While most of us are aware of the real estate adage of “location, location, location”, fewer of us might be aware of the adage for emerging and middle market companies of “financing, financing, financing”.
There are many sources for financing today, which make the choices for emerging and middle market companies more challenging. While many lenders are eagerly seeking to provide financing to well capitalized, successful companies, the number of lenders willing to finance difficult or higher risk transactions has decreased dramatically. This is due, in part, to a variety of ownership structures for these lending institutions.
The banking industry has been stratified to a variety of lending sources. Some commercial finance companies are publicly owned, while others are owned by banks. The differences in ownership structure may impact the type and kind of lending arrangements that can be completed. For example, a commercial finance company owned by a bank is subject to regulatory constraints and usually required to report problem loans, much like its parent bank. Privately owned commercial finance companies may not be subject to the same restrictions and have more latitude in completing a financing. In addition, while international, national, regional and community banks are all in the business of making loans, they serve different segments of the market. Some may focus primarily on real estate and equipment term loans, while others may favor revolving credit arrangements collateralized by inventory and accounts receivable. What complicates this further are changes in bank ownership, and the regulatory environment. Lenders who may have been very conservative during the financial downturn may now be aggressive, due to increased competition among lenders.
Finding the right lender begins with development of a well-defined business strategy presented as part of a financing package. The financing package must be complete and accurate. It should also include the history of the business, products or services offered, target market, and information about customers and competitors.
Most importantly, the financing package should include the financial history of the company (where it has been) and a forward-looking financial projection (where it is going), as well as information about the management team that will get it there. The information on the management team should focus on both the past success of management, as individuals, and their unique skills to lead to the future success of the company. In many instances, lenders will make decisions based heavily on the confidence they have in the management team. I have heard a lender say, “A bad management team will overcome good company products, and a good management team will overcome bad company products”.
The financing package is an important first step. The second step is to identify the right financial partner whose lending philosophy fits well with the needs of the company. A large international or national bank may not be well-suited or eager to enter into a $1 million credit facility, as would a regional or community bank. Conversely, while a regional or community bank may be keenly interested in a $10 million credit facility, its lending constraints and target market may hinder completing this type of arrangement. Ideally, a more focused approach makes the process far less time consuming and more likely to succeed. This would include preliminary discussions, with no more than half a dozen potential lenders, to determine the best fit.
The next step is negotiating a financing agreement that provides the company with sufficient liquidity and flexibility. This can become a contentious discussion regarding loan amounts, financial covenants and personal guarantees. A company should carefully review the agreements to determine that complying with financial covenants is a reasonable expectation rather than a stretch goal. Failure to comply with financial covenants can be both costly in terms of higher fees and interest rates and limitations on the amount available under the financing agreement.
Financing and liquidity are essential for emerging and middle market companies. Without an adequate level of financing, the ability of a company to accomplish its goals may be significantly diminished.
Carl Kampel, a certified public accountant, is the director in charge of professional standards at Ellin & Tucker, an accounting and business consulting firm with offices in Baltimore, Frederick and Belcamp, Maryland and Washington, D.C. He is a member of the FASB Emerging Issues Task Force and past vice chair of the AICPA Financial Reporting Executive Committee. He is also a member of the Board of Directors of the Baltimore Chapter of Financial Executives International and the Maryland Association of CPAs.