Is the Interest Rate or Cash Flow of a Loan More Important?

Do you think that a conventional bank loan or an SBA guaranteed loan is the best option for a business that wants to finance the purchase of new equipment?  Many experienced business people, and even some bankers, might quickly answer that conventional bank loans are a better option.  But they shouldn’t be too quick to answer without further investigation.  To accurately answer the question, they should first seek to understand if the goals of the company are dependent on maximizing short-term earnings or if the company would be better served by maximizing cash flow and long-term earnings.

If the goals of the company rely on maximizing short-term earnings, then conventional bank loans will beat an SBA guaranteed loan every time because of the differences in upfront fee and interest rates.  Banks don’t always charge an upfront fee for conventional bank loans, but when they do the fee is usually 1.0% or less of the loan amount.  SBA guaranteed loans require that borrowers pay a loan fee of between 2.5% and 3.5% of the guarantee amount of the loan.  Conventional bank loans also carry interest rates that are typically 100 to 300 basis points lower than SBA guaranteed loans.  Those two factors will cause conventional bank loans to be the less expensive option for borrowers and will thus help companies maximize short-term earnings.

However, for most small- and medium-sized businesses, their goals aren’t dependent on short-term earnings.  Most companies seeking a loan are doing so because they don’t have the cash available to pay in full for the equipment at the time of purchase, or they are conserving their available cash to support future growth.  In both of those instances, cash flow is more important to a company’s success than short-term earnings.  Maximizing cash flow helps companies reduce the risk of going out of business, and gives them the resources to support growth that can maximize future earnings.  So in those cases where the goals of the company are dependent on maximizing cash flow, choosing an SBA guaranteed loan is the best choice for the company.

SBA guaranteed loans will always provide borrowers with higher cash flow than a comparable conventional bank loan.  This is possible because when compared to conventional bank loans, SBA guaranteed loans have a higher advance rate against the collateral, and longer amortization periods that allow for a slower repayment of the loan.  The cash flow advantages of the higher advance rate and longer amortization period will outweigh the negative cash flow effect of the higher interest rate and loan fee charged on an SBA guaranteed loan.

The table below highlights the cash flow advantages of an SBA guaranteed loan by comparing the cash flow of a $1 million equipment purchase financed with an SBA guaranteed loan versus a conventional bank loan.  For this loan, a bank will typically lend only 75% of the purchase price, requiring the company to fund $250,000 of the equipment purchase price.  The bank will also only allow an amortization of the principal over a 5-year period.  For that same equipment, if the bank utilizes the 7(a) SBA guaranteed loan program and advances 80% of the purchase price (they can advance up to 90%), the company would be required to fund only $200,000 at the time of purchase.  The SBA program can also accommodate an amortization of the principal over a 10-year period if the equipment has an adequate useful life.  What this means is that the SBA guaranteed loan, with the fees added to the initial loan balance, will result in the borrower having to use $103,000 less cash in year one of the loan, and $317,000 less cash over the first five years of the loan, when compared to a conventional bank loan.  The cash flow impact doesn’t turn in favor of the conventional bank loan until year 8 of the SBA loan (long after the conventional bank loan has been paid off).

Equipment Loan

The professionals at Waypoint Private Capital have a significant amount of experience helping companies analyze different loan options so they can select the type of loan that best matches their goals.  We also work with clients to find lenders that are a good fit for their company and help them negotiate the terms of the loan.  If you would like to discuss a new loan need or the refinancing of existing debt, please give us a call.  You can find the contact information for our professionals at Waypoint Contact Info.

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How to Sell Your Business to a Competitor

game of chessWhen a business owner decides it is time to sell his business, one of the many decisions he will have to make is whether he is willing to sell to a competitor. There are other types of buyers to consider, including financial buyers (private equity firms, high net worth individuals), family members, and employees. However, because of the synergies that can be achieved, competitors are often willing to pay the highest price for a business. So if your primary goal when selling your business is to maximize value, competitors should definitely be included in the list of potential buyers.

Although the process of selling to a competitor is similar in many ways to selling to any other type of buyer, the seller and his advisors should be cautious when sharing proprietary data with competitors. The proprietary data needs to be released in a modulated manner at the appropriate time and in suitable form. Following are areas where a careful and gradual release of information is important:

The initial solicitation of buyers should include a blinded executive summary.

One of the first outward facing activities in the process of selling a business is putting together an executive summary (often called a “teaser” by industry professionals) and sending it to all agreed upon prospective buyers. When including competitors in the buyers list the executive summary should be blinded, which means it will not include the company name or any other information that would allow recipients to identify the business for sale.

