The primary sources of business financing that are well branded via the banks are traditional forms of lending that provide lower risk rate for low risk deals, and only finance low risk deals. Any by definition provided by banks, low risk relates to a business balance sheet with a debt to equity level before and after new business financing is issued of 2:1 and a debt serving ratio of at least 1.20 (available cash flow must be 1.2 times the projected debt service).
But what if you’re business does not fall into these parameters? Are you out of luck, or do you keep knocking on similar doors to see if anyone will change their rules?
The reality is that conventional bank financing only provides about 1/3 of the required business financing that makes the economy go round.
The rest of the capital required comes from a number of different lending categories including the following three that I will briefly touch on.
Asset based lending as the name suggests focuses on leveraging the equity in assets that the business owns. There are many different slices to this market and a wide range of financing costs, call lending back to the amount of overall leverage the business is carrying and the inherent risk of loss to the lender.
For situations where there is a strong enough cash flow to cover off higher levels of leverage, there are investment banking and venture capital solutions.
Investment banking is another example of a business financing source that has many different variations, but for the most part this type of financing is placing other peoples money and providing a return on capital between 10% and 20% for the most part. This is accomplished by charging an interest rate on capital advanced as well as taking an equity stake in the business. Financing can be at or close to 100% of the capital required, depending on the deal. Approvals tend to be granted towards deals in specific industries and with well established and proven applicants or business teams.
Venture capital is a very common term in the business financing world, but tends to relate to a small percentage of cases where capital is required.
This largely due to the fact that venture capital is typically looking for a 30%+ return and are prepared to invest in growth industries that can be high risk but are also high potential for big returns. Because of the risk element associated with these types of deals, the majority of investments tend to fail, with the overall weighted return on capital being provided by a small percentage of deals that achieved their market potential.
There are many more examples of business financing sources out in the market place that may or may not be relevant to any particular situation.
The point here is that understanding where to look for money and what is relevant to your business requirements is going to be very important to locating and securing the capital you’re looking for.
And while even a blind squirrel can trip over an acorn every once in awhile, looking for capital strictly by trial and error is likely not going to be very successful, or can result in you paying far more for the capital you secure that you need to.
When a small business owner intends to sell their business, and when someone is considering purchasing a small business, there are some business financing basics that both sides should consider.
And for the purposes of this discussion, when I speak of small business, I’m talking about a business entity with no greater than $2,000,000 in annual sales.
When it comes to business financing, the most important aspect of any small business purchase is historical cash flow that is supported by third party financial statements and seller provided source documents if required.
The harder the cash flow is to figure out or verify, the harder its going to be to get both sides to agree on a sale price.
The second element of financing a small business purchase is the composition of the assets being purchased and offered as security to a third party lender.
When the sales price is allocated into tangible and intangible assets, third party lenders are going to be very interested in the amount of goodwill that is included in the deal.
Goodwill represents the value placed by the seller on the future revenues of the business which represents potential revenues not yet earned.
Its not uncommon for a third party source of business financing to only finance a portion of goodwill or none at all.
The expectation of the lender is that either the buyer will be paying cash for the goodwill or the seller will finance it over time.
The biggest risk to the lender when considering a business acquisition financing request is the change of control risk.
The transition period where ownership and control shifts from the buyer to the seller will always be key to longer term business success.
To help manage this risk, business lending sources will look to a financing structure where the risk of potential loss is shared fairly among the buyer, seller, and lender.
Many small business purchases are financed on this basis with each party contributing or being responsible for financing one third of the final purchase price.
Especially when there is a significant amount of goodwill involved, the lender may only be interested if the vendor is also providing financing.
This is also why its very uncommon to see a small business purchase being financed largely by just a third party lender.
When you have a buying or selling situation where all parties involved understand and are prepared to help guarding against short term business failure, then its more likely that third party business financing can be arranged to complete the transaction.
2011 has been an interesting year as the business financing market place continues to redefine itself since the beginning of the 2008 recession.
It was clear this year that business financing in general was starting to become more available and from more sources, but it also became clear that things were no where near where they were prior to 2008.
In fact, there have been so many changes in the dynamics of global finance, that it seems unlikely that things are going to return to what we got conditioned to with respect to business financing practices for the better part of two decades.
So my first prediction is that the world of business financing is going to continue to evolve in different directions that are going to be more in keeping with lender and investor risk management and in greater search for value.
