The SBA has finally realized the error of their ways and reversed their Standard Operating Procedure change enacted on March 1, 2009. The SBA, at a time when small business sellers and buyers needed them most, made the decision to limit the amount of goodwill a bank could finance in a business acquisition loan. The rules change restricted a lenders’ ability to finance goodwill under a 7(a) program for the lesser of 50% of the purchase price or $250,000, whichever is less. The effect of this change was catastrophic - causing the banking industry to essentially halt most, if not all, lending related to business acquisitions. In a business sale transaction the Goodwill is the amount of the purchase that is over and above the value of the fixed assets in a business. This SBA change was particularly acute given the fact that most US businesses are service based with the majority of value derived from Goodwill.
After months of lobbying by various industry groups the SBA has taken steps to correct their mistake. Effective October 1, 2009, the new rules will now allow for Goodwill and Intangible Assets as follows;
A) Financing of a loan with Less Than $500,000 of Goodwill is ALLOWED without Restrictions
B) Financing of a loan with More Than $500,000 of Goodwill is Permitted IF the combined equity from the Buyer and Seller is 25% or more of the Purchase Price
C) Financing of a loan with More Than $500,000 of Goodwill AND the equity from the Buyer and Seller is less than 25% MAY still be eligible, however it will require a full SBA approval under CLP and GP processing.
These changes combined with the SBA’s 90% loan guarantee to the banks is VERY positive news. It will take awhile for this change to filter through and impact small businesses but these actions are a big step in the right direction and to be applauded.
The challenge that will remain is the declining financial performance of many small businesses. Thus, business acquisition lending will probably not come back in a big way until the top and bottom lines of these businesses recover from the effects of the worldwide recession. The good news is that many small businesses have attacked their expenses through layoffs and the introduction other cost cutting measures and it may not take very long to see positive earnings when the economy turns around.
Wednesday, September 16, 2009
Tuesday, September 8, 2009
Factoring to Finance a Business Acquisition
Financing has been a common theme for most of our blog posts this year. The lack of bank funds for business acquisitions has left the marketplace to scramble for alternatives. One such option is to 'factor' a company's receivables to secure a transaction. Factoring is simply the ability to obtain upfront cash against a company's accounts receivables.
As with most financing options, factoring has its pros and cons, and I recently had the opportunity to interview Sean Lelchuk of Bibby Financial Services to learn more about this service. Below is a recap of my interview with Sean and some insights into how this may apply to your business acquisition plans.
First, a little background on Sean and Bibby Financial. Bibby Financial Services is an independent, family owned business that operates in 27 countries. Bibby provides receivables funding services for domestic and export receivables, and purchase order financing. Sean is a Business Development Officer in their Florida office and is responsible for assisting clients with their factoring needs. Sean is a former small business owner and understands the importance of having access to capital for business growth and maintenance.
Interview with Sean Lelchuk from Bibby Financial Services:
Q: Please explain factoring.
A: Factoring is where an advance of cash is made to a Client against the purchase of an accounts receivable by a financing company (aka Factor). The Factor then proceeds to collect the receivable. The balance of the receivable less any fees due to the Factor is then payable to the Client on collection of the receivable by the Factor. Factoring is an effective way for a business to finance growth or to assist in the restructuring of a business. It is also a means by which an acquiring company may leverage existing assets of a target company as collateral for secured financing to help close a deal. It also does not lead to any loss in equity of your business nor does it involve taking specific security over personal assets.
Q: How can factoring be used to help buyers and sellers in a business sale transaction?
A: For the buyer, there are two main ways to use receivables finance to creatively finance an acquisition transaction.
1. Funding your receivables: In this scenario, you establish a factoring facility on your own receivables to extract cash out of your business to bring to the closing table. Usually, this can be done on a relatively short term basis allowing for the purchase of the target company with the conversion of a current asset.
2. Funding the target company's receivables: This approach is a little bit more complicated, but can work to even greater advantage. Assuming it is an asset sale, you can work with a factoring company to finance the existing receivables of the target allowing for the seller to essentially help finance the sale of their business. At the closing table, the factoring company will provide an advance on the outstanding receivables of the seller's company to contribute to the cost of acquisition.
For the seller, the advantages of this approach are that the seller usually does not need to offer direct financing to the buyer, can "take home" some of the money they have earned through delivering their product or service, and can, in some instances, offer this method as a way to finalize a deal.
Q: What are the Pros of Factoring?
A: The biggest pro in working with a factoring company is that the main determinant in whether or not the funding will come through is the credit of the business's customers - not the credit of the buyer or seller or their companies. To obtain traditional debt financing everyone knows that it can be a challenge to close on a facility, especially for an acquisition, and more challenging in these times. The other pros are that you will also acquire a built in credit team to monitor the business's customer quality and aid in decisions to sell to new customers, a collections team to help make sure payments are received in good order, and access to other types of secured financing as most factoring companies have a long list of colleagues that finance other assets (i.e. equipment, inventory, property, etc.) that may prove to be helpful in the event additional funding is needed. Also, factoring companies do not require the submission of a regular borrowing base certificate and all the time necessary to compile one, and in the event additional availability on the facility is needed it is much easier to obtain an increase from a factor than it would be with a bank - if the invoices are there and the debtor credit is good, these companies make money by putting money out the door.
