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Sources of Capital: Asset-based Lenders

Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser et al


Asset-based lenders encompass a broad category of firms that provide debt financing by lending against the assets of a company. As we have seen in other areas of finance, there is a lack of standardization with the use of terms among firms; we will, however, attempt to provide a reasonable level of differentiation. Typically, ABLs are unregulated nonbank lenders (though they may be owned by a bank) that have the flexibility to make more highly leveraged loans based on the situation and collateral specific to their client's business. A true asset-based loan will be repaid from the liquidation of the collateral regardless of the state of the business. It is more important for the collateral to perform than for the company to perform. An ABL's key concerns are the liquidation value of its loan's underlying assets and potential management fraud. These concerns lead to control and close monitoring of their collateral. 13

The larger ABLs tend to have specific financing programs based on industry, company stage, or type of financing. The broad categories of asset based lending are discussed hereafter. Keep in mind that we are discussing the generic version of these financings, and that there are hybrid versions that may contain a mix of terms or features from several.

To balance the subsequent discussion of asset-based loans and some potential negative attributes, we highlight four benefits of asset-based financing:

  1. The entire cost of an asset-based loan is paid with pretax dollars, unlike most equity costs.
  2. ABLs do not seek a seat on the board or any control of the company, just a risk-adjusted and fair return on their money.
  3. ABL relationships can usually be terminated by paying off the balance of outstanding debt to the ABL and any accrued interest and fees. Equity and other sources can be much more difficult to exit.
  4. Asset-based loans are evergreen in nature, with no set amortization or payment schedule. They can grow as the business grows, unlike many other forms of financing.

Documents required to begin meaningful discussions with an ABL usually include: prior year and most recent interim financial statements; the previous month-end's accounts receivable and accounts payable agings; personal financial statements from the primary stockholder(s) with Social Security number(s); and the potential client company tax identification number.

Accounts Receivable Financing

In accounts receivables financing (A/R financing), the lender, which may be an asset-based lender, commercial finance company, or commercial bank, advances funds to the client's bank account against a line of credit (LOC) based on a percentage of the eligible outstanding receivables. Prior to an advance, the client company usually submits a report that shows the calculated availability and the requested draw against the LOC. This allows the lender to closely monitor the collateral supporting the LOC. The lender has a bank lockbox in which payments from the client company's customers are received and credited against the outstanding balance of the LOC. If the lender is a bank, the formal monitoring process just described may be somewhat relaxed; a lockbox may not be used and reporting may only be required monthly. This dynamic exists because the financially stronger firms probably have supporting cash flow and other risk-mitigating characteristics. Unlike in factoring, the client company retains legal ownership of its invoices throughout the process and has the risk of collection. Figure 5.3 illustrates this process.

Example Availability

Following is a simplified analysis (neither fees nor interest taken into consideration) of the available funds for an accounts receivable LOC where the company has $1 million of receivables outstanding and has already drawn $400,000 in a prior period:

Outstanding accounts receivable balance

$1,000,000

Less A/R > 90 days past due (ineligibles)

(75,000)

Total eligible A/R

925,000

Available to borrow (80% of eligible)

740,000

Less the outstanding LOC balance

(400,000)

Available to borrow

$340,000

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Terms and Conditions

The various terms and conditions are subject to negotiation at the time of establishing the LOC. Following is a typical list of terms contained in an ABL term sheet, with some editorial comments as appropriate:

  • Borrower. Establishes what entity is being lent to.
  • Guarantor(s). Who is required to guarantee the LOC. This may be individuals or another corporation.
  • Credit line or amount. Establishes the maximum amount the lender is willing to advance.
  • Purpose. Defines the use of proceeds of the LOC.
  • Sublimits. May limit advances to a single customer or against a specific collateral.
  • Advance formula. Outlines the specific formula to be used in calculating the LOC availability. Typical advance rates range from 70 percent to 85 percent of eligible receivables. Defines the phaseout of eligibility of past due receivables, which is sometimes gradual versus binary.
  • Interest rate. Typically based on the prime rate or LIBOR. Ranges from prime to prime plus 10 percent for very difficult situations. The higher interest rate covers the commercial interest rate plus added interest for the additional risk. A subparameter to this term is the number of days in which interest is charged after receipt of payment of an invoice, which is typically one to five days. Also will include a default rate and possibly an overadvance rate.
  • Fees:
  • Closing commitment fee. This is a one-time origination fee, and ranges from 0.25 percent to 2 percent.
  • Facility fee. Charged for providing the credit facility; ranges from 0 percent to 2 percent and sometimes payable in multiple years.
  • Minimum loan fee. Provides a minimum interest payment to the lender if the outstanding loan balance drops below a predetermined amount.
  • Early termination fee. Provides a fee for early termination by the client company.
  • Collateral monitoring fee or service charge. In some instances, the lender will charge a monthly fee to support the staff required to monitor the LOC. Typical monthly amounts range from $1,000 to $8,000.
  • Collateral. Specifies the collateral that is securing the LOC and what lien position is required. In some cases, this term will prohibit other liens or loans. It is important to anticipate future financings and make provisions early on if other debt is expected.
  • Term. Provides for the length of time that the LOC is committed by the lender.
  • Conditions. Usually provides for such items as: required agreements, material adverse change clauses, lockbox and bank account requirements, reporting and audit requirements, key man insurance, and special terms specific to the client company.
  • Expenses. A company can expect to pay for costs and fees related to periodic audits and visits by the lender. In addition, defines party responsible for payment of expenses related to closing.
  • Deposits. Usually required at the time of acceptance by the client company of the lender's term sheet as a show of good faith. Refundable or credited against the LOC at some future time.
  • Cash Flow. When a company's sales are increasing, A/R financing creates positive cash flow by accelerating the cash cycle by the number of days for payment granted to the client company's customers. Warning! If a company is using A/R financing and sales begin to slow, causing negative cash flow and reduced borrowing availability, at that time cash receipts will be going to pay off the LOC, not for operating purposes.
  • Total Cost. In comparing the cost of various financing alternatives, the total cost including all fees needs to be considered, not just the interest rate. While A/R financing can be comparable in cost to a traditional bank LOC, this is typically true only for companies with very strong balance sheets and solid credit history. Typically, A/R financing is somewhat more expensive than a traditional bank LOC; however, it offers more flexibility and may be available to companies that are not bankable. There are lenders that routinely provide A/R financing to troubled companies and for turnaround situations. The total cost of A/R financing is based on the various factors, many of which are defined by the terms listed before, including the actual utilization of the LOC. These total costs range from prime plus a few tenths of a percent to prime plus 10 to 12 percent.

Factoring

Factoring is expensive, but it is a valuable form of financing. Factoring is an agreement between the lender (factor) and your company (client company) in which the factor purchases the accounts receivable generated by the company's product or services. As such, a company with a weak balance sheet and/or losses can fund new sales more easily-however, with a higher cost than conventional bank financing. The reasons for factoring as a source of working capital include taking advantage of supplier discounts for early payments and cash discounts, fewer lending covenants than a standard bank line of credit, and not losing business to better financed competitors. A factoring relationship can often be established in one to two weeks. With factoring there may be no credit limit placed on your company; the credit constraints are based on the creditworthiness of the client company customers. For factoring to be a viable financing alternative, the company factoring its receivables needs to have either a significant gross margin, low overhead costs, and/or enough price elasticity to be able to pass the cost of factoring to the buyer to absorb the cost. In working capital crisis situations such as rapid sales growth or turnaround, the cost is often worth the speed, flexibility, and funding availability to solve the cash need.

Factoring Terminology

  • Nonrecourse and full recourse factoring pertains to the financial obligation of the company in the event of nonpayment by the end customer of the purchased accounts receivable. With nonrecourse factoring, the factor buys the receivable and assumes the risk of customer payment. The factor, in effect, guarantees against customer payment loss, unlike a secured lending facility. The factor will also provide the end customer credit check, undertake collection, and manage the bookkeeping functions relating to accounts receivable. 14
    Recourse factoring is far more prevalent in the current economy. With recourse factoring, the factor accepts assignment of the receivable but does not assume the credit risk; the company retains responsibility for managing the receivable. Generally, the lender will finance invoices up to 90 days from delivery of goods or services, then charge them back to the company if not paid by the end customer. 15
  • Notification refers to the practice of providing notice to the end customer that a particular invoice has been factored. Some factors charge an additional fee for not notifying the end customer. This is done in cases where the company assesses a risk of loss of business from a potential show of financial weakness for having to factor (which is historically seldom the case).
  • Advance rate is the amount of money provided immediately to the company factoring its accounts receivable, expressed as a percentage (usually from 75 percent to 90 percent) of the total invoice.
  • Discount rate is the fee charged to the company factoring its accounts receivable.
  • Factor refers to the company that purchases accounts receivable.
  • Reserve for holdback is the amount of money that is not immediately provided to the company factoring its accounts receivable, expressed as a percentage of the total invoice amount. That is, Advance Rate + Reserve = 100% of Total Invoice Amount. This money, minus the discount rate, is paid to the factor's client company once payment is received by the factor. 16

Factoring Process

The major steps involved in the factoring process are shown in Figure 5.4. They include: delivery of the product or service to the buyer, buyer acceptance, merchant submission of invoice to the factor, and discounted payment to the merchant.

