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Sources of Capital: Commercial Banks and Commercial Finance Companies

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al


Commercial banks are widely known as a source of debt financing for businesses. They generally provide lines of credit, term loans, and revolving loans. Traditionally, commercial banks are cash flow lenders and view collateral as a secondary source of repayment; from experience, bankers' actions do not always evidence this thinking. Focus is placed on lending to borrowers that have durability and predictability of cash flows. To assure liquidity and stability for the public, banks are highly regulated by state banking commissions or similar bodies, the Federal Deposit Insurance Corporation (FDIC), and by the Office of the Comptroller of the Currency (OCC). Banks are scrutinized for base capital, profitability, liquidity, credit quality, and management, and are required to monitor and rate each loan with quality codes or risk ratings. These codes are established by the bank and relate to, among other things, the type collateral, loan-to asset value, cash flow coverage, and guarantees. Combined, these impact the price charged a borrower, or cost of capital or interest rate, and the status of the loan in the bank's portfolio. 6 Bank regulators can force a bank to place a loan in nonaccrual or write down a fully performing loan if some factor is of concern to them. This regulatory control is a large determinant of what might be deemed an acceptable risk. 7 This mode of operation coupled with the commodity nature of the banking business translates into a relatively conservative posture inherent in the culture and mind-set of bankers in relation to growth companies-especially given that most growth companies consume cash, not generate it. For start-up companies, collateral becomes more important given that most fail within the first five years. 8

Most loans are made based on historical financial performance and minimum asset collateral values. The decision to lend is based on the 3 C's of credit: character, collateral, and capacity, where capacity is the ability and willingness to pay.9

The bank is not an investor, nor do the bank's returns justify accepting significant risk. Banks are essentially the lowest-risk lenders. You will find that most banks will not lend to a company with a debt-to-equity ratio greater than 2.0 to 3.0 without some additional guarantee or collateral.

This is the converse of asset-based lenders (ABLs), which primarily make their lending decisions based on the quality of the underlying assets and secondarily on cash flow. There are many specialty lenders and commercial finance companies that provide various forms of debt; these lenders tend to understand a specific form of debt exceptionally well and have the business processes in place to manage their risk, or they have expertise in a specific industry and have adjusted their lending program and structure to accommodate the nuances of that business.

It is important to note that many larger regional and national banks now have asset-based lending divisions as well as capital market groups that provide private equity. A key in selecting a financing source is the inherent culture and the actual people that you will interface with and those that make the decisions affecting your relationship with them. We recommend that you determine the work experience and background of the lending team assigned to your company. Most commercial bankers turned asset-based lenders do fine in a relationship until the client's business has difficulties or goes sideways. Then they revert to their instincts, which may be much more conservative. This is not necessarily bad, except that a knee-jerk reaction may be to push your company to take action that is not in its best interest; the bank may call your line of credit and force you into a reactionary mode.

Now the converse argument: Many of the major banks have acquired strong and credible asset-based lending firms and have allowed them to maintain their autonomy. These lenders bring the expertise, temperament, and monitoring processes as true asset-based sources of finance. We advocate knowing your lender and what his or her true disposition is relative to what your business is likely to need with regard to its size, stage, and industry.

Confidence in a company and management is developed from a variety of sources. Many times it begins with referrals from known professionals such as attorneys and accountants, and is coupled with the quality of financial data; over time it is a function of doing what you say. As with many other sources of capital, banks tend to look at the background and depth of management, management's focus on the customer, the type customers and the company's value to them, why customers buy from the company, and a thoughtfully developed and viable business plan. Lastly, banks look for management that is willing to "work through the tough times." 10 For many lenders, their greatest fear is how management will act when the business goes sideways or in the ditch.

Financial covenants should be more important to company management than the interest rate or up-front fees charged in establishing a credit facility with a bank. The financial covenants need to be structured in a manner that will provide the least constraint given a company's business and operations. It is difficult to foresee the future and foretell a problem that does not exist today but could be one tomorrow. Covenants have often forced companies to take action that was not good business in order to avoid defaulting on the loans; you want to avoid this.

