Start-Up companies do not need theoretical or impractical advice. They need tips and suggestions that they can easily and swiftly implement to improve their chances for success. In the spirit of this need, here are ten tips in the areas of accounting and finance that they should consider implementing in a hurry:
Most businesses have at least some seasonality to them. Perhaps the first quarter of every calendar year is always slow, or your business comes to a stand-still every November through December. Here is an example of a business that slows dramatically ever summer:
Short term working capital financing is most commonly facilitated with an asset-based line of credit. As its name suggests, the loan is secured by an asset in the business – usually accounts receivable. If you ever consider using this type of a vehicle in your business, here are the 5 most critical terms you should understand and know how to negotiate.
ASSET
What is the asset that will be securing the line? These loans are normally tied to current assets like accounts receivable and inventory, but they can also be secured by equipment and even intangible assets like intellectual property and goodwill.
If we default on our payment of the obligation, the lender will have the right to seize ownership of the asset. Banks and lenders do not want to have to do this and they will be the first to admit that they are not structured or equipped to effectively liquidate such assets. These assets are usually very valuable to the business which makes payments on the line of credit a top priority for most businesses.
BORROWING BASE REQUIREMENTS
Assuming the asset is the accounts receivable of the business, the lender usually sets limits and conditions on the amount of the receivables that can be included in the borrowing base. The two most commonly used limitations are past due accounts and customer over-concentration.
The lender will often only allow current receivables in the borrowing base. This is often set as all receivables less than 60 days old or only receivables less than 60 days past due. Lenders will often limit the percentage of the total receivables that one customer can hold. This is usually set at no more than 20% of the total eligible borrowing base. For example, if we have total receivables of $1,000,000 and they are all current (very unlikely in this economy), no single customer can account for more than $200,000 of the total receivables. If they do, then all amounts over $200,000 are excluded from the borrowing base.
Once the total borrowing base is established, the lender will then often only allow a certain percentage of those assets as the final base. On accounts receivable, this percentage usually ranges from 60-80%. As an additional note, borrowers are usually required to report on the status of the borrowing base on a monthly or more frequent basis.
So, how does all of this work. Here is a basic example: let’s assume the lender allows us to borrow a maximum of $100,000 against 75% of our eligible receivables. The lender excludes all receivables over 90 days old and has no limit on customer concentration. Our total accounts receivable is $150,000, but $50,000 is over 90 days past due and we are about to write it off as bad debt. This means our eligible AR is $100,000, which means our borrowing base is actually only $75,000 ($100k AR times 75% of eligible AR).
MAXIMUM
This is very simply the maximum amount the lender is willing to lend on the line of credit, regardless of the value of your borrowing base. Most lenders set this amount by looking at their secondary sources of repayment, which are usually the financial strength of the owner(s) and/or the equity in un-related assets (like their home). These are often secured with a personal guarantee.
FEES
Each bank structures its fees a little differently, and it is important to understand these so that we can make an “apples-to-apples” comparison on costs. Most lenders assess an origination fee of between .5-1.5%. In addition, they will often charge document and other fees. We have also seen banks require borrowers to pay an independent third-party to verify and validate the assets in to be secured. We recommend receiving proposals from more than one bank and then comparing the total cost proposal from each potential lender to understand which may present the best deal for you.
INTEREST RATE & FLOOR
When you establish your borrowing base and you draw on the line, interest will begin to accrue. Most banks are setting the interest rate on these lines at prime plus 1.5-2.0%. Prime is currently at 3.25%, so that would equate to an interest rate of 4.75-5.25%. Because these rates have dropped so low, most banks have instituted a floor, or a rate below which they will not drop. Interestingly, those floors are being set at 6.5-7.0% in this market.
CONCULSION
Asset-based lines of credit are an affordable and effective way to finance the peaks and valley in working capital. As a word of caution, most require a personal guarantee from all owners of 20% or more of the business. We recommend you seek legal counsel before agreeing to personally guarantee the debt, especially if the guarantee is unlimited – which means each partner can be held responsible for 100% of the obligation personally.
In our role of part-time CFO, we have helped our clients secure tens of millions of dollars in asset-based credit. I hope this brief explanation will be helpful as you consider this option for financing your business.
Here is a real situation that has a partnership of four up-in-arms:
Each partner owns 25% of the business. Three of the four partners have stellar credit and decent net worth. The fourth partner had a bankruptcy 4 years ago and does not have much net worth, other than the value of the business, to speak of.