  • Client company customer credit approval. The factor establishes preapproved credit lines for its client's customers.
  • Product or service delivery. The client delivers its product or service for approved orders to its customers and bills them. Proof is then provided to the factor. In the case of notification factoring, the invoice indicates that payment is due to the factor.
  • Collection. Payment from the end customer to the factor is typically via a secured lockbox. When received, the factor credits the client company's account. In nonrecourse factoring, the factor fully manages the receivables including the lockbox, cash application, and collection of past dues. Customer deductions or disputes over delivery terms or product/service are immediately reported to the client company. The factor maintains the accounts receivable ledgers and provides this information either by paper reports or electronically to the client company.

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  • Default. In the event an end customer defaults, the amount in question is charged to the client company's factoring account by the factor. The client company repays the default by submitting new sales that will not have advances or the factor retains the reserve for holdback. The client has incentive to expedite the collection effort.
  • Funding. As needed, the factor will provide the client company with cash advances prior to the maturity date of the invoices. This allows the client company to be paid upon delivery of the product/service while actually offering credit terms to its customers. Typical advance rates are up to 90 percent of the value of the invoice. These advances are subsequently liquidated by collection proceeds from their customers.

Total Cost

There are several methods that factors use singly or in combination: discounts, the interest charged on advances against receivables, a factoring commission, and a monthly administration fee.

  • The discount is a set fee amount that is charged on each invoice. The range in many cases varies significantly from 0.5 percent to 3 percent.
  • The interest charged on the face value of invoice or actual funds outstanding may range from prime or a base rate plus 2 percent to 4 percent.
  • The factoring fee/commission is quoted in 5- or 10-day increments: 0.5 percent per 10 days (which is .25 percent/5 days) to 1 percent per 10 days (0.5 percent/5 days). The standard range is 0.6 percent to 1.0 percent per 10 days. A staggered cost such as 3 percent for the first month and 0.6 percent per 10-day period thereafter may be made available.
  • The monthly fee may be a fixed dollar amount or a percent of funds used or invoices outstanding (a subtle but potentially significant cost difference). This may be included as a loan covenant known as monthly minimum fee for anticipated volume of factored accounts.

This potentially complex pricing matrix needs to be understood. The teaser rate of prime plus 2 percent (which is near a bank rate if that were all to be charged) is routinely combined with the discount and/or monthly fee. When all of those costs are combined, this cost is in excess of a standalone 0.6 to 1.0 percent per 10-day fee despite its enticing introduction. If the client company understands its collection cycle and aberrations it can negotiate more favorable pricing. 17 In total, factoring can easily cost 20 to 40 percent annually.

Factoring versus Credit Insurance

Credit or A/R indemnity insurance can be purchased to protect your company in the event of default in payment by a customer. To some degree, factoring provides the same effect as credit insurance coupled with collection services. Unlike factoring, credit insurance does not improve cash flow unless your company has a claim. Generally, factoring is more expensive.

Inventory Financing

The financing of inventory is typically combined with A/R financing. The terms discussed in the prior section regarding A/R financing apply. Terms that will be added or modified to the list discussed in the A/R financing section include:

  • Sublimit will be modified to include an inventory limit.
  • Advance rate will be specified for the inventory. These rates are typically low relative to the A/R limit, ranging from 10 to 50 percent of the inventory liquidation value. There may be staggered advance rates for raw materials work in process and finished goods. The advance is determined by marketability of the inventory in the event the lender must sell it.
  • Fees typically are expressed as prime rate plus a percentage. In addition, there may be a monthly analysis fee. Inventory appraisals may be required preloan to provide the "expert" assessment of marketability to assist in establishing the advance rate. The more complex the inventory, the higher the cost of appraisal. Quarterly audits by the asset-based lender are at the client company's cost in most cases.
  • Collateral will be expanded to include inventory.
  • Reporting will be expanded to include inventory. Detailed monthly reports on raw materials and finished goods typically from a perpetual inventory system are required.

Adding inventory to an A/R LOC usually increases total LOC availability. In most cases the inventory loan does not exceed the accounts receivable line of credit or factoring.

Purchase Order Financing

Purchase order (PO) financing can be used to finance the purchase or manufacture of specific goods that have already been sold. It can used for payments to third party suppliers for goods, for issuing letters of credit, and for making payments for direct labor, raw materials, and other directly related expenses. 18 PO financing tends to work well for importers and exporters of finished goods; outsourced manufacturing; and wholesalers, assemblers, and distributors.

