Commercial bank lending has risen steadily during this past year. However, it is still difficult for many companies to finance their operations with traditional bank debt. There are always companies (and industries) that are just not bankable. These include companies that are cash-flow negative, early stage companies with intellectual property but no customers, and early stage manufacturing companies that need to finance fixed assets before entering into increased production phase. The lending situation for these types of companies can get worse in the next few years, as pieces of the new Basel III bank capital rules may force banks to be more selective with their capital commitments, especially when lending to companies of marginal creditworthiness.
For the right situation, companies may find it advantageous to turn to alternative financing sources that are hungry to deploy money and willing to finance higher-risk projects. These sources are available as a potential resource for lower-cost financing as a result of the current low interest rate environment. As investors are not finding satisfactory yields in the public and bond markets and private-capital providers need yield in their portfolios to attract investors, more capital is available for alternative lending.
Growth companies many times hit financing hurdles trying to secure bank financing when sudden surges in customer demand outstrip their current capacity. Many times growth companies in their early stages invest significant amounts for sales and marketing to build brand awareness and to accelerate the growth of its top line at the sacrifice of short term operating profits and cash flow. Many companies in this situation report operating losses even as sales grow. As a result, many traditional banks may view the company’s business model as not being creditworthy, at least not without personal guarantees.
Companies in this situation may be better served to seek alternative lending sources to traditional bank financing to fund needed capacity growth. Non-traditional financing sources may be willing to take a deeper look into the business model, and agree with the business leaders that the company does in fact have a fundamentally strong business. Obtaining lease lines of credit for capital equipment can be one solution. Combining an equipment lease to buy expand capacity combined with a sale-leaseback of existing equipment to generate additional working capital may provide the needed financing for a company to get to “its next level”.
A non-traditional lender’s cost of capital is higher than a traditional bank, which means the resulting cost of financing for the business will also be higher. In some cases the financing cost will be significantly higher. However, compared to the opportunity cost of equity financing at this stage or losing customers as a result of not being able to deliver, alternative financing will in most cases be the less costly route to go.
Another option for alternative lending is business development corporations (BDCs). These are publicly held investment companies that must distribute 90% of their profits to shareholders. Such entities are able to lower their cost of capital by leveraging their balance sheets. Technology companies with valuable IP can in the right situations secure senior secured loans from BDCs, often collateralized with intellectual property, with a cost of capital that is not significantly different than the traditional bank.
The advantage of BDC lending is not only in the financing costs. Companies with $20 million to $100 million in sales, but inconsistent cash profits—can in many cases continue to place their deposits and operating accounts into any bank. In addition, this type of financing agreement is usually a lot less covenant-driven. In the event a company does get into trouble, the loan will not typically be passed to a workout group whose sole purpose is to get the bank’s money back at whatever cost. This “leniency” arises from the fact that BDCs are not regulated like a bank and have permanent capital on their balance sheets. This enables the BDC to work with companies through difficult times.
Interest rates higher than typical bank financing may make alternative financing seem like an unattractive source. However, alternative financing can enable companies to save expensive equity capital for future strategic uses. For example, it usually does not make sense for a growth or early-stage company to buy equipment, furniture, servers, and routers or fund working capital with equity dollars. In most cases, it is better to supplement the company’s capital structure with alternative debt financing that enables the company to bridge a two-to-three-year period until it reaches a milestone that attracts a higher equity valuation.
Alternative lenders don’t have an infinite appetite for risk. Companies still need to have the ability to demonstrate that it can be successful and the management team has the ability to deliver. However, in general, alternative lending sources typically take a much more expansive view of the company’s prospects than that of traditional banks.
Harvest CFO Consulting provides growth and middle market companies with highly-skilled CFOs for interim, fractional and permanent needs. A Harvest CFO will assist CEOs, investors and management teams to build the financial foundation necessary to achieve company goals.