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.

 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.

So for a change of pace, below is the result of an analysis we recently completed expressed in a single chart with a reasonably simple conclusion as follows:

If you are a business with a working capital line that is fully drawn – and your financing provider is unable or unwilling to offer you more financing capacity – you will be better off with a new working capital line that does offer you greater capacity – even if you have to pay more for it – so long as the new working capital line offers you sufficient availability to finance incremental new sales equal to the difference you have to pay for the new facility compared to the old – and, of course, you are able to win this amount of new business.

As the analysis in chart demonstrates the relationship is nearly 1 to 1 based on the variables used. This means that you can pay 5% more in annual financing costs so long as you can win incremental new sales (just one time – so not each year) of 5+% and you will be better off – or 10% more in financing costs so long as you can win incremental new sales of 10+% – and so on.

We’ll discuss some of the variables to the analysis in greater detail below for those that are interested, but the message is largely similar even if the variables differ slightly depending on the circumstance. With this analysis, we reinforce an age old adage instinctively known to all successful business owners: New sales are the life blood of any great business and they are very often worth pursuing even if some of the costs associated with securing them are incremental higher.

So without further adieu, the chart:

Discussion of analysis variables:

We assumed a company with a 10% after tax net margin. If you have a smaller net margin, you will need marginally greater incremental sales for each higher increment of financing costs to break even. If you have a higher net margin the reverse is true. It is important to note here that the relationship is non-linear on either side of a 10% net margin so it will be important to understand the specifics if your business net margin is different than 10%. We can help you with this if interested.

We assume a 35% tax rate and all financing costs being fully tax deductible.

We assume an annual base cost of financing of 8% – so if you have to pay 13% per annum for new financing that would correspond to the 5% figure on the y-axis in the chart since the cost is 5% higher than the old financing costs. We would point out, however, that the analysis results hold regardless of your annual base cost of financing – whether it is 3% or 23% – it’s only the increment between new and old that matters.

It is important to note that the x-axis represents incremental new sales. This is important to the analysis because a business that generates a 10% net margin can use that profit to finance new sales with that earned equity. For a business owner to realize the break-even outlined in the chart, it must generate new sales in addition to the amount it would be able to finance with new earned equity.

As mentioned in the opening, the incremental new sales must only be one-time for the analysis to hold. This means that a business could pay 5% more in financing costs each year, but need only generate 5+% new sales one-time and then retain those new sales in future years for the analysis to hold. Importantly, it expressly does not mean that the business would have to win 5+% incremental new sales each year – just one-time and then retain them.

The size of your business (i.e. annual revenues) also does not matter for the analysis to hold. This analysis applies whether you business generates $100K or $100MM in annual revenues.

The analysis also assumes that there would be no other changes to the commercial profile of the business – so such things are Days Outstanding for A/R and A/P, marginal costs of fulfillment, etc. would all remain the same.

Description:

The company in question is just a few years old and produces a highly reliable and sophisticated information service that it sells to select industries who stand to reap significant rewards for having timely and accurate access to the information being provided. The addressable market for the new product is large and the company’s product uniquely addresses a largely unmet need in the market. The company has gained considerable experience in the technology and know-how necessary to produce the high quality information it provides to its clients. The company also has developed a strong stable of clients and is currently growing its revenues rapidly.

The company has historically been funded through a combination of owner’s equity, third party equity and some debt financing. It recently completed a small additional third party equity raise and restructured in remaining bank debt with the aim of amortizing fully within the next year. The company maintains approximately $750,000 in accounts receivable (its primary financial asset) and expects to grow its A/R balance commensurate with its sales going forward. The company is profitable, but continues to have large cash flow requirements associated with investing further in its technology and expanding its distribution capabilities.

Financing Question:

How best should the business owners optimize their cost of capital while at the same time gaining access to the cash flow to make the investments necessary to accelerate its growth?

Assessment:

To find the optimal solution to this problem, it is probably best to ask (and answer) the following two questions:

1. Is the target balance sheet optimal? If no, why?
2. Are there any important economic or financial caveats that might change the answers the questions above?

First let’s take a look the company’s “Target” balance sheet and compare it to an “Improved” balance sheet. (Btw – we’ll answer the question of why the “Improved” balance sheet is better in the next section):

The important thing to note is the two balance sheet structures above is simply that the “Target” is 100% equity financed and the “Improved” is financed with a combination of debt and equity.