Firms that provide PO financing seek client companies with strong management expertise in their particular field/industry; client company suppliers and subcontractors who have a proven track record-reliable sourcing; valid purchase orders issued by creditworthy customers; and verifiable repayment from a factor, bank, another asset-based lender, letter of credit, or the ultimate customer. 19

PO Financing Process

A simplified PO financing process includes the following steps: 20

  1. The end customer purchase order is verified.
  2. The client company provides a budget showing the cost to produce the final product.
  3. Funds are disbursed to support fulfillment of the order.
  4. The production cycle is monitored and inspected.
  5. When the final product is delivered to the end customer, the lender factors that invoice; part of those factoring proceeds are used to repay the purchase order financing.

Term Loans

Term loans are typically provided for the financing of fixed assets such as computers, machinery, equipment, leasehold improvements, and real estate. These loans vary in length from several years for computers to 10 to 40 years for real estate based on the expected life of the asset. Equipment-loan to-value rates are based on a percentage of the orderly or forced liquidation appraisal of the asset, and real estate loans are based on a percentage of a fair market value (FMV) appraisal. Rates charged are based on the creditworthiness of the client company and the marketability of the asset(s).

Key facets of a term loan include:

  • Amount , which may be based on a percent of the underlying assets.
  • Type of amortization -full or partial amortization.
  • Length of amortization .
  • Interest rate .

Term loans are also used to provide permanent working capital. Given the relative financial strength and stage of the borrowing company, some lenders will seek a guarantee from the Small Business Administration (SBA) to reduce the risk of the loan to them (see the section later in this chapter on the types of SBA loans).

Other Types of Asset-Backed Lender Financing

Among the other types of ABL financing, we list a few:

  • Capital expense (capex) lines of credit assist capital-intensive companies with preapproved financing for equipment purchases.
  • Import financing provides cash to secure inventory when the end buyer has acceptable credit and/or the underlying commodity is exchange traded or has a large liquid market. 21 Figure 5.5 provides a typical example of the import financing process.
  • Debtor-in-possession financing supports bankruptcy reorganizations.
  • Sales leaseback arrangements provide a method to refinance existing fixed assets and owner-occupied real estate. See additional content on this topic later in the chapter under the "Leasing Companies" section.
  • Venture banking or trade tranche is a concept similar to trade finance. Transcap Trade Finance in Northbrook, Illinois, provides what it terms a "global trade tranche." Transcap acts on behalf of a client company to purchase finished goods inventory for a fee, primarily from non-U.S. suppliers. Then Transcap supports order fulfillment from the purchasing of the inventory through delivery to the client's customer by monitoring the transactions logistics. The funding is provided almost without regard to the current financial condition of the client. What must be clear is Transcap's exit. This type of transaction is usually completed in 30 to 120 days at a fee of 1 to 3 percent of the inventory cost per month. The funding can even work for a start-up if it can convince Transcap that the overall opportunity is significant. On the other end of the spectrum, it is appropriate for $500 million and larger companies with cash flow issues. The value for the client company is access to goods, global purchasing expertise and logistics, improved cash flow, and nonimpairment of existing working capital. It does not work for the purchase of services or intellectual property. 22

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  • Transactional Equity (a trademark of IIG Capital LLC) consists of co- financing the down payment required by banks as part of credit or other financing. This is an attractive structure for merchants whose transactions backlogs exceed available capital because it allows them to add incremental profit to their bottom line. 23 Figure 5.6 illustrates a typical transaction.

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  • Warehouse financing involves the use of securely stored goods as financing collateral. It allows companies operating in the soft commodities as well as in the mining, metals, and petroleum industries to deposit their inventory in a secure warehouse operated by an independent party. The warehouse operator provides a receipt certifying the deposit of goods of a particular quantity, quality, or grade. A company can use the receipt, usually by transferring title, to obtain financing. From a financier's point of view the credit risk of certain companies may be unacceptable. But the potential client may have a viable business. If the client has an inventory of commodities, waiting to be delivered to buyers, the financier can shift the credit risks away from the client by financing the commodity and not the commodities firm. Through the use of warehouse financing, the financier utilizes the services of an independent, bonded collateral manager to control the underlying goods, thereby mitigating the credit risks of the commodity processor, trader, or intermediary. In case of bankruptcy or payment delays the financier can liquidate the goods in order to make itself whole. 24 Figure 5.7 illustrates the process.

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The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.