First of all, what do we mean by the term asset based loan?
There are certainly may definitions available in the market place to choose from, but for the purposes of this discussion we are going to refer to asset based lending in the context that the assets provided as security are the primary focus of the lending decision.
When we speak of bank or institutional business financing, there is lots of asset based loans being provided as banks want hard security as much or more so than any other type of lender. The difference with a bank or institutional lender is that they will not consider lending against assets or taking assets as security unless there is the presence of strong cash flow and credit standing.
With an asset based lender, credit and cash flow are still important, but the value placed on those criteria in the decision making process is lower.
The one exception to this definition is when banks or institutional lenders have their own asset based lending program which will be an extension of their traditional business lending programs, but with higher asset leverage and more operational controls in place.
So based on this definition, when is an asset based loan a good fit?
Let’s drill down on the two most common scenarios.
The business is having some trouble for whatever reason and can no longer secure or retain financing from a bank or institutional lender. In this situation, the risk of lending loss is much higher and requires a greater focus on cash control by the lender and loan protect through the lender’s ability to liquidate the assets for a predictable value if required to repay the loan.
This type of asset based financing is high cost and short term in nature, typically not more than two years. A business accepting this type of loan is either going to be taking one last shot to right the ship or is buying time to orchestrate an orderly wind down in order to maximize the cash generated from wind down.
There are two tiers of asset based lending with respect to business growth. The first tier which is more traditional asset based lending still is providing higher cost financing as the growth period, especially for early stage companies can be quite risky. This again is short term financing in most cases, allowing the business to grow to a size and level of stability that can qualify for lower cost conventional financing.
The second tier of growth financing is for more established businesses that already have a strong balance sheet and past profit performance record, but require higher levels of asset leverage than what conventional lending programs can provide.
Determining the right fit of asset based lender to your particular situation can take some work and time. The best approach is to work with an experienced business financing specialist who can accurately assess your situation and guide you through the market.
I good portion of what I do is to arrange business financing facilities for small and medium sized business owners.
And a good amount of the initial time I spend with a client is figuring out if they are ready to apply for financing or as I like to say, are in a “finance-able” position.
Unfortunately, I good bit of the time I have to try and convince them that until certain things are brought into order, the financing they’re looking for is unlikely to be coming their way any time soon and some potential financing opportunities may get destroyed by an incomplete or uninspiring credit package.
The truth of the matter is that business financing is much harder to secure in 2011 than it was only a few short years ago. And business owners have been spoiled into believing that close enough is good enough when it comes to putting forward the information a lender or debt provider is likely going to want to see and review.
And the old adage that you never get a second chance to make a first impression was probably first uttered by a bank manager or debt financing source of some type. A lender is going to say N0 more than Yes and the process of going through an application in many ways is a disqualification process as they try to get to N0 as fast as possible.
The fastest pathway to NO today and perhaps for a long time with a lender is to present an incomplete and somewhat sloppy application package. While most people do not have any desire to become an anal retentive bean counter, the reality is that they are initial being judged on both their physical appearance and information appearance. And by the way, a nice hair cut and a sharp looking business suit will not make up for a less than stellar information package.
When lenders turn business owners down because of incomplete information, poor information system reporting, lack of up to date business knowledge, etc., they typically will even go so far as to put notes on the file so the next time you come in to apply for business financing, even if the people you initially met with aren’t there anymore, the notes will be left behind for those that are.
From the files I work on, there are basically two types of situations that, unless you’re completely desperate for cash, should cause you to hold off applying for a loan or financing facility.
The first is about the wrong point in time. If the last business cycle was less than stellar and you’re in the middle of a pretty good year, until you can get third party financial statements completed, the application is likely going to suffer.
The right point in time is always when things are not only going good, but when you can verify that they are going good through third party validation.
The second situation where you should throw out the anchor and slow down is when the business is running a bit ragged. Sure, you may be making money and not owe much debt, but the accounting systems and other information systems are in shambles or not up to date, providing a low level of confidence that you’re in a position to manage growth or take on debt for whatever reason.
Its easy to not only waste a lot of time trying to plow a road with poor equipment, but its even easier to screw up opportunities where someone would have been prepared to advance a financing facility if you would have had your —- together at the time of application.
