Essential Guide in Raising Capital For Your Business Through Asset Based Financing?
Does your company need more capital than your banker can provide? Here are three growth tools every entrepreneur should know, what they do and how much they cost
Until recently, companies in need of financing options had few places to turn. “When I started in the financial industry about 20 years ago, there was bank financing and then there was bank financing,” says Silvio Marsili, managing director of equity for Roynat Capital in Ontario.
Today business’s needs are more complex and so are the solutions. “The number of players and the amount of money in the marketplace is increasing,” says Marsili. “Everybody’s looking for an angle.” With more money available than ever –at a price, of course — it’s up to business owners (or their CFOs) to understand what the options are, and how these choices may influence the future of their business.
Here’s your essential guide to three emerging financing sources. While they’re not for everyone, the time may definitely come when one is right for you.
Subordinated Debt: Loans with legs
Some people can’t wait to get to work. The management team at Kitchener, Ont.-based National Engineered Fasteners (NEF) liked the business so much that last year they bought the company.
A manufacturer and distributor of automotive and industrial fasteners, NEF is well established in its industry and enjoys healthy cash flow. This enabled the aspiring owners to structure a leveraged buyout, in which the purchasers use the company’s future earnings to pay back the debt incurred. But conventional financing wouldn’t work, as the proposed deal would have violated the loan covenants the company had agreed to with previous lenders.
Solution: NEF’s managers completed the transaction using subordinated debt, a specialty loan product often used by ambitious companies that need more money to finance their growth than the chartered banks will normally provide. “Sub debt” is commonly used to fuel strategic growth initiatives, such as management buyouts, construction of new facilities or acquisition of new production equipment.
As the name suggests, subordinated debt ranks behind conventional loans secured by the company’s assets or real estate. In case of default, lenders of subordinated debt don’t recover their money until the banks or other senior lenders are paid in full. Typical candidates for sub-debt deals are established firms with a track record of earnings, growth and profitability.
Because of the risk involved (some sub debt is entirely unsecured), subordinated debt usually carries a premium interest rate. While conventional lenders may charge prime plus 1% or 2% on an operating line or prime plus 3% on an equipment loan, sub-debt lenders may charge as much as prime plus 12%.
While that may sound high, keep in mind that the lender is betting on the company’s future viability – not expecting to make its money back on an asset fire sale if the deal goes south. As well, sub-debt lenders may defer repayment for a year or more to ensure the borrower starts on a firm footing. This kind of risk-tolerant capital is often compared to equity, but “it’s still a lot cheaper than raising equity,” says Randy Chappell, Roynat’s Calgary-based managing director of equity and syndications for Western Canada. Sub debt may come with a high price, but it doesn’t require business owners to give up shares in the company at a time when it’s planning a major growth initiative.
“When you tell an owner that subordinated debt gives him another way to achieve financial growth besides giving up equity, he gets Me idea pretty quickly,” says Roynat’s Marsili. “A lot of entrepreneurs don’t want to give up equity. They’ve worked hard and dropped a lot of sweat for it, so subordinated debt is an attractive alternative.”
In addition to specialized lenders such as Roynat, subordinated debt is available from some pension funds and private niche-financing companies. Some lenders attach an equity “kicker” to sub deals, to create a little more upside in return for the risk they’re taking. Whether or not you’re asked to put some equity in the deal, be aware that one way or another, these investors are looking for annual returns of about 20%.
Bridge Financing: When timing is money
When a hotel and gift shop in Northern Ontario burned to the ground in fall 2005, the owner wanted to rebuild before the new tourist season began the following spring. Her insurance company said it would cover the cost, but the cheque would take months to arrive.
If she waited for payment, the owner knew that all the construction companies in the region would be closed for the winter. But she didn’t have the money to rebuild sooner.
When she asked her bank manager if he knew of any government grants that might help, he offered a better solution: a short-term bridge loan. “You get the money and pay interest until your insurance money arrives.”
With a bridge loan, also called an interim loan, the owner was able to hire a contractor to rebuild the outer shell of her hotel and install the plumbing and wiring, so that tradesmen could be working indoors when winter hit. They finished the job just as the tourists began to return. And with its brand-new facilities, her business had its best season ever.
