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When the bank says no
Your best financing alternatives in four common scenarios
Published By: ProfitGuide.com
Date: PROFIT / March 2005
Section: Financing
By: Jim McElgunn
Internet Link: ProfitGuide.com
Apart from your rich Aunt Gladys and your own savings
account, bank financing is usually the cheapest and most
immediate source of funds you can get. Yet what if your firm
needs capital and your banker turns you down?
There's no shortage of alternative financing options. While
some of these sources are little known, they should be
understood by all entrepreneurs-because you can't always know
when you'll need money. To help shape your understanding of
higher-profile options, PROFIT asked finance specialists where
they would advise a growing company in solid financial shape
to seek capital in the following common scenarios.
Objective: Avoid a cash-flow crunch
Funding needed: $250,000
Scenario: You require working capital to finance
inventory during a two-month cash-flow squeeze. Payment terms
on your receivables are 90 days, so you won't collect enough
of what's outstanding in time to raise the $250,000.
Your best bets: Call your suppliers. If you're a
good customer, you might be surprised by how willing they are
to extend terms. They might, for instance, let you pay a third
of what you owe now and the rest once your receivables come
in, says Jason Sparaga, president of
Spara Capital Partners Inc.,
an Oakville, Ont.-based investment bank and corporate
finance consultancy.
Many suppliers may not even charge interest for extending
30-day credit terms to 60 or 90 days, provided you're a
reasonably solid customer-and the supplier isn't itself
cash-strapped. The quid pro quo is an understanding that
you'll give them more business, says Frank Hayes, president of
Stanley Software Finance Inc., a Toronto-based financial
consultancy and merchant bank mainly for software firms.
Another good bet is the Business Development Bank of
Canada, a federal agency with the mandate to help small and
medium-sized businesses. If you need short-term money beyond
what your bank is comfortable lending, the BDC can offer a
working capital top-up.
If that doesn't pan out, try an asset-based lender, such as
Mississauga, Ont.-based General Electric Capital Canada
Funding Co. or Halifax-based Congress Financial Capital Co.
ABLs provide working capital secured against your inventory,
which they measure far more frequently than banks do-often
weekly or even daily. Because they keep such close tabs on
you, "they'll lend a greater percentage against those
assets than a bank would," says Hayes. "But they'd
also charge a higher interest rate and fees, because they have
to do more administration and take on more risk."
Don McLauchlin points to another option for companies with
real estate assets. The vice-president at Roynat Capital, a
Toronto-based merchant bank specializing in long-term capital
for mid-sized companies, says you should be able to negotiate
a three-month moratorium on a term loan from your mortgage
lender: "A mortgage is a 50- or 60-year asset, so a
three-month deferral won't spook a lender." But you'll
need to convince the lender that you have a firm grasp of your
cash flow, as well as a persuasive explanation for why your
firm is in a crunch and why that situation won't persist.
Objective: Lease production equipment
Funding needed: $1.5 million
Scenario: You want to lease new equipment so you can
boost output enough to supply larger companies.
Your best bets: Ask whether the equipment maker
offers financing. Many will fund about 90% of the cost through
in-house leasing arms or relationships with major commercial
financiers such as GE Capital, Toronto-based ABN AMRO Canada
or Hewlett-Packard Financial Services Canada Co. of
Mississauga.
The BDC is another good option. And don't overlook credit
unions. "If you're a significant local player, especially
if you're a unionized business, they'll love you," says
Sparaga. Credit unions may be more flexible than other lenders
about the rate, amortization term and initial interest-free
period. Unfortunately, with exceptions such as VanCity in
Vancouver and the giant Mouvement Desjardins caisses
populaires across Quebec, many local markets lack credit
unions with the capacity for large-scale lending.
Hayes says you may qualify for major savings by leasing from a
foreign equipment maker. Many of them offer low-cost financing
at below-market rates, thanks to a subsidy from the company's
home government.
Objective: Stop paying rent
Funding needed: $4 million
Scenario: You want to purchase the building you operate
in.
Your best bets: Sparaga
generally warns against
buying your building, urging firms to invest in their own
growth, not real estate. But if you opt to do so, he advises
approaching the BDC first. It finances many commercial
mortgages of $1 million to $5 million, funding up to 90% of
the price, sometimes more. Banks typically loan only 60% to
65%. Also, with its government mandate, says
Sparaga, "if
you're in a troubled loan situation, there's no one better to
owe money to than the BDC, because they don't want to look bad
by calling in a loan."
One challenge is choosing from all the organizations that
love to lend against real estate, because, as Hayes puts it,
"it's not going anywhere, and it's in a safe
country." Other than the BDC, your options include
insurance companies, pension funds, Roynat, private lenders
and credit unions.
Here's where a good financial advisor can point you not
only to the right institution but to the right person there.
If you don't already have an advisor, find one through your
business network, starting with your accountant or lawyer.
The lender may cover only 65% to 80% of the total cost. If
you don't have the cash for the rest, Hayes recommends trying
to negotiate a vendor takeback, in which you take out a second
mortgage from the seller. But, because they'd rank among your
creditors behind the first mortgage's holder, you'd pay a risk
premium of a few percentage points above the rate for the
first mortgage.
Objective: Make an acquisition
Funding Needed: $8 million
Scenario: Having grown your firm to $20 million in
revenue, you want to finance a friendly acquisition while
minimizing dilution of your equity.
Your best bets: Negotiate multiple sources of
funding. This is a tricky task, says McLauchlin: "the
home-run scenario, in terms of complexity."
Here, retaining a financial advisor is not just a good idea
but essential. Work with your advisor to assemble a package
that starts with the cheapest financing, then the
second-cheapest and so on. You might begin with $3 million in
senior debt (which means the lender is first in line if you
default) from a financial institution at the prime rate or
prime plus 1%, secured against fixed assets such as machinery,
equipment and real estate.
Next, you might add a vendor takeback, in which the
acquired firm issues a $2-million promissory note payable over
two to seven years. McLauchlin says one benefit for the vendor
is that this strategy would defer tax on the $2 million until
it gets the cash. Sparaga says,
"you'd almost insist on a
vendor note for 10% to 25% of the purchase price." This
would typically cost prime plus 2% to 3%.
The next $1 million might come from a subordinated debt
lender such as Roynat, Toronto-based BMO Capital Corp. or the
BDC's sub debt group. (Sub debt ranks behind senior debt if
you default.) Because this debt would be secured against the
company's cash flow rather than its assets, you'll pay a risk
premium. Sparaga says sub debt
typically costs prime plus 6% to 10%.
For the final piece, you might turn to an equity investor.
Roynat, the BDC, a high-net-worth individual or private equity
fund might supply $2 million in return for a minority stake in
the merged company and a seat on its board of directors. This
financing would be by far the most expensive. The investor
would likely expect an annualized return of 20% to 40%,
depending on the perceived risk, collectible once it sells its
stake. This would compensate it for being an unsecured
creditor with an investment it couldn't liquidate for perhaps
three to seven years. Avoid such expensive financing if you
can, although you may need it to ensure the merged company has
enough cash flow.
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