The company has a customer present an opportunity to them to double their business in 12 months. The catch – they will need to buy over $1,000,000 of equipment to capitalize on the lucrative opportunity. Even though the credit markets are tough, this company is able to secure the financing it needs under one condition – the three partners with good credit have to guarantee the loans, but the fourth partner cannot.
The three partners have exposed themselves to more risk than the fourth. So, is the partnership still actually equal? Not in terms of risk.
In this scenario, the three partners are fine to expose themselves to this additional risk to give the company a chance to grow. They do wonder, however, if they should in some way receive compensation for taking on more risk than the fourth partner. If for some reason the company defaults on the loans, then the three who signed personal guarantees will have to resolve the issue eventually with the creditors. The fourth partner gets to walk away without these issues.
I have seen some interesting ways to handle this issue, and I would welcome additional feedback on how to best handle this. Any and all ideas are welcome.
One last thought – if anyone is considering taking on one or more partners in their business, this is an issue that should be considered and can even get in the way of financing your business. If your partner owns at least 20% of the company, some lending institutions will require that they run a credit check on them – and if their credit is bad, the lender will probably decline the loan!
ADDITIONAL COMMENTS
I received some great feedback on a social network for startup CFOs that I wanted to add.
Mark McLeod says:
Interesting situation Ken. You could approach this a few ways:
1.) Risk adjusted return on the leverage the 3 partners are taking on: some additional premium either as a % of the loan or non equal distribution of profits from the incremental business
2.) Separating the legacy and new business on paper and again having non-equal profit split on the new piece.
3.) Re-evaluating whether this 4th partner is necessary for the future of the business. Will he drag them down or can he be an equal and full contributor?
Peter Towle says:
Another option to explore IF the other partners want to keep the ‘bad-credit’ partner in as an equal profit participant (or try to keep it equitable) is to create a side agreement between the partners that encumbers the ‘bad-credit’ partners assets, future assets, or share of the business should there be a problem.
Richard Wong says:
Some good answers from Mark and Peter, I would also add the possibility of another:
Since this new business will result in a major change in the net assets of the company and I am under the assumption the partners like working with each other and that’s the reasons they’re still partners that they revise the partnership agreement to show the new partnership percentage based on this, otherwise it may be time to incorporate.
They have a holding company, where 3 of the 4 are given a larger %ge of the shares, a subsidiary (the main operating co.) and then based on some measure ie. net profits of the added customer business dividends could be given to the 3 shareholders who took the credit risk, until the loan is repaid, then based on some sort of gentleman’s agreement that the 4th partner earn his way to an equal shareholder percentage.
Now the above could all be thrown out the window if say the 4th partner is the one who brought in the customer and negotiated the extra business because let’s say he’s a better salesperson than the other 3?
Hope you can facilitate a paper solution to this Ken.
Great feedback so far…I’m open to more ideas, thoughts, and suggestions!
If a CFO partnership faced the same challenge, how would each CFO partner resolve this same issue?
The Commission for Economic Development in Orem confirms that Brad Jones is the newest director that has been invited to sit on the board for CEDO.
PLEASANT GROVE, Utah, May 6, 2009 - This week Brad Jones, one of our CFO Partners, has been appointed as a member of the Incubator Board of Trustees for the Commission of Economic Development in Orem (CEDO). This non profit organization serves as an advocate for businesses in Orem and Brad will be an exceptional addition to their board.
CFOwise founder Ken Kaufman commented on this news by stating the following, “It is a real privilege to have one of our CFO’s be on the board of directors for such a proactive organization like CEDO. We look forward to seeing all that Brad can offer to that organization”.
About CFOwise
With over a century of senior-level executive experience, CFO wise is the premier provider of permanent part-time CFO services to start-up, emerging, and medium-sized companies in the United States. As business finance consulants, the CFO partners help their clients maximize cash flow, improve profitability, strengthen financial health, and gain clarity. For more information, please visit: www.cfowise.com or contact Kim Waldron at 801-380-5615.
About CEDO (Commission for Economic Development in Orem)
The Commission for Economic Development in Orem is a non-profit organization that serves as an advocate for Orem businesses. The CEDO staff works closely with Orem business professionals and Orem City officials to promote the economic vitality of Orem. For more information, please visit: www.cedo.org .
If you want to sell your business, seller-financing has become an even more common requirement. First of all, seller-financing is common and there are many resources on the Internet that explain the risks and rewards associated with such a practice.
