By Nicholas B. Jalowski, Managing Director, CTP, CMC
Cambridge Financial Services, LLC
In today’s economic cessation, many companies are experiencing difficulties in getting their banks to help fund them through the COVID-19 crisis and beyond. Commercial banks are regulated institutions and are characteristically risk adverse. They are entrusted with public money and structured to avoid losses on their loans.
In addition, most commercial bank lenders underwrite their loans to businesses based on the historical cash flows of each company. By analyzing historical cash flows, a banker can make an educated guess whether the company can repay a debt over the proposed amortization schedule. Simple enough to understand. But what are lenders doing in this new environment that makes the predictability of cash flows untenable? They may avoid making loans or advancing additional funds to existing customers to mitigate potential losses.
So where can a company turn to borrow money? The answer lies with the other broad concept in underwriting which is used by asset-based lenders (ABL.) These lenders advance a percentage on the asset they will take as collateral, and then look at the turnover of the asset to repay the loan. For example, a lender may advance 85% against accounts receivable. As the receivables are collected, they pay off the loan. As new receivables are created, the lender advances cash again. Even on hard assets such as equipment, the lender advances cash based upon the liquidation value of the collateral. If the cash flow cannot service the debt, a sale of the equipment will pay it off.
- Most alternative lenders are non-regulated or less regulated finance companies, and the following are some of the types of alternative lenders and a description of how they underwrite deals. ABL Finance companies specialize in working capital loans. These lenders strictly lend on accounts receivable and inventory by using a borrowing base that is updated periodically as the borrower needs more money. As previously mentioned, there are bank based asset-based lenders, but they are more credit-conscious because they are regulated. However, private and public finance companies are more concerned with the quality and turnover of the collateral and can even provide funding for companies that are losing money.
- Factors are companies that purchase accounts receivable as compared to lending against them. There are spot factors that will fund an individual invoice as well as portfolio factors that will purchase the entire accounts receivable of a company. Because they own the account receivable, they usually are more concerned about the credit of the account receivable than the credit of the company that generated the invoice. Usually, factor financing is much more expensive than lender debt, but there are some that are comparable.
- Purchase order finance companies (PO) specialize in advancing money to a company to fill an order that has not yet been delivered and billed to the customer. For example, say a company gets a huge order for $500,000 of widgets. It costs $250,000 to purchase the widgets from a supplier, but the supplier wants to get paid in advance. A purchase order finance company will advance the money to purchase the widgets and will get paid after the order is delivered by whomever is financing the company’s accounts receivable. In this case, the purchase order finance company is not worried about the company not being able to deliver on the order because the company does not add value to the order. It is just placed and drop shipped. Which brings us to….
- Production finance companies work much like a purchase order company in that they advance money based on the company’s purchase order. However, perhaps the company must purchase inventory and convert it into the order by adding labor or component parts. The production finance company will perform additional diligence to ensure the borrower can convert the order before agreeing to finance it. Production financing is somewhat riskier than PO financing, but the credit is priced accordingly to offset the risk.
- There are equipment lenders limited to offering term loans or leases on equipment. There are numerous categories of these types of lenders, and while some rely on a combination of cash flow and asset-based underwriting standards, there are some that are strictly “hard money” lenders. These companies will usually lend up to 75% of the net orderly or forced sale liquidation value of the collateral. If the borrower fails to pay the loan from cash flow, the collateral is liquidated, and the proceeds pay the loan.
- Hard money real estate lenders will advance cash against certain types of real estate, but the difference with these lenders is that they look at valuations differently.
- Usually, an appraiser will opine on the “market value” of a property. Market value assumes that there is a reasonable period to market and sell the property. Hard money lenders value the property based on what it will sell for in a short period of time — three (3) to six (6) months and then they only advance 50% to 60% of the valuation. If the loan cannot be repaid, a quick foreclosure and sale follows to recover the loan. For certain situations where a borrower is asset rich but cash poor, it fills a gap.
- There is another form of alternative financing that started around 2003 or so and has grown dramatically since then. That would be merchant cash advance financing (MCA.) The original concept of MCAs was to underwrite advances based upon a merchant’s monthly credit card receipts, as compared to financial statements. Examples include restaurants and other cash businesses that would not report all their revenue on a financial statement and consequently would not qualify for traditional bank loans. Enter MCA. Based upon the monthly average credit card receipts, an MCA would advance an amount and get paid a percentage of the monthly receipts from the credit card processor until the deal was finalized. The only stipulation is that the payback be substantially larger than the advance in some cases — possibly double the advance in only a short period of time! For a merchant sweating to make payroll, it is a quick and easy way to get essential financing without a hassle.
The MCA business has morphed into financing for almost any business, but recently the underwriting has changed. MCA lenders now review monthly bank statements for a period of time. Based on the inflows and outflows, they use an algorithm to determine the amount to advance. Then they take their financing back by debiting the bank account on a daily or weekly basis. Again, when you look at the payback versus the advance and convert it to an annual percentage rate, you may wind up just shy of usury rates. But again, if the business needs cash in days and not weeks or months, it is available. These finance companies justify the huge returns on the funds deployed because they are purchasing assets called “future cash receipts,” as compared to being “lenders.” The industry is still evolving, so we will see where it goes.
I should note that within each category of the above-mentioned alternative financing sources, there are multiple firms focused on several different markets. Some funders focus on smaller borrowers and will do $100,000 deals. Others only focus on larger deals and may only consider $5,000,000 and up. Under the working capital lenders, there are some that only advance on receivables, others only on inventory.
The universe of alternative lenders in every category is large and you may need to locate a finance professional to assist in your search. A good place to start is the Secured Finance Network. (“SFNet”) SFNet is the premiere association of asset-based lenders, factoring firms and other secured finance constituents. If you go to its web site, https://www.sfnet.com/ and select the membership directory, you can search for lenders that may assist you in fulfilling your unique funding needs.
Nicholas B. Jalowski is the Founder and Managing Director of Cambridge Financial Services, LLC. He is a practitioner specializing in strategic consulting to firms in need of guidance in turnaround management, corporate revitalization, financing negotiations, loan restructuring and/or workout management.
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