarterly Journal of Economics, 106 (4), 1039-1061.

SBA programs allow banks to take higher levels of risk and lend at reduced rates. Laughrey says monthly debt service reductions of 25 percent and 50 percent are common. It’s achieved by lengthening the amortization period on “term debt” and lowering the interest rate.

Current loan maximums and guarantee maximums under current SBA program law are $2 million and $1.5 million, respectively, but the U.S. Senate is considering a bill that would raise it to $5 million and approximately $3.5 million, respectively. Lenders and the SBA generally need the following from you when you apply:

• Business Profile: Description of your business. Include what it does, type of legal entity, its products, whom it sells to, number of employees, brief history and who owns the business.
• Loan Request: Description of how much money is needed and what the funds will be used for.
• Collateral: Description of collateral offered to secure the loan. Include equity in the business, borrowed funds, available cash, and assets such as accounts receivable, inventory, equipment and real estate.
• Business Financial Statements: Complete financial statements for the past three full years plus year-to-date. This includes balance sheets and income statements.
• Projections: Expected revenue, expenses and cash flow for the next three years. Must show that the business can support repayment of requested funds.
• Business Tax Returns: Most recent three years.
• Personal Financial Statements: For each person who owns 20 percent or more of the business, current personal balance sheets (i.e., list of all assets, liabilities and personal tax returns for the past three years).

Don’t sweat the paperwork. Banks that specialize in SBA loans can help you comply, as can independent SBA loan consultants such as David Laughrey. Finally, if someone asks you for a large up-front fee, find someone else. For more information, including a complete list of SBA lenders, go to www.sba.gov.

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^* David Laughrey does not have a website. You can reach him at 918-524-9400.

Have a line of credit that is never fully paid off? Consider taking out a term loan and using the proceeds to pay off the portion that doesn’t “revolve.” You may want to consider doing the same with credit card debt.^*

Interest rates remain at historic lows. Residential mortgage rates recently dipped to 5 percent. Interest burden is low today, but the reprieve won’t last. Rates will soon rise and before you know it, you’ll be paying 8, 9, even 10 percent on variable-rate debt. Don’t think it will happen? Look at the accompanying chart of historical rates — prime and residential mortgage. Yes, the future will reflect the past.

Weighted average rate of initial mortgage interest rates paid by home buyers on conventional fixed and adjustable rate mortgages.

Source: Mortgage-x.com

If you want more evidence that rates are poised to rise, listen to the comments of Ben Bernanke, U.S. Federal Reserve chairman. The Federal Reserve sets interest rates and Bernanke says they are going to hold rates at their current low levels until the economy is clearly out of the recession. He has said this for a couple of years now, and economic data show the economy is out of the recession. Gross domestic product (GDP) is growing again — a robust 3 percent (annualized) in the most recently reported quarter.

During periods of GDP growth, interest rates rise. During periods of low or negative GDP growth, interest rates decline. We’ve been through low, even negative, growth for a few years now. We’re now shifting to a period of interest rate increases.

Convert Variable Rate Debt to Fixed

If you currently have debt you pay a rate on that changes as the prime rate changes, talk to your lender about locking in a fixed rate. You might pay a slightly higher rate today, but you’ll be protected from rate increases and also know exactly what you’ll owe in interest and principal going forward, which helps for budgeting.

Credit card debt carried as variable-rate debt is at punishingly high rates. If you carry a balance on credit cards, talk to your banker about a loan to pay off your credit card(s) with a term loan (which has a fixed rate of interest).

Refinance Fixed-Rate Debt

If you have fixed-rate debt at a rate above 7 percent, talk to the bankers you know today about refinancing. The table on page 11 shows how the change in interest rates can affect annual interest expenses paid on a loan. Over the life of a loan, the interest rate impact is even more significant. For example, a 2-percentage-point interest savings on a $1 million, 25-year note is $390,000 over the life of the mortgage.

Again, if you don’t think we’ll ever see rates at 10 percent or greater, think again. History tends to repeat itself. Also, one way to deal with our federal debt problem is inflation.

Pay Attention to Terms

In evaluating loan options, there’s more to consider than the interest rate. Up-front expenses such as “points,” closing costs and even legal fees must be evaluated. The best method for comparing loans with varying terms is net present value (NPV). Review this article online to download a calculator (in Excel). It makes the job easy. The loan with the lowest NPV (all loans have a negative NPV) is the least expensive and therefore most attractive.

Effective Interest Rate

Another way to compare loans with varying terms is to calculate effective interest rates (EIR). It entails amortizing up-front costs over the life of the loan, i.e., adding the cost to the interest expense and recalculating the rate. Although this method is simple, it is not as desirable as NPV because it doesn’t take into account the time value of money. One thing that makes up-front costs so expensive is they’re due up front. Given a choice, you would rather pay in installments over the life of the loan. That’s what the effective interest rate calculation assumes, but not how it is in real life. So the EIR method understates the true cost of up-front fees. The NPV method does not. Still, EIR calculations are one way of viewing the cost of points and up-front fees.

