LOAN CLOSING STRATEGIES DURING ECONOMIC VOLATILITY
Ben T. Nicholson
At a Glance
The following presentation was first delivered at the SBA Lender Training Conference held at the UGA Small Business Development Center at Kennesaw State University.
As interest rates remain high and lending standards tighten, alternative capital structures that include a working capital line of credit in addition to a term loan may help get a debt coverage-challenged deal over the finish line that a term loan alone is unable to do.
By utilizing an alternative capital structure that includes a working capital line of credit, as the assets fluctuate, so does the availability, allowing for access to cash to grow as the business grows, and tighten when necessary to ensure the business does not get overleveraged.
Hello, everyone – This is Ben Nicholson with Fortis Business Advisors. Thank you for taking a look at the following presentation. It was first delivered at the SBA Lender’s Conference organized by the University of Georgia Small Business Development Center at Kennesaw State University.
Some background about myself – I come from the small business and startup world. My first company was a 180 sqft gourmet food store on Madison Avenue in New York City that generated over $550k in revenue per year. And more recently, I developed 4 temporary “Pop-Up” stores from Atlanta across to Dallas liquidating the inventory from a defaulted apparel company. If you annualized the revenue on all 4 stores, it was a $3.5mm revenue company built in 3.5 months.
I have owned or been a partner in multiple businesses in multiple verticals that include food service, publishing and marketing, several retail stores, and advisory firms.
With Fortis, among the services that I provide I am most recognized as a turnaround management and liquidation advisor focused on helping small businesses in distress situations find a path forward or an exit for the highest possible return. However, I also assist with both buy-side and sell-side M&A transaction advisory, valuation validation, capital structure efficiency, and inventory and asset optimization, including inventory audits and appraisals.
As a business owner myself, I am a champion of small businesses.
SLIDE 1 – SMALL BUSINESS LOAN CLOSING STRATEGIES DURING ECONOMIC VOLATILITY
While what is being discussed can apply to other lending strategies, this has a particular focus on SBA lending.
When the economy goes through transitions that lead to uncertainty, there is a strong argument that turnaround and liquidation professionals offer a unique perspective when it comes to due diligence and performance improvement measures prior to a transaction or funding a startup. Because we view businesses through the lens of distress, we can oftentimes identify asset management and other issues that occurred long before challenges struct.
What you may find is there are some practices in the secured finance and turnaround management world that if exercised even on a cursory level may help get more small business deals closed, or at least ensure lenders don’t make loans they shouldn’t have.
SLIDE 2 – THE NEW ECONOMY
As I am sure many of you are seeing from the businesses on the market these days, we have a large generation of future retirees looking to sell their businesses – some stats say 31% of Boomers think now is the time to sell with 45% wanting the sale to fund their retirement.
But demographic transitions are playing a large part in the future success of many of these transactions. By 2034, there will be more Americans over 65 than children, which will potentially pose challenges to continuity with certain small businesses in the near and long term. While strategies like earnouts and seller notes may ameliorate some of the challenges, they, and the entire capital structure, must be set up in a manner that makes all parties comfortable that challenges that arise in the future will not potentially lead a seller to have to take back over a business because a buyers business plan blew up. With today’s economic volatility, this can make the post-transaction retirement scenario a little more tenuous.
Nevertheless, in keeping with the demographic theme, let’s apply the shifts to another level with what we could anticipate happening with the tech sector. If you want to do tech at scale you need people in their 20s and 30s to imagine the future, develop and prototype the tech, and then bring it to mass manufacturing before going to market. To do this, you need cheap capital because operating expenses need to be paid until when, and if, the company takes off. But those days are over. Baby boomers are retiring and shifting their financial focus, the oldest millennials are approaching their mid-40s, people in their 20s and 30s are demographically shrinking, and GenZ is the most educated but smallest generation we have ever had. Demographically speaking, tech companies that aren’t at operalization today may be too late.
Now let’s shift to the interest rate/inflation dynamic for some further context. The US response to Covid authorized $5t in govt spending. This coupled with rising commodity prices and supply chain disruptions were the principal triggers of the burst of inflation. But, as these factors have faded, tight labor markets and wage pressures have become the main drivers of the lower, but still elevated, rate of price increases.
In February of 2021, the CPI was 1.7% but rose to 5% in June 2021 to peak at 9% in June 2022. Or viewed differently since May 2020 our currency has lost 19.7% of its purchasing power with potentially more to come.