One of the things I really noticed in 2011 is that there is a lot of money out there looking for a home, especially in the form of business financing in established and relatively secure economies. With all the global economic chaos of the past year, you may justifiably think that there are no sure bets anywhere in the world these days as the global financial network is highly intertwined across borders.
That being said, money is attracted to the best bets and the greatest opportunity to attract value.
And because of the recent recession, there has never been a better time to acquire assets at greatly discounted prices which is of great interest to those that hold and control the money supply.
My second prediction is that there is going to be lots of money available for the true value creators in the economy.
What this also says on the flip side is that speculative money is going to remain hard to find as lenders and investors are still trying to recover or still dig themselves out of the down turns in their portfolios.
The smarter money is on the smarter bets and for those individuals who can create the “add money and stir” type scenarios where all the elements of profitability and risk management are well thought out are going to likely have a sorts of financing options available to them.
Predication number three is that there are going to be more and more alternative forms of financing with unique risk management models out in the market place as sources of money continue to work towards filling the large gap that remains in what I will describe as the business sub prime lending market.
This is good and bad news in that many of these alternative sources can be quite anonymous and perhaps invisible in terms of their profile and working model as compared to the highly branded commercial financing entities that remain largely removed from higher risk opportunities.
The challenge here is while there are legitimate alternative sources out there, there is a lot of fraud and fee collecting entities as well who make more money collecting fees as they do on fund actually lent or invested.
Which leads into predication number four…more and more enders and investors are going to be charging up front due diligence fees to review financing and investing opportunities.
In the past, up front due diligence fees was something you would come across occasionally, but now we are seeing this more and more.
And what it amounts to is that business owners are going to have to pay for the time of money lenders and investors to review their requests and take their chances as to whether or not they actually get funding.
The process of business financing is becoming more and more of a hit and miss process as lender and investor criteria remains constantly influx, reducing any accurate predictability of what any one source of money may be able to do for you at any given point in time.
So in order to kiss some frogs, its going to cost money, especially for anything that does not fall under the lending/funding requirements of the “A” institutional lenders who may not charge an upfront due diligence fee, but many times still charge a commitment fee, which can basically work out to the same thing…it just happens later in the process when your hopes have been raised.
My final prediction is that business owners are going to be slow to react to the new world order of business financing and as a result there is going to be more upheaval in the economy as capital will fail to be in place when its supposed to be causing transactions to fail and businesses to collapse as business owners and managers hold on to old lending and investing axioms that no longer apply.
This creates tremendous opportunity for those that understand the change in the business financing markets and are either taking the time to educate themselves towards more effective business financing strategies going forward, and/or are prepared to invest in the experience of those that can help them navigate the landscape more effeciently.
The reality is that in the business financing world, not much is going to happen after December 15th in any given year and the progress on applications and funding requirements in the two weeks prior will not likely be moving at any great rate of speed either.
And once we hit the middle of December, everything basically comes to a stop until the second week of January.
So if you you’re just starting a search for business financing, or you’re in the middle of an application to one or more lenders, then be prepared for things to slowly grind to a halt in the days ahead.
While the same can be said for other industries as well, this is especially true in the field of business financing due to the number of individuals that can be involved with any one particular file.
And the more complex the financing requirements, the less likely anything will get completed from the middle of December through to the middle of January.
It only takes one key person in a deal to be away to prematurely grind things to a stop as well. That can be an accountant, lawyer, insurance broker, appraiser, environmental consultant, dealer, underwriter, and so on.
So even though the actual lender you’re dealing with may be open for business and ready willing and able to move the file forward, there can be outside elements that are required to be completed that will hold everything up until the new year when everyone is back in action.
The key message here is that December business financing activities can be very much like beating your head against the wall and the holiday time is more likely better spent on other things.
If this year marks your first experience with this sort of occurrence with your business financing activities, then please make a mental note of it for future years so that next time you will consciously get things started sooner, or at least allow for the down time and not try to push a rope up hill during the holiday season.
If you’re trying to get a deal funded and are near the end of the process, a full court press may get things done, but don’t count on it.
Being at the mercy of others is never any fun, but working to hard against what is inevitable is likely going to be even worse.
The year end time period is a good time for financial performance reflection and planning for the coming year. Much of anything else in the area of business financing is not likely to be fruitful.
