For modular office furniture manufacturer Design Resource Group
International Inc., timing was everything. Though its niche was
small office installations, the Pine Brook, New Jersey, producer
wanted to bid on larger projects when the right opportunity
presented itself.
Larger competitors, however, had an advantage. Deep pockets
allowed them to offer customers flexible financing terms, while
Design Resource Group used deposits to fund orders for the three-
to four-month period it took to get paid. Meanwhile, some potential
clients, particularly government agencies, rarely made down
payments.
Even with bank credit, constricted cash flow hampered growth.
"Banks tend to say, ‘Make money slowly and build your
own cash flow so that, at some point, you can do these jobs off of
your own profits and your own cash,'" says David LaTorre,
CFO of the $50 million company. "The window of opportunity is
generally short, and if we're not there to at least bid on
these projects, they may not be there next year or the following
year."
"Once the company
is through this growth period requiring purchase order financing,
they can get into receivables
financing."
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LaTorre's previous employer, a gourmet food manufacturer,
had a similar funding shortfall during an expansion opportunity in
the late 1990s. Its accountant recommended purchase order
financing, a form of asset-based lending through which businesses
can obtain credit to pay suppliers, laborers and other
intermediaries for goods or services they need to generate
additional sales. For rapidly growing companies, the need for
capital is often acute. Huge orders, seasonal sales spikes and
market expansions can place strain on a business's cash flow,
thus jeopardizing future sales opportunities.
After joining Design Resource Group last year, LaTorre learned
that the company would need extra credit to capitalize on
significant business opportunities, such as refurbishing the
corporate offices of a multinational firm. He called Westgate
Financial Corp., the Hoboken, New Jersey-based lender that financed
the earlier growth spurt at his former company.
1 in 6
Americans do not have a credit card.
SOURCE: The Gallup
Organization.
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"It's out-of-the-box financing that banks typically
don't like to do on the front side of large projects,"
LaTorre, 37, explains. "We have grown explosively over the
past several years, and much of that is because we're able to
obtain financing like this. That can add 20 to 30 percent in growth
opportunities right away."
Closing the Credit Gap
Whereas a factor advances funds on a company's receivables,
purchase order financing is used to buy inventory. In exchange for
advancing funds for inventory-typically finished or nearly finished
goods-the lender receives a percentage of the cost of the goods,
usually in the range of 1 to 3 percent for a 30- to 45-day
transaction. However, the cost varies depending on how the deal is
underwritten and the client's historical performance.
While lenders have industry preferences, actual transactions are
similarly structured. The funds are applied to the manufacture of
goods to fulfill a purchase order, including raw materials and
labor, or used to purchase finished goods, either from a domestic
or overseas manufacturer. "It fits the gap between traditional
bank financing or debt financing and equity," says Paul
Schuldiner, national business development director for Northbrook,
Illinois-based Transcap Trade Finance, a joint venture with
Transamerica Commercial Finance Corp.
Purchase order financing is geared to wholesalers, distributors
or importers that outsource production of consumer goods, including
apparel, sporting goods, furniture, computer hardware and
housewares. "There's a time frame needed to build up the
inventory and production requirements," says Schuldiner,
"and if they're importing from overseas, frequently the
lead times could be 30, 60 or 90 days. They would typically tie up
their collateral with their other lenders for that period of
time."
Schuldiner maintains that purchase order financing can coexist
with bank or venture capital funding. "It creates better cash
flow for the client, which flows through to the existing
lender," he adds. "Clients may have an equity sponsor or
venture capital group that has sponsored the first round or two,
but they don't necessarily want to put in additional equity.
They're able to leverage off our funding because we provide
transaction capital and don't typically take an equity position
in a company. As such, we don't dilute the ownership interests
of the existing shareholders."
23%
of Americans have five or more credit
cards.
SOURCE: The Gallup
Organization.
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In fact, banks are a leading referral source, along with factors
and other asset-based lenders, followed by accountants and
consultants, then brokers and attorneys. In terms of lending
criteria, industry experience and whether the company has
sufficient cash flow to cover expenses are key considerations.
Additionally, lenders prefer relationships with borrowing
companies-the typical credit line is set up for a 12- to 18-month
period-to one-off deals.
Bring on the Bank
Niche players who lend against purchase orders are typically
providing credit to companies with established bank ties. Even with
a bank's support, it's a complicated arrangement in which
concerns arise over ownership of collateral. Additionally, banks
are reluctant to have multiple institutions filing liens and rights
to a company's assets. "Typically, inventory receivables
are the most tangible assets a bank wants to have as collateral,
and when you're financing purchase orders, the first thing it
does is create inventory," LaTorre says. "When that
inventory, in our case, is in the water from Korea, it's
technically Westgate's inventory. Then it gets sent to the
end-user and becomes a receivable. It becomes an issue of who owns
and has rights to the two pieces-when it's inventory and then
when it becomes receivables."
Businesses can allay concerns by proactively managing the
relationship between bank and purchase order lender, says banker
Lyle Frederickson. "It's important that the business owner
act as mediator to establish and enhance the relationship," he
says. "Take them both to lunch and make sure everyone
understands the terms. You want everyone to be invested and
committed."
Frederickson, senior vice president of Arizona Business Bank in
Phoenix, says the financing tool is mutually beneficial for the
bank and borrower. The bank can further gauge the company's
creditworthiness, while the entrepreneur eventually gains access to
less expensive credit. "Once the company is through this
growth period requiring purchase order financing, they can get into
receivables financing," he says. "Once that happens, it
will be easier for them to get that financing because we've
watched the behavior, we've seen that there haven't been
overdrafts, we've seen the lockbox funds coming in, and we know
who their customers are. We'll probably be able to move into
asset-based lending more quickly than if we hadn't been
affiliated with the credit."
Crystal detamore-rodman is a Charlottesville, Virginia,
writer who covers the small-business finance market.
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Originally published in the August 2002 issue of Entrepreneur Magazine