The next logical topic surrounds the use of personal guarantees. Our collective experience shows that banks will request, and many times require, personal guarantees from the principals and management of emerging growth and middle-market client companies. These guarantees usually include spousal guarantees where the bank is looking to personal assets as backup collateral. Guarantees are usually intended to assure that management does not walk away or abdicate their responsibility to the bank when trouble occurs within the company. A principal's personal guarantee gives the lender comfort that when the going gets difficult, the principal will remain committed to corrective actions or an orderly liquidation. 11

Strategies for Structuring Personal Guarantees

Developing an effective strategy for structuring and managing the personal guarantee begins with understanding your lender's objectives and perspective. Secondly, it is important to understand your company's current and forecasted financial position relative to liquidation under federal bankruptcy laws.

A philosophy we promote is that of isolating the risk of your business from personal assets, even when personal guarantees are involved. This requires personal and business financial planning. If you are a significant shareholder and manager of an emerging growth or middle-market company, and anticipate you will be required to sign a personal guarantee, you may consider engaging counsel that fully understands personal and corporate bankruptcy. As an individual, this counsel should not be counsel to your company to prevent the conflict of interest inherent in the discussions. Conversely, we recommend the same from a company perspective; that you have experienced bankruptcy counsel review your debt strategy. We discuss the concept of a liquidation balance sheet in more detail in Chapter 4, "Capital Structure."

Here are six proposed actions to consider when negotiating the terms of debt with the bank and other lenders with the general objective of committing to as little as required when signing a guarantee:

  1. Pursue a written agreement specifying that certain terms of the guarantee will change based on improved financial performance of the company. An example: If your company will have a debt-to-equity ratio of 3:1 post financing, agree to reduce or limit your guarantee when the company's debt-to-equity ratio falls below 2:1. Also consider having the guarantee become less onerous over time, based on the bank's continued relationship with your company.
  2. Seek to limit the guarantee by not having your spouse sign, so that it is based solely on your personal guarantee. Be prepared to provide a financial statement showing only your individually owned assets and liabilities. In most states this limits the risk to only assets held solely in your name, not joint assets or those of your spouse.
  3. Seek quantified limits on the amount of the guarantee either in relative terms or absolute terms. For example: You may have a line of credit with $2 million total availability. You may seek to limit your exposure to 20 percent of the outstanding balance or a maximum of $200,000. This is particularly appropriate with multiple owners whereby you may seek to limit your exposure based on your percentage ownership.
  4. Seek to exclude any assignment or lien on a personal asset or real estate such as a house or property.
  5. Seek to limit any risk unless you commit a fraud in managing the business; this is sometimes referred to as a fiduciary guarantee.
  6. Assure that the lender must exhaust all remedies against the collateral underlying the loan before the lender can seek recovery from the guarantor. Blanket guarantees usually allow the lender to go directly to the guarantor and ignore the collateral-they will go to the quickest source of liquidation. 12

Practically Speaking

Unless the banker feels very comfortable with the operations and their security, the bank will ask for a guarantee. And as a borrower, you have a choice not to sign but the bank knows that it is not likely. At this stage, the bank clearly has the advantage in negotiations. Unless there has been a trust violated, banks generally do not like to go after personal assets, particularly homes or belongings. They want your attention and your best efforts to make the company successful. One of the common phrases in banking regarding guarantees is "Who has whom?" In most cases, the loans far exceed the value of the guarantor's personal net worth and often with high net worth individuals their equity is not liquid; it is in real estate or equity in private companies. If things go badly, generally it is in both parties' interest to negotiate a mutually acceptable plan to rescue or protect the bank and company. If you have signed a guarantee and it is for a small portion of your net worth, then it is meaningful. If it is more a multiple of your net worth, then you and the bank need to work together (and generally the guarantee will be waived over time), which is what the bank wants anyway. For the bank to be repaid, it needs management's expertise to resolve the operating issues.