The two tables display the effective rate calculations for various points paid on loans with 5-year and 25-year amortizations. One point is simply 1 percent of the loan value. So, for a $100,000 loan, two points is $2,000.

Comparing the two effective interest rate tables, you can see that up-front expenses have a far more substantial impact on short-term loans compared to long-term loans. When points are required to “buy down” an interest rate, doing so is far more attractive when the loan term is long.

Prepayment Penalties

Many loan terms include prepayment penalties. Calculating their effect can be tricky because they come into play only if you need to pay off the loan before its natural expiration date. This most often comes into play when interest rates fall and you wish to refinance. The chances of this happening to you on a loan you close today are slight, but you should consider this feature nonetheless. Comparing options to refinance involving a prepayment penalty, simply calculate the NPV of the existing note, using the calculator we provide online. Then calculate the NPV of the refinance option by entering the data for the new loan and include any prepayment penalty on the old note as an up-front expense on the new. Whichever option offers the lowest NPV is the most attractive (financially). Again, when using the Excel calculator, the loan with the lowest negative number is the least expensive.

^*Term loans require collateral and are therefore secured debt. Credit card debt is unsecured, of course, so you should take this into consideration before refinancing credit card debt with term debt.

Reviewed by David L. Perkins, Jr.

More than an insider’s account of events that led to the collapse of Lehman Brothers, it’s also a truly amazing story of a young man’s ”by hook or by crook” determination to break into the ultra-exclusive club that is Wall Street. Although the story could have been told in fewer pages, it’s chock-full of tales of hustle, determination, greed, ego, intelligence, big bets and the chase for big bonuses. It also reveals the complexity of the world’s economic system and financial markets; how relationships and power struggles at this level can swing billions, if not trillions; and how even the smartest people can, and often do, get it wrong.

Lawrence McDonald, a confused kid from a broken home, steadied his ship and set a goal to work on Wall Street after graduating from college in 1989 in the middle of the pack at a middling university. Despite exerting an almost impossible-to-believe effort to secure any job at all on or near “The Street,” he failed. Plan B was to follow the advice of the only investment banker willing to talk to him: Take any sales job you can find and demonstrate an ability to sell. So he took a job selling pork chops door to door. Yes, pork chops. As in the other white meat.

He went at it as if his very life depended on it and soon became the #1 pork chop salesman on the East Coast. Then with this one bullet point of experience on his resume — one that showed an ability to sell — he again knocked on the doors of investment banks. This time, he landed a commission-only securities sales job for a god-awful, hard-selling, cold-call-out-of-the-phone-book “boiler room” operating hundreds of miles from Manhattan. He again worked day and night with near-maniacal determination, built a little book and earned some money. He obtained his securities license and developed a love and passion for convertible bonds (“converts”). It was 1997 and no online services offered information on convertible bond issues, so he quit his job and started www.convertbond.com with a friend.

Once again, working day and night and using creativity, ingenuity and a willingness to break through any and every barrier, rule and unwritten law that was in his way, he and his buddy built and then sold www.convertbond.com for a tidy profit.

With his new bit of street credit, documented sales ability and Series 7 certification, he cashed in on a boyhood relationship he’d worked hard to maintain and nurture. The result was a low-level job on the bond trading desk with one of the top investment banks on The Street — Lehman Brothers. Little did he know that the seeds of the firm’s demise were already planted.

McDonald spent four years at Lehman Brothers, 2004 through 2008, rising to become a successful and respected bond trader. He became familiar with the inner workings of the firm and as he studied the financial markets — particularly the bond market — he saw reasons for concern. He listened to concerns expressed by others he respected in the firm, and even did some gumshoeing, making a firsthand assessment of the residential mortgage origination process and of the true credit quality of residential mortgage-backed securities. Lehman had hundreds of billions of dollars of exposure to them, and the top brass was operating under the assumption that their quality was good as gold. But McDonald and others had reason to believe otherwise and, if they were right, the firm’s very existence was in jeopardy.

Lehman was operating with incredible amounts of leverage — 40+ times debt-to-equity — and with a concentration of assets in commercial real estate and residential and commercial mortgage debt to boot. But despite repeated and multi-point warnings, Lehman Chairman and Chief Executive Officer Richard S. Fuld, Jr. and President and Chief Operating Officer Joseph Gregory spent most of their time secluded in their penthouse offices, unwilling or unable to converse with the troops or give any credence to repeated pleas for a course change. Fuld and Gregory were instead focused on becoming the largest investment bank in the world, on competing with the likes of Goldman Sachs and Blackstone Group, gaining title to the world’s most prestigious real estate assets, founding and investing in hedge funds, being the leader in mortgage securitizations, and manufacturing continuous revenue and profit increases.

