This post is co-authored by Ellen Wood and Chris Hysinger.
Access to Working Capital – Understanding the Options and Improving the Odds
Compounding the COVID-19 crisis, banks have tightened available capital and lines of credit for borrowers, especially for small to medium sized businesses. Other working capital programs have completely cut off virtually all their small business clients. Not surprisingly, the sudden loss of these sources has been a real shock for many companies. For example, when a business has a $500,000 revolver available to draw down and sees availability drop to zero almost overnight, a cash flow crunch can quickly become a crisis.
This tightening has happened for several reasons. The most consistently encountered problem has been that banks have changed their underwriting in response to the increased repayment risks they are experiencing as an impact of the pandemic. Existing lines of credit are generally negotiated annually with many coming due during this period when a borrower’s financial performance does not support a renewal under acceptable terms. Other businesses have been impacted by “adverse material change” clauses that are found in virtually all commercial loans. These clauses protect the bank by providing that when lenders perceive a business as being negatively affected by an event (such as the COVID-19 crisis), they can restrict, suspend, or even cancel lending on a line of credit, overriding the agreed upon borrowing terms. Indeed, some existing lending agreements allow a lender to terminate borrowing under an existing loan if the lender feels insecure about the financial position or credit worthiness of the borrower.
To further complicate matters, lenders are struggling with how to respond to PPP loans that many of their clients received. The loans are mostly forgiven – a very good thing – but because they are a one-time source of funds, cannot be considered recurring income for bank underwriting. The expenses the loans paid, however, are very real and likely recurring. This creates an even more challenging underwriting scenario for banks reviewing credit facilities. If you have a facility with undrawn funds on it, you might want to consider drawing them down even though you will pay interest. You are probably committed to keeping your cash in the bank that lends it to you, and a bank can offset your cash account if they feel it’s necessary. However, having the cash drawn is a step closer to being able to use it when you need it. Maintaining close, regular communication with your lender during this period will go a long way in avoiding a misunderstanding by your banker of your condition and a bad surprise for you with an unanticipated action. Your banker needs to hear from you and understand what you are doing to mitigate any downturns.
For businesses that do lose their access to credit lines, the good news is bank loans are not the only option available.
Working Capital Access Options
Having a working capital line “called” for missing covenants or a claim of material adverse condition generally creates an emergency situation.
Do not get caught flat footed. Look ahead at other sources available to you should you find yourself without access to your banking facility. Usually, these sources are more expensive than bank lines and their underwriting varies, but a lot less expensive than losing the business. They can be incredibly important lifelines to companies in need.
- Factoring: Factoring (also known as accounts receivable financing) is a financing solution that helps companies free up and stabilize cash flow from their unpaid accounts receivable. There are a wide variety of firms that factor invoices for clients. This basically means they buy them from you for a discount. On one end of the spectrum, as an example, you might have a farmer who sends out a truck of vegetables to a vendor. The farmer needs his cash faster than he would be able to get it if he waits for the vendor to process a payment (which could mean waiting for the vegetables to sell), so the farmer sells his invoice with the vendor to a factoring company for some percentage of face value. The vendor then pays the factor the full amount due. On the other end, you might have a company invoicing routine clients and then turning around and selling those invoices to a factor to accelerate receipt of cash. This is more expensive borrowing compared to bank lines, and there is underwriting involved here as well. The quality of the invoice and the vendor behind it will be of key interest to decisions and pricing.
- Purchase Order Financing: Also known as PO Financing, lenders will often finance larger amounts of materials, supplies, and labor needed for you to deliver orders to your customers. Similar in some ways to factoring, lending sources evaluate your purchase orders for their credit worthiness. They will look at the transaction creating it, the vendor issuing it, your ability to perform, and related matters in making their decision. This will typically be more expensive than factoring but can be very helpful to a firm with a large order and inadequate cash resources to deliver on it. Generally, lenders will start by reviewing the purchase orders you are requesting be financed. They will request that you provide the amounts of your purchases to fulfill these orders. The lender will then advance cash to you or your suppliers to fulfill these orders. You will fulfill and confirm delivery of the orders with your customers. Upon delivery, you will then invoice your customers for the finished orders. Many PO Financing lenders will request that you assign those invoices to them. The lenders will accept payment from your customers for those invoices and then remit to you the difference between the amounts they collect and the advances they made to you as well as any agreed upon fees.
