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”!

We advise a couple of straightforward next steps as follows:

1. Develop a simple, yet clinical, analysis of the entire cost picture

Here’s an example:

Gross Margin on new sales: 15%

Accounts Receivable balance: $500K (amounts less than 90 days)

Working Capital Line Limit: $400K (fully drawn – implied advance rate of 80%)

Interest rate on bank W/C Line: 8%

Average Days Outstanding: 45

Trade terms – days: 7 (common for service companies with weekly payroll)

In the example above, the company must invest $8,500 in payroll for every $10,000 in sales – and must do so for nearly 40 days – until it is paid by its customer.

So what is the Gross Profit – after financing costs – on a sale?

Gross Profit (before financing): $1,500

Financing costs: $72 (8% annual rate to borrow $8,500 for 38 days)

Net Gross Profit: $1,428

This example makes clear that a company could double or even triple it’s financing costs and still earn a large Net Gross Profit – so long as it can make and finance the new sale. If the company is not able to invest in the payroll to produce the sale due to financing constraints, however, it forgoes a Net Gross Opportunity of ~$1,400. By any measure, this is a bad outcome for the company.

2. Review this analysis with your existing working capital line provider

A clinical assessment of the forgone sales opportunity should resonate with your current financing provider. And because it is so commercially compelling, will hopefully lay the foundation for an increase in your Working Capital Line limit.

If the logic does not resonate with your existing financing provider and does not result in an increase in your line limit, we advise companies to reconsider their financing relationship. Sales opportunities are the life blood of any company and an inability to finance bona fide and profitable new sales that will pay on acceptable commercial terms is an unacceptable result for a business owner.

We encourage business owners faced with cash flow constraints to develop an analysis like the one above for their business. Doing so will make evident that there are few scenarios where the cost of financing is economically unattractive when faced with a potential missed sale due to an inability to flexibly finance it. This type of analysis even demonstrates the economic power of flexible financing for businesses with very low margins – even ones with Gross Margins as low as 3% in the example above.

Mostly we encourage our clients and prospective clients to foremost stay focused on being clinical when assessing the commercial needs of their businesses and on topics that might not be entirely analytically straightforward, to consult with a trusted advisor who can help.

The Consensual

Facts: Company’s 5- year lease expires in Nov. 2010. Company is a government contractor with a large contract starting in June 2010, but minimal revenues (and ongoing expenses) currently.

Solution: Company rolls current lease into additional 5-years and obtains 6 months of rent abatement (next payment due July 2010). Although the new rent was not reduced as much as might otherwise have been due to market conditions, the company was able to have its landlord effectively finance 20% of its operating cost structure (i.e. its rent expense) for the next 6 months.

The Strong Arm

Facts: Company has 8 years remaining on 10 year lease. Company recently lost its largest customer and reduced staff by nearly 50%.

Solution: At the time the lease was signed, Company cleverly used a thinly capitalized subsidiary as the obligated entity – with no corporate or personal guarantees. Left with the threat of the Company liquidating the subsidiary and walking away, the landlord agreed to move them into a much smaller space with materially lower rent – and a 6 month option to take back the original space at the now current market price (which is much lower than 2 years ago). The main operating entity of the Company (including cross guarantees from other subsidiaries) is the obligated party on the new deal – but of course.

The Hard Way

Facts: Company has 4 years remaining on 5 year lease. Company provides staffing services and had client representing 60% of revenues go bankrupt. Faced with the prospect of its own insolvency (due in no small part to its rent obligation), the company tried to restructure its lease but was rebuffed by the landlord.

Solution: Company proceeded to set up a new company and began booking new revenues through the new company. Employees of the old company were migrated to the new company and to the extent new company used old company’s equipment (i.e. copiers, computers, etc.) it paid an arms length rent. New company retained the remaining clients of old company and used old company receivables proceeds to pay wind down expenses at old company. After effectively liquidating old company into new company and doing so in a manner it believes was entirely legal, it handed the keys back to the original landlord. No word yet on whether or not any legal claims have been filed, but the old cash rent expense is certainly gone – at least for the time being.

A. The Baseline – The Implied Value of 2% – 10, Net 30

There is perhaps no better endorsement of the inherent value of the speed of cash flow than this common billing convention. And because it is so commonplace, we’ll use it as the basis for making our case. Offering a full 2% discount on the price if payment is made in 10 days or less is a pretty large concession. How large? Believe it or not the annualized value is 36%. (e.g. 2% discount for accelerating payment by 20 days – the difference between 30 days and 10 days; and 18 x 20 day periods in a year – 360 divided by 20; so 2 x 18 = 36%). So fairly large indeed from our lens.

B. The Rationale – How Can 36% Make Sense?

Actually it does make sense – in fact it often makes tremendous sense. The following little example should make this point quite clear. Suppose you sell a product for a margin of 10%. If you sell that product once per month then you have earned a 10% margin 12 times during the year – or 120% annualized. So you can think about it one of two ways 1) you offer a 2% discount on a 10% margin product and still earn a net margin of 8% on each sale, or 2) you could think about it in annual terms – which in the example above would imply 36% discount on a total annualized margin of 120% – or a net annualized margin of 84%. As illustrated in part by the example, either way you think about, you always come out ahead so long as your margin on each sale is at least 2%.

