Financing a growing business can be extremely complex, and while options may be plentiful, chances are you simply don’t have all of the knowledge necessary to navigate every possible option. So, the earlier you recognize your needs, the better the likelihood of success.
There are three main reasons that financing is needed:
- Finance losses or recover from declining financial performance.
- Finance purchase of another company or perhaps a management buyout.
- Finance growth of the business.
The first reason may be legitimate due to unforeseeable circumstances, such as the business being adversely affected by external factors that are not within management’s control. Let’s face it, no one foresaw the rapid decline in the oil and gas industry.
But occasionally business owners come to us thinking that access to additional capital will put an end to their troubles. Yet they fail to address the most crucial issue – the lack of strategy and prevailing operational issues that were the root cause of the problem.
Most lenders are not excited about the prospects of financing losses, and more often than not, a credit application with the only purpose of propping up an underperforming company is not palatable. That said, for a long-standing valued client, some lenders will find ways to accommodate this financing, provided that the business owner shows them a clear and actionable turnaround strategy.
For the second and third financing needs, lending sources are abundant, especially if the company has historically strong cash flow and a healthy balance sheet. The latter suggests that the company has not been heavily dependent on bank loans to finance business growth.
The Business Development Bank of Canada (BDC) has created a product called subordinated debt (also called sub debt) to finance even highly leveraged businesses, albeit at a much higher rate than traditional bank loans. In the past year or so, this product evolved into what’s now appropriately called growth and transition capital. It has a few variations under its umbrella, namely mezzanine loans and cash flow term loans. These products were created to accommodate businesses whose financing needs fall under the last two categories written about here: those that are transitioning ownership and those that need growth financing.
Financing Business Growth
Hardly any large corporation succeeds and grows without using other people’s money. Since my expertise is debt financing, let’s pay attention to the dynamics of bank and alternative lending.
When your company has a combination of a strong historical cash flow and stable balance sheet, it will likely qualify for a traditional bank loan.
A strong cash flow is typically above 20 per cent of earnings before income tax, depreciation, and amortization (EBITDA) and its ratio to sales margin. A strong balance sheet is equal to a leverage ratio of at least 2.5-to-1 (for every $2.5 of debt, there is $1 in equity) or lower.
However, in situations where the company’s cash flow is strong but the balance sheet is weak or debt exceeds equity by more than three times, it may not qualify for a traditional bank loan.
Where Do You Go?
Online lending platforms typically are for microbusinesses or those with under $1 million in sales. Leasing companies typically deal only with equipment financing, while equity is for early-stage companies that have potential to generate multiple returns for money invested.
Remember the risk and reward concept? Factoring companies are only for accounts receivables, and purchase orders are for inventories. The rates for both products are typically high.
If your financing needs don’t fall under any of these categories, you may consider seeking a subordinated debt, mezzanine loan, or cash flow term loan. Although most of these products are geared toward larger credit requirements, some may be as low as $1 million.
The highly competitive commercial lending environment has prompted banks to create products that cater to varying clients’ needs. Most chartered banks now provide financing that was otherwise reserved for nontraditional lenders.
The mezzanine loans, cash flow term loans, sub debts — or whatever they are labelled – simply are variations of financing available to companies with exceptional ability to generate cash flow, but whose balance sheet is a few years away from being stable.
These loans are considered quasi-equity, because they have the characteristics of both debt and equity and are priced as such. For example, a traditional bank loan is priced anywhere from prime + 1 to prime + 3 per cent, while quasi-equity (sometimes referred to as quasi-debt) loans have rates ranging from 10 to 18 per cent. As the markets become progressively more competitive, lenders have considered lending at rates of 8 per cent or even prime-based rates to get the client’s business.
Where to Start
My advice: First, speak to your banker. If you’re apprehensive about sharing your plan with your banker because you think that it might spook the bank, speak to your accountant.
In some cases, bankers and accountants may not be sophisticated enough in their understanding of these types of financing, particularly if your business is located outside of a major industrial hub. In that case, seek consultants who are familiar with navigating the capital markets, especially if your total credit needs exceed $1 million, or your latest revenue is more than $5 million and your business is poised for growth.
This article, by Alma Johns, has also been published in Canadian Metalworking’s web site.