The financial crisis and resulting slow recovery continue to have a negative impact on various business and industrial sectors limiting the ability of affected companies to grow. Access to capital for growth is restrained by balance sheet issues and the limitations that have been placed on banks as a result of Dodd-Frank financial legislation. It is the ‘law of the land,’ but the actual regulations are still a work in progress.
As a result of these uncertainties, the financial industry must adapt to these realities and create new structures within the factoring industry to maintain strength in the backbone of our economy — small businesses.
Factoring has often been a dirty word in corporate finance. Its connotation was out of a desperate need of capital, unable to borrow from a bank or finance company. However, with the economic and legislative realities of the current economy and what the Fed has on tap for the foreseeable future, factoring is poised to become a central part of a company’s capital structure.
In fact, factoring is set to become more mainstream than ever before. Why? This phenomenon is a result of borrowers’ balance sheets recovering as slowly as the economy. In order to grow, entrepreneurs need capital and in many cases their existing bank lines are limited or have been terminated because of the loss of equity. The choices are quite stark for small companies that are facing reductions in working capital availability because of required pay downs, restrictions on advances for working capital from their banks and not having access to the equity markets. The entrepreneur can either put more cash into the company (if it is available) or shut its doors.
A New Era for Factoring
What if a financial structure existed that could help both the lender and small business owner simultaneously? A structure rooted in factoring that combines a modern mix of purchase order finance and trade finance that helps the lender get paid back and provides working capital to the small business to grow.
At Capstone we developed a program where we can participate in the capital structure of a growing or struggling company by entering into a limited subordination agreement with a client’s senior lender. We have found this was just what many of the clients in our portfolio needed to grow and increase their profitability.
Transactional Lending: Growth Capital for the Overleveraged
To assist our clients’ growth in a flat economy, we developed the concept of a limited subordination agreement (LSA). Under an LSA, the forbearing lender does not subordinate all of its security to the transactional lender. The forbearing lender only subordinates the accounts that are identified by the transactional lender as accounts it intends to finance or factor.
Our experience reviewing thousands of funding requests from companies that are highly leveraged with insufficient assets to collateralize their debt has been to decline the funding request. Any rational lender or factor would have to classify the funding request as hopeless or as an excellent candidate for a bankruptcy filing.
This exact situation has created an opportunity for a new transactional lending structure to meet the needs of both the entrepreneur and the lender’s credit committee. The current market challenges include the need to accomplish three objectives:
• Growth: Help the over-leveraged company grow
• Pay back debt: Help the over-leveraged company pay off its lender
• Manage unintended risk: Grow our portfolio without adding unintended risk
Most forbearing lenders will not agree to a subordination agreement, so a new lender or factor can get a first lien on the assets of the borrower as this would defeat the purpose of the forbearance. At Capstone, we know that the lender’s goal is to be paid in full whether or not the business survives. Our new solution would have to be novel enough to get the lender’s credit committee to go along with the proposed financing structure.
Case Studies: How the LSA Strengthens Balance Sheets
The overall benefits of this structure apply to many different types of companies. Within our portfolio, we have used the LSA with an electrical contractor, an outerwear company and a watch company. Let’s take a practical look on how the LSA has helped each of the clients to grow:
Sales at the outerwear company when we began funding the company four years ago were $2.5 million and it had licenses for a couple of tertiary brands augmented by contract manufacturing for large consumer brands. Sales the following year were approximately $11 million, and a new license agreement was entered into while the tertiary licenses were phased out and the contract manufacturing business wound down. Sales in year three were $23 million and a second lender was brought in to manage the increase in sales volume. By the end of 2012, the company had booked $52 million in sales and began negotiating for two additional licenses that will allow the company to reduce seasonality and increase its sales further. This was accomplished during the worst economy since the Great Depression.
For an electric contractor in our portfolio with sale of approximately $7 million per year for the last several years, we entered in to an LSA with its bank and began to factor its slower paying general contractors. The increased cash-flow has led to a $2 million per year increase in business because the owner can now bid on additional work without having to be concerned about paying his suppliers and employees. This client banks at a small regional bank and likes the customer service and attention that is paid to his account. As he builds up his balance sheet, he will have no obligation to factor with Capstone, as we have no minimums or financial penalties in our agreements should the client not meet certain factoring volumes. In an uncertain business environment, our flexibility gives comfort to our customer base, while we provide the appropriate level of funding to help them grow and stay within their covenants at their bank.