One thing that many entrepreneurs are not not keen on is paper work and bean counter type activities that may drive them to the Aspirin or Tylenol bottle for headache pain relief.
But regardless of what a business owner or manager likes or believes is a good enough representation of their business, debt financing sources and equity investors have other ideas.
To this point, whether you are looking for business financing today or not, there is a certain degree of readiness that should always be in place so that there are no delays in applying for financing and there is no lost opportunities from a lack of basic information being available or presented to a source of capital.
For instance, one of the most basic requirements any lender or investor will ask for is the last two or three years of third party accountant prepared financial statements for the business.
If this is not always available and up to date, it should be as it will be very difficult to be considered without historical financials.
And if the amount being requested is over a couple of hundred thousand dollars, then the type of accountant opinion is also going to be important.
For small financing amounts, a notice to reader accountant statement can be sufficient to most lenders, but as the amount of financing requested and overall financing outstanding and the overall level of business complexity growths, the more importance will be placed on the accountants opinion through either a review engagement or audit.
These additional levels of verification cost more money, but these can also be the difference between getting serious consideration from the type of lender or investor you want to work with and missing out on a good business financing opportunity.
The same can be said for management accounting reports that show product margins, variance reports, and operating break even. Projections and forecasts of both cash flow and income are also going to be important to complete the picture of where the business is headed.
Having good records of company assets and reports of good standing with with respect to any government regulations can also be helpful.
These are some of the basics that relate to virtually every business and the more these items are kept up to date, the faster the business will be able to react to capital requirements.
Scrambling to get many of these items up to date can not only cause delays, but lead to mistakes and a poor representation of the business and your business management.
Having the basic core financial information for past, present, and future at the ready provides confidence to lenders and investors and can immediately separate you from other accounts they are considering.
One of the ways that business owners and managers access incremental capital for business operations is through the refinancing or recapitalization of equipment that is owned outright by the company or nearly owned outright with significant equity in the assets to leverage.
We call this refinancing because in most cases the equipment was previously financed and since been paid off. For longer use types of equipment, there can still be an opportunity to refinance the assets a second time around in order to inject capital back into the business.
While this practice does work and in theory sounds reasonable to most, there are some things to consider when crunching the numbers.
First of all, most sources of equipment financing will only recapitalize or debt finance 65% to 75% of the appraised forced liquidation value of owned equipment.
So if you think the orderly liquidation value of your assets is $1,000,000, the forced liquidation value may only be $750,000, which can make quite a different in the amount of funding that can be made available.
Second, the financing that is available is not typically prime plus three or four, its more like prime plus nine or ten as the financing is on used equipment that has not gone through a sale transaction to crystallize value or go through a condition review by a dealer. The higher cost of financing is not in itself unreasonable and can be explained in terms of risk to the lender, but it still needs to be factored in to the cost of financing you can expect.
In situations where the business is in financial distress, the cost of financing will be even higher, likely falling somewhere in the 18% to 24% per annum range.
Third, most of these transactions will need to be done through a sale and lease back transaction where by the financing or equipment leasing company purchases the assets from the business and provides an equipment lease back in return for a defined period of time. The sale and lease back transaction can potentially trigger income tax effects due to the fact that the assets are being sold, so this also should be factored into the transaction.
Fourth, the process, especially for the lower cost sources of equipment refinancing, is going to take some time. Third party appraisals are typically required as well as background searches on the assets to make sure a clear title is available to the financing company. The entire process from application to funding can take 30 to 60 days to complete. Faster money is typically going to be more expensive money, so its important to plan ahead and not leave this financing option to the last minute.
First of all, lets get clear as to what we mean by equity financing.
Equity financing occurs when ownership in a company is sold in exchange for an agreed upon purchase price.
The purchase price becomes new capital in the business and is recorded as such on the balance sheet.
In the business financing world, there are basically three general forms of financing…debt financing, equity financing, and some combination of debt and equity.
Equity financing, in many situations, occurs when a business or company can not qualify for debt financing.
Part of the reason for not being able to qualify for debt financing may be a lack of equity on the corporate balance sheet. Once this has been corrected through an equity investment, the business entity may immediately be eligible for different types of debt financing programs.
When a business is in a startup and development mode and has not generated revenues nor is cash flow positive on a monthly basis, then an equity investor is typically required to provide the cash flow necessary to complete the development process and get to a cash flow positive position.