C. The Clarity – This Part Can Sometimes Be Counter Intuitive – But It’s True

When you offer 2% – 10, Net 30, you are doing 2 things very clearly. Let’s take a look at both:

First – You are attempting to self finance your working capital needs (as opposed to borrowing from a third party) by offering a financial incentive for customers to pay early.

Second – You are placing an annualized value on the speed of your cash flow of 36%.

At first blush this may feel outlandish – who after all would pay 36% annually to finance anything? Uncomfortable as it may feel to acknowledge, you can rest assured of at least two things: 1) the implied value of the speed of cash flow is – when offering 2% – 10, net 30 – in fact 36% annually – no matter how you slice it, and 2) it makes all the sense in the world to do in many, if not most, circumstances – as our example in B (above) helps to illustrate. Which probably explains why it is so commonly offered.

D. The Comparison – How To Use This Knowledge In Practice?

So are we suggesting that businesses stop offering 2% – 10, net 30 payment terms to their customers? Hopefully it’s clear that our answer is “No”. Unless, however, the business can borrow for less than 36% annually (or earns a margin of 2% or less). Many business are able to borrow from traditional banks for interest rates (in this environment at least) meaningfully less than 36%. This is terrific and we endorse it without qualification provided the business is otherwise a good candidate for borrowing.

Many small and medium businesses are not, however, able to borrow the money they need to grow from traditional bank sources. For these companies the cost of borrowing will be higher. So our counsel to them is simply this: If you are (or would consider) offering 2% -10, net 30 payments terms, borrowing your working capital needs from a third party is in your financial best interest so long as you can 1) do so for less than 36% annually (hopefully much less) and 2) are otherwise a good candidate for borrowing.

The Lagging Indicator theory suggests that in a typical business cycle that unemployment is obviously one of the last economic statistics to turn positive. Why after all would businesses turn first towards increased hiring to meet growing demand when other cheaper options – like increasing work hours for example – are typically available? The answer of course is that businesses would indeed tend to opt for the cheaper option. And, as it happens, the Coincident Indicator crowd generally agrees with this assessment.

So where’s the beef? The “beef” – as it were – effectively turns on the question of which type of downturn is occurring – a typical business cycle or a downturn induced by credit contraction?

A typical business cycle is generally characterized by continuing strong underlying fundamentals – competitiveness, good demand growth expectations, productivity gains and the like. But a period preceded by excess production and investment in capacity. So the resulting excess inventories and production capacity requires rebalancing – a little time to be absorbed by the economy. During such rebalancing periods, businesses often shed some workers for a period – until demand has a chance to catch up.

A credit contraction induced downturn is generally characterized by consumers and businesses having taken on too much debt in the previous period – generally in amounts that exceeded their income growth potential. And when credit growth subsides, they find that a greater portion of their income must now devoted to servicing those debt balances – thereby not being available to direct towards the key drivers of GDP growth – those being consumption and/or investment. In short, the credit contraction theory essentially argues that excessive debt has weakened the underlying fundamentals.

Although few can credibly argue that there is not an element of credit contraction associated with our current downturn, there remains widespread debate on the continuing strength – or lack thereof – of the underlying fundamentals.

In such an environment Bulls and Bears can point to the same event and credibly reach two nearly polar opposite conclusions. Take Warren Buffet’s recent bid for Burlington Northern (railroad) for example. Bulls point out that arguably the greatest investor of the modern era has seen fit to plunk down $34 billion (the largest ever acquisition by Berkshire by factor of two) as a “Bet on America”. Bears say it is nothing more than a terrifically shrewd bet on the long term price of energy (since rail transportation becomes increasingly competitive compared to truck transportation as fuel prices increase) and perhaps a back door bet on international demand for coal (since Burlington derives a majority of its marginal income from shipping coal from U.S. heartland to the west coast for export – mostly to Asia).

So the debate rages onward. But what does it all mean for our clients – the small and medium sized businesses at the heart of our economy? On the one hand, we can’t say with any conviction which argument seems better – our crystal ball is no better than others in the end. On the other hand, however, the buzzword that strikes us as quite sensible in this environment is “prudence”. Managing towards preservation of capital (i.e. keeping operating costs down) and maintaining liquidity (i.e. making sure that borrowing capacity is maintained or increased) seems to us to be a mantra with little downside risks. No one ever went broker after all – to paraphrase Mr. Buffet – by being profitable and having access to a stable source of funding.

Of course we welcome your participation. Whether you wish to comment on a post, share an experience, pose a question or even challenge the advice offered in a post – all constructive contributions are not only welcome, but encouraged. In short, we want to hear from you – the dynamic companies that drive economic growth – about your business challenges, experienced and needs. You can comment on various posts, submit questions via our contact form, or call us for a private discussion.

We expect to frequently write on topics that we encounter through our work with our clients, but in all such instances will be careful to protect their privacy by refraining from the use of specific names. We want our clients and prospective clients to rest assured that their stories and challenges are safe with us – always and without exception.

Welcome to The Capital Insights Blog! We hope you find it a valuable resource.