The credit crunch appears to be making seller-financing even more common, although I have yet to see statistics to back that up. It is no secret that the commercial loan market has slowed dramatically, and the number of SBA loans have dropped as well. This has not provided any financial help for small business. Private equity firms are acting much more conservatively, mainly because they employ a strategy of maximal leverage when they buy small companies with high growth potential. The debt financing is not as available as it used to be, and they are not willing to tie up more of their investors’ funds in these high risk enterprises. These and other factors mean a motivated seller needs to be more ready than ever to finance at least a portion of the price of the transaction. This is a reality of the current market in which we operate.
The SBA exists to get cash, resources and financial help for small business and entrepreneurs (defined as companies with fewer than 500 employees) of America. By every measurable result, they are failing. So, can they be fixed?
An article discusses some of the issues and some suggestions to fix the agency. While this article is of value, I beleive the issue at hand is much larger than addressing some of its problems. The entire SBA is broken. The entity is broken in so many ways that it is hard to count, and each issue seems to further entrench its operations in the same old way of doing business, causing somewhat of a death spiral. I do not know of one high growth, technology, or clean tech company with an SBA loan. They are too complex, too costly, and too hard to access. SBA loans are mostly in place for low growth industries with little or no profitability with owners that have significant real estate to collateralize their SBA loans. The SBA needs desperately to move into the 21st century. It should be leading the charge in our highest growth industries as well as continuing to provide support to the low growth or even receding industries. The SBA needs to re-brand itself into the number one resource for all entrepreneurs and small to medium-sized business owners. When I think of what the SBA needs to do I think of the amazing job the United States Postal Service has done to completely redefine itself to adjust to a changing and more competitive marketplace.
Here is my conclusion: The SBA is not worth fixing unless they completely re-brand, re-define, and re-structure themselves. All other efforts will be futile at best!
The main reason the Fed is cutting rates is to spur borrowing and economic spending. In response, the commercial banks are cutting the prime rate from 5.25% to 5% (USA TODAY, 1 May 2008). This means that the cost of debt for businesses should be on the decline.
However, the credit crisis caused by the collapse of the sub-prime lending market has banks tightening their lending policies. In the past few months, we have been told by several loan officers and other bankers that banks are just not doing many deals right now. It seems to me that the Fed’s actions are having no real affect on getting borrowed funds into the hands of businesses. The borrowed funds that their customers already have are just cheaper. A knowledgable CFO consultant can help you with acquiring financing.
INTRODUCTION
A lot of business owners have a hard time differentiating between their personal and company finances, yet they need to be regarded as completely and wholly separate. Many business owners who subscribe to a debt-free philosophy for their family (except for a home mortgage) want to impose the same philosophy on their business. Experience shows that not only is this not prudent, but it actually will cost them money in the long-term. Allow me to explain:
COST OF CAPITAL
Every company has a cost of capital, or in other words, a cost associated with the money it either borrows or receives as equity contributions. The cost of debt is typically much lower than the cost of equity, but this is what confuses business owners – they do not associate a cost with the equity they either have or are going to invest or retain in their company. We know that traditional debt is costing most businesses 8-9% per year right now (not including the tax benefits associated with debt), but how much does equity cost?
COST OF EQUITY
Using a basic analysis, let’s assume that a large, well-established, multi-national corporation returns 10% per year to its shareholders (in the form of dividends and growth in stock price). This 10% return represents the firm’s cost of equity, or the return with which the shareholders are satisfactorily compensated for their risk. Your company’s cost of equity is most likely higher because your business represents much more risk. Perhaps you are not very geographically diverse, or perhaps you have one customer that accounts for more than 50% of your business. Maybe your industry is traditionally volatile and/or cyclical, or maybe your product or service is not yet proven. And don’t forget that emerging and medium-sized businesses are viewed as more risky than larger companies.
RISK PREMIUM
There are many ways to quantify this risk, and it is called a risk premium. In other words, how much more than the 10% would someone expect to earn from investing in your firm. Assuming your risk premium is 6%, then your cost of equity is 16% (average market return of 10% plus your risk premium of 6% equals 16%).
EXAMPLE
So, how does this apply to you? Let’s use an example that assumes your cost of debt is 8% and your cost of equity is 16%. First of all, since interest is tax deductible and equity is not, we need to reduce your cost of debt to truly understand your overall cost of capital. Assuming you are in a 35% tax bracket (federal and state marginal brackets combined), your cost of debt drops to just 5.2% (one minus 35% equals 65%, then multiply 65% by 8% to arrive at 5.2%).
Now, let’s assume you need $100,000 to grow your business to the next level. You could draw against your company’s line of credit at 8% or sell enough of your company to raise the $100,000 required. The debt will cost you $5,200 in interest the first year, but your investor will be looking for a return of at least $16,000 in the first year (sometimes they are willing to wait longer than a year to realize their return, but they eventually will want at least a 16% annualized return). Obviously, the debt solution is the most prudent for the current shareholders.
