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.

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.

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.

We are pleased to announce that we have relocated our New York office. Effective today (Feb. 25, 2010), please note that our headquarters information will be as follows:

Fundamental Financial

1325 6^th Avenue – 28^th floor

New York, New York 10019

Telephone : (212) 763-8488

Website : www.fundamental.com

Email : fundamental@fundamental.com

Please also note that information for our Loan Servicing Center remains the same as follows:

Fundamental Financial

3201 Highfield Circle – Suite J

Bethlehem, Pennsylvania 18020

Telephone : (610) 419-1513

We sincerely appreciate the trust and confidence placed in us by our clients and partners and look forward to providing all of you the same high level of service as has become our tradition.

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.

We recently were asked by a prospective client to offer our advice on an equity investment they were negotiating with a potential strategic partner. By the time we were asked to be involved many of the investment terms had been broadly agreed and the company co-founder and CEO was “comfortable” with providing a ROFR to the investor. Most of the deal terms actually looked fine to us in the context of the opportunity, but we challenged the CEO to think further about the ROFR.

Since a ROFR typically provides the new minority investor (ROFR’s are mostly relevant in practice for minority investors) a right only to match any offer made by another to buy the company it seemed harmless enough to the CEO. We challenged him to think about whether or not it would be truly harmless in practice.

Let’s assume for example that another party wanted to buy his company at some point in the future – which the CEO views as a likely scenario once he has built his company to sufficient scale. Would that party be willing to make an aggressive bid for the company knowing that an existing minority shareholder would have a right to match the offer? In practice, the answer to this question is probably not and the effect of having a ROFR would be to chill the bidding and hinder the CEO from realizing maximum value for himself and his other shareholders in a sale transaction.

Once viewed through this lens, our CEO rethought his position and was able to negotiate some important conditions to ROFR (he unfortunately was not able to remove it entirely, but in the context of the deal felt he obtained the flexibility he needed).

Of course all situations are different and ROFR’s are quite common terms in investment transactions. As such, we cannot say whether they make sense in a particular situation or not absent all the facts unique to that deal. What we can say, however, is that ROFR’s are important terms with important considerations that should be throughly vetted before any agreement is reached.

Since Fundamental Financial does not provide advisory services as a line of business, the advice we offered in this situation was simply done as a value added service to a prospective client with whom we hope to have to have a long fruitful receivables based lending relationship. One which we feel confident will be an important component of the company’s financial management strategy even after the minority equity investment is completed.