Banking Business

Companies want to develop a good working relationship with a bank and have an advocate for the company within the bank. We suggest that you develop a working relationship with more than one bank-not to play one bank against another, but to mitigate the risk of bank policy changes and to assure that your company has alternatives when your needs may not suit an existing relationship. Banking is built on personal relationships, and you cannot build a relationship quick enough when difficult situations or needs arise. In addition, bank officers have a high turnover rate and it is difficult to predict when turnover will occur. So you do not want to be caught in the early stage of building a new relationship and have a crisis occur.

Sometimes banks get in trouble when bank management leads its lenders to increase the number of loans on their books at a rapid rate. This is generally done because their existing loan portfolio cannot earn enough to fulfill industry earnings expectations. So why do we care? If your company's loan is one of those that is really marginal in the bank's normal mode operation, once the wave of rapid loan-making is over, your loan may very well be deemed a problem credit-even if you make all the payments on time. This may lead to pressure by the bank for you to repay the loan or for you to improve your financial position at a rate that was not expected. In a worst case, the bank may call the loan and demand repayment.

There are other instances in the life of a bank and other macroeconomic issues that sometimes cause the bank to change its disposition relative to credit risk. Though you cannot control these, they may affect you and your company.

Lastly, the size of the asset base of the bank matters as you consider which banking relationship to establish. Each bank has a loan lending limit per risk (that is you or your company). If you choose a smaller bank as your lender, look ahead several years and determine if their borrowing limit is adequate to support your company's foreseeable borrowing needs.

Keep in mind that most loan documentation provides demand for repayment features if the bank feels insecure, regardless of the term of the loan. This is a very subjective covenant and leaves the company at risk if it does not have alternatives at hand. Thus we are back to the recommendation of having more than one banking relationship established.

Commercial finance companies are sometimes asset-based lenders that have a narrower niche (specialty finance) or a broader scope of services and credit facilities. In some cases they provide financing only of those items listed here under "Offerings" or a subset thereof. For example: There are companies that solely provide purchase order financing and factoring, and they classify themselves as commercial finance companies. There are also very large finance organizations with a broad spectrum of lending and investing activities that deem themselves commercial finance companies. Once again, there is not industry consistency in the use of the term. For examples of actual companies, see the Financing Source Directory in Part Three.

Here is a list of offerings that we have found regarding commercial finance companies that are in addition to the ones listed in the section discussing ABLs.

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Offerings

  • Senior debt broadly defines lending with a first lien position against a company's assets. It includes letters of credit, revolving lines of credit, term loans, bridge loans and short-term credit lines.
  • A revolver or revolving credit line is a debt facility made available up to a specified amount, without a fixed repayment schedule, that the borrower may draw on and repay as needed. It is usually secured by a first lien position on the current assets of the company. Banks and commercial finance companies offer these with certain financial and operational covenants.
  • A senior term loan is an amortizing or partially amortizing term loan that is secured with a first lien position on the assets of a company. The term is usually three to five years. Partially amortizing term loans may include a warrant position to offset some of the risk of repayment. This type of loan is sometimes referred to as a senior stretch term loan.
  • Bridge loans provide interim financing with the provision to roll over to a longer-term financing vehicle.
  • Junior debt is either unsecured or has a lower priority than that of another debt claim on the same asset or property. It is also called subordinated debt or mezzanine debt. See the "Private Equity" section of this chapter.
  • Equity co-investments with senior debt occur in certain cases when a lender will agree to take a relatively small equity position in a transaction in conjunction with making available a senior debt facility. The equity portion is usually under the same terms and coincides with a private equity investment.
  • Mortgage debt financing.
  • Cash flow collateralized debt obligation and other structured finance.
  • Leases. See the next section, "Leasing Companies."

Figure 5.8 provides a summary view of the characteristics of the various types of term loans.

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The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.