Higher rate forms of asset based lending that provide financing debt to equity ratios higher than conventional lenders, will say that they are renting equity to the business due to the high level of debt and risk that the business is covering.
All things being equal, most business owners will prefer to debt finance their business needs as it comes at a lower cost than and equity investment in most cases, and the business owner retains ownership and control of the company.
That being said, debt financing can be difficult to manage, especially when you are working with more than one lender where the risk of being offside with some lender covenant is going to be that much higher. Debt financing sources can also demand repayment at times for no reason or wrong doing on the part of the business, potentially leaving the business owner or manager scrambling to manage cash flow.
Because equity financing is connected to ownership, its typically not always straightforward how an owner will be able to sell their shares and exit the business. Most corporations have shareholder’s agreements that outline this process, but it can still take considerable amount of time to exit and there is no guarantee that the initial investment will be reclaimed.
Equity financing in many cases is considered to be a more patient form of capital as its placement is usually connected to the future earnings potential of a given business versus existing financial returns.
The higher risk associated with speculating on future returns also demands a higher risk which is going to be expected by most any equity investor.
More and more often, we are seeing business financing solutions with both debt and equity elements where the investor/borrower is only looking to be in place for a period of three to five years, exit the business, and make a high rate of return on the capital provided upon exit.
For most start up business situations, the entrepreneur is first utilizing their own equity to get the business going, leverage debt to grow the business, and then use third party equity financing to scale out the business in order for it to reach it market potential.
So depending on where you are at in your business cycle, there can be different debt and/or equity financing solutions that are going to be more relevant to you.
The key point here is that each situation is unique and as a result most business financing solutions are customized towards available sources of debt and equity that are available and relevant at the time of need.
First of all, there can be many definitions of asset based loans.
For this discussion, we are referring to asset based loans in the context of a working capital facility that leverages the equity in accounts receivable at a minimum, but can also provide leverage on inventory, equipment, and even real estate.
The standard asset based loan or ABL type arrangement requires the borrower to open a joint account with the lender and that all funds paid to the business be deposited in this joint account.
The lender will, as they say, sweep the account every day and apply funds coming in to the balance outstanding on the loan. The borrower will request funds from the lender on a daily or weekly basis, depending on the requirements, to pay bills as they come due.
This is a highly simplified overview of how an asset based financing facility actually works from an operational stand point… each lender and financing scenario will have its own unique aspects.
There are two basic scenarios (with lots of variation within each one) where asset based loans can be considered to finance business operations.
The two scenarios include situations of growth and situations of financial distress…basically opposite ends of the lending spectrum.
In both cases, what is common is that the business requires high asset leverage to generate the cash needed to operate the business.
Under both these scenarios, conventional lending parameters may not provide sufficient leverage, causing the business to fail outright, or not be able to take advantage of growth opportunities immediately available to the business.
Most asset based loan facilities are born out of the inability of a conventional financing arrangement through a bank or institutional lender to provide the level of financing the business requires.
In highly stable companies with very strong balance sheets and cash flow, the ABL solution can be provided in house through the conventional lenders own asset based lending group. These institutional asset based lenders provide the higher leverage required at slightly higher rates than what their conventional business division would lend money out at. The large bank asset based lending programs are also only going to be available for growth and market development scenarios.
When a business cannot qualify for what we’ll call low cost institutional asset based loans, they turn to boutique lenders that provide ABL services at similar leverage, but at higher rates.
If a business is in distress, the asset based lender will provide higher leverage on assets and very tight cash management to give the business the best chance to turn things around or wind down the operations without destroying equity. Either way, this tends to be a short term solution until the business can once again qualify for a lower cost source of capital.
In situations of growth, the higher cost, traditional asset based lender will once again provide higher leverage at higher rates and serve as the senior lender until the business can qualify for a lower cost form of financing within a manageable range of leverage.
Unless a business is being funded by a low cost form of institutional ABL, the time period of business financing via an asset based loan is typically two or three years as the high cost of financing cannot be sustained over a long period of time in most cases.
Therefore, most traditional asset based loan providers are a form of bridge lender that does not expect to be financing the business into the long term.
Once again, there are many variations to these asset based loan programs, each with their own unique fit in the market place.
