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A growing concern: Financing, legal issues can hinder an expansion-stage company

When precision metal finishing company Master Metal Finishers wanted to expand its market with an expensive new processing line, the company successfully tapped Lakeland Bank for an SBA loan. “The SBA application process was simple,” according to company President Jeff Almeyda. “The SBA loan we received from Lakeland Bank helped us establish a new processing line enabling us to expand into new markets and create new jobs.”

Each loan application is judged on its own merits, said John F. Rath III, Lakeland’s executive vice president and chief lending officer. But a growing company can take steps to improve its chances of getting approved.

Avoiding mistakes

Some common errors include a lack of a plan or a poorly documented one; insufficient equity and contribution by the owners; and a lack of a strong historical cash flow, Rath noted.

“We also want to see reasonable projections that show you’ll be able to pay off the loan,” said Rath. “For a working capital loan, for example, we like to see evidence that documents the company’s historical performance and a plan to use the working capital loan to move to a higher level of performance. If the funds will be used for a merger or acquisition, we want to see documents and reasonable projections that indicate the combined entity will be able to support the M&A debt.”

He said financial institutions like Lakeland also typically look for a balance between demonstrated ability and sound planning. “We want to be comfortable that management knows how to accomplish its plans and has the ability to execute on them,” he said. “The particulars will depend on our assessment of the company, the size of the loan and any previous relationship that has been established with the borrower. “

Depending on the size of the requested loan, a lender may want audited financial statements — which can be pricey — or it may do with a review, where a CPA does a narrower set of analytical procedures, inquiries and other procedures.

“Every bank has its own policies,” according to Rath. “At Lakeland, we usually want audited statements if the loan is north of $5 million, but it also depends on our past experience with the company and what kind of collateral it can offer. We are a relationship-oriented bank, so we try to gain a deep understanding of our clients.”

Ideally, the process starts before the application, noted Patrick Ryan, president and CEO of First Bank. “Business owners usually intuitively know their company, so their gut feeling about an expansion or M&A is probably pretty solid, but that’s not enough for a loan application,” he said. “You may wish to consider putting pen to paper and calculate your return on investment and document whether the business already generates enough cash flow to support the incremental debt or, if it’s an equipment or other loan, go into detail and document how the increased cash flow from the assets acquired will let you handle the increased debt.”

First Bank recently extended a loan to a pair of serial entrepreneurs who had created a successful company, sold it, and then later launched a new business in the metals recycling space. “We provided a multimillion-dollar loan for seed capital, a working capital line of credit and an equipment loan,” Ryan noted. “We were comfortable because of the bank’s previous relationship with the entrepreneurs and their reputation and character, since neither one took shortcuts.”

They also had a good business plan with a low level of fixed costs, “so even if the business went south they will likely be able to wind it down and still repay the loan. Finally, they have an experienced, high-quality CFO, so we were comfortable with the financial statements.”

Asking tough questions

The management at a growing company looking at an M&A or other significant expansion could start by considering the strategic reasons behind the proposed transaction, counseled Peter Laughlin, a partner with the law firm McElroy, Deutsch, Mulvaney & Carpenter LLP, whose practice focus includes corporate and commercial law. “Are you looking to expand market share, or enable a vertical integration? All of these issues will impact your strategy,” he said. “Once you’ve got your basics squared away, you can start to build your team: the internal management, legal and accounting professionals, and others.”

This is also a good to time to evaluate your current advisers, he added. “Your CPA, for example, may be a solo or small firm that might not be able to handle a significantly sized M&A. Think about whether you need a larger, perhaps regional firm.”

It’s all part of getting a handle on the processes and procedures, he said. “After you’ve done some initial, limited due diligence and identified a potential target company, you’ll begin to initiate high-level talks with the business and execute a [nondisclosure agreement].”

If the preliminary talks work out, the acquiring company may work with its advisers to create an expression of interest, a formal document laying out the basic proposed terms of the M&A. If both parties are still on board, the game is stepped up with a letter of intent.

“An LOI is usually issued if the acquirer and target companies are really serious about moving ahead,” said Laughlin. This document can give the acquirer a period of exclusivity, usually 90 days, during which it will formally engage in due diligence and write up the necessary legal documents.”

Think ahead

A business owner who even thinks he or she may consider selling their firm at some point may want to plan ahead by getting audited financial statements, according to Michael Weiner, a partner at Fox Rothschild LLP and member of the law firm’s corporate practice. “This will help a buyer formulate a baseline value for your company,” he said. “It will also help to position your firm to attract the broadest spectrum of buyers, including private equity or publicly traded companies.”

Weiner also advised buyers be aware of possible pitfalls. “Particularly in states like New Jersey, where there’s a sizable number of tech firms, a buyer needs to be able to understand the ownership status and quality of intellectual property, including trademarks and patents,” he noted.

Part of gaining a “baseline understanding” of a target company means running a search for bankruptcies, judgements and other litigation, Weiner advised.

“Has the company ever declared bankruptcy, or been involved in significant litigation? If yes, then you should investigate further,” he said.

But sometimes, an inexperienced seller may not be comfortable with the interrogations. “A few years ago we represented the owners of a successful 30-year-old manufacturing company that was being purchased for about $40 million by a strategic acquirer that was backed by private equity,” he said. “Our clients were used to doing deals on a handshake, so they took offense at the deep questioning on the part of the acquirers. I worked with the investment banker to assure them that this was standard operating procedure, and the deal eventually went through.”

Some attorneys, like Tiffany Wagner Donio, said they’re seeing more companies negotiate earnouts — a limited upfront payment, followed by larger ones that depend on the performance of the acquired company — as part of an M&A.

 “This isn’t unusual when a larger company buys a smaller one, and the target doesn’t have the record-keeping and internal controls that the buyer would like,” related Donio, a partner with the Archer law firm who focuses on corporate and tax law. “We’ve seen this in food, manufacturing, logistics and transportation, retail and other companies.”

An earnout agreement requires flexibility on the part of both parties, she added. “In some cases, in an earnout situation the target company’s principal may stay on board for a period of time after the purchase to try to ensure that the company will be able to meet the key performance indicators specified in the sales contract.”

Growing a company, like so many other aspects of running a successful business, calls for entrepreneurs to be flexible and open to new ideas.

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