LEVERAGE
Even if you want to put the capital into the business yourself, your ownership won’t change (if you already own 100% of the company). So, you would be risking $100,000 for no additional stake in the business and its future profits. Sure, you would benefit from the growth your $100,000 facilitated, but you could still benefit by using the bank’s money. In essence, you give away $5,200 per year to the bank until you can pay back the line of credit in return for keeping all of the profits and value generated from the capital. No matter how you slice it, you would be much better served to use the bank’s money than your own capital. The best case scenario is you generate a return far in excess of 16%. The worst case scenario is $5,200 per year, not your entire $100,000.
SHAREHOLDERS SHOULD DIVERSIFY
You should, for all intents and purposes, diversify yourself personally with your $100,000. Most of your net worth and your salary probably come from your business. It is your role as a shareholder to diversify yourself. And, although this may seem counter-intuitive, investors and outside professionals do not normally favor or assess any additional value to a firm that operates debt-free. According to an article in the USA TODAY on April 17, 2008, the 164 companies (including Microsoft and Google) in the S&P 1500 that are currently debt-free have experienced worse returns during this credit crisis than those with debt (“Lack of Debt Doesn’t Boost Firms’ Stock”). A Financial model can help you keep to the goals you have with your business.
CONCLUSION
The proper structure and utilization of debt is one of the most beneficial financial strategies a business can have and execute. In fact, research and experience have shown over and over that the right use of debt in your business will increase the value of your business. Contact a CFO consultant to see if your company should have debt.
I think it would be worthwhile to cover the four C’s of credit from the perspective of the start-up, emerging, and medium-sized company perspectives. Particularly, understanding the four C’s from this perspective should help these businesses better understand the banker’s perspective when trying to determine the credit worthiness of the company to which they may extend a loan.
The four C’s are: character, capacity, capital, and conditions.
CHARACTER
Business owners sometimes struggle with this the most. The reason – we feel like the loan should be based on the character of the business ALONE. The reality – unless it is for a small amount, banks do not offer loans or lending based solely on the assets or free cash flow generated by the business. They always look to a secondary source of repayment, primarily in the form of a personal guarantee from anyone who owns at least 20% of the business. This means that banks will be looking at the character of the business as well as the character of the owners of the business in underwriting lending opportunities.
On the personal side, this means they will want to see your most recent three years of tax returns, including all K-1s you received and reported on those returns. This underlines a very important reason to get your taxes done on-time every year with a competent tax CPA. Bankers will become uncomfortable if you tell them you are behind on your returns for a couple of years, and they will become leery if they see blatant mistakes on your returns. Also, they will require a personal financial statement, which includes all of your sources of income and your current balance sheet (Assets = Liabilities + Net Worth). They will not begin the underwriting process without this information, so you should give it to them before they even have to ask for it. Nurturing the banking relationship in this way is often overlooked by business owners, so you can become one of the banks favorite customers, and receive better treatment and their best offer.
On the business side, be prepared to provide the company’s most recent three years of tax returns and financial statements (along with the most recent interim financial statements) as well as a formal business plan and pro formas, or projections, of the plans for the business. Again, the tax returns should be correct and current for the reasons listed above. Also, the financial statements should match the tax returns. If they don’t, then the bankers begin to worry about what is going on and they become less comfortable with putting a deal together. Your projections and business plan should include a pro forma income statement, balance sheet, and statement of cash flows. These projections should justify the use of the funds requested and clearly identify the firm’s ability to repay the loan well within the timeline requested.
All of these items help the bank understand the character of the business and its principals. They will most likely run credit reports on the owners and the business, and they will search for liens, judgements, and any other information they can find. Both your and your company’s character are paramount in a bank wanting to do business with you. A savvy business owner will set themselves up to put their best foot forward with their bank. We have found that we have been able to help businesses in this area, and our presence as the firm’s part-time CFO has improved the company’s ability to obtain financing. For example, we helped one of our clients increase their bank loans from under $750,000 to almost $5,000,000 in a very short period of time.
Do you know what your debt-to-equity ratio is? How about your current ratio? At what multiple is your interest coverage ratio? These and other ratios derived from your firm’s financial statements help a bank determine how much money they are willing to lend you. In essence, the bank is going to assess the capacity that your company has for debt and how much they are willing to lend your business.