To better understand what type of asset based loan facility might be appropriate for your situation, you might consider utilizing the services of a business financing specialist that can help you navigate the landscape.
When a business starts to have cash flow issues, one of the first things that start to fall behind is government remittances for income tax, payroll deductions, and sales taxes.
The argument from the business owner is that there is no money available to pay these bills and still cover off wages and essential operating costs, so the government will have to wait.
And while this may very well be the case, the long term survival of the business is going to depend on having this be a short term scenario.
If it can’t be made short term, then a growing or consistent level of government arrears is likely going to start a death spiral for the business.
This is largely because you start the process of death by a thousand cuts.
Lets discuss further what can potentially transpire.
First, your existing primary business lenders will typically have a covenant that you are up to date with your government remittances. If you fall behind, at best they will charge you a higher interest rate until the remittances are brought up to date. At worst, they will demand repayment and kill your cash flow if you are utilizing any type of bank or institutional operating facility.
Second, if you want to try and restructure your existing debt, even if you have the cash flow and equity to attract more business financing capital, no lender is likely going to advance any new funds to you unless the government arrears are brought up to date. If there isn’t enough incremental capital available to do this, then restructuring will not be possible. Even if there is a way to restructure to get everything in order, it will likely involve moving to another lender, potentially a higher cost lender that works with company’s in a certain amount of financial distress, where the costs of transfer to the lender can be considerable, further putting you behind the eight ball.
Third, at some point the government will take action against you. Many times you can negotiate a repayment plan to catch things up, but if this goes sideways, then in many jurisdictions the government agency you owe the money to will step in and seize your bank account, register garnishee orders with your customers, and put you in cash flow management hell.
If you can keep the government stuff paid up to date, you improve your chances to maintain existing credit and improve your chances to secure incremental debt or equity financing.
When you’re behind with these accounts, your options are limited and in most cases non existent.
Having a plan to stay out of government arrears, or putting a plan in place to pay them up as quickly as possible is going to be important to long term survival of the business.
While there can be several different definitions to what constitutes someone calling themselves a business financing specialist, I’m going to give you my own spin based on my own opinion of the role.
To start with, a business financing specialist must be someone that is well versed in both finance and accounting with some direct experience working in a business.
The reason for these specific requirements is that the key to being able to assist a business owner or manager with their business financing needs is to first be able to understand exactly what is going on in the business and what their financing and credit profiles look like.
By having a solid background in business and finance, a business financing specialist can then determine what types of financing strategies will work and what types won’t work.
The second key requirement that a business financing specialist needs to possess is access to sources of debt and/or equity financing that providing business financing to the market that the business finance specialist serves. In addition to having direct access, the specialist must also be able to understand the lending/funding requirements of each and every source of business financing they work with and he or she must also stay up with their funding interests and criteria on an ongoing basis.
A business financing specialist is middle man (or woman), trying to connect borrower to lender, owner to investor, and so on. Without both sides of the equation, no amount of brilliant understanding of customer needs is going to do any good. The exercise here is to locate and secure capital that meets the requirements of the client.
If the business financing specialist or financing consultant cannot meet the client’s expectations, then he or she needs to work with the client to better define a financiable scenario or decline the engagement. Pushing a rope up hill is not an options. Either you have a workable engagement or you don’t.
The next characteristic of a business financing consultant is the ability to properly assemble information into a format and presentation that proactively addresses the targeted lender or investors key questions, concerns, and criteria. This is partially art and science which is developed over years of practice. The ability to tell the story properly separates the good consultants from the not so good.
The final main characteristic I will speak about is the ability to get a deal approved AND funded.
There is no consolation prize for getting close. Many times a financing deal will be 95% complete and fall apart at the last minute or level of sign off or both material and obscure reasons.
The ability to stay ahead of everyone else in the funding process, communicate on relevant and clear information on a timely basis, and problem solve issues as they arise are all keys to having business financing success.
The business financing or commercial financing process is not easy, and has even gotten harder since the start of 2008 when we have been pushed into a financial market place not seen since the second world war.
As a result, the need for business financing specialist is more prevalent now then ever.
It costs money to utilize this type of expertise, but that is no different than with other professionals including accountants, lawyers, insurance brokers, and so on.
The questions business owners and managers have to ask themselves are 1) do I know enough about the business financing process to do it myself; and 2) do I have the time to invest in the process or is my time better spent on core business activities?