Bridge financing helps qualified companies seize opportunities quickly, even when they don’t have cash readily available. With a short fixed term, a bridge loan is usually secured by future income’, such as an insurance payment, a government grant or receivables. Depending on the certainty of repayment and the type of security involved, says Toronto financial advisor Laurence Ginsberg lenders charge a rate of prime plus 1 or 2 percentage points.
Other applications of bridge financing include borrowing in anticipation of a public share offering or receiving federal R&D tax credits; or using accounts-receivables contracts to obtain a short-term loan for immediate requirements, such as payroll or operating expenses. Until recently, most companies obtained bridge financing from the lender (usually their bank) with whom they’d arranged conventional financing. The lenders provided bridge loans almost as a favour to good customers, since rates were relatively low and borrowers repaid so quickly. Roynat, for instance, only lends bridge financing in a pinch. “If a client needs it, we’ll look at it,” says Marsili, “but it’s not our specialty. At the end of the day, we’re a merchant bank.”
More recently, however, specialty niche players have begun to specialize in bridge financing, extending loans of as much as $30 million. Toronto-based Bridge Fund, for example, provides short-term bridge loans of several million dollars “to companies whose going-concern value exceeds their conventional credit criteria.” Borrowers may use the money for cash-flow financing, restructuring, buying out minority owners or acquiring assets or real estate, says a Bridge Fund spokesperson, “particularly where time is of the essence.”
Rather than applying conventional ratios to assess the company’s credit stability, specialized bridge lenders look at the enterprise value of the business: an alternative approach to market capitalization that’s calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents. It’s a fancy way of saying that your company may be worth more than you think — when you match your needs with the right lender and the right product.
Asset-Based Lending: Pushing the envelope
When a cyclical industry slump left a Toronto-based steel processor strapped for operating capital, the company couldn’t raise enough conventional financing to support its continuing expansion program. The problem: its existing loans had restrictive covenants in place that would be broken if the company added more term debt.
Fortunately, the company had an alternative to conventional financing: it turned to asset–based lending, a fast-growing field in which specialty players lend money against inventory or accounts receivable. One asset–based lender offered the Toronto steel processor a $15-million loan secured by its receivables and other balance-sheet assets. Not only did the loan cover the firm’s working-capital requirements during the temporary cyclical downturn, it also enabled management to undertake an important maintenance program that eventually helped the company increase both its production and its profits — and that’s as close to an ideal outcome as any borrower (or lender) could ask for.
Asset–based lending [ABL] started originally in the U.S. retail industry among companies that had a lot of inventory but were low on receivables, observes Silvio Marsili of Roynat Capital. (Banks traditionally discount companies’ receivables when valuing them as security for a loan, but they’re even harsher on inventory.) Asset–based specialists will lend more against both asset classes, but there’s a catch: they demand to keep close watch on clients’ sales, inventory and receivables, sometimes on a daily basis.
In the U.S., according to KPMG, asset–based lending now accounts for about a third of operating loans. ABL migrated north of the border to Canada in the 1990s, and while it has not achieved the penetration here that it has in the States, both domestic and U.S.-based banks now vie to offer asset–based solutions to Canadian firms. “The business is now extremely competitive,” says Marsili.
As a result, rates have come down, and lenders are sharpening their pencils to make the best deals possible. Where a conventional lender will usually accept 60% of the value of a borrower’s receivables as security, for instance, an asset–based lender may top that up to a full 90%.
Asset–based arrangements usually take the form of a revolving line of credit or a term loan. Companies may use the money to finance an acquisition or turnaround, for example, or to beef up their cash flow during cyclical industry lulls. Because the loan is secured by an asset that the lender can always seize to recover its costs in the event of default, the interest rate is usually lower than that which the borrower would pay for an unsecured loan or a line of credit.
The absence of restrictive bank covenants on asset–based loans makes them most appropriate for highly leveraged companies and businesses in turnaround situations. This means management can focus on building the business, instead of worrying if their working-capital ratios are out of whack, says Randy Chappell, Roynat’s managing director of equity and syndications for Western Canada. “When companies are highly leveraged, but you need to go beyond acceptable ratios, an asset–based lender will say, ‘Don’t worry about the ratios. Worry about the underlying assets‘.”
Since selling product and collecting on receivables is the first priority for most Canadian entrepreneurs, this kind of financial advice is easy to take.