The key here is to make sure you are in a “finance-able position” prior to applying and the best way to do that is to work with experienced business financing specialist who knows what the market is likely to accept or not accept.
First of all, what do I mean by a debt financing contingency plan?
Well, if you’re in business and require third party debt financing to partially fund your operation in some way, shape, or form, then it’s important to have a debt financing contingency plan in the event that your current debt lender or lenders can no longer provide you with funding.
This has always been something that business owners should be mindful of, but most stable businesses consider the potential of their banking or financing relationship going south for no apparent being the most unlikely of events and not worth the time to continually stay on top of a contingency plan.
But guess what? Since 2008, the one of the most common financing requests are those that are required for no reason at all…that is one or more of the lenders financing a given business either called in their demand loans and chose not to renew them…for no apparent reason.
As I continually mentioned, the world of business financing has significantly changed during this last go round of economic down turn and the ongoing ripple effect from the fall out continues to pound the portfolios of the remaining debt providers. As a result, they will periodically need to shore up their risk profile by shedding accounts that don’t score high enough on the score card, or leave certain regions and/or markets altogether.
The end result is that many companies with otherwise solid balance sheets and a significant track records of business performance are getting their loans called for nothing they could have foreseen.
When this occurs, if there isn’t some type of meaningful contingency plan in place, the scramble to get alternative financing in place at best destroys equity due to higher short term rates, and at worst puts the company out of business.
So what do I mean by a contingency plan?
While by no means a comprehensive list of things to do, here are a few points that every business owner requiring third party capital to operate should consider.
First, make sure you maintain a relationship with your current banking representative. For many institutions, the personnel turnover very quickly from position to position. For many businesses, the owner may not even know who his contact in the bank or lending institution is. Having an active relationship where there is at least a quarterly touch point can help spot trouble before it lands on your door step.
Second, stay on top of who your next best option or options are and find a way to borrow some money from them. Its always going to be much easier to get additional financing from a debt provider that is already somewhat comfortable with you as compared to someone starting from scratch where there is a time pressure involved in getting a new facility in place.
Third, keep all your financial statements, asset lists, customer lists, credit profiles, company business plans, etc. up to date so that you’re always in a position to provide a complete package of information at any time or within very short order if required.
Fourth, constantly be on the look out for even a better debt financing program than what you have today, or alternatives that would also potentially work for your business. Debt lenders come and go as well as continually change their appetite for certain types of lending and industries, especially on a regional basis. So if someone is hot for getting into your market, take a serious look at what they have to offer and at least consider starting a relationship.
Fifth, maintain a moderate level of paranoia with your current debt financing source or sources. Banks and other institutional lenders are brilliant at lulling you into a false sense of security. But be forewarned… there is appreciable customer loyalty, at least not enough to save your account if you get in the risk managers cross hairs for whatever reason.
I understand that some people reading this will say they don’t have time as it is to do the daily stuff required in the business let alone make and continually update a back up plan for something that may never happen.
Just remember that if you accept debt financing or investor money from a third party that someday they’re going to want it back and it might now be when you’re ready or able to accommodate them.
We are in a period of time where asset based loans have grown in significance due to the more conservative approach currently being taken by banks and institutional lenders.
In most cases, Asset Based lending is significantly more expensive than bank or institutional lending, reflecting the higher level of risk inherent in the business being financed. With greater cash flow comes lower cost forms of asset based lending as well, but for the purposes of this discussion, I’m referring to asset based lending that falls in the 18% to 24% per annum type rate range.
Any business owner will tell you that you can’t function long term on those types of rates and for the most part, they are absolutely correct.
The higher priced, and more traditional form of asset based lending is meant to be short term in nature, dealing with either distress or growth.
In a distress situation where the business is failing, gone through a down turn in the market, or has been unceremoniously dumped by its institutional lender for some reason, an asset based financing facility buys time to either turn things around, wind down, or sell off in a manner that does not destroy value or equity in the process.
For situations of growth, if the growth rate is too high, especially for newer businesses or smaller scale businesses, banks and institutional lenders will shy away from business financing these situations due to risk of the business not being able to properly scale growth and crashing and burning at some point along the way to a better top and bottom line. Once higher levels of sales are maintained over a period of time, then lower cost forms of money will be more than happy to step in and take over the business. They just don’t have the stomach for the potential wild ride that may occur during a growth spurt.
