September/October 2019

FINANCING A COMPANY THROUGH ITS UPS AND DOWNS: A Primer for Borrowers

Middle market businesses experience different stages of growth and stagnation from start-up to success. Sometimes there is a need for restructuring to turn a struggling business around. Derrick Wong explains different asset-based loan options that can help a company achieve financial stability, whatever stage it may be in.



Derrick Wong
Manager, Commercial Banking,
Pacific Premier Bank

As lower middle market companies progress (and at times, regress) through the different stages of their life cycle, they must remain flexible and nimble in embracing different forms of debt financing.

The same companies that utilize asset-based lending when revenues are accelerating at a rapid pace may also utilize the same asset-based lending tools if they encounter operational challenges, growth stalls or if earnings become inconsistent.

By virtue of underwriting collateral on par with or, at times, as a priority over cash flow, asset- based lending is an incredibly versatile tool in accommodating companies throughout their life cycle.

THE NEXT STEP IN THE BORROWER’S LIFE CYCLE

Many lower middle market companies and their executives lack the network and resources to tap into the broader galaxy of bank and non-bank debt financing resources. They may not attend their regional Commercial Finance Association meetings and do not regularly network with lenders from regional or national banks or asset-based lenders.

This is the reason these companies turn to their banks and non-bank lending advisors to help them navigate their full range of options as they move through their life cycle. Lower middle market companies may often ask the following questions of their advisors:

• We have been awarded a major contract by a large customer and we are being asked to deliver products in 90 days. How do we finance this growth?

• We recently lost a major customer and have begun showing operating losses and have breached a financial covenant. What type of financing do you recommend if we are no longer able to secure traditional bank financing?

ASSET BASED FINANCING OPTIONS

For the purpose of this article, I will broadly address a few of the many asset-based lending financing options available to lower middle market companies:

• Startup and Pre-Revenue: Financing obtained by fundraising through friends and family, crowd funding

• Early Stage: Purchase order financing, accounts receivable factoring and non-bank asset-based lending

• Growth and mature stage: Bank asset-based lending and non-bank ABL lending

• Mature stage: Traditional, non-ABL bank financing

• Declining performance and turnaround: Bank and non-bank asset-based lending, purchase order financing, factoring

PURCHASE ORDER FINANCING

Purchase order financing is a short-term commercial finance option that provides capital to pay suppliers upfront for verified purchase orders. PO financing allows businesses to avoid raising additional equity or, more often, having to decline an order because of cash flow challenges. Purchase order financing companies are non-bank lenders that focus on verifying the quality of the contract by evaluating the creditworthiness of the borrower’s customer as well as evaluating criteria including gross margin and the appeal and market for the product being produced.

During the process of rapid growth, lower middle market companies will be asked at times to rapidly scale up, often with very short notice, by a large customer. If internal cash flow is insufficient to support this rapid growth, purchase order financing is a viable non-dilutive alternative.

ACCOUNTS RECEIVABLE FACTORING

Accounts receivable factoring is a financing solution that allows businesses owners to convert invoices into working capital, usually by selling their invoices to an accounts receivable factoring company.

Unlike PO financing, which is underwritten based on the quality of a purchase order, accounts receivable factoring begins after a business provides goods or services to a creditworthy customer. Typically, advance rates against invoices range from 70% to 90%.

After a company provides goods or services to its customers, it often has to wait 30, 60, 90 or even more than 90 days for payment. Having to wait an extended period of time to be paid by customers can put tremendous stress on a lower middle market company’s cash flow as it must still ensure essentials are paid up, including making payroll and reimbursing mission critical suppliers.

Many under-capitalized, growing lower middle market companies may not qualify for bank financing and need a tool to speed up cash flow. Accounts receivable factoring is an appropriate tool to speed up cash flow in this situation by allowing borrowers to exchange invoices for cash.

NON-BANK ASSET-BASED LENDING

Non-bank asset-based lending involves revolving lines of credit secured by accounts receivable and inventory and/or term loans secured by machinery and equipment, furniture, fixtures and equipment and/or real estate assets. Non-bank asset-based lenders have the ability to underwrite collateral as a priority before cash flow, thus providing more flexibility.

This added flexibility comes in the form of fewer or no financial covenants, the ability to maximize borrowing power through assets, freedom from recourse financing and the ability to accommodate customer concentrations. Non-bank asset-based lenders will require more frequent collateral monitoring by way of collateral audits and regular collateral monitoring.

At times companies may need to leverage additional assets outside of accounts receivable for borrowing, and this may not be feasible through their accounts receivable factor or bank asset-based lender. These companies can turn to non-bank asset-based lenders that can leverage specific assets including inventory, machinery and equipment and real estate to create additional borrowing power.

Non-bank asset-based lenders will pay particular attention to the following items when underwriting inventory and equipment:

• Inventory, including turnover, perishability, obsolescence, need for landlord waiver and the presence of a perpetual inventory system

• Machinery and equipment, including sufficient equity in machinery and equipment, orderly and/or forced liquidation and value appraisal

BANK ASSET-BASED LENDING

Commercial bank ABL platforms broadly provide a similar suite of products to their non-ABL counterparts. The main difference is that commercial bank ABL platforms will underwrite a company’s cash flow as a priority over underwriting a company’s collateral. Bank ABL credit facilities typically require more financial covenants than non-bank asset-based lenders.

Companies no longer in turnaround or hyper-growth mode that are well-capitalized and have demonstrated repeatable, consistent cash flow are candidates for bank asset-based lending platforms.

While these platforms may not require the more frequent collateral monitoring that non-bank asset-based lenders require, bank ABL facilities will likely have more financial covenants. Financial covenants are a set of conditions built into the structure of the loan to protect the lender’s interests. The two most common set of bank ABL credit facilities relate to debt service coverage/fixed charge coverage ratio and balance sheet leverage.

Whether lower middle market companies are experiencing hyper growth or are in the process of a turnaround, secured lending solutions including purchase order financing, accounts receivable factoring, non-bank asset-based lending and bank asset-based lending are flexible, non-dilutive financing solutions that allow companies to weather all business conditions. •