9-9-09 has come and gone. A friend’s birthday and a couple Hollywood movies with 9 in the title were the biggest events I noticed, perhaps it had the disadvantage of being a Wednesday. The 9 on my mind recently is Ice-Nine: a fictional form of water invented by Kurt Vonnegut for the book Cats Cradle. Ice-Nine is a lab engineered crystalline form of water that is “frozen” at Earth ambient temperatures. When it comes in contact with any other water, those molecules quickly align onto the Ice-Nine structure, also now becoming frozen. As you might imagine, Ice-Nine was a fairly deadly substance and by the end of the book the world pretty much ends, frozen.
That’s a bit melodramatic, but the concept that Ice-Nine has this structure that it communicates to any additional water molecules it comes in contact with is brought to mind for me as I study banking and think about it as a core part of how our economy works. Bankers have a lot of rules – perhaps a little bit like the FAA – each rule added after some deal or series of deals crashed and burned. My banking instructor has a great saying that you should not “take ownership risk for loan-ership rates”. It’s in banking that the concept of a risk-return curve truly makes sense to me – you have a loan pool, you build a loan portfolio to a specific return profile, you can afford to lose a specific number of dollars and still make your numbers, period. There is no unpredictable equity upside that makes the whole thing a bit of a gamble. Lenders do an insane amount of verification, as anyone with a business loan probably already knows, because it’s all about managing that downside risk.
I find myself thinking that lending institutions are like Ice-Nine – that in order to interface with them you have to conform to their structure. Their structure is driven by minimizing downside risk and unsurprisingly has a narrow interpretation of what a successful business looks like – ratios like the quick ratio and the current ratio, debt-to-equity ratios and turns on payables and receivables are all expected to fall within industry norms. Businesses who need credit will find themselves shaped into a box where success is known to have been achieved before.
There is recognition that businesses will vary across industries and so norms are by industry. The RMA is a national association for banks that has existed since 1934. One of its services is that every year member banks submit the (anonymized) financials of their borrowers and RMA compiles them and produces Annual Statement Studies that summarize key ratios by NAICS code, broken down into buckets of company sizes (by sales or assets) and split out into top quarter, median, bottom quarter values. Most libraries have a copy in the business reference section, and it’s a way to see how successful businesses (that use bank credit) are structured financially. It includes things like gross & net profit margins too.
Understanding high-probability success is a great thing, particularly because the flow of value internally in a business is complex. Small businesses by their nature of having few employees have more generalists than specialists so roadmaps are helpful. However roadmaps will only take you the same way everyone else is going. If you want to run your business differently – having stronger relationships with your supply chain and perhaps carrying more than industry standard inventory or paying your employees more than industry standard wages and benefits, you’ll need to find specialized partners willing to hear you out on why your differences are better.
To some extent community development lenders fill this gap – as non-depository institutions they can take a little more risk in the name of supporting the local economy. A few creative banks are in this space as well, but they’re so few that while looking at a socially responsible investment, when they mentioned they had some traditional bank debt I was able to name the bank on the first guess. Building confidence in different models is another system change that needs to expand to support community stakeholder businesses, and perhaps building examples of financial models, and new ratios to watch will be part of that. Better yet, we need lenders that aren’t just be open to different models, but can also mentor to them.