Sales at our watch company client were on a downward spiral as a result of the financial crisis, where longtime customers of the company had not paid for the merchandise they received and sold. Its bank had classified the loan and moved it to workout. The owner had put in additional equity to the point where he had no more personal liquidity. The company’s overseas and domestic vendors would not ship new merchandise unless they were paid in advance and sales were at a standstill. We engaged in a lengthy due diligence process because we were very concerned about the past credit and collection policies of the client, the value of the collateral and the strength of the purchase orders. The company has been operating for 40 years and had an excellent reputation and customer base.
Once we had underwritten the transaction to our satisfaction, we met with the bank, presented our LSA and agreed which accounts we would fund both on a PO financing and factoring basis. The bank’s inventory and receivable collateral are segregated from ours, which is located at a third-party warehouse and paid into a lockbox. We received sales projections from the company for 2013 of $8.4 million coming off sales for 2012 of $3.7 million. Frankly, we did not believe they would achieve the projections, but by the end of January it became clear that the company would meet its projections and net income for the first quarter of 2013. We are as confident as the client that it will meet or exceed its projections for 2013.
In all three instances, the use of the LSA has allowed these companies to grow, stay in compliance with their bank lending agreements, cover the additional operating and growth expenses and book profits — thereby strengthening their balance sheets. Each client sells or services a distinct customer base and in all cases the growth has resulted in significant top line and bottom line growth.
Capstone steps into the capital structure and negotiates an LSA with the lender. In that agreement, the purchase orders and the proceeds thereof from specific account debtors would be assigned to a firm like ours, in exchange for financing the goods through our trade finance program or single invoice factoring program.
After our initial contact with the lender, we work out the details of which firm the profits related to the sales are to be paid to, what happens in the event they collect accounts receivable that belong to us, and we collect accounts receivable belonging to them. The list of accounts to be subordinated is listed on an exhibit to the LSA to provide flexibility to both the lender and Capstone. At the lenders option, all the purchase orders from the Exhibit A account debtors can be subordinated to the transactional lender until the transactional lender elects not to provide financing to the borrower, or the LSA can be written in such a way that the lender has to consent in writing to each purchase order that falls under the LSA. The lender retains as collateral all other accounts, the proceeds thereof and other assets of the borrower.
From the borrower’s perspective, the LSA allows the company to grow because the transactional lender is funding those orders and/or those accounts receivable that require the most working capital to fulfill or complete. By operating with the transactional funder, entrepreneurs can use the limited working capital available through their bank to finance operations and other smaller customers with their normal cash-flow.
Growing Out of Financial Difficulties: A Closer Look
We have adapted two of our funding programs to facilitate the use of the LSA.
Delivering Goods to Customers — To accomplish this goal, the use of purchase order and trade finance is used for clients. Under the program, once the LSA is executed and due diligence is completed, we will establish a supplier credit facility for our customer by either issuing a letter of credit, a letter of guarantee or making a cash payment. The goods are shipped to a warehouse under our control and are shipped to the account debtor that is specified under the terms of the LSA. The invoice is either factored on a collection or discount basis depending on other underwriting criteria. Once the accounts receivable is collected into our lockbox, we recover our advance and fees and advise the forbearing bank that we will wire them the profit from the transaction. In the event that under the LSA each additional purchase order has to be approved by the forbearing lender, we would advise them of the next order and repeat the process.
Delivering a Service — For companies that deliver a service or have sufficient supplier credit to deliver the goods required under their customer’s purchase order, we use our single invoice factoring program. In this case, we still require the assignment of the specific purchase order and the proceeds thereof. The lender has the same two options that were discussed earlier under the purchase order financing and trade finance program. This LSA specifies all purchase orders from specific account debtors or specific purchase orders from specific account debtors.
For lenders and factors that have reached their credit limit with a given account debtor, the LSA program works very well. In these instances, Capstone steps in and for specific accounts will provide capital or factor the related accounts receivable above the credit limit established by the bank or factor. Our participation allows the lender or factor to retain the borrower relationship and maintain the credit quality of their portfolio, while the client’s business grows.
Entrepreneurs and small businesses need innovative thinking to provide new structures to help them grow out of their financial difficulties caused by the slow economy. The LSA program provides a secure method to assist the company in its growth trajectory to outgrow its financial difficulties and to aid its bank in getting its principal paid back as quickly as it desires. The ultimate goal and hope is for the bank to stay in the credit and to lend again to the company once its collateral and loan balances are in formula.
Joseph F. Ingrassia is managing member of Capstone Capital Group, a NYC-based factor and trade finance firm that provides alternative financing to firms involved in the domestic and international trade of finished consumer and industrial products. To learn more, visit www.capstonetrade.com.