What's It Worth?
If there's easily recognizable value somewhere, anywhere, in your business, you can generally get a loan against it to help fund the growth of your company.
This is the fundamental idea behind so-called asset-based loans--a potent source of funding for established small businesses, according to William Barnett, an attorney with the law firm Herrick, Feinstein LLP in New York City who specializes in asset-based lending. Specifically, he says, "Asset-based lending is formula lending based on the liquidation value of accounts receivable and inventory."
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A Framework For Lending
While lenders making term loans (loans that are paid back over a span of two to five years) certainly consider the value of these assets, value is only a secondary consideration. For the most part, when a banker makes a term loan, he or she is looking at the cash flow of the enterprise and trying to determine whether it is sufficient to service the debt and whether it can be sustained for the term of the loan.
Asset-based lenders, on the other hand, have a dual focus. They, too, look at cash flow, but they also look at two asset classes--accounts receivable and inventory--in terms of their ability to be liquidated to pay off the loan if the cash flow goes south. Short-term asset-based loans generally get paid off as accounts receivable and inventory liquidate.
In growing businesses, however, more accounts receivable and inventory are being generated all the time. As a result of this cycle, an asset-based loan has a revolving quality to it. This can be a good thing because it gives a company time to catch its breath. But it can also work to a company's disadvantage. If an asset-based loan isn't renewed by the lender, for example, the company may be forced to pay the borrowed money back before it's prepared to do so.
People Who Need People
An asset-based lender's emphasis on assets rather than cash flow makes a significant impact on the relationship between lender and borrower, according to Barnett.
The asset-based lender is taking a so-called security position in the underlying assets and views liquidation of them as a viable means of recovering the loan principal. In addition, because the asset-based lender is lending against assets, which can rapidly fluctuate in value, it monitors these assets more intensively. "It's not uncommon for asset-based lenders to look at a company's inventory or accounts receivable once a month, sometimes even more frequently," says Barnett. Conventional lenders making term loans, on the other hand, might review financial data just once a quarter and never look at inventory after the initial loan is made.
Adding Up Your Assets
Your borrowing capacity for an asset-based loan rests on what your assets will support and the maximum line a lender will grant you. Barnett says most asset-based lenders will lend 80 percent of "eligible" receivables and 50 percent of "eligible" inventory. So what do we mean by eligible?
Basically, just because you have an asset on the books doesn't necessarily mean a lender will advance you funds against it. "Asset-based lenders deduct ineligible receivables such as those from mom-and-pop shops, those from customers who have had a bad debt on prior receivables, ones that are more than 90 days old or, perhaps, receivables due from customers overseas," says Barnett.
So on the receivables side, the equation looks like this:
The same concept applies to inventory. That is, the inventory on hand needs to be adjusted by the lender. Specifically, ineligible components must be removed to estimate the eligible portion. Ineligible inventory might include items that are obsolete, certain exotic goods that would be difficult to liquidate, perishables that may spoil before they can be liquidated or materials that are damaged. The inventory equation is as follows:
Barnett says adding the two sums together and subtracting any outstanding debt gives you the amount you can borrow, as long as it doesn't exceed the total line available to your company, which is spelled out in your agreement with the lender.
Why does inventory get such a low advance rate, just 50 percent of eligible inventory, while accounts receivable gets 80 percent of the eligible amount? According to Timothy Gannon, senior vice president of the asset-based group at Sterling National Bank, a publicly held New York City bank that specializes in small- and middle-market companies, "Accounts receivable are self-liquidating, while inventory is not. If a lender needs to liquidate to recover the loan, it will have to take possession of the inventory and sell it, which can be difficult, time consuming and expensive." By contrast, he says, the majority of a company's accounts receivable will, over time (hopefully in 30 days), turn themselves into cash through payments from customers.
Anatomy of a Loan
Here's how a typical asset-based loan made against a company's receivables might work.
Step 1. The company sells its product or service to customers. Unless it's a cash-based business or a business where customers pay for all their purchases by credit card, a receivable is created. The receivable, really a debt owed to the company, is usually repaid in 10, 15, 30 or 45 days.
Step 2. The lender makes a loan to the company based on the value of the receivables, typically advancing 80 percent of eligible receivables. The moment the funds are advanced, the company starts paying interest on the loan.
Step 3. Customers are instructed to send their payments directly to the finance company.
Step 4. The lender remits to the company the invoice payments, less the principal on loans it has already advanced, less interest.
Step three can make borrowers queasy--and for good reason. After all, in any business, cash flow equals life, and placing your lifeblood under the control of a third party can bring risks. For instance, suppose a borrower has a large outstanding balance that's continuously revolving. Further suppose that an entire group of the borrower's customers had sold products to a region of the world which experienced a financial meltdown. The lender, who monitors the assets very closely and begins to see the length of these customers' receivables expanding, may take a "reserve" to protect itself. Instead of remitting customer payments to the company, the lender holds some of them as a reserve against future loan losses. Suddenly, the company doesn't have funds it may have been counting on.
Requirements and Scenarios
Sterling's Gannon says that to successfully negotiate an asset-based deal, borrowers must come to the table with financial information that paints a positive picture and is detailed and accurate. Among the requirements he cites:
- The business must have a reasonable net worth and long-term viability.
- Financial statements must be reviewed by a certified public accountant whom the lender deems acceptable.
- Borrowers must submit one year's worth of monthly projections.
- The business's principals must guarantee the loan and support the guarantee with personal financial statements.
- Keyman life insurance may be required.
Gannon says even if you qualify for an asset-based loan, it might not be the best way to go. "Asset-based loans are more expensive than bank lines of credit and often much more intrusive on the borrower," he warns.
For instance, he says, if you have a good guarantee, are profitable and need to borrow, say, $500,000 for 60 days twice a year, you should go to a commercial bank. "That's the cheapest, easiest way to go," Gannon says.
Similarly, if you have a good guarantee and need a line of credit to support inventory and receivables that can be paid back within one year, there's a good chance a bank will take a security interest in your inventory and receivables and offer a line of credit or a revolving line of credit. "This also will be cheaper than a traditional asset-based loan," says Gannon.
But, he says, "If your guarantee is not that strong, you're not that profitable, your business is undercapitalized, you need working capital, and there's no way you can pay off a line of credit for perhaps two or three years, you present a problem for most banks even if your business is a good one." In these instances, he says, a bank will often refer you to a finance company offering asset-based loans--this may be your only salvation.
- You can start your search for an asset-based lender at the Commercial Finance Association's Web site, http://www.cfa.com Using the site's search engine, enter the amount and type of capital you're looking for. You'll be given contact information for commercial finance companies matching your criteria.
Herrick, Feinstein LLP, 2 Park Ave., New York, NY 10016, (212) 592-1400
Sterling National Bank, 500 Seventh Ave., New York, NY 10018-4502, (212) 826-8000