A Structured Approach to Business Financing, Part 1: Current Landscape Tiered Financing By MARK EIKELAND, CGA Times have changed Show me the money A tiered approach to financing More reasons to use the tiered approach A framework for success This article is the first in a three-part series by Mr. Eikeland on the subject of Corporate Finance Strategic Financing to be carried on PD Net. The client base of many public practitioners includes a number of entrepreneurs and small business owners. And when these clients need capital, their first thought is often the bank. But these days, the bank represents only one funding source out of many, as there are a myriad of financing options available that most entrepreneurs or even their accountants may not be aware of. Part 1 discusses financing trends and how financing a business has changed during the last several years, with a focus on some of the approaches successfully used today. It introduces the strategy known as tiered financing, which will be explored further in the next two articles of this series. Times have changed In the past, if the bank said No, the business owner would likely be without a suitable financing alternative. Today, however, the situation has changed drastically. The sources available to entrepreneurs to raise capital have never been greater. Yet, at the same time, they have never been so confusing. This is the primary reason for the difficulty entrepreneurs are having financing their business today. A lack of available capital comes from a lack of information on who the alternative suppliers are, what is available, and what their criteria are. The marketplace is increasingly one of specialization and niche lending. The Canadian small business financing landscape continues to open up to new alternative and foreign sources of capital. For the entrepreneur, gaining access to these new financing sources is something like trying to navigate through uncharted waters without a guide. A lack of knowledge and expertise, combined with not knowing where to go, make financing a business both complicated and frustrating. Today, more than ever, entrepreneurs need to clearly identify and understand their requirements and the lender s preferences. Some lenders look for and do deals that other lenders avoid; these differences exist even among the big five major banks. Yesterday, lenders differentiated themselves by focusing on the client relationship money was money. Today, money is a product and lenders differentiate themselves with financing initiatives that focus and target services, industry, region, class, asset type, life cycle/growth stage, product, risk, sales, customer base, growth, leverage, the dollar size of the credit facility, and so on.
Financing has become a niche business with niche players. This is both good and bad news. The good news is that as the lending game continues to open up, more players are entering, and the increased competition is bringing added specialization with more competitive and innovative financing options and products to choose from. The bad news is that an already complicated and confusing marketplace becomes even more so. Show me the money Who are these new players, what is their specialization, and where do you find them? In British Columbia alone, there are 16 chartered banks, 61 credit unions, 19 factoring companies, and 48 foreign banks in operation. Add to this a growing list of U.S. banks such as Wells Fargo, merchant and investment banks, near-banks like GE Capital, leasing companies, venture capital companies, asset-based lenders, sub-debt lenders, boutique lenders, private companies, investment funds, federal and provincial government programs, mortgage and finance companies, enterprise centres, Community Futures Development Corporations, Export Development Corporation, and Canadian Commercial Corporation. Who wouldn t be confused? In this new and changing landscape new trends have emerged. One such development is that small business financing has become a commodity, a product. Yesterday, it was all about the relationship between the entrepreneur and the branch manager, who often funded requests based primarily on this relationship. Today, because decisionmaking has become centralized and automated outside the branch, the branch manager does not have the same decision-making powers. Now an entrepreneur will choose a bank or lender relationship based strictly on available credit and cost. And with today s technology, the process of financing is being done more often remotely through e-mail, fax, or the Internet than person-to-person. A tiered approach to financing Today, small business financing is a financial puzzle with many pieces. The pieces are those niche lenders filling the gap or outright replacing the bank. This situation has given rise to another trend, that of tiered or layered financing, which uses multiple funding sources. This is a common and well-used strategy in big business financing syndicating large loans and spreading risk. But now we see a version of this strategy being used more frequently in small business for a variety of good reasons, including spreading the risk. Gone are the days when one bank was the sole funding source and met all of the financing requirements of a business. Now even small operating lines of credit under $500,000 can be split between two different banks; one bank is in the senior position with security and the other is in an unsecured position providing top up financing. Today, a small business financing program might include some, all, or more of the following products: 1. Operating line Secured A secured operating line of credit (LOC) is a cornerstone to any mature business financing program. Funded by the bank, it typically margins the facility on inventory and accounts receivable. Rates are low starting at prime. 2. Operating line Unsecured There are many opportunities to top up an LOC, such as adding another unsecured facility, insuring accounts receivable balances for higher margining, or factoring specific accounts receivable in excess of margining requirements. A second lender comes in on an unsecured basis to top up working capital with an unsecured operating LOC to supplement the primary operating line. This works well A Structured Approach to Business Financing, Part 1: Current Landscape Tiered Financing 2
