When a growing middle market company defaults on a loan, it is common to blame the company’s misrepresentation or its mismanagement of the proceeds from the borrowing. In truth, many loans that go bad are the result of improper structuring by the bank or other lender. Many lenders and borrowers fail to structure financing to fit the company’s operational characteristics. Good banks and good borrowers can assure the quality of the banking relationship as well as the borrower’s ability to repay by having a series of conversations about the company’s credit needs and a loan structure that will serve the requirements of both sides.
Beware of the collateral trap
Many banks put excessive emphasis on available collateral in underwriting business loans. 
Collateral should not be the primary determinant of credit amount, structure or conditions. To be sure, collateral is important as a secondary source of repayment and is an assurance to regulators that the bank has covered the risks of the loan transaction. But it should not be the only or even the main factor in proper credit underwriting and loan structuring. If your bank starts the discussion of financing your business by asking “How much collateral do you have?” this could be an indication of problems in the lending process.
Loan purpose
The initial evaluation of your bank credit request should begin with, “What is the purpose of the loan?” There are only four acceptable answers:
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Seasonal working capital (carrying current assets until they convert to cash)
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Purchasing assets with an identifiable long term life and clear business purpose
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Financing growth (increase in the level of permanent working capital)
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A temporary bridge to a very certain event, to facilitate payment of business obligations until the event takes place
Any answer to the question about the purpose of the loan needs to be a variation of one of the above. If your banker accepts anything else, he/she is doing a disservice to both borrower and lender.
Source of repayment
The next question that your bank should ask is, “How will the loan be repaid, and if that fails, what is the secondary source of repayment?” There are only so many primary and secondary sources of repayment. Primary sources of repayment are:
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Conversion of current assets to cash in the normal course of business (seasonal working capital loans)
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Positive operating cash flows in the normal course of business (production asset loans)
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Improved operating cash flows when growth slows or from new capital ( growth loans)
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Cash proceeds of a predictable event (bridge loans)
Secondary sources of repayment include:
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Sale of the collateral
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Sale of excess assets that were not part of the collateral
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Injection of new equity
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Substitution of debt (a questionable secondary source for most banks)
If your bank thinks that sale of the collateral is going to be the primary source of repayment, they are creating a major potential problem for you.
How much money I can borrow and for how long
The amount of money the borrower needs and the maturity of the loan are numbers that can be determined based on your financial condition and performance. Your bank will need to analyze your financial statements to answer the ”How much and how long” questions as well as questions pertaining to terms and conditions. I will examine those questions in the second part of this article.
The key point for now is that a middle-market borrower and its bank will be a lot happier with the outcome if the bank credit conversation focuses on a series of clear questions that crystallize the operating needs and characteristics of the borrower’s business.
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Contact Ted at ted.parrish@newportboardgroup.com
