A common perception in today’s economy is that commercial banks do not want to lend. As anyone who works for a commercial bank can attest, this quite frankly is dead wrong. In fact, commercial banks are clamoring to put money into operating companies that have annual positive cash flow of more than $5 million and working capital assets.
That said, traditional commercial banks won’t lend to all comers, and their standards for getting a loan application through the loan committee are more stringent than they were prior to Lehman Brothers’ collapse. In those heady “covenant-lite” days, banks essentially became order takers because their perceived risk was minimal and it was easy to sell off loans as quickly as they came in, often as part of various securitized debt instruments. These instruments were prepackaged by large investment banks and sold around the world.
Lending standards have stiffened considerably since then, but banks still desperately want to provide loans to creditworthy companies. They are flush with cash, and interest rates are at historic lows. The main issue lenders are having with making loans is that their customers are showing very little demand for them. Corporations have record amounts of cash on their balance sheets, and companies that have credit lines continue to use them at abnormally low levels. While 60 percent was once viewed as a normal overall usage rate for credit lines, the figure has hovered around the 40 percent range for the past several years.
A common joke is that the only companies that can get loans are those that don’t need them, and there is a lot of truth to that. Despite the willingness of commercial lenders to provide capital to qualified borrowers, companies that are in challenging circumstances, including those that do not have solid cash flow or high-quality working capital, are not likely to find traditional lenders eager to make loans to them.
That is not to say, however, that challenged companies do not have options for capital infusions. In fact, many of these companies have good options, and willing entrepreneurial capital providers are looking to help them. The problem seems to be that most of these troubled companies do not properly understand their options.
Typically, the initial reaction to their financial troubles by these companies is to seek outside investors interested in investing via minority equity. In most cases, however, this is unrealistic. Few capital providers are willing to put money into a venture if their capital is not secured by some collateral. Smart equity investors only look to invest in a challenged deal if they have control and the ability to make changes at their discretion. That leaves as the most likely prospects for minority equity investments the “three Fs”—friends, family, or the foolhardy.
Instead, the best sources of capital for challenged companies are often alternative lenders that understand the challenging dynamics facing midsize firms and are interested in investing in either collateral or potential cash flows that are often overlooked by traditional bank lenders. What follows is a brief overview and summary of some of the most common and useful options.
An asset-based loan is secured by a company’s collateral, typically through its working capital. Collateral used includes accounts receivable and the raw material and finished goods portion of inventory. Secured capital can be up to 85 percent of accounts receivable and up to 60 percent of inventory. There are two main types of loan structures for asset-based loans:
A revolver, which is a line of credit that a company can borrow from and repay as long as the secured collateral is viable.
A term loan, which has a finite maturity and a fixed principal and interest repayment schedule and is usually secured by equipment or real estate.
Asset-based loans are used in a multitude of business situations. They are particularly useful when traditional credit is tight or a company does not have sufficient cash-flow stability to qualify for a traditional loan. An asset-based loan is also an option for companies that have large amounts of working capital, are seeking expansion, or need to restructure.
Companies seeking alternative lending options often do not have the luxury of time to wait for approval of a traditional loan. Turnaround time for securing an asset-based loan can be quite short. Asset-based loans can be used to help smooth out the unpredictability that operating firms face as they navigate through changing business climates. They can help to stabilize liquidity, enabling a company to operate more efficiently. Funds and nontraditional banks lend at a higher percentage of accounts receivable and inventory than traditional banks do. Asset-based loans also allow companies to maintain ownership of their assets.
As with any loan, asset-based loans carry a degree of risk. The main risk, of course, is default. If a company cannot make its payments, the lender can seize assets. If the company becomes insolvent, the asset-based lender has a senior claim on its assets. Interest rates are higher for asset-based loans, which effectively makes them more costly than traditional loans.
Factoring involves the sale of an asset, such as accounts receivable or purchase orders, to an outside firm to help a company manage its collections and finances. Factoring creates an environment in which a lender becomes intimately involved with a company because the factor becomes the owner of the asset. Therefore, the factor is vested in the success of the firm, although a factoring arrangement is usually short-term.
Factoring is an option for companies that are growing rapidly, such as a start-up, but need assistance with managing their receivables and invoices. It is also an option for a company that cannot obtain traditional or alternative lending, but has either substantial working capital to collateralize or purchase orders that are enticing to factors.
There are several advantages to factoring. One, a factoring arrangement can be approved quickly because it does not require nearly the amount of due diligence required for a traditional loan. Two, factoring provides a rapid infusion of cash, which can help fund a company’s growth stage. Lastly, start-ups and companies in need of restructuring receive the benefit of the efficient management that factors bring to the table.