Q: What are the Cons of Factoring?
A: Most often the biggest concern is cost. It is true that factoring rates are higher than a traditional line of credit, but the flexibility with a factor, the ease with which a factoring facility may be obtained, and the opportunities that can be realized usually outweigh the additional cost. There is documentation that is required on a regular basis, but this is usually related to the transactions conducted by the business (i.e. PO's, invoices, and proofs of delivery) and is typically readily available. Customer notification and invoice verification can be worrisome for those who are guarded with their customers, but I have found that this is usually managed very well by the better factoring companies.
Q: Can you give a recent example of how you used factoring in a sale transaction?
One other item to look into is whether the assets are currently secured.
In this case, you must make sure that the receivables you intend to use as collateral are unencumbered since almost all factoring companies require a UCC-1 filing in the first position on at least the receivables themselves. The best way to avoid these issues is to do your due diligence and speak directly to a factoring company that is capable of handling these types of transactions during the purchase and sale negotiations.
Q: What are the costs of Factoring and typical terms?
In these uncertain times, finding creative ways to finance an acquisition is a given. You need to be aware that the cost of money derived from factoring receivables is usually higher than if you were to take out a traditional loan or line of credit, but the flexibility and ease of obtaining increased limits often allow for more business to be transacted or supplier discounts to be realized, thus offsetting (an in some cases eliminating) the effective costs.
As with most financing options, factoring has its pros and cons, and I recently had the opportunity to interview Sean Lelchuk of Bibby Financial Services to learn more about this service. Below is a recap of my interview with Sean and some insights into how this may apply to your business acquisition plans.
First, a little background on Sean and Bibby Financial. Bibby Financial Services is an independent, family owned business that operates in 27 countries. Bibby provides receivables funding services for domestic and export receivables, and purchase order financing. Sean is a Business Development Officer in their Florida office and is responsible for assisting clients with their factoring needs. Sean is a former small business owner and understands the importance of having access to capital for business growth and maintenance.
Interview with Sean Lelchuk from Bibby Financial Services:
Q: Please explain factoring.
A: Factoring is where an advance of cash is made to a Client against the purchase of an accounts receivable by a financing company (aka Factor). The Factor then proceeds to collect the receivable. The balance of the receivable less any fees due to the Factor is then payable to the Client on collection of the receivable by the Factor. Factoring is an effective way for a business to finance growth or to assist in the restructuring of a business. It is also a means by which an acquiring company may leverage existing assets of a target company as collateral for secured financing to help close a deal. It also does not lead to any loss in equity of your business nor does it involve taking specific security over personal assets.
Q: How can factoring be used to help buyers and sellers in a business sale transaction?
A: For the buyer, there are two main ways to use receivables finance to creatively finance an acquisition transaction.
1. Funding your receivables: In this scenario, you establish a factoring facility on your own receivables to extract cash out of your business to bring to the closing table. Usually, this can be done on a relatively short term basis allowing for the purchase of the target company with the conversion of a current asset.
2. Funding the target company's receivables: This approach is a little bit more complicated, but can work to even greater advantage. Assuming it is an asset sale, you can work with a factoring company to finance the existing receivables of the target allowing for the seller to essentially help finance the sale of their business. At the closing table, the factoring company will provide an advance on the outstanding receivables of the seller's company to contribute to the cost of acquisition.
For the seller, the advantages of this approach are that the seller usually does not need to offer direct financing to the buyer, can "take home" some of the money they have earned through delivering their product or service, and can, in some instances, offer this method as a way to finalize a deal.
Q: What are the Pros of Factoring?
A: The biggest pro in working with a factoring company is that the main determinant in whether or not the funding will come through is the credit of the business's customers - not the credit of the buyer or seller or their companies. To obtain traditional debt financing everyone knows that it can be a challenge to close on a facility, especially for an acquisition, and more challenging in these times. The other pros are that you will also acquire a built in credit team to monitor the business's customer quality and aid in decisions to sell to new customers, a collections team to help make sure payments are received in good order, and access to other types of secured financing as most factoring companies have a long list of colleagues that finance other assets (i.e. equipment, inventory, property, etc.) that may prove to be helpful in the event additional funding is needed. Also, factoring companies do not require the submission of a regular borrowing base certificate and all the time necessary to compile one, and in the event additional availability on the facility is needed it is much easier to obtain an increase from a factor than it would be with a bank - if the invoices are there and the debtor credit is good, these companies make money by putting money out the door.
