There’s little doubt among local executives that commercial lenders are eager to deploy capital to growing businesses.
However, that willingness to lend changes when it comes to service-based companies or startup organizations. Even in a commercial lending market rife with competition and amid demand from bank shareholders to grow earnings, bankers still remain hesitant to lend to companies that lack physical assets or a long track record.
That’s according to Scott McLean, the chief administration officer for Livonia-based New Horizons Great Lakes Hold Corp., who works from Grand Rapids.
It’s a situation McLean experienced firsthand when New Horizons sought financing for a $10 million deal to acquire an underperforming I.T. and computer training franchise in 2014. The transaction nearly fell through because of New Horizon’s inability to secure the necessary senior bank debt.
“Just about every commercial banker will tell you they are interested and looking for these types of businesses,” McLean said. “But then you get the information in front of them and regardless of the story, once they start peeling back the layers, none came to the table in the way they indicated they would.”
Even with a strong track record of growth and detailed plans to capitalize on low-hanging fruit to turn around the company, New Horizons was unable to court commercial lenders, McLean said.
The issue: New Horizons had what McLean deemed an “entrepreneurial” balance sheet.
In other words, the company is run by a management team who knows the organization well and manages it appropriately, but has trouble translating specific business practices into a balance sheet that commercial lenders are comfortable with, McLean said.
For example, New Horizons often collects payments from clients months prior to delivering an actual training class. Under standard accounting principles, that money is listed as deferred revenue on the company’s balance sheet. That caused bankers to view all of the deferred revenue as a liability, but only about 20 percent of the deferred revenue was a liability, McLean said.
“When service-based companies have things like deferred revenue or subscription contracts or intangible intellectual property, it’s very difficult for any financing company to get their arms around what that is really worth,” McLean said.
Eventually, New Horizons was able to secure senior bank debt from Huntington Bank, which also held the debt from the distressed company. The bank allowed New Horizons to assume the debt, transfer all personal guarantees and borrow against its balance sheet, McLean said.
“The bank put themselves in a much better position,” he said. “Otherwise, if they hadn’t been in that situation, then I don’t know if we would have gotten our deal done.”
Without Huntington stepping in, the company would have needed to turn to two interested private investors and cover the remainder of the debt with mezzanine financing — both options that would have cost significantly more, McLean said.
LEVERAGING OTHER OPTIONS
Navigating higher capital costs in lieu of bank financing has become the norm for service-based companies and entrepreneurs. However, that’s not necessarily the fault of the banks, said Brian Steketee, the president and founder of Modustri LLC, a Grand Rapids-based technology firm that develops diagnostic tools and web-based platforms for the heavy equipment industry.
“These guys make three to five percent on your money so they can’t afford to swing and miss even once,” Steketee said. “That can really mess up their balance sheet. They’re not typically the first place to go.”
In Modustri’s case, Steketee was able to leverage a relationship and a line of credit that his previous company, Agent X LLC, had with Mercantile Bank Corp. as well as secure investments from friends and family.
To fund further expansions, Steketee turned to personal guarantees on his private assets to get the bank to lend.
“I personally guaranteed about everything I owned in life, or had owned, including the children’s trust — to my wife’s dismay,” Steketee said.
After proving out its technology and courting several heavy equipment dealers as potential customers, Modustri initiated a mezzanine raise with several high-net worth individuals from West Michigan to fund its next stage of growth. That move ultimately led to the company’s strategic partnership with Caterpillar Inc. (NYSE: CAT).
Modustri employs 30 workers and plans to double its workforce this year to accommodate further growth with Caterpillar.
Even though startup companies may not be bankable at the outset, Steketee suggests they begin to build relationships with banks early on. That way, the bank will be more familiar with the company’s process and track record, increasing the likelihood of lending to the company as it matures, Steketee said.
He also advocates that entrepreneurs cultivate and maintain relationships with mentors and advisers, who may also eventually become investors down the road.
Most importantly, Steketee believes that entrepreneurs need to develop functional products with interested customers before courting investors.
“I can’t say this is my quote, but don’t think about PowerPoint — think prototypes,” he said. “If you want to sell someone on a loan, you want to walk in and show your technology, how it works and be able to back it up quickly with why it matters, who it is important to, what kind of value are you creating for them and why you.”