when a business is experiencing a growth spurt or has seasonal cash flow swings. This is also an opportunity to introduce a second lender into the business. Rates can start at prime plus 2%. 3. Factoring A factoring program turns a company s accounts receivable invoices into immediate cash. The factoring company buys the invoices and charges a fee. A carrying cost is charged until the customer pays the invoice, usually directly to the factoring company. For many businesses, a growth spurt has consumed the entire LOC, yet there may be excess margin available. A factoring company can work with the bank to purchase invoices over margin. Factoring is often a good alternative when a company is precluded from bank financing or when used in tandem with an existing operating line. Rates can start at 2% per month or 1% for every 10-day period that the invoice remains unpaid. 4. Capital term loan Secured This is the traditional long-term capital asset financing program fully secured by capital assets. In the past, the bank providing the operating loan was expected to supply this financing product as well. Today this is an opportunity to introduce an alternative lender and reduce overall exposure to any one financial institution. In many cases, this can be achieved with better terms, rates, and conditions. Rates can start at prime plus 1%. 5. Capital lease Secured Capital leases are commonly used for acquiring specialized equipment, in specialized industries, or in cases where attractive terms such as 100% financing is available. Frequently, in-house dealer programs make acquiring capital assets with a lease very easy. Sale lease-backs are often used to turn equity in equipment into cash. They are often a good alternative when conventional loan programs are not available, or the company has no other credit alternatives. Rates can vary significantly. 6. Working capital term loan Unsecured Working capital loans are sometimes called subordinated debt or mezzanine financing and are used in situations where sales are expanding and the company needs additional working capital to support the sales growth. In this case, the company assets are already fully secured with senior debt. As a result, this specialized type of financing is based on cash flow and debt serviceability, and is essentially unsecured. Rates are higher because of the unsecured risk. This specialized product might also include convertible instruments and warrants. Rates can range from prime plus 4% to prime plus14%. 7. Operating lease Secured The operating lease is easily available and is typically used to acquire small to mid-size equipment. It often comes with no money down options and is an attractive financing alternative. With proper planning, larger equipment leases can be structured as operating leases for financial statement purposes. With the June 2001 tax changes, all leases, even capital leases, are treated as operating leases for tax purposes. This can present some significant tax planning opportunities when financing capital equipment. The premises lease is included in this category and is how leasehold improvements are most appropriately financed. In most cases the landlord is willing, and is best able, to provide some financing on the project over and above negotiated tenant inducements. If applicable, the landlord can simply adjust the lease obligation to reflect the additional investment. It is not hard to imagine these seven types of financing products as part of any overall financing program and strategy. At the same time, we could easily have a different lender A Structured Approach to Business Financing, Part 1: Current Landscape Tiered Financing 3
supplying each product. Add any government-sponsored specialty program to the mix such as Export Development Corporation, which provides additional lending support on accounts receivable for a company s export program. Another example would be the new Canada Small Business Financing Act (CSBFA) Federal Government program that replaced the former Business Improvement Loan (BIL) program. (As of April 2003, this program has expanded to include capital leases.) With so many options available, it s easy to see why a tiered financing approach can be a very desirable and successful strategy for small business. Part 3 of this series presents an actual case study that illustrates how tiered financing could be used. More reasons to use the tiered approach Here are some other reasons why this tiered approach to financing is a good strategy: Reduce credit risk Overexposure to any one financial institution can lead to financial constraints that ultimately limit growth and leave you wondering who is really in control of your business. Most business loans today are on a demand basis, regardless of term or amortization, and can get called with little advance warning. As a result, the best time to establish a new banking relationship is when you do not need one. Multiple banking relationships build in financial flexibility with future