Few things focus the mind of a prospective borrower more than that of the unconditional personal guaranty.  And while there is no denying the gravity of committing oneself (and ones family) to such an obligation, it is important to remain clinical when assessing the riskiness of deploying capital.

Since business owner’s wealth is typically tied substantially to his or her equity in their company, in most cases and from a financial point of view, it should not matter if an investment is made using equity or debt.  Let us explain.  In all cases the return on capital deployed for a project is the same whether or not the capital is debt capital or equity capital.  And this holds true even in the downside scenario where a partial or even total loss is realized.  If there is a gain on the investment, wealth is created and if there is a loss, wealth is destroyed.

This fundamental (pardon the pun) truth is an important back drop for properly assessing investment risks.  Because while it is true that access to debt generally expands capital availability and it is also true that debt pay back takes priority over equity returns, in a rational world an investor should not make or forgo investment decisions based on the type of capital used – the weighted average cost of that capital yes – but never the individual type of capital.

The theory says a firm should pursue all projects that offer a risk adjusted return greater than the firms cost of capital.  And theory meets practice in this realm all of the time – even if informally nearly every business owner instinctively understands the potential return profile of a new opportunity – and also the risks.  The new opportunity can be as simple as taking on an additional customer or expanding exposure to a customer materially, all the way through installing a new piece of machinery or equipment.

But in all cases the risks and return potential associated with those opportunities exist whether or not they are pursued and are the exact same if pursued regardless if financed with debt or equity.

We can guess that this assessment may not be sitting well instinctively with all readers at this point.  So we offer a distinction that will hopefully resonate as follows – while it is the case the risk adjusted return profile is always the same for any given project regardless of capital source – the returns to equity (the chief concern of a business owner) – be they positive or negative do in fact change based on capital type. 

Simply stated the use of leverage amplifies the returns to equity – either in the positive direction if the investment is a good one – or in the negative direction if the investment does not work out as anticipated.  As we heard Donald Trump say once in an interview (paraphrased) “Using debt in good times or for good investments is terrific – you make a ton of money.  But if times turn bad or if the investment is a bad, you get crushed.”

While we can’t say we agree with all Donald Trump has to say, on this one we could not be more supportive.

Which leads us to our advice – which we follow in spades in our own company – which is to simply focus all of our energy trying to figure if the investment will be a good one and how to mitigate its risks.  Assuming we like the project, we make the investment – regardless of the source of capital to do so.  If we don’t like it – we just won’t invest.

The costs and availability of debt and/or equity do matter very much in determining the weighted average cost of capital.  While it is obvious that less is better when it comes to costs, we’ll take a closer look in a future article at some of the trade offs related to new projects when the costs of incremental capital is higher.

 About the Author

 Tim Haddock is the Co-Founder and CEO of Fundamental Financial.  Prior to Co-Founding Fundamental Financial, Mr. Haddock was a Partner & Managing Director with the global merchant banking firm Greenhill & Co. (NYSE: GHL).  During his career he has advised on over $75 billion of capital raising, financing and merger transactions.

The bad news is that incumbent lenders (i.e. banks) typically won’t agree to the conditions necessary to enable it to become a reality.

Let’s start first with what an A/R lender or factor typically needs to offer financing – which is at least a first lien position on the assets against which it is lending (i.e. the A/R).  Sounds reasonable enough right?

In fact, many A/R lenders (us included) do not even require a blanket first priority lien against all of the A/R of a company – in favor of a first priority lien on the A/R only against which we are lending.  In practice this generally works by having the A/R lender provide financing against receivables from only selected customers of the borrower.

So how does one “carve out” certain receivables to permit an A/R lender to finance them?  We know that many of our competitors make this process complicated, but we don’t!  We simply require the incumbent lien holder to sign a simple one-page waiver permitting the borrower to sell certain A/R to us from time to time and releasing any and all collateral claims the bank might have against those A/R.