Neither a growth or distress situation can be sustained for any length of time which is why the asset based financing can be a very good fit, even at significantly higher rates of interest than what can be secured through an institutional lender.
In situations where the business is asset intensive and needs a high level of financing leverage over the long term, an asset based financing solution can still work, but its going to have to be a lower cost version which tends to require a minimum facility size of $5,000,000 and strong cash flows and margins to support a lower cost of funds.
In any business, there are basically three parts that need to be working in balance for the business to grow and prosper.
The three parts are Marketing/Sales, Operations/Administration, and Accounting/Finance.
For smaller businesses that are on the come, it can be hard at times to have all three areas firing on all cylinders.
The importance of this when it comes to securing debt financing can be significant as no matter how well you can present the business, its opportunities, and what you’ve been able to accomplish so far, a debt financing source or lender is going to want to be sure that everything is going to hold together as you move towards warp speed in your business plan.
Increasing size means more people, more transactions, more stuff to keep track of and manage. Without some amount of stability in each of the three areas, the brilliant up front presentation requesting growth capital can be quickly dismissed if a lender discovers that one or more of the key business areas is under developed or lagging behind the others.
And in many cases, the weakest link in the chain is the area of Finance.
Here’s a typical example.
A business has successfully got off the ground, been operating for a couple of years, made some profits, and is well positioned in the market to start taking greater chunks of market share from competitors with inferior business models or offerings. The only thing the business owner believes they need is more capital.
But when interested debt lenders start pealing back the covers, they discover that the score keeping system is a total mess and information tracking for management purposes is mostly done on scratch pads outside of the accounting system.
This is not an uncommon occurrence that typically is trivialized by the owner as their main focus is market and sales (which it should be) with a secondary focus on operations, and limited to no focus on finance.
But from a lender’s point of view, not maintaining an up to date bookkeeping system is a big deal, especially if you’re planning to double or triple the size of the business in a relatively short period of time. And its not just about not having the historical bookkeeping completed. It’s about the business not knowing exactly where its at all the time and flying a little bit blind. This type of unbalanced approach can lead to customer bad debts, loss of supplier credit, government arrears, cash flow shortages, debt covenant failures, and so on.
In most cases, one or two weeks of intensive work utilizing some outside resources can fix the problems and get the finance function up to an acceptable level to support the other areas of the business. And this is not just to satisfy a banker. Getting the finance and accounting systems in place and up to date are essential if the business ever intends to reach its goals.
Failure to meet the lender expectations in this regard is going to make it hard to secure business financing, especially lower cost forms of capital.
Being able to demonstrate the financial aspects of your business on command is expected. The sooner a business owner comes to this conclusion, the faster the business is going to be able to grow and easier it will become to secure the capital required.
For most business owners and entrepreneurs, this thing called equity financing is some what nebulous to say the least with all slices and sections of the market all thrown in together.
And while different forms of equity capital may be interested in very different types of business financing deals, there is some logic that can and should be applied to the pursuit of equity financing.
First of all, is your project is a pure development stage, pre commercial, or commercial with the need for expansion?
Each one of these stages of business development will tend to attract a different audience and command much different levels of interest.
For the pure capitalists, any type of deal may be something to consider if the investor believes they have the potential to get a strong enough return, but like most things in life, people in general, including equity investors, tend to have specific business stages they will consider for specific product or service categories servicing certain markets.
Second, the farther away you are from being able to sell something and make a profit, the harder its going to be to attract financing, and the financing you do attract is likely going to want the cake and eat it too along with the kitchen sink and all types of control.
The best way to attract equity is to 1) work from a position of strength and 2) be most focused on sources of money that already have a direct interest in what you’re trying to develop or bring to the market.
While I did say that equity investors can have very particular appetites, you can generalize somewhat and put them all into two groups. Group one is a pure venture capitalist that while only focusing on a narrow band of stuff, is still prepared to get involved in a project in the earlier stages. This group of investors are also prepared to look at a large number of opportunities before ever considering putting out any money.