alternatives. Stability Today s financial institutions experience fast-paced changes to their policies as well as frequent movement of branch managers. Financing stability can be improved through using multiple financial suppliers. Current bank facility at maximum Current bank facilities could be stretched and yet the business needs additional capital to operate. The bank may not be in the position to satisfy all the requirements of the business because they may have loaned the maximum amount their lending policies allow. This is where alternatives and the niche lenders can play a significant role. Improve security Financing is not always about money. It could simply be about changing, reducing, or eliminating the old security arrangements. Examples of this include removing personal guarantees or removing principal residence collateral. Flexibility of niche lenders and products With specialization and niche lending come new and innovative products with better features. Speciality lenders can sometimes provide financing programs better suited to the business, with terms and conditions that are focused and specific to the industry the business operates in. As well, these lenders know the industry they operate in and are not so quick to panic when the industry experiences a downturn. Access and ease of process With the advent of new technology and the Internet, financing a business is as close as the computer. New web-based services provide instant access to a multiple range of lenders and financing products. And an application can be completed without leaving the office. Reduce cost of funds Refinancing is often a case of replacing existing debt with better terms and conditions, so that both cost and cash flow have been improved. Reduce impact of economic fluctuations Industry and economic fluctuations can affect banking relationships. When banks are overexposed in certain industries, everyone in that industry experiences a tightening of A Structured Approach to Business Financing, Part 1: Current Landscape Tiered Financing 4
lending policies. Compare the fast and furious financing practices of the high-tech industry in 1999 to the challenges of financing a high-tech company today. A framework for success Successful financing is a puzzle with many pieces, so developing structure for a proposed financing program is critical to success. Be sure to identify and match the: purpose to the product product to the asset asset to the lender lender to the industry By doing this, the financing proposal now becomes a crucial component in every business plan. Similar to structuring and tailoring a resume for a specific employment position and company, the financing proposal must be structured and tailored to identify and meet the preferences and security requirements of specific lenders versus a hit and miss approach. This article has discussed some of the many alternatives and solutions available for financing a business. CGAs can play a valuable role in guiding their clients through the ever-expanding maze of options to establish an effective, tiered financing strategy. Part 2 in this three-part series will discuss the key components of a successful financing proposal within a tiered structured approach that considers the matching steps mentioned earlier. Part 3 will present an actual case study to demonstrate some of the key concepts discussed throughout the series and show how the tiered financing approach can be used successfully. To sum up, access to capital is one of the biggest issues facing entrepreneurs. It is also one of the best opportunities for CGAs to deliver valuable professional services to their small and medium-sized business clients. Adding value Adding value to existing professional business services can incorporate a checklist for use in business planning or at financial statement year-end reviews. The checklist might include questions such as: Is there an opportunity to: Reduce financing costs? Remove/reduce personal guarantees? Improve cash flow with refinancing? Improve security agreements? Improve the current financing program? Is it adequate? As well: What are the future capital requirements? Is there a need for new working capital, capital purchases, expansion? Is the business plan up-to-date? Is there a cash flow forecast for the coming year? Taking a proactive approach can address potential financing issues well before the need arises. A Structured Approach to Business Financing, Part 1: Current Landscape Tiered Financing 5
Mark Eikeland, CGA, is the founder and President of NetFinance.ca (e-capital Networks Group), an online corporate finance resource for accountants and accounting firms in B.C. and Alberta. He has been an entrepreneur, a business counsellor with the Business Development Bank of Canada, a college business lecturer, a sought-after seminar leader, and has held a variety of senior financial positions including Senior Finance Officer within the banking industry. Prior to forming NetFinance.ca in 2002, Mr. Eikeland operated a successful 10-year private practice as a professional accountant and business consultant to clients throughout B.C. and Alberta. Focusing in the area of Corporate Finance, he raised capital for small to mid-sized businesses to finance their start-up, acquisition, reorganization, and expansion plans. Visit NetFinance.ca for more information about NetFinance.ca. Or contact Mr. Eikeland at mark@netfinance.ca. This is the first of three articles by Mr. Eikeland on Corporate Finance Strategic Financing to be carried on PD Net. Appendix Debt Financing Glossary of Terms A Structured Approach to Business Financing, Part 1: Current Landscape Tiered Financing 6