Have all interested prospective buyers sign an NDA.

It is standard practice for professionals in the industry to have interested prospective buyers sign a non-disclosure agreement (NDA) that prohibits the company from using the information for any purpose other than the evaluation of the acquisition. NDAs typically include clauses forbidding the signing party from sharing the information or soliciting employees of the seller for hire for a period of twelve to twenty-four months after the signing of the agreement. After this agreement is signed the investment banker (i.e., M&A Advisor) will release the name and location of the company and typically send the full confidential offering memorandum.

Limit the inclusion of sensitive information in the confidential offering memorandum.

The goal of the offering memorandum is to expand on the limited information contained in the executive summary. It should provide the prospective buyer with enough information to begin their evaluation of the company and decide if there is a true strategic fit with their company. The investment banker preparing the document should work with management to anticipate and answer most questions a buyer will have. However, there is a significant amount of information that should be left out of the offering memorandum and reserved for the due diligence stage of the process. For example, a detailed customer list should not be included in an offering memorandum. Instead, and what an informed buyer should really be evaluating anyway, the offering memorandum can include information about customer concentration and key distribution channels. This data will give them enough information to perform their critical analysis but not enough information to interfere with the seller’s customers if they are not the successful buyer.

Vet the interested potential buyer before sharing additional information

As sellers and their investment bankers start interacting with prospective buyers it is very reasonable for the sellers to request financial information, business plans, and other pertinent information from the prospective buyers. This information will allow sellers to determine if the buyer has the financial strength to complete the transaction and has thought through the transaction in enough detail to describe their post-acquisition plans and expected synergies. If they are not willing to share some of their information that should raise a red flag about their real intentions and cause the seller to become even more cautious about sharing their sensitive information.

Reserve truly sensitive information until after a single buyer has been selected and Letter of Intent (LOI) to purchase the company has been signed.

Truly sensitive information such as detailed customer lists, pricing, customer and supplier contracts, and detailed new product and R&D efforts should not be disclosed untila LOI has been signed with a single buyer and the company has entered into due diligence. Even then, if the size of the transaction is $78.2 million or higher (as of 2/25/2016 and adjusted periodically) and thus the transaction is subject to a Hart-Scott-Rodino antitrust filing and review, the seller should consult experienced legal counsel before revealing certain sensitive information (see Kirkland Article – dated but informative). If there is certain information the seller believes is too sensitive to share with the prospective buyer prior to the closing of the transaction, but the buyer insists on reviewing, the parties may be able to compromise by having a qualified third-party consultant review and opine on the detailed information without sharing the details directly with the buyer. A cautious but flexible approach to sharing the data will be important for completing the sale.

Business owners should not make the mistake of excluding competitors from the buyers list when selling their business because selling to a competitor is often the best choice. Despite the competitive risks involved, if the sale process is managed in a competent and collaborative manner by the investment banker and business owner, sensitive information can be shared gradually and in the appropriate format such that the prospective buyer can complete the necessary due diligence and close on the acquisition while minimizing the competitive risks to the seller. The professionals at Waypoint Private Capital have significant experience managing the sell-side transaction process and helping business owners navigate the challenges of selling to a competitor.

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What is Your Company Worth?

Ballmer BasketballWhen the professionals at Waypoint Private Capital are talking to business owners about selling their companies, one of the questions we are always asked is, “What is my company worth?” We have quite a bit of finance and valuation education and experience, so after analyzing a company’s financial statements, risk factors, and market variables, we can determine a theoretical valuation for the company. However, theory only determines what the company should be worth, while real buyers in the market determine what it is really worth. John Naisbitt summed up market based valuation best with his famous quote, “Value is what people are willing to pay for it.”

 Theoretical Valuation

Theoretical valuation is an academic method for estimating the value of a company. For stable and mature companies, the easiest starting point for valuation is determining what the EBITDA multiple is for companies with similar characteristics then multiplying that factor by the EBITDA of the company. Likewise, for some companies it is more appropriate to determine a revenue multiple for similar companies and multiply that factor by the revenue of the company. Another theoretical method commonly used is the Discounted Cash Flow (“DCF”) method, which discounts the projected free cash flow of the business by an appropriate risk adjusted rate of return to determine a present value of future cash flow and thus the value of the business. Yet another theoretical valuation method focusses on net asset values in either an orderly liquidation or forced liquidation situation. The multiples and discounted cash flow methods should lead to similar valuations that are a good indicator of theoretical valuation, while the asset value methods are more appropriate for setting a valuation floor. Despite their academic and theoretical basis, none of these valuation techniques will necessarily lead to the sale price of a business.