Historically, and these days this has become up for discussion, it is commonly known that the Fed aims to have inflation at 2% and short-term interest rates 2%-3% above inflation for an extended period. The current risk-free rate is 5.5% with inflation at 3.7% - we are not quite there, yet. So unless a crisis strikes, there is no reason to believe rates will be lowered anytime soon.
Also, historically speaking, one can argue we are actually in the process of returning to normal rates. Over the last 700+ years, average global nominal interest rates clocked in at 5.98% with inflation at 1.59%.
If you are a proponent of “regressing to the mean,” higher for longer could be for a lot longer.
SLIDE 3 – THE SMALL BUSINESS & LENDER DISCONNECT
In today’s environment, business owners and lenders find themselves in agreement less and less about what is bankable.
Small business owners are typically masters of their craft and rightfully believe in their business, but they often can’t get into the mind of a lender and overcome challenges like:
An overleveraged balance sheet
Working capital issues
Tightening coverage and operating ratios
Market share erosion
And note as we go through this that several of these issues are directly tied to the Balance Sheet.
Also, as I am sure you have all experienced, there is always a belief that a banker can be “convinced” that the business is credit-worthy because projections are “always accurate” even if they are clearly unrealistic.
The fact is, while there is a symbiotic relationship, entrepreneurs and business owners have challenges recognizing that lenders simply do not operate in the same risky business environments that they do, especially when they see there could be potential challenges with servicing debt.
SLIDE 4 – VALUATION & FINANCIAL ANALYSIS
A colleague refers to me as the Mark Baum of the small business world. As you may recall, Mark Baum was the character played by Steve Carrell in The Big Short who challenges everything and everybody as he tries to better understand what is unraveling around him.
I was once in a seminar on business valuations where the panel only touched on the Balance Sheet. Curious, I raised my hand to ask about assets, especially how inventory is dealt with, and the reply was that for the most part, an inventory or asset appraisal is not the focus. I understood why considering that valuation reports are often used to support transactions and help with cash flow loans but held a dose of skepticism as to how that might play out during economic volatility.
Profitability is necessary, but assets are where the cash is.
Understanding that the seller is oftentimes the client, and the objective is to get the highest value for both the seller and the potential capital deployment in a strong loan to a robust business, consider some of the details in the reporting that might give pause:
Projections can sometimes look like hockey sticks.
EBITDA adjustments can sometimes go a little too far, particularly with adjustments to salaries and other necessary operating expenses.
Gross profit margin and operating ratio fluctuations invariably need further explanation, or at a minimum corrective measures explained in the business plan.
Also, a better understanding of the quality of the cash-driving assets and any measures being taken to optimize those assets, including inventory, and cleaning up the A/R and A/P aging could be a welcome addition to the analysis.
A better understanding of what is driving these types of issues could go a long way to helping a lender get more comfortable with a loan, but clearly, that doesn't always happen. But let’s say the issues have been addressed, or at least corrective measures have been picked up in the buyer’s business plan. And yet, unfortunately, while there may not be a profitability issue, there is a cash flow issue that a lender just can’t quite get comfortable with.
What's an option to consider?
SLIDE 5 – A QUICK DIVE INTO THE ASSETS
Let's start by looking at the assets and see where it could lead.
As interest rates remain high and lending standards tighten, alternative capital structures that include a working capital line of credit in addition to a term loan may help get a debt coverage-challenged deal over the finish line that a term loan alone is unable to do. There is a quick and easy way to test if a working capital line of credit is even an option that originators can do well before the deal even lands on an underwriter’s desk.
Start with getting the Balance Sheet, A/R, A/P, and Inventory reports all with matching dates – This ensures everyone is talking about the same thing.
First, make sure the values from each report match the corresponding value on the Balance Sheet – If there is a discrepancy, how much and why?
Next, check if there is A/R that is over 90 days, and by how much. If the percentage over 90 days to the total outstanding is in double digits, you can pretty much shut this idea down and move on. Most accounts over 90 days do not get collected, and chances are the business does not have a bad debt policy. Also, if you see weight flowing into accounts going from 45 days to 60 days, check the collection policy, or if there is a problem with the product, the customers, or both.
Then inventory – if the inventory-to-sales ratio is over 25%, then there is a good chance there is some excess and obsolete inventory in the mix. Measure the actual inventory turnover against the optimal inventory turnover to see how much. Most businesses don’t need more than 4-6 months of inventory on hand. And if available, look at the date that the inventory was acquired, and the last date sold to check if there is any what we commonly call FISH inventory - First In-Still Here.
