Tully’s Coffeei had been dealing with liquidity issues for years and called upon Deloitte CRG to provide a high-level assessment of the situation, as well as potential restructuring options. It became evident very quickly that the operating losses could not be stopped fast enough to avoid a situation where the company would run out of cash without massive changes to the operations.
The company had a long history of operating losses and no traditional assets to pledge as collateral to a debtor-in-possession (DIP) lender. However, Tully’s did have two critical advantages: a strong brand name, although not owned by the company, and no secured debt. In discussing the current situation with Tully’s management and its legal advisors, Deloitte CRG identified a number of possible options, all of which required additional cash. Even a barebones Chapter 11 bankruptcy filing was not viable without cash to fund the case and complete the sale process.
Tully’s, founded in 1992 with one location in Seattle, expanded to 114 company-owned locations by 2001. During this time, Tully’s generated losses each year of operations, which along with the capital used for store expansion, was primarily financed by raising more than $60 million in equity securities and convertible debt, plus more than $17 million in licensing fees paid by foreign licensees.
In 2009, due to continued operating losses and the economic downturn, the company sold its roasting operations and rights to the brand name for $30 million. This allowed Tully’s to pay off all senior debt, and created a core business of retail, franchised and licensed locations. While never generating positive operating cash-flow, Tully’s had become a popular concept due to the quality of its product and served as an alternative to larger coffee store chains.
Restructuring Through a Bankruptcy Filing
Due to the number of money-losing locations that needed to be closed and the continuing pressure from trade vendors, the company’s only option was to file for Chapter 11 bankruptcy protection. However, before a filing could occur, a source of cash was needed to fund the case. The management team and Deloitte CRG contacted more than 60 potential DIP lenders to secure funding for the bankruptcy. Although a few lenders were interested, none could get comfortable with the small size of the company, lack of adequate collateral and its long history of operating losses. As a coffee house, Tully’s had no traditional assets to pledge, including no owned real estate, brand name or other intangible assets.
In order to get to a §363 sale, Tully’s management team quickly implemented a number of cash-saving initiatives, including closing 19 unprofitable stores and eliminating 10 corporate positions. As a result, the company was cash-flow positive in the month following its bankruptcy filing.ii However, due to working capital needs of the company and added costs from the bankruptcy, the company was quickly running out of cash and options to continue in business. Tully’s needed to find a DIP lender quickly.
One financing option Deloitte CRG suggested was a merchant cash advance (MCA). An MCA is not a loan, but a sale of a company’s future credit card receipts. Small restaurants and retailers are perfect candidates for this type of financing due to their small size, lack of hard assets and high credit card volume. MCAs are normally structured as a “forward factoring” arrangement whereby a “merchant funding company” purchases a certain percentage of a merchant’s future credit card sales. The amount advanced is based upon the merchant’s last four to six months of credit card volume. Merchant cash advance companies want to see a history of steady credit card receipts, which is perfect for a company like Tully’s with consistent credit card sales.
The standard advance is structured with a funding amount and a repayment amount. The funding amount is the cash advanced to the merchant for the purchase and sale of the future credit card receipts. The repayment amount is the amount that must be remitted to the merchant funding company through a pre-arranged split of the merchant’s future credit card receipts. The daily split of credit card receipts to the merchant funding company range between 15% and 25% of the merchants’ credit card charges. As an example, a cash advance of $10,000 would be repaid over the next six to nine months on a daily basis until the advance plus a profit margin had been repaid to the merchant funding company. On a $10,000 advance a borrower would typically repay between $13,000 and $14,000.
The merchant funding company requires the merchant to utilize a pre-approved credit card processor for all credit card transactions. This allows the credit card processor to remit directly to both the merchant and the merchant funding company their respective split of that day’s credit card charges. For example, a credit card purchase of a grande caramel macchiato from Tully’s for $4.05 with an agreed repayment percentage on the MCA of 15%, $0.61 is forwarded to pay down the MCA, and the remaining $3.44 is remitted to Tully’s bank account.
MCA Pros and Cons
Before proceeding with an MCA, borrowers should be aware of the pros and cons.
o The underwriting process is much less stringent than a standard loan from a commercial bank. Merchant funding companies are mainly concerned with the size and stability of the merchant’s credit card receipts, the company’s overall sales, the length of time the merchant has been in business and the owner’s credit profile. Collateral and profitability, while important, are not the main factors for an MCA. For distressed companies, a funding process that does not require a lengthy underwriting and diligence process is rare but preferred due to the already heavy demands on the management team.
The time for approval and funding an MCA is much shorter than a small business loan secured by a pledge of collateral. The time from application to funding for an MCA can be completed in seven to 10 business days. A bank loan closing and funding usually takes 30 to 60 days with a credit review process that is much more in-depth. For Tully’s, the speed of underwriting, approval and funding was critical, as the company was quickly running out of capital to fund its business.
o The repayment structure is based upon a percentage of the merchant’s daily credit card sales, which provides much more flexibility than a fixed amortization schedule. For an MCA, payments are remitted to the funding source through the daily credit card settlement process, so daily or seasonally low transactions mean lower payments, and higher seasonal transactions mean higher payments. With a secured term loan, the repayments are a fixed amount per month, and there is no is no flexibility for fluctuations in a company’s revenues. If you miss a principal payment the loan is in default.
o An MCA is not governed by a borrowing base that restricts the amount borrowers can draw based upon specific collateral values. For distressed borrowers with shrinking working capital, minimal availability on the borrowing base can be a big issue, and often lenders find themselves over-advanced very quickly. An MCA is available for use at close without further draws or availability based on certain working capital balances.
o After the advance is funded, there are few covenants and reporting requirements compared to a bank loan. For Tully’s, the reporting requirements included the weekly delivery of its 13-week cash-flow forecast as well as the weekly cash receipts covenant test. In addition, the covenants for an advance include prohibiting the merchant from disconnecting the credit card terminal or using an alternative credit card processor. These minimal reporting requirements reduced the administrative burden and overall cost of the MCA program.
o Relative to traditional bank loans a merchant cash advance is expensive. It is not unusual for the merchant funding company to earn an annualized rate of return approaching 50%. For Tully’s, the overall cost of the advance was approximately $300,000 for a series of advances that totaled to $800,000; however, the advances allowed for the company to pursue a sale process to repay its creditors and continue employment for approximately 500 jobs in the Seattle area.
o Like any funding product, there is significant risk of overleveraging the company with expensive repayment obligations. Merchants need to be aware of the potential risk and seasonal factors in the business that could affect the future repayment of the advance.
o If the business has existing loans secured by its credit card receivables, the merchant would need to obtain approval from its secured lender for the merchant advance or use the MCA to extinguish the debt secured by the company’s credit card receivables.
Tully’s was able to secure a series of MCAs, allowing the company to continue operating during the Chapter 11 bankruptcy filing and complete the §363 sale process. The proceeds from the sale should be sufficient to satisfy all of Tully’s creditors, while preserving 500 jobs. Not a bad result for a company with a long history of operating losses, no collateral and time quickly approaching when the only option was to lock the doors and give the keys to a Chapter 7 trustee.
Although a merchant cash advance is more expensive than a traditional bank loan, the fewer obstacles and speed to close makes MCA funding an attractive alternative and a product that should be a permanent option for any restaurant or retail company looking to expand, refurbish or gain some much needed liquidity, whether or not the standard financing options have been exhausted.
Rob Carringer is principal at Deloitte CRG, and Matt Farrell is vice president at Renovo Capital.
iTully’s Coffee is the d/b/a for TC Global, Inc.
iiTC Global, Inc. filed for Chapter 11 protection on October 10, 2012