So will a bank typically sign a waiver releasing some or all of their A/R collateral?  As mentioned above, the answer is frequently and unfortunately “No”.  And the reason is pretty simple from the banks point of view – which is – that they are relying on all of the collateral to support the loan that they have made to the company – and that releasing some of that collateral makes them worse off.  Indeed, we agree that the banks position on this is entirely rationale.

So does all this mean the topic is not worth pursuing at all?  Not at all.  We think it is worth pursuing because there are enough potential circumstances available that may give rise to a bank making an exception – so it is worth presenting to them.  Here are some of the exceptions we see as working most often:

1. If the incumbent loan is a SBA loan, the process of releasing the A/R and related collateral can be done in a way that does not impair the SBA guaranty – so the bank will look to the SBA guaranty foremost – and often will not find it a material risk to release on the A/R.
2. If there is significant other collateral pledged to the loan (i.e. property, etc.) and the credit profile of the borrower has improved since the bank loan was originated.  In this circumstance it is more likely, however, that the bank will offer more availability.
3. If the bank loan is under collateralized due to eroded conditions and the company finds itself stabilized but cash strapped – and the bank is unwilling to extend additional credit.  In this situation the banks best hope for a good outcome may be stabilized cash flow to repay their loan – and the bank may not be willing to risk new money to provide working capital – A/R financing companies will often be willing to offer risk capital in these situations.

Some thoughts on incremental liquidity options.  Hope this helps.

About the Author

Tim Haddock is the Co-Founder and CEO of Fundamental Financial.  Prior to Co-Founding Fundamental Financial, Mr. Haddock was a Partner & Managing Director with the global merchant banking firm Greenhill & Co. (NYSE: GHL).  During his career he has advised on over $75 billion of capital raising, financing and merger transactions.

 So what does leveraging working capital mean anyway?  It simply means borrowing against A/R and inventory balances – which although they are individually generally short lived assets – are constantly replenished as businesses operate and therefore create a financing need in most business models.

 In most instances, a company’s working capital is financed by a combination of debt and equity.  Some companies, however, do not have much, if any, debt.  And if this situation exists contemporaneously with an attractive investment opportunity, leveraging working capital can be a quite attractive option.  The stars fitting this description don’t align all that frequently in practice, but when it does here is how it works.

 The company simply borrows against its working capital assets – either for the first time or in an amount greater than the debt currently outstanding against those assets.  The company then uses a portion of the proceeds (excess proceeds in the case of incremental borrowing) to invest in the new opportunity.  All seems straightforward enough up to point right?

 The trick is determining what portion, if any, of the excess proceeds can be reasonably directed towards the new investment opportunity – without placing an undue burden on the cash flow profile of the company.  The most complete way to make this assessment is by building out a cash flow model and testing the tolerances in various projected scenarios.  Given that modeling can be a time consuming and messy process, there are some rules of thumb a company can use to determine if it will work – and if so, in what magnitude.  Some of those rules of thumb are as follows:

1. The higher the operating margin on the product or service – the more likely excess working capital will be available.  To determine roughly how much, the following formula is a decent proxy – the sum of 80% of A/R + 50% of inventory (at cost) multiplied by your operating margin.  So if you have A/R of $100 and Inventory of $100 and your operating margin is 20% – you can estimate that you have ~$26 in excess working capital to invest.

2. The higher the net worth of the company prior to the investment – the more likely a company will be able to leverage its working capital.  This rule of thumb essentially permits existing equity to be leveraged more, but is nonetheless a viable proximity tool.

3. The less the existing debt on the company – the more likely excess working capital will be available.  This one is simple enough as you will only have “excess” availability based on nature of your assets – and those are already partially levered, then additional “excess’ will be lesser.

 As we mentioned above, this circumstance does not present itself in practice all that frequently, but when it does it can be a very nice option.  We ran into this situation again just recently – so although somewhat rare – it does happen – so be on the lookout.  

