Surviving the Loan Underwriting Process: Part Two

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RUNNING THE GAUNTLET

With that background context in mind, let’s enter the Thunderdome!

Hurdles and Gates. The best way to think of the underwriting process is as a series of
stages, each with its own steps to complete and hurdles to clear before the gates open to the
next stage. Regardless of the “highly-underwritten” loan product contemplated, most lenders
utilize some variation of the following three-stage approach to underwriting: Discovery,
Initial Analysis, and Due Diligence.

☝️ You could technically add a beginning stage called Screening and a final stage
called Closing, but typically the underwriter isn't materially involved at either of these
stages. The Screening stage usually consists of an inbound application and quick
company website review to ensure a high-level fit, and is more a function of the
lender's Sales & Marketing teams. Then, in the Closing stage, which happens once the
underwriting and structuring are completed and the term sheet is signed, the
underwriter usually moves on to the next deal, leaving the final legal negotiation to the
relationship manager and legal counsel. It's probably fair to think of this last stage as
its own separate mini-gauntlet (or circle of purgatory!), so we'll cover that in a separate
post.

At the heart of this traditional gating system is a simple concept: Opportunity Cost. Not only
does the lender want to efficiently allocate their limited underwriting resources to the deals
with the best chance of closing, but they also appreciate that your time is finite and that, if
they can’t offer you credit and win your business this time around, they’d prefer to let you
know that as soon as possible so as not to waste your time, thereby increasing the chance of
getting another shot at your business down the road.

☝️ There are actually two ways this should be read: (1) the deals with the strongest
credit profiles and (2) the companies exhibiting the strongest intent to close. At the risk
of exposing my glass-half-empty demeanor, the truth is that lenders put the gates in
place to make sure that both low-credit AND low-intent companies don't make it
through.

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Discovery: The primary objective of this stage is to quickly determine if your company is a
potential fit for the lender and their loan product offering. Or, said more bluntly, whether there
are any obvious deal-killers that put you too far outside the lender’s credit box to warrant
additional analysis.

☝️ My former mentor was an avid golfer and would often ask if a prospective borrower
was "in the fairway" or "in the rough," meaning did it fall squarely inside the credit box
or did it exhibit risks that warranted more analysis. Think of the Discovery stage as
trying to determine if the deal is "out of bounds" and therefore unplayable, meaning
that it's just too far out on the risk curve.

In this stage, lenders will start by reviewing your website, asking some basic questions, and
requesting high-level company information and summary financial statements (see table
below for more details). The intent is to get a sense of what the company sells, who it sells
to, and how well it’s doing in those efforts.

☝️A lot of lenders will ask for stats like client retention, CAC, and inventory turnover,
then use your self-reported numbers to start to rough out the risk of the deal. Don't be
surprised if and when they ask for reporting to validate those numbers later in the Initial
Analysis and Due Diligence stages.

If that information suggests you’re a potential fit, you’ll be moved to the Initial Analysis stage.
Depending on the situation, the lender may provide you with some basic and informal ideas
around a potential loan structure, like estimated amount and specific loan product(s). This is
as much a sales tool as it is an underwriting tool, as you may be a good fit for the lender but
not at the dollar amount or loan structure you’re envisioning. A good lender will be
transparent as to the range of outcomes you’re likely to experience post-underwriting
in order to avoid confusion or frustration later on in the process.

If the information suggests you are not a good fit, it’s usually a point-in-time issue with your
financial performance (e.g., you’re currently experiencing losses or your debt-to-equity ratio
is too high), in which case a good lender will (1) succinctly explain the reasons for the
declination, (2) provide you with some concrete steps, actions, and timelines they’d need to
see in order to take another look (e.g., a return to profitability measured over the next six
months), and (3) refer you to other capital providers who are better-suited to your current
situation and cash need.

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 ☝️If you've ever been declined during the Discovery phase, it can be frustrating and
maybe even a bit of an ego-hit. Keep in mind that all lenders have a wide range of risk
philosophies and return objectives, so a decline typically isn't an indictment of your
business plan, execution, or leadership. Lenders often have internal limits on how
many deals they can do in a specific sector or geography or product type, and
sometimes lenders have specific limitations on how loan proceeds can be used, for
example barring acquisition financing or partner buy-out requests. As noted, most of
the time the decline is not a "never" but a "not yet."