Market Value

A business owner can never really know what their business is worth until they sell it. When a sale occurs it is a clear indication of the value at least one real buyer puts on the company. The best way ensure that maximum value is achieved is to create a market for the company by inviting a group of interested buyers to evaluate the relevant information about a company and make an offer to buy it. When multiple offers are received and simultaneously negotiated, the maximum valuation is quickly discovered. Each potential buyers will evaluate the company from their own perspective, adding value for opportunities they identify for the company, and subtracting value for perceived risks. The benefit of this method is that there will inevitably be a buyer who sees more opportunities and fewer risks with the business than others evaluating the opportunity. We have seen buyers who wanted to gain a quick foothold in a market pay an EBITDA multiple of twenty for a company with a theoretical value of five times EBITDA because they determined that strategically they just could not risk losing the bidding process for the company. We have seen financial buyers pay six times EBITDA for a company when all other buyers were willing to pay only four times EBITDA because that financial buyer had not completed a deal in two years and was feeling pressure from their investors. We just cannot know what will drive buyers to bid more than theoretical value until they are given the chance to buy the company.

One very public example of a buyer paying much more than the theoretical value of a business is when Steve Ballmer (former CEO of Microsoft) bought the Los Angeles Clippers professional basketball team in August 2014. In January 2014, Forbes had published an article estimating the value of the team to be $575 million, yet Ballmer paid $2.0 billion for the team months later. The acquisition price defied all logic and theoretical valuations for the company, but Ballmer’s perspective is quite different than that of most others. He had just finished a career at Microsoft where he was used to paying very high multiples for acquisitions of technology companies with no earnings and significant risks, and thus saw an acquisition of a profitable NBA franchise as a relatively riskless investment. Additionally, he had a net worth $21 billion at the time and really wanted to own an NBA franchise, so securing the deal was much more important to him than paying a reasonable valuation.

There are all sorts of factors that enter into the logic of potential buyers that do not follow the norms of theoretical finance and valuation techniques. Waypoint has a great deal of experience preparing companies for sale and running a sale process that creates a market for companies and reveals the maximum price a buyer is willing to pay for a company at that time. We would be happy to talk to you or your clients in more detail about how we help business owners maximize the sale prices for their companies.

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Are Capital Constraints Negatively Impacting Year-End Planning?

capConstraintDecember is always a challenging month for executives as they finalize their budgeting and planning for the next year while simultaneously trying to meet their goals for the current year. Despite the importance of this budgeting and planning, we find that many middle-market companies undertake this process in the shadow of capital constraints and thus limit the opportunities they pursue.

Planning in the Shadow of Capital Constraints

Budgets and planning at middle-market companies are usually prepared within the bounds of the unwritten rule that the only money available to support those plans is capital already in the business or that which will be generated from operating cash flow. With those bounds in place the result is predictable – slow to modest growth at best. But what might happen if that constraint is removed and executives are challenged to submit plans that are not limited by the status quo and perceived available cash? What if, for example, the sales executive is asked to consider acquisitions of competitors in different geographic regions of the country as part of her plan? Or acquisitions of companies with complimentary products that can be added to the product offering. Similarly, what would happen if executives are told that revenue estimates and new product development should not be limited by the capacity and capabilities of existing manufacturing equipment?

Understand the Current Cash Flow

If capital is going to be removed as a constraint of the company, the executives need to have a solid understanding of their existing cash flow. They should start by reviewing the cash flow statements for the company if they are available, or the balance sheets if they are not. Common items that use cash but do not appear on the income statement include increases in the asset accounts on the balance sheet (e.g. accounts receivable, inventory, prepaid expenses, equipment, other fixed assets), and decreases in liability accounts (e.g. accounts payable, accrued expenses, notes payable). If any of those balance sheet changes are large on a monthly or annual basis management needs to dig into them to understand the changes and try to manage and finance them if possible. Maybe sales with a key customer have increased rapidly but their payments are falling behind. Maybe the purchasing manager is buying higher quantities of materials in an effort to receive a discount, but those inventory levels are not supported by sales. Maybe the current debt is being paid down too fast. All of those issues will be revealed on a cash flow statement or by examining changes on a balance sheet.