Group Two represents people or companies with money or access to money who would be very interested in incorporating what you have developed or are developing into their business model to help fill a void, provide a missing piece, or turbo charge something they’re working on. The key to attracting this type of money is to have at least a working model or prototype of what you’re trying to do available to prove you’ve moved from theory to reality.
And if you have something Group Two wants, you’ve immediately increased your chances of securing equity financing as there may not be any other opportunities they are even considering funding that are related to what you have.
My advise on equity financing is, if at all possible, to focus on Group Two. Put together whatever money you can to get whatever you’re trying to do working at the smallest possible scale. At that point, you have something to sell and it shouldn’t be all that hard to find parties that would be interested, providing you’re trying to tap into an established market demand.
If you’re trying to blaze a new trail, that’s a whole other matter which will likely end up being more of a needle in the haystack approach of sourcing equity (sorry).
Hard money loans are part of the world of asset based lending, and in simplest terms, they are asset based loans.
And while there may be several different potential definitions or variations to the term “Hard Money”, for the purposes of this post I’m referring to it as an asset based loan whereby the lender is primarily making a lending decision based on the value of the security being offered and the lender’s confidence in his or her ability to liquidate the assets if the loan goes bad.
True hard money doesn’t really care if the loan goes bad or not as the lender is completely comfortable going through the legal process to gain control and ownership of the assets and liquidate same to get their money back.
In many ways, this is the purest form of lending where a promise made is a promise kept. Many people compare hard money lenders to loan sharks, but there is a considerable difference between the two starting with the fact that no legitimate lender is going to break anyone’s legs or off their friends for lack of payment. And the interest rate, security registrations, and lending practices still must conform to the laws of the land.
The only real similarity to the two is that they are both linear, black hearted approaches to lending whereby recovery actions are swift and not subject to emotional biases or personal considerations. Or at least that’s typically the approach if someone is going to survive as a hard money lender.
From the lender’s point of view, the deal is all about the available security being offered and the all in position of the borrower. The more committed the borrowers are to their business or need for money, the harder they will also work at paying the loan back and retaining what they have.
Hard money also only comes into play when all other options for business financing have been exhausted in most cases, so its not like anyone has a gun pointed to the borrower’s head. They are entering into the lending agreement willingly and many times gratefully as the hard money business loan provider is likely the lender of last resort.
Most hard money lenders work through broker networks to make the market aware of their available money. So typically they are not hard to find. In terms of the cost and terms of financing, each deal is likely going to be customized to the situation with many hard money lenders charging what the circumstances will bear. In general terms, the cost of financing is going to be equivalent to a return on equity because that’s essentially the type of risk the lender is taking. And to manage risk, the lender will consider every form of registration available and look to secure any and all assets owned by the borrower, even if in some cases they are in third or fourth security position.
Like any source of capital, the decision to accept a hard money loan or not should be based on the foreseeable cash flow of the business. If the business can’t see a path to repay the loan, then it shouldn’t take it. This is somewhat the reverse of conventional financing where the lender decides if the cash flow is sufficient to support repayment. But with hard money, the repayment decision is more in the hands of the borrower.
Hard money, as I have described it, is a loan of last resort and should be pursued and managed as such. The consequences of not meeting the repayment requirements is foreclosure and asset liquidation. While one could argue that this always is the case, most conventional lenders are much less precise and surgical as a hard money lender when it comes to getting their money back. Creative borrowers will work all kinds of angles to block foreclosure and postpone or get out of repayment. Good luck trying to do that with a hard money lender.
Like anything else in life, its buyer beware. But it does have a role, and used properly, can save a business or at least give the owner one more fighting chance to make a go of things.
Commercial debt financing has a lot to do with figuring out the term structure jigsaw puzzle that relates to your business or the capital requirements of what you require funding for.
Each category of asset will command a different type of risk profile and will attract different lending programs. On the surface, that seems clear enough to most, but the challenge comes in trying to get the right amount of leverage at the lowest cost of borrowing.
For instance, many lenders will have primary and secondary financing options. They will provide you with their primary offering on a certain class of assets and a secondary offering on other assets you hold. Or they can bundle their offering whereby you can get the business financing you’re after from them, provided that you transfer personal financing requirements and investments to them.
For more established businesses, the challenge is to take what you have to leverage both commercially and personally to secure the best potential deal at any give point in time.