In the process of determining your company’s borrowing capacity, the bank wants to know in what position they will be against your company’s assets. If it is a small enough loan, they may be willing to offer an unsecured loan, meaning they have no claim on company or personal assets if you default. Or, the bank may want to secure, or collateralize, itself against some or all of your assets. Banks will usually file a UCC-1 lien on your business stating the assets to which they have rights should you default. Some business owners are offended that the bank would take such drastic preliminary measures. The bank has shareholders and federal regulators that they must appease – this is how their industry works.
The way a company accounts for its assets and liabilities can make a big difference in the bank’s perspective of the company’s capacity to borrow. It is very important that all of your loans are booked correctly, meaning the current portion (the next twelve months of payments) is separated from the long-term portion (all payments due later than 12 months) on your balance sheet. Inter-company transactions and shareholder loans need to be treated correctly or they can hurt the bank’s view of your overall lending capacity.
CAPACITY
Do you know what your debt-to-equity ratio is? How about your current ratio? At what multiple is your interest coverage ratio? These and other ratios derived from your firm’s financial statements help a bank determine how much money they are willing to lend you. In essence, the bank is going to assess the capacity that your company has for debt and how much they are willing to lend your business.
In the process of determining your company’s borrowing capacity, the bank wants to know in what position they will be against your company’s assets. If it is a small enough loan, they may be willing to offer an unsecured loan, meaning they have no claim on company or personal assets if you default. Or, the bank may want to secure, or collateralize, itself against some or all of your assets. Banks will usually file a UCC-1 lien on your business stating the assets to which they have rights should you default. Some business owners are offended that the bank would take such drastic preliminary measures. The bank has shareholders and federal regulators that they must appease – this is how their industry works.
The way a company accounts for its assets and liabilities can make a big difference in the bank’s perspective of the company’s capacity to borrow. It is very important that all of your loans are booked correctly, meaning the current portion (the next twelve months of payments) is separated from the long-term portion (all payments due later than 12 months) on your balance sheet. Inter-company transactions and shareholder loans need to be treated correctly or they can hurt the bank’s view of your overall lending capacity.
CAPITAL
The bank wants validated proof that your company and the personal guarantors have the financial wherewithal to repay the loan. They will first look to the free cash flow the business has generated over each of the last three years. As a general rule of thumb, free cash flow calculates the amount of cash available for distribution to equity and debt holders. Generally, a firm’s free cash flow is derived from the following formula: Net Income plus depreciation/amortization plus or minus the change in working capital minus capital expenditures.
Next, the bank will look at the equity, or net worth, in the company. First of all, they want to see a positive net worth. Second of all, they want to see that the net worth is increasing. If it is decreasing, they will jump to one of two conclusions – either the company is not profitable or the owners are taking too much money out of the company. I once sat in a meeting in which the banker accused my client of using the bank loan to distribute cash to all of the owners of the company. We were able to quickly help the banker understand what really happened, but therein lies the point – the bank has certain things for which it looks. Without the right information, the bank will make assumptions, whether the assumptions are correct or not.
A savvy borrower will understand this and head the bank off by anticipating its questions, in advance, and answering them voluntarily before the assumptions are made. The bank will next, somewhat hesitantly, look over your projections to understand if the cash flow trends may change in the next 12-24 months. Unless you have proven to them that you really understand your business and can make relatively accurate projections, they will put very little weight on the information in your projections. This is often a frustrating point for business owners – bankers loan money based on the past. Once the bank considers the capital in the business, it will next analyze the capital of the personal guarantors or collateral offered as a secondary source of repayment.
I have often seen a business receive financing based solely on the capital of the owners. I had a client once tell me that the bank was willing to loan him only as much money as he could write a check for and personally pay-off himself. While this is not entirely true, a strong personal financial statement of the owners brings a high degree of comfort to the bank.
CONDITIONS
What are the external factors that the bank considers in its underwriting process? Normally, the bank is concerned with shielding itself from risks that may be outside of the bank and the company’s control – these are referred to as Conditions. Some of these external factors include the economic conditions of the geographic market and industry in which the company operates, political and/or legislative concerns, among other items.
Here is an extreme example – a bank of one of my client’s refused to allow us to increase the company’s line of credit because they felt the industry in which the company operated was headed for a major downturn. With a phenomenally strong balance sheet and enough work and orders on the books to justify a healthy and profitable rate of growth, the bank still refused to consider the request for an increase in the line of credit. The point is that banks are about hedging their risks. They are trying to avoid over-concentration, and they often make decisions based on big picture trends and concerns that have nothing to do with the attractiveness of an individual loan.
In the example above, we found three other banks more than willing to compete for this wonderful customer with a perfect credit history. The result – we doubled their line of credit into seven figures and got better pricing on the deal than we previously had.