If you want to take it a step further, calculate the totals and deduct the uncollected A/R and excess inventory from the rolling 12-month Income Statement and see what it does to the EBITDA. Then measure that against the EBITDA multiple used in the valuation. Don’t be surprised if the results make the deal look a lot more palatable.
Finally, take a quick look at the A/P report and make sure there is not a flow of aging A/P that may be distorting what looks like a better, albeit unrealistic, cash position. If there is some weight in older payables, there is likely a cash problem.
And if you feel the need to go even deeper, consider analyzing a complete Borrowing Base. I have included an attachment at the top of this page.
If an originator sees there are problems in the assets, they could, and possibly should, cut bait and move on. It won’t solve the coverage issue, and problems don’t get better with age.
But let’s assume that we cleared this hurdle – we have clean A/R and A/P aging reports, and optimized inventory. At first pass, the business is eligible for a working capital line of credit.
SLIDE 6 – AN ALTERNATIVE APPROACH TO THE CAPITAL STRUCTURE
Let’s do this by example. You have a company ready to be purchased with a $1mm acquisition loan. It is a good company, ideal for SBA, but the debt coverage is not clearing the rate sensitivity hurdle, and the new buyer is maxed out on the equity commitment.
If the assets have checked out, instead of declining the term loan, consider spreading the risk:
Project the working capital needs and pull the cash needs out of the requested term loan.
We will use an A/R lender in this example. Once the cash is carved out, have an A/R Lender assess the quality of the receivables to determine eligibility for a Working Capital line of credit. Let’s say hypothetically there is $200,000 of eligible receivables, and the lender is comfortable with an advance rate of 85%. The working capital line of credit will start at $170,000 leaving the remaining balance for the term loan at $800,000.
After the revised capital structure is modeled, while acknowledging it is a moving target, reassess the Debt Coverage Ratio and see if it now clears the sensitivity hurdle. If it does, and the lender is more comfortable, while this may lead to a lower overall term loan deployment, it could also lead to getting a deal done.
Now, it is worth recognizing that with this capital structure, because it can get expensive in a hurry, the new business owner will be forced to manage cash, which will help with the overall health of the business. However, there is also a huge benefit - with the new structure, as the assets fluctuate, so does the availability, allowing for access to cash to grow as the business grows, and tighten when necessary to ensure the business does not get overleveraged.
And a few other things to consider:
If a receivables lender is not ideal, other asset lenders, including inventory lenders, can be tapped not only for a stand-alone line of credit but also if both asset classes show eligibility, another lender can come into the deal and help increase the access to cash and further spread the risk.
Also, a good asset lender may not have a problem carving out a month of availability to ensure an extra note payment is secured, or even set up a draw-down on the term loan.
And finally, for originators, it’s worth considering putting a package like this together before going to underwriting. If an asset lender has already approved, there is a good chance the underwriter could see a path forward.
SLIDE 7 – WHO WE ARE AND HOW WE HELP SBA LENDERS
While we are oftentimes referred to borrowers by lenders, particularly in assisting buyers and sellers pre- or post-transaction with strategies like the one discussed today, we also represent SBA lenders directly, particularly with:
Post-Default, Site Visit Support
Feasibility of Workout Plan Support
Inventory & Collateral Appraisal
Liquidation Plan & Recovery Estimates
Liquidation Sale Execution
Comprehensive Asset Recovery
SLIDE 8 – FORTIS BUSINESS ADVISORS
Fortis Business Advisors specializes in helping small businesses with $500k-$20mm in revenue in healthy or distressed situations transition through change.
We operate in 3 distinct verticals:
Performance Advisory - Performance Improvement, M&A and Transaction Advisory, Valuation Validation, Turnaround Management and Restructuring
Retail Solutions and Asset Maximization - promotional services, asset monetization, and liquidation services
And we are pioneers in the “Pop-Up” liquidation concept, creating unique selling environments to liquidate inventory assets.
Each service specializes in achieving a distinct outcome but is wholly integrable given the nature of the complexity being addressed.
And perhaps most importantly, we approach challenges from an owner’s perspective, which drives our uniqueness.
SLIDE 9 – Q&A
If you have any questions about the information presented, or if you would like to discuss how we can help, please contact Ben Nicholson directly at 770.744.0753 or firstname.lastname@example.org.