There are two main risks involved with factoring. One, an owner relinquishes control of specific company assets, allowing them to be managed at the discretion of the factor. Second, factoring involves high interest rates, making it a costly financing alternative.
Purchase Order Financing
Purchase order financing is a short-term financing method that allows companies to collateralize their invoice orders to obtain financing.
Purchase order financing can be a funding source for companies that have purchase orders representing large amounts of future revenue on their books, but low levels of cash flow or collateral assets. The financing arrangement allows a company to purchase raw materials to continue developing goods that buyers have previously ordered. Financiers are willing to lend on purchase orders because buyers have set a demand precedent for the product. Purchase order financing is an option for companies that are undergoing rapid growth, such as start-ups or companies executing aggressive growth strategies.
The main advantages of purchase order financing are that qualifying is relatively simple and that it can be implemented quickly. The main disadvantage is that it is more costly than traditional lending.
International Accounts Receivable
International accounts receivable involves international lenders financing foreign companies based on their collateral assets, in particular accounts receivable. This form of financing is important because of the increasingly global nature of the market. It allows midsize companies with foreign exposure to access funds that otherwise would not be available to them through domestic banks.
One advantage of international accounts receivable is that it allows a company to expand its credit market. This lending option will most likely present itself when domestic banks will not lend to companies due to credit risk, country risk, and exchange rate risk, leaving a firm conducting foreign business to seek an international loan. However, such alternative financing tends to be costly.
Intellectual Property Loan
An intellectual property (IP) loan is based on the lender gaining an interest in a company’s intellectual property, such as patents, trademarks, and copyrights. IP is a critical component of many industries, such as health care, pharmaceuticals, and technology. It represents a major investment to these corporations in research and development costs, but it can also reap a substantial return.
IP may contain great value, which enables a company to raise substantial amounts of capital. An IP loan allows a company to raise capital without its owners being forced to relinquish equity through an equity capital raise. Such loans generally are not options for start-ups, however, because of the difficulty of valuing their IP.
U.S. Small Business Administration (SBA) loans are orchestrated to help small businesses meet their capital funding needs when they are having problems securing traditional loans. Designed to spur small-business activity and therefore increase overall economic activity, SBA loans help small businesses secure financing through a variety of lending sources by guaranteeing repayment of up to 75 percent of the amount of the loan.
The SBA connects companies with third-party lenders that are geared to meeting specific lending needs of small businesses. Typically, SBA loans are available for up to $5 million but in some cases may be as high as $10 million.
Because of the repayment guarantee, underwriting due diligence is not as stringent for SBA loan approval as it is for traditional loans. One drawback to an SBA loan is the upfront cost. Borrowers must pay from 2.5 to 3.5 percent of the loan amount upon initiation.
Mezzanine financing is a capital raise that involves a mix of both debt and equity. Namely, it is debt capital with equity warrants attached. Mezzanine financing is a subordinated form of capital, junior to the senior loans of banks and venture capitalists. It is a viable alternative for companies looking to expand via acquisitions, initial public offerings (IPOs), or organic growth. The advantage of mezzanine financing is that it can be obtained quickly because little or no collateral is required to secure the loan. It also acts as an equity component on the balance sheet and may ultimately help a firm secure a traditional loan. The main disadvantage is cost. Lenders who issue mezzanine financing typically seek returns in the 20 to 30 percent range.
Hard Money Lenders
Hard money lenders are often referred to as lenders of last resort. A hard money loan is secured by the value of a company’s property, not by its collateral. These loans are sometimes used for distressed debt and turnaround situations, normally by companies that have a great deal of equity on their balance sheets. The loans are usually short-term. Under no circumstances will traditional lenders issue loans under these terms. The advantage is that a company finds a lender that is willing to issue a loan. The disadvantage is the cost of the loan and the risk inherent with a loan of this nature.
No Lack of Access
There are many other alternative forms of finance. Often to qualify for these loans, companies first must undergo a balance sheet restructuring, usually in the form of an out-of-court alternative to bankruptcy, such as an assignment for benefit of the creditors (ABC), Uniform Commercial Code (UCC) Article 9, or receivership. The restructuring allows the next debt to come into the company and have collateral on the assets. Such financing can provide new life for a company that still has value as a going concern even though its value is less than its existing debt.
Financial firms and banks in particular have received a lot of negative press and blame recently for the slow economic recovery. A primary criticism is that these financial institutions refuse to make loans. This simply is not true. Qualified borrowers are not likely to have trouble obtaining conventional loans. For borrowers that do not qualify for traditional financing, however, alternative loans may be available. The economy continues to face many hurdles, but lack of access to credit is not one of them.