Q: What are the Cons of Factoring?
A: Most often the biggest concern is cost. It is true that factoring rates are higher than a traditional line of credit, but the flexibility with a factor, the ease with which a factoring facility may be obtained, and the opportunities that can be realized usually outweigh the additional cost. There is documentation that is required on a regular basis, but this is usually related to the transactions conducted by the business (i.e. PO's, invoices, and proofs of delivery) and is typically readily available. Customer notification and invoice verification can be worrisome for those who are guarded with their customers, but I have found that this is usually managed very well by the better factoring companies.
Q: Can you give a recent example of how you used factoring in a sale transaction?
A: Recently, a venture fund wanted to acquire a company that manufactures flooring and sells to distributors. The fund had allocated a set aside amount for the acquisition, and expected, based upon purchase and sale negotiations that it would be sufficient to close the deal. At the last minute, the seller decided to raise the selling price due to an uptick in backlog orders and argued that the price increase was justified by the addition of the pending business. The fund went back to management, but was denied an increase in allocation for the purchase. The lead agent contacted one of our brokers who directed him to us. We discussed the opportunity, reviewed the supporting documentation (i.e.transactional paperwork for the target company's typical sale, financials, receivables and payables, legal entity documentation, etc.) and the revised draft of the purchase agreement. We proposed on the transaction where we would finance the receivables of the target company for 12 months at the specified discount, advance on the eligible receivables outstanding at the time of purchase to contribute the shortfall created by the revised selling price for the business, and the fund was pleased that they did not have to come up with additional cash to finalize the deal. The target company did not have any secured financing, so we were able to secure the assets and close on the transaction.
Q: Where are the pitfalls in this type of acquisition financing?
Q: Where are the pitfalls in this type of acquisition financing?
A: The biggest thing you want to watch out for using receivables financing as collateral for secured funding in an acquisition transaction is that you do not want to strip the target company of operating capital. This may happen by taking too large an advance on the receivables to support the purchase - make sure the company will have sufficient working capital to operate when the transaction closes and those funds are removed from the business. Another thing you want to watch out for using receivables (or any other asset) as collateral for secured financing in an acquisition transaction is that you do not pay too dearly for the asset as a line item in the purchase agreement. If the seller wants to sell at a price over book value of the asset try to structure the purchase such that you pay for the book value at closing and any amounts over that (i.e. goodwill) on a schedule out of future profits from the accounts sold or as some kind of royalty. Make sure that any receivables collected by the seller during the negotiation stage are either removed from the asset listings or credited against the purchase price. You may want to include a provision in the purchase agreement that allows for a credit or repayment for any accounts uncollected (bad debt) after 90 days from closing. As an alternative to the above, you may consider setting an allowance for bad debt/uncollectable accounts and discount that from the purchase price.
One other item to look into is whether the assets are currently secured.
In this case, you must make sure that the receivables you intend to use as collateral are unencumbered since almost all factoring companies require a UCC-1 filing in the first position on at least the receivables themselves. The best way to avoid these issues is to do your due diligence and speak directly to a factoring company that is capable of handling these types of transactions during the purchase and sale negotiations.
Q: What are the costs of Factoring and typical terms?
A: Some factoring companies will provide you a rate sheet showing you what discount they will take for x number of days an invoice is unpaid. I find this to be misleading and counterproductive since each business is unique and you cannot put a generic formula to task for businesses in various industries, operating a differing volumes, and, most importantly, with very different customers. Most factoring contracts are structured on a 12 month commitment with minimum monthly factoring volumes. They are typically full-turn which means that all invoicing must be submitted to the factor regardless of whether or not you want an advance on the sale. Advances, once product or service is delivered and verified (directly by the factoring company), range from 70 - 95% of eligible receivables. Accounts that will be excluded from eligibility are those that are over 90 days old, are cross-aged (meaning that even though there may be outstanding invoices under 90 days, there are some, usually a percentage of total outstandings, that are over 90 days for the same account), and those for which a credit limit decision was unfavorable. Pricing can range widely and is dependent upon two main
criteria: 1. Debtor (customer) credit, and 2. Monthly volume. These items are inversely related to pricing - the better the quality of the customer and the higher the committed volumes, the better the rate. Rates typically range from 12 - 24% on an annualized basis.
Summary
criteria: 1. Debtor (customer) credit, and 2. Monthly volume. These items are inversely related to pricing - the better the quality of the customer and the higher the committed volumes, the better the rate. Rates typically range from 12 - 24% on an annualized basis.
Summary
In these uncertain times, finding creative ways to finance an acquisition is a given. You need to be aware that the cost of money derived from factoring receivables is usually higher than if you were to take out a traditional loan or line of credit, but the flexibility and ease of obtaining increased limits often allow for more business to be transacted or supplier discounts to be realized, thus offsetting (an in some cases eliminating) the effective costs.
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