- Subordinated Debt: The company can borrow from individuals and entities that subordinate their right to repayment to any senior lender (your bank or anyone with a lien already in place on your assets). These command a higher interest rate commensurate with the risk assessed by the subordinated lenders from being “second” in line for repayment. Some of these subordinated debt lenders will also take a small piece of equity in your company on top of their interest to achieve the rate of return they are seeking.
- Equity Funding and Investor-level Debt: Larger businesses looking for equity funding or perhaps more investor-level debt during the pandemic have found that those activities have mostly paused due to the uncertainty of the environment and the economy. Some equity and debt deals that were near closing have been pushed out into the future or dropped altogether. Other sources of equity and debt funding see the current environment as a source of bargain deals. It is worth exploring this with a heavy dose of caution related to the terms of these financing options if you are at the point where your next step is an equity raise or significant investor debt injection.
- Federal programs (that have stepped in to replace private sources of capital):
- A Standard SBA loan: The government participation in these loans makes them less risky to the banks that provide them as the federal government will become an additional guarantor of the loan with the bank. This is not a quick fix and there is substantial underwriting that goes along with a successful SBA application. Once in hand though, the terms are attractive for many small businesses. You may not be able to do this right now depending on how you have been impacted but consider it as soon as you are on a path to recovery as part of your go-forward strategy.
- The Main Street Lending Program was established by the Federal Reserve “to support lending to small and medium-sized for-profit businesses and nonprofit organizations that were in sound financial condition before the onset of the COVID-19 pandemic.”
- The window for borrowing through the SBA’s Paycheck Protection Program under the CARES Act closed on August 8, 2020. There are, however, still traditional SBA loans available for smaller businesses that qualify, as mentioned above.
- There is legislation under consideration now, in a package called The HEROES act, that if passed will likely contain a second round of PPP for qualifying businesses. The most recent version of the draft will provide loans up to $2M for companies whose revenue dropped at least 25% in Q2 2020.
- Personal Loans: A word of caution here — before you inject more personal funds, be sure you have eliminated all unnecessary spend and tightened up the operation as much as possible. Generally, when a business owner is investing personal money, they are doing so because other sources are not available. It is hard sometimes to confront that and ask yourself the hard questions about why. The why may be a good reason for you not to compound the problem with further investment.
- Family Loans: Before you do this, read the caution on Personal Loans and multiply by 100.
Improving the Odds
Capital and credit availability for smaller businesses has been negatively impacted by COVID-19. While small business owners and leaders generally have an intimate understanding of their businesses, most do not know how to present their case for capital in a way lenders and investors will easily understand. It is especially important when sourcing funds to prepare financial statements and forecasts that investors understand. Equity investors in particular get bombarded with potential deals and are looking for quick ways to narrow the field. A disorganized and incomplete financial package can lead to a quick “no” over concerns the company cannot present an accurate picture of the opportunity.
With professional presentation, banks and investors see a competent and error-free preparation and develop a picture that shows them a credible likelihood of a return on their investment of debt or capital. Completeness in one’s financial packages when seeking assistance from a bank, private equity investor, or other lender makes it easier for them to say yes.
Preparation and Honest Assessment
Business leaders planning for the year ahead are facing another period of uncertainty. Do your best to project the next year under what you believe to be most likely circumstances. Consider what cash resources you will need, what you have, and what you will have to secure to execute your plan. Put a complete financial presentation together to explain your plan in the terms your funding sources will understand. Start your search for additional funding well before your facility renews or your needs exceed your current facilities. If this preparation and search for capital is new territory for you, consider engaging a professional to help you evaluate and optimize your opportunities.
Looking to strengthen your financial position and access working capital? Request a free consultation from a vcfo expert who can help.