When a borrower approaches a lender with a loan request to acquire a company, it initiates a process designed to help the buyer and bank evaluate this life-changing business opportunity. Banks utilize this process to assist the buyer’s evaluation process and to be a sounding board for the buyer. In general, the banker’s view will be oriented around the following:
Buyer Evaluation For starters, an objective banker evaluates an individual’s personal wherewithal: how an individual has overcome challenges and pursued objectives with sustained determination. In her New York Times Bestseller Grit, Angela Duckworth quantified an individual’s ability to persevere and achieve long-term goals. Her book suggests that while IQ is important, an individual’s conscientiousness is a greater predictor of success.
Due Diligence Driven by an industry with low tolerance for loan losses, bankers can be seen as pessimistic. It is their job to consider the numbers and how they would look if things were not all sunshine and rainbows. If a downward economic cycle occurs, is the financial information provided by the company a reliable source of data to make the necessary financial decisions? A financial evaluation is important; however, understanding the acquisition target’s cyclicality is also important. For example, commercial construction in general tends to lag economic cycles while businesses tied to consumers tend to lead economic cycles. Bankers will drill down to the micro-economic factors that apply to a business’ specific situation to give this deal the best chance of success.
Loan Structuring Cash flow is the largest determinant of the business’ ability to repay a loan and often determines how a loan is structured. Loans are structured based on the risk assessment and due diligence findings from the lending team. Loans made based on the cash flow of the business typically have shorter (ideally 3 years or less) amortizations whereas loans with appropriately margined collateral may extend beyond this. There are various structuring options that combine both options, so it is not just one of the other. If a company has excess cash flow, bankers could include a clause to decrease the principal balance by capturing this cash flow. A key to success at this point is transparency. It is important to find a banker that will be transparent with you and include you in the discussions to allow both parties to make an informed decision.
Collateral Evaluation In addition to the buyer evaluation, a banker evaluates the marketability of the collateral supporting the loan if cash flow deteriorates materially, and the collateral is needed to repay the loan. For example, a titled asset may be more marketable than a paint booth in a manufacturing plant. The loan to value ratio will be lower for less marketable assets. To properly identify the value, appraisals (equipment, property, etc.) are often used to substantiate the collateral value used. To further protect their financial interest, banks will typically require a first lien position on all collateral.
Approval Whether by a committee or individual signer, loan approval is a key element of the entire process. As much as the bank is responsible for diligence throughout the process, the buyer must also understand the bank’s (or the credit approver’s) background in financing Merger and Acquisition transactions. There are subjective factors that are relevant in commercial lending, and even more specific nuances are prevalent in acquisition financing. It is important to ensure your bank is equipped to offer the financing and support you need.
Funding It is not unique that an approval contains contingencies for funding the loan. These could include minimum revolver availability at closing, verification of liquidity, or receipt of an appraisal. Once the documents are signed and the loan funded, these items are typically monitored and require ongoing loan reporting on the borrower’s part.
Post-Close Management After closing, the bank will likely want to maintain regular dialogue with the borrower. Depending on the loan size and loan structure, the borrower will have ongoing reporting requirements they will owe the bank. If the deal is structured properly, it should create a lasting, mutually beneficial relationship.
Written by Aaron Schaffer
Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
March, 2024
Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
March, 2024