We make the assertion above that the “Target” balance sheet is not optimal and offer an “Improved” balance sheet to show one we believe is better (i.e. maintains a lower cost of capital). Let’s take a look at the following analysis to understand why the “Improved” balance sheet is materially less expensive for the company as compared to the “Target”:

As evidenced in the income statements above, the company with the “Improved” balance sheet produces a Return on Equity that is nearly half again greater that with the “Target” balance sheet. So at this point we know the answer to question 1, above:

1) The “Target” balance sheet is not optimal from a cost of capital point of view and we can see this by noting the significant Return on Equity differential.

What about the answer to question 2? We offer the following analysis and commentary to look at potential answers to this second question:

First an analysis – how much more expensive would the cost of debt financing (i.e. the interest rate) have to be for it to be an inferior solution for the company? See the table below (please note that for example purposes, the only variable change in the table below is that of the interest rate):

As demonstrated above, the interest rate on the debt would have to be greater than 26.3% per annum for the company’s cost of capital to be equal based on the two balance sheet options evaluated in this example. Hopefully it goes without saying that that costs of debt in excess of 26.3% would result in an inferior solution for the company. Certainly this seems a powerful demonstration of the real costs of financing decisions.

There are clearly a number of other considerations that could affect the analyses presented in this article – but any such impact would – from a financial point of view – most likely be at the margins. In the end, the cost rationale for making certain capital raising decisions is frequently a compelling one. Our counsel to this prospective client – of course solely from a financial point of view – is simply this: To raise additional capital – not necessarily only as needed – but more so as can be productively deployed – through the issuance of either debt or equity – in whichever combination produces the lowest cost of capital. And do not delay making high return investments unless you are simply not able to access the capital necessary to make investments at a price that will generate a positive marginal return.

Description:

The company in question is a new company with an exciting new consumer product. The addressable market for the new product is large and the company’s product addresses a largely unmet need in the market. The business owner is highly experienced in the product segment, but for the first time is launching a branded consumer product venture. To date, the company has been financed entirely with owner’s equity – primarily from savings and mortgaging owned commercial real estate. The company has secured purchase orders with several large national and regional retailers and is on the cusp of significantly ramping sales and in doing so, expects to expend considerable resources on the marketing and advertising necessary to drive the product launch.

Financing Alternatives:

The business owner is currently evaluating how best to finance the next – and first considerable – growth phase of the company. The realistic options are twofold as follows:

1. Take out an additional mortgage on his owned commercial real estate property, or,
2. Enter into a accounts receivable financing relationship

Assessment:

The mortgage option will provide the business owner a lower nominal cost of financing – probably 5-6% – since the creditworthiness and interest rate is based primarily on the considerable equity in the property. But this type of financing should be properly understood for what it truly is – an additional equity investment in the business – not different in substance than writing a personal check. The accounts receivable financing facility would likely have a notional cost of 8-10% plus a small per invoice service fee. Comparing these two options on a nominal cost basis will, however, yield an answer that from a corporate finance point of view, fails to properly consider the entire cost of the equity.

The proper corporate finance analysis of this situation is perhaps further complicated by the fact that the business owner does have the resources to make an additional considerable equity investment in the company – thereby being able to directly avoid the real cost of diluting his equity and the intangible cost of having to wrestle with governance and other complications associated with having a third party equity partner.

Yet as the Nobel Economist Milton Friedman famously said “there is no free lunch” – and while properly assessing of the entire cost of this equity investment may be somewhat clouded by certain of the facts – the costs do nonetheless continue to exist – even if seemingly (although not in fact) indirectly.

The following comparison will help make this clear:

As evidenced above – and assuming there is no cost of dilution or intangible governance costs – you can see that two companies that are identical in every way – except that one is 100% equity financed and the other is financed with 50% equity and 50% debt – produce very different returns on equity – again solely due to the way they are capitalized. The difference in the returns profile is significant – with Company B generating equity returns that are 50% better than those of Company A. By any measure this is a marked difference.

There may be other considerations (i.e. not yet generating sufficient A/R that can be financed) for our prospective client that could tilt the equation towards the additional equity investment, but like Milton Friedman said – “there is no free lunch”!