Rapid growth is an example of an activity that can cause a cash flow issue but is commonly misunderstood by executives because it looks great on an income statement. An example is the easiest way to explain it. Suppose a company receives a $1 million order from Wal-Mart, who wants it to arrive at their distribution center in 120 days so they can have it on the shelves in 150 days. If the company outsources its manufacturing to China they likely have a lead time on the order of 90 days, but to allow for possible delays they place the order 120 days in advance. If the fully loaded manufacturing cost is $600,000, they will need to pay $180,000 (30%) at the time of the order, and $420,000 (70%) thirty days later when it is completed and shipped by the manufacturer. The company will receive and warehouse the product until it is ready to ship to the customer. Wal-Mart will pay for the order 60 days after it reaches their store shelves, but wants it in their distribution center 30 days before it will hit the shelves. That entire timeframe from when money was first paid for the inventory until payment was received from the customer is 210 days, with the weighted average time of 189 days. That timeframe is commonly known as the cash conversion cycle. The deceiving part of a large order like the one in this example is that the associated revenue and expense will hit the income statement when the product is shipped to Wal-Mart, and it will have a positive impact on profitability, but for 120 days before, and 90 days after booking that revenue the company will have that $600,000 of cash tied up. Therefore, the executives need to understand the cash conversion cycle and that $600,000 will be tied up for every $1 million in growth for a weighted average of 189 days for this customer. That type of slow cash conversion cycle can cripple a business and potentially cause its collapse if it is not understood and planned for.

Find the Necessary Capital

Financing solutions are available to make acquisition and capital equipment purchases possible, as well as alleviate the pressure of fast growth and extended cash conversion cycles. Sometimes that solution can be found at a company’s existing bank if the opportunity or problem is adequately modeled and explained to the loan officer. Other times the opportunity will need to be marketed to a broader audience of banks and finance companies to find an institution that adequately understands the risk and is willing to structure the loan more aggressively or include collateral that the existing bank will not. Some financial institutions are adept at using government guaranteed financing such as SBA and USDA guaranteed loans to help the borrowers. Others will finance overseas inventory or purchase orders that are exceedingly difficult to get financed by typical banks. Finally, if senior lenders are not the best financing solution, there are subordinated debt lenders and equity investors who are willing to invest in compelling opportunities.

In 2015 Waypoint worked with a company that wanted to remove their capital constraints so they could continue to grow. The company debt had been spread among a number of banks who were all approached about restructuring it but were unwilling to make any accommodations. The company then engaged Waypoint to analyze the situation and present the opportunity to appropriate financing sources. We were successful in securing $22 million in bank debt for the company that paid off the other lenders and increased the annual cash flow of the company by over $700,000. That increase was significant for the company and will allow them to continue pursuing their growth initiatives.

If management takes a different approach to budgeting and planning, one which is not constrained by capital, but rather by the availability of good opportunities, the budgets and plans for next year will look much different. Reducing constraints by adding financing options can result in companies that grow faster, are more competitive, and more profitable. Waypoint Private Capital welcomes the opportunity to work with management teams to explore their financing options and source, negotiate, and close on the appropriate financing.

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Communicating With Capital – Part 2 – After the Deal is Done

Capital is one of the essential ingredients necessary for starting and growing a company. That capital can come from an angel investor, venture capital firm, private equity firm, bank, or one of the many other available capital sources. Regardless of the source, once you take their money they are a stakeholder in your company. All stakeholders have contractual rights to certain information, but we have found that going beyond contractual requirements and communicating openly and regularly with your investors and lenders will always serve you better than just providing the minimum amount of information required.

Try to keep the following in mind when dealing with your stakeholders:

Send monthly financial statements
Nothing tells a company’s story better than financial statements, so the absolute minimum level of communication you should have with your stakeholders is sending them monthly financial statements (income statement, balance sheet, and cash flow statement). Include explanations for anything out of the ordinary and an offer to answer any questions.

Discuss the good and bad so there are no surprises
Sharing good news is easy. It might even result in an “atta boy” or two. However, effective communication with your stakeholders should also include the bad news and challenges being faced by the company. By sharing both the good and bad, management will build the trust and continuing support of the stakeholders.

Share your plans before implementing them
Businesses are continually evolving and reacting to opportunities and changes in their marketplace. Before making any major changes or implementing significant new initiatives, call or meet with your stakeholders to discuss your plans. Knowing you will have to explain yourself will help you fully think through the business case for your plans and thus make better decisions. The discussions with the stakeholders will also allow you to hear their perspectives, which are often different than yours, so you can take them into consideration