 About the Author

 Tim Haddock is the Co-Founder and CEO of Fundamental Financial.  Prior to Co-Founding Fundamental Financial, Mr. Haddock was a Partner & Managing Director with the global merchant banking firm Greenhill & Co. (NYSE: GHL).  During his career he has advised on over $75 billion of capital raising, financing and merger transactions.

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And indeed that is the most common response because it is also the most practical.

So the process normally proceeds as follows:

1. Product is delivered / work is completed
2. Invoice sent
3. Wait for payment on invoice
4. If there is an incomplete order or dispute – it is usually addressed via a telephone conversation about the issue or simply short paying the invoice

But what happens when the nature of the issue is such that it cannot be readily verified or substantiated?  In most cases merely another simple answer – work it out best you are able with your customer.

There are some situations, however, where this common business practice of just “working it out” may lead to imprudent risk taking on the part of the service / product provider.  We highlight the following situations where we commonly see business owners taking on excessive risk (to make the sale we are told) – and in the process, potentially assuming greater than prudent risk of not be paid properly.  These may seem fairly obvious, but we see them ignored or minimized frequently:

1. A first time or new customer
2. Existing customer, but unusually large amount
3. Larger orders (certainly above 20% of monthly sales)
4. Performance based services that may be difficult to establish, after the fact, that the work was done properly (cleaning and repairing on a performance basis are notable examples)

If one or more of these situations exists, we encourage (and in many cases insist) that our clients have the customer sign off in writing at the time (and before or coincident with invoicing) that the work was completed or the product was delivered.   This can often be accomplished any number of ways – simply signing an authorization statement on the invoice, signing a more formal acceptance letter, responding to a confirming email – or several other methods.

While we understand that instituting a confirming procedure into the business process may seem outside of the “ordinary course”, it is actually quite and common – and importantly – a prudent business practice to implement when the risk of not be paid properly could cause material harm.  Making the sale is important.  Getting paid for the sale is more important.

 About the Author

 Tim Haddock is the Co-Founder and CEO of Fundamental Financial.  Prior to Co-Founding Fundamental Financial, Mr. Haddock was a Partner & Managing Director with the global merchant banking firm Greenhill & Co. (NYSE: GHL).  During his career he has advised on over $75 billion of capital raising, financing and merger transactions.

Since most commercial contracts are for goods or services in return for a specified price, the payment owed typically does not become due and payable until the goods or services are properly delivered to the customer in a satisfactory manner. This means that any associated invoice only becomes bona fide – and indeed genuine collateral – once the product is delivered or the work is complete.

These standard types of contractual arrangements are typically not able to be financed stand alone – rather the resulting invoice is the financeable asset once it becomes bona fide (i.e. product or service is delivered).

You may ask – “How can this be right? I am aware of several situations where a loan has been extended against a signed contract.”

While nothing of course is impossible in a world where humans make lending decisions, typically something else is in play when a standard type contract is being “financed” – including, other collateral is being pledged to the loan, a corporate or personal guaranty is being offered, etc.

To the extent these other items are involved it is less accurate to suggest that the contract is being “financed” – rather that the lender is providing a loan to help fulfill on the contract and is really relying on other collateral pledged and/or strength of the corporate / personal guaranty to make the loan credit worthy.

On their surface these distinctions may not seem relevant in any particular case – you either received the loan or you did not – seems as simple as that – right? Well yes – we agree – and we offer the above explanation only to help those who have been denied a loan based on a contract understand why.

So what are the questions to help better understand if your particular commercial contract can be financed? If you answer “Yes” to any of the following questions, you may have a chance at this type of financing:

1. Can you pledge other unencumbered assets equal to the loan size?
2. Does the borrowing company have a strong financial history and current profile and is that entity willing and able to guaranty the loan?
3. Does the company owner have a strong financial history and current profile and is that individual willing and able to guaranty the loan?