This may involve one lender or a number of lenders, each focusing on a different classification of asset and term structure of debt. While the single lender model may be preferred, it doesn’t always provide the amount of leverage required. For greater leverage, the different categories of assets (working capital – accounts receivable and inventory, equipment, real estate) need to be financed through lenders that specialize in that particular asset class. This can also drive up the overall weighted average cost of borrowing, but this may be a necessary trade off to secure the amount of capital required in the short term. Obviously there will need to be sufficient sales and margins to cover the cost of financing and over time the goal would be to reduce the cost of funds and take on a better term debt structure overall.
The challenge to any business owner is that their situation will always be somewhat unique to anyone else and therefore a customized solution is required whereby the business owner figures out the best lender offering or combination of lender offerings that best fit his or her business at a given point in time.
And once a financing structure is decided on and put into place, there is still going to be an ongoing requirement to stay ahead of the curve and either find better financing options that improves leverage and cost requirements or provide for alternative financing scenarios in the event that one or more lending partner changes their interest in financing your business.
While asset based lending models have been well entrenched in the U.S. landscape for decades, they are still evolving in the Canadian market place.
This is largely because corporate lending criteria doesn’t work in recessionary periods and post recessionary periods where the economy as a whole is operating at a lower level of performance resulting in poor or suboptimal financial statements in many industries.
Corporate finance lends off of financial statements that show strong cash flow and low debt to equity ratios. During and immediate after a recession, especially one as severe as the current one, hardly any money is being provided from these sources for businesses to operate and in many cases, the money supply is contracted due to risk and perceived risk.
Enter the world of the asset based lender where there is a stronger link between lender and borrower with more established rules for managing cash flow and risk that allows the lender to participate in situations where they would otherwise have to pass.
In the last few years in Canada, all the major banks and several U.S. entrants into the market have jumped into the asset based lending world with some being fairly aggressive with their programs for lending money.
While most of these programs are only focused on loan requirements of $5,000,000 or higher, the advancement of the industry in general is good news for small and medium sized business owners who are scratching their head trying to find a source of capital they can cash flow within the profits available in their business.
Institutional asset based lending can have considerable pricing variations off of prime, but this is still considerably cheaper than what I will all traditional asset based boutiques that start at 18% and go up from there.
The key to getting the money and making it work for you is to take on or evolve your financial discipline so you can make all the rules and regulations with this type of money work. In the end, the discipline that any asset based lending facility injects into a business is almost always a good thing that will help not only with short term survival but also long term growth and prosperity.
From a commercial lenders point of view, the evolution to asset based lending makes a great deal of sense in terms of not only managing risk but being more comfortable putting money out into the market.
I believe asset based lending will continue to evolve in all lending categories and become a more prominent form of business financing for many business owners now and in the future.
I don’t want to over simply things as business financing applications can become fairly complex and involved, depending on the amount of funding a business owner is looking for and its application.
That being said, regardless of the level of complexity attached to not only getting an approval in place, but getting funds advanced, virtually all lenders are going to focus on these three main areas:
Each category of lender is going to put different weights on each of these areas as well, but as one institutional lender who provides low cost financing put it to me the other day, “in the first 10 questions we ask, 9 are about debt service”.
So it goes without saying that if you’re in search of low cost financing, the proof and support for debt service are going to be the most important element being reviewed.
As the cost of financing goes up due to perceived higher risk, which is usually associated with less predictable or supportable debt service, the shift in attention moves to the other two areas as there is a greater possibility of a loan default which would require the lender to realize on securities and guarantees.
This is not to say that debt service is not going to be very important to the asset based lenders of the word. It just means that at least half of their top ten questions are going to be directed to security and guarantees pledged.
And when I speak of guarantees, this does not automatically include personal guarantees. If a business has accumulated enough retained earnings over time and non pledge asset value to provide the comfort the lender is looking for, then a business guarantee may be all that’s required. In situations where there are multiple business entities within a business group for tax purposes, its not unusual to see corporate guarantees from each entity to support a loan issued to one business in the group of companies.
These three areas are basically the 80/20 of business financing for most lenders. If the 500 page business plan or elaborate financial projections don’t adequately cover off these three areas in accordance to the lender category and risk category they are trying to get funding from, then the loan application is likely going to be a non starter.