There are many themes and lessons in A Colossal Failure. Not surprisingly, greed, selfishness, ego, excess and foolishness. Also covered are the complexity of the financial markets and the dilemma of what to do when a firm becomes too big to fail but also too large to bail out. And then there is what to do about the fact that large, public companies such as Lehman are run by boards of directors who are simply members of a mutual admiration and support society with the CEO and president.

When a bank becomes impossibly large and complex and sparingly regulated, tremendous power is concentrated in the hands of a few. Bad things can and do happen. Lehman Brothers — one of the largest investment banks in the world — more than 100 years old and with nearly a trillion dollars of equity — evaporated — added fuel to the fire already burning in worldwide financial markets, resulting in an inferno that nearly enveloped the entire modern financial system.

The first step in preventing it from happening again is, of course, understanding what happened.

Q: Is your SBA lending more active now with the new programs initiated by the federal government?

A: Yes, it really made it attractive to people. The fee waiver and the increase in the guarantee level have created more demand for SBA loans.

Q: Will Bank of Oklahoma participate in the 100 percent guarantee program approved by Congress?

A: Yes we will, at least for existing customers with a viable business. We won’t be taking on new customers with this loan program right now because our take is it’s designed to help our existing customers first. We believe the program is set up to help our current customers retain jobs and to make loan payments for that six- to nine-month period.

Q: Are you seeing your loan demand increase?

A: Actually, I think we’re seeing an increase in awareness more than anything. The program and all of its benefits have been in the news more and we’re starting to get some questions answered. I think we have all the information as it pertains to the borrower, but there remain unanswered questions with respect to how the new programs will impact the lender.

Q: Are you still worried about loan quality even though the government guarantees up to 100 percent of the loan?

A: Actually, we don’t have all the information about the program yet. We know it’s a 100 percent guarantee, that the interest will be paid by the SBA, and the loan amount is $35,000. What we don’t know is how and when the loans will be subsidized. Will it be 1, 2, 3 percent interest that is paid to the lender? It’s certainly an attractive program, but we still care about loan quality. The SBA developed the program to bridge some gaps and to help eliminate credit risks that we might not be able to take on otherwise. But yes, the underlying credit qualities are still needed. We wouldn’t want to put loans on the books that cost the bank money, which can occur even in a 100 percent guarantee situation because it costs a lot of money for a bank to service a troubled account.

Pretty shocking, given the punishingly high cost. And since respondents reported using their credit cards as sources of funding, we can safely assume they carry balances. Add to this the turmoil in the credit card market today and we have at hand a real challenge for small companies.

In the NSBA’s recent study, conducted between April 27 and May 5, some 79 percent of the companies that responded reported worse terms on their cards (i.e., higher interest rates and fees) compared to the prior year. To be sure, credit card companies are paring down their loan limits, raising interest rates and fees, and reducing their risk. They’re doing so to try stemming their losses. See the accompanying tables that show the spike in delinquent accounts and bankruptcies.

Capital Is Critical

The issue here – funds needed to operate your business – is deadly serious. Run out of money and it’s game over. So what’s a business owner to do?

Of course, the best option is to build a business that generates cash and allows you to fund its operations through cash flow. Many business owners do achieve this, and you can, too.

This publication gives many tips for building such a business. And, of course, doing so is a long-term project. Furthermore, even businesses that generate strong operating cash flow may choose to use debt to fund rapid growth, enhance return on equity, or smooth the hit to cash caused by periodic capital expenditures.

So, what are your options?

Traditional Bank Financing

Have you tried to obtain traditional bank financing? Despite what you read in the press, banks are lending. More than that, they’re lending at all-time low rates of interest. So if you already have a relationship with a banker, give him/her a call to discuss paying off or paying down your credit card debt. If you don’t have a lender, get a referral from one of your business owner peers.

Keep in mind that new SBA loan programs are incredibly attractive. Your lender will be able to help you evaluate the programs and assess the opportunities.

In summary, business owners must get the funds they need. Credit cards are a substantial source of funds for small businesses and, at times, one of the only sources available. Every business owner should endeavor to move beyond credit card dependence as a primary source of funds. It’s just too expensive. Credit cards should be used for emergencies only.

A short-term funding source of last resort.

To qualify for a regular business loan, all you need is to build a relatively stable business that is profitable, has organized books and records, pays its income taxes and maintains modest levels of leverage.

You can get there. The Business Owner can help.

Yes, the U.S. government has taken bold steps to keep companies afloat during the downturn. Small Business Administration (SBA) guarantee levels have been increased to as high as 100 percent on some loans. In addition, it has waived all fees through the end of the year, raised the maximum business size threshold, and in some cases will even make your interest payment(s) for you!

Loan proceeds can be used for most sound business purposes, including working capital, machinery and equipment, furniture and fixtures, land and building (including purchase, new construction and leasehold improvement), and debt refinancing (under special conditions). Loan maturity is up to 10 years for working capital and generally up to 25 years for fixed assets.

Government Guarantee Helps Banks Say “Yes”
You still go to a bank to get the loan or refinancing, but government guarantees help banks say “yes” when they otherwise could not.

“We believe these changes are making a difference,” said Fred Munden, lead development specialist for the SBA’s Oklahoma City office. “Commercial lending is increasing and some businesses that were at risk of closure due to inability to refinance debt are now getting the funding they need. In some cases, it’s with a different bank, but the money spends just the same.”

“The program was a godsend for us,” said David LaGere, president and owner of Cherokee Architectural, a 12-person firm that manufactures ornamental staircases.

More Businesses Eligible
SBA loans are available to small businesses, and the definition of “small” has been temporarily expanded. From now until September 30, 2010, it’s any businesses with a tangible net worth of under $8.5 million and average after tax-income of less than $3 million during two fiscal years.

Borrowers cannot use the money to pay down SBA-backed loans made prior to Feb. 17, 2009.

100 Percent Guarantee, No-Interest Loans
A 100 percent guarantee program began June 15 and has a maximum loan amount of $35,000. Even more, all interest and fees will be paid by the SBA. The borrower has to repay only the principal. The best candidates are small businesses that have been profitable for one of the past three years but are now struggling and starting to miss loan payments.

Loan proceeds are disbursed over six months and repayment does not have to begin for 12 months after the last loan disbursement. Further, repayment can extend up to five years. Loans of this type will remain available until either the allocated funding runs out or Sept. 30, 2010, whichever comes first. Businesses are limited to one ARC loan apiece.

“This type of loan is designed to provide a shot in the arm for struggling companies,” said Munden of the SBA. “We want to help the qualifying companies make it through these tough times and come out the other end whole.”

Not for Start-Ups
Munden stressed that ARC loans are not for start-up businesses. “They are designed to help existing small businesses deal with making other loan payments,” he said. “Examples of qualifying loans include credit card obligations for your business, capital leases or notes payable to suppliers. They might also involve other loans made without an SBA guaranty.”

Application Requirements
Although SBA programs may make loans available to businesses that otherwise would not be able to qualify, there are underwriting standards that must be met. Lenders and the SBA will generally need the following from you when you apply:

Business Profile: A description of your business. Include what it does, the type of legal entity, its products, whom it sells to, the number of employees, a brief history and who owns the business.

Loan Request: A description of how much money is needed and what the funds will be used for.

Collateral: Description of collateral offered to secure the loan. Include equity in the business, borrowed funds, available cash, and assets such as accounts receivable, inventory, equipment and real estate.

Business Financial Statements: Complete financial statements for the past three full years plus year-to-date. This includes balance sheets and income statements.

Projections: Of revenue, expenses and cash flow for the next three years. Must show that the business can support repayment of the requested funds.

Business Tax Returns: Most recent three years.

Personal Financial Statements: For each person who owns 20 percent or more of the business, current personal balance sheets (i.e., a listing of all assets and liabilities and personal tax returns for the past three years).

For more information, including a complete list of SBA lenders, go to www.sba.gov.

Synonymous with “equity.” Calculated by subtracting the total value of all liabilities owed by the business from the total value of all assets owned by the business. A key question is how the assets and liabilities themselves are valued. One well-known method is “according to generally accepted accounting principles (GAAP).”

Tangible Net Worth

Net worth minus intangible assets.

Intangible Assets

Assets that have value but cannot be physically touched or easily valued, such as a brand, franchise, trademark or patent. Cash, receivables and payables are not difficult to value and therefore are considered tangible assets. Small and midsize private businesses may not have any intangible assets on their balance sheet, but if they do, it’s typically goodwill, which may have been derived from the purchase of another business, or capitalized expenses such as organization or research and development costs.

Book Net Worth

Simply the net worth of your business as shown on your financial statements. Also described as “unadjusted.”

Adjusted Net Worth

Derived by subtracting total liabilities from total assets after adjusting each to reflect its true value. For example, business assets almost always include accounts receivable. Let’s say that XYZ Company’s accounts receivable are shown on “the books” at $249,303, but the business owner knows that this amount includes $33,424 owed by PDQ Inc. that is past due and likely uncollectable. If the business owner were to prepare an adjusted balance sheet, he or she would amend the book value of receivables to reflect a more accurate estimate of value, including all assets and liabilities.