In fewer instances, the lack of fit might be due to some fundamental mismatch that
permanently disqualifies you from consideration, like a prior financial crime conviction or
offshore ownership that legally precludes the lender from securing your assets as collateral.
Lenders try to uncover these fundamental deal-killers during the Screening phase (i.e.,
before the underwriter is involved), typically by asking you to disclose this information in an
upfront application.

☝️More on self-reporting in the last section of this paper.

Table: Discovery Stage

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Initial Analysis: As noted above, when you make it past the Discovery stage it’s because
the lender thinks there’s a potential fit based on your high-level financial performance and
how you plan to utilize the loan proceeds. The Initial Analysis stage is trying to confirm that
you are indeed a good fit for the lender. Said another way, while the Discovery stage is set
up to determine that there are no obvious reasons not to do the deal, the Initial Analysis
stage is designed to confirm that there are obvious reasons to do the deal.

To get to that decision point or gate, the lender is trying to (1) uncover, categorize, and rate
“all” material risks with your business and financial performance and (2) model how your
company is likely to perform in the future, in order to (3) determine that your repayment
sources are in fact strong and then (4) craft an appropriate loan structure (i.e., loan
product(s), total amount, pricing, term) that aligns with those repayment sources. To
accomplish this, the lender may start with an in-depth interview in which they ask questions
based on their preliminary findings from the Discovery phase. They’ll then follow up the call
with a laundry list of requested financial information that will be needed to complete their
analysis.

☝️If you ask, most lenders will provide you with a complete underwriting checklist
during the Discovery phase, if you're curious of the total lift and/or confident enough to
want to jumpstart the gathering process. One of the ways that fintechs and tech-
enabled lenders are trying to streamline the process is by requesting upfront direct
access to your accounting, banking, and eCommerce platforms so they can
immediately jump into the Initial Analysis and Due Diligence stages with minimal lift on
your side. The obvious caveat here is that you must be confident in the lender's privacy
safeguards and reputation in the market before granting access to your sensitive
information.

If the underwriter gets through that process and determines that you are a good fit, then the
usual output is a term sheet that describes the proposed loan structure in some level of
detail. In “most” instances this is a strong indicator the lender is confident you meet their
credit criteria and they can deliver on the proposed loan structure.

☝️ More on this below in the Term Sheets and Commitment Letters section.

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Most lenders will require that you sign the term sheet before they’ll move you forward into the
Due Diligence stage, and they may require that you provide them with some upfront money
needed to finalize their analysis. Again, there’s both an opportunity cost and a real cost to
the lender of engaging the underwriter’s time and any third-party agencies to complete the
process, so lenders want to be confident that you’ll actually take the loan before they
proceed.

☝️ This also includes understanding who are your final decision makers, as many
times the lender will be dealing with a CFO or a CEO who reports to a Board or
requires final sign-off by the primary business owner before proceeding.

If you don’t make it to a term sheet, it’s usually because the sum of the financial parts didn’t
add up to a good fit, as opposed to any single financial metric being a deal-killer. I appreciate
that this may seem borderline crazy, since you already passed the Discovery stage where
the high-level financial metrics were reviewed, but there are a couple points to keep in mind:

1. The Discovery stage is typically based on yes-or-no application questions and

quantifiable point-in-time financial metrics, given the limited time and information with
which to make the decision.

☝️ And therein lies the rub...like every other decision-making process, underwriting is
a trade-off between time and information. Technology is helping lenders to obtain (and
interpret) information more quickly, but it's also introducing a new variable: data
security.

In contrast, the Initial Analysis stage allows the underwriter to fully access and analyze
detailed historical financial trends and strategic forecasts, then overlay and incorporate
nuanced qualitative assessments of the business environment in order to assess your
company’s overall odds of successfully paying back the proposed loan. It’s the synthesis of
these quantitative, qualitative, and in-motion variables that ultimately separates the potential
fits into the good and not-so-good fits.

☝️ It's also not uncommon that the underwriter's analysis ends up clarifying some of
the information self-reported in the Discovery phase, for better or worse.

2. Lenders usually utilize some form of risk scorecard to quantify this analysis, wherein
each key variable and financial metric is assigned a weighted score and the total is summed
to come up with an assigned rating for each deal. The scorecard will incorporate many of the
financial metrics used in the Discovery phase, but should also incorporate the trend analysis

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and qualitative variables uncovered in the Initial Analysis stage. A decline in the Initial
Analysis stage usually means that the weight of these newly-assessed risk variables
dragged down the overall score below the lender’s required minimum.