If the answer to all of the questions above is “No” or “Not really”, it is not likely to matter much if other seemingly relevant facts and circumstances might appear mitigating. Below are a couple of examples of “reasons” that really do not have material bearing on the loan decision:

1. The contract is with the federal / state government or a multinational corporation.

Although these entities are highly credit worthy, their obligation to pay only become effective once the good or service has been properly delivered – at which time there is a financeable invoice.

1. This is a service agreement and is due and payable every month whether or not any work is actually performed during that month.

Although you may not perform any work in a given month, you are typically obligated to do so if required by the client – so there is generally a performance obligation for the fee to be earned. This said, many lenders (us included) will give material cash flow credit to future income streams that are highly predictable.

Hope this helps clarify a little. As ever, we would be happy to discuss your individual situation in person and in detail. Good luck and happy contracting.

About the Author

Tim Haddock is the Co-Founder and CEO of Fundamental Financial. Prior to Co-Founding Fundamental Financial, Mr. Haddock was a Partner & Managing Director with the global merchant banking firm Greenhill & Co. (NYSE: GHL). During his career he has advised on over $75 billion of capital raising, financing and merger transactions.

About Fundamental Financial

Fundamental Financial is trusted lender to small and medium sized businesses. Fundamental is an asset based lender that specializes in financing companies that have been unable to secure the funding they need from traditional bank sources. Companies that sell a product or provide a service to other businesses and/or governmental entities (i.e. business to business) and require between $100K and $5 million of capital are candidates for the type of financing provided by Fundamental. To learn more about Fundamental Financial, please visit our website www.fundamental.com or contact us by telephone at (866) 442-4040. Additional publications by Mr. Haddock are available on the Capital Insights Blog section of the website at www.fundamental.com/capital-insghts-blog.

1. Grow sales faster – provided they had the liquidity to fund additional revenue opportunities, and,

2. Improve margins – by taking advantage of generous early pay discounts being offered by many of their vendors

In addition to all of the routine considerations that any prospective client takes into account when deciding whether or not to proceed with alternative finance, this prospective client wanted (very astutely in our judgment) to better understand the threshold required to make it work for them – from a value creation point of view. To answer this question, we developed a side by side and apples to apples comparison of the two scenarios they had in mind – namely:

A. An internally funded growth model (predicated on having no access to additional bank debt – which they report was the answer received from many banks with whom they had spoken) whereby all earned cash flow would be plowed back into to the business to support growth, and,

B. An alternative finance funding model – which offers greater access to capital, but at a greater cost

The questions they wanted answered were primarily twofold: (i) which scenario produces greater value, and, (ii) how sensitive is potential value creation to the two identified variables (#1 and #2, above). The answer was exactly what we expected, but was at some level a surprise to our prospective client – not so much a surprise of direction – but more so how low they judged the threshold to be to make the alternative finance model a better result for them.

The following table is the result of this analysis – exactly as presented to our prospective client. The x-axis variables being the amount of gross margin improvement they would have to realize from taking advantage of early pay discounts as compared to the y-axis variables – the amount of revenue growth they would have to generate incremental to the revenue growth supported by their internally funded growth model.

For scaling purposes it is helpful to note that the prospective client will produce ~$3.8 million in revenues in 2010. All figures presented in the table below are in 000’s and are the difference in total value created as compared to the internally funded growth model which was analyzed to be ~$2.8 million.

Total Value Created / (Destroyed) Using Alternative Finance Model – 000’s

(a) Incremental revenue growth (i.e. in addition to internal funding scenario)

After going through all of the detailed assumptions with our prospective client – the ones they specified that we use – and realizing that in every scenario where they produce incremental growth of 2.5% or greater (whether or not they realize any margin improvement from early pay discounts) – they requested a proposal.

The potential to create several hundred thousand – or even a few million more in value – which is potentially as much as 80% more than the base value of ~$2.8 million – was as compelling to them – as it was to us.