It may be helpful to think of a quick and overly simplified example to illustrate the concept:
Suppose the Discovery stage asks for four pieces of information: (1) prior year revenues, (2)
prior year gross margins, (3) prior year profits, (4) inventory turnover. Each of these four
variables meets the lender’s bare minimums, so the deal progresses to the next stage.

Now in the Initial Analysis stage, the underwriter gets access to detailed financials and sees
the following: (1) sales mix has abruptly shifted in recent months, (2) monthly revenue levels
have stalled, (3) repeat purchases have fallen off a cliff, (4) returns are up, (5) a key supplier
went out of business and the new supplier is offering worse terms, and (5) CAC is up
considerably. The underwriter takes all those recent trends, pivots, and shifts into
consideration (none of which were readily evident in the Discovery metrics), and forecasts
that the company is in serious jeopardy of becoming unprofitable within the next quarter.
Should the lender proceed?

Usually though, there’s not such a material difference between the output in the Discovery
stage and the Initial Analysis stage. If the deal barely meets multiple criteria in the Discovery
stage, a good lender will inform you that there’s a real chance that they won’t get comfortable
at the end of a full underwriting, at which point they may offer to limit their analysis to a small
subset of additional information to determine whether to keep moving the process
forward. Or, even more likely, they will determine that you’re still eligible for a loan at the end
of the Initial Analysis stage, but it’s either priced more expensively or is more restrictive from
a structural standpoint due to the additional risks uncovered in the second stage.

Table: Initial Analysis Stage

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Due Diligence: At this point, after clearing the hurdles in the Discovery and Initial Analysis
stages, you’re probably thinking “okay, I’m a good fit and I signed the term sheet…aren’t we
done yet?!”. In many cases, the Due Diligence phase is in fact pretty quick and painless
relative to the Initial Analysis stage, but there are a few important steps remaining. Typically
after the term sheet is issued, there are still a few assumptions that the underwriter has
made, based either on the analysis performed or on information self-reported by
management, that need to be validated before the loan can be closed.

These generally fall into two categories: (1) the underwriter’s satisfactory review of company
documents and (2) satisfactory receipt and review of third-party reports, audits, or
appraisals. The former category includes items such as supplier and 3PL agreements;
insurance policies; cybersecurity and financial crimes control processes; and key-person and
staffing contingency plans. Examples of the latter category include collateral appraisals and
onsite audits; key person background and credit checks; and reference checks.

In essence, most of the focus in the final analysis stage is on items that are crucial to the
ultimate success of your business and loan repayment, but are either (1) costly to undertake
until both parties are certain that they want to work together and (2) not typically so unique or
controversial that the underwriter expects them to swing a deal from the “go” to “no-go”
category. A good lender will give you a head’s up on these specific items early in the
underwriting process, as well as clearly spell out these requirements as part of the term
sheet.

Once all of the specific items have been reviewed and all key assumptions have been
validated, the underwriter will take the final step of submitting a credit memo internally to get
the loan formally approved. Often this approval comes in the form of a loan committee
meeting of key lender personnel, usually with the Chief Credit Officer as the committee chair.

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Some lenders have a distributed or tiered approval process where certain personnel have
authority to approve loans within a certain size range or other parameters, but in all cases
there's someone or some group that oversees and must formally approve the underwriter's
final recommendations. A good lender will have a well-aligned credit policy such that there
are no surprises between the underwriter’s work and the loan committee’s approval. Or, in
situations where the deal is a little closer to the edge, good underwriters will build consensus
with key decision makers throughout the underwriting process.

If you make it through the Due Diligence stage, you are officially through the underwriting
process! Typically this is signified with a Commitment Letter, which may include additional
costs to be borne by the borrower in order to cover legal documentation costs and other
closing costs.

If you don’t make it through the Due Diligence process, then something has gone terribly
wrong in the process! It’s very rare that a reputable lender will flat-out decline the loan
opportunity once the term sheet has been issued and signed, and in the few cases where it
does happen it’s usually because one of the last validation steps uncovered a material
systemic weakness or fraudulent behavior. Still rare but a bit more likely is that the collateral
appraisals or other third-party checks uncovered something that required a change to the
final loan structure, as opposed to a complete rejection of the request.

Table: Due Diligence Stage

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In Part Three, we will cover specific loan product information requests, pitfalls and
rabbit holes, term sheets and letters of commitment, tips for impressing the Chief
Credit Officer, and how to maximize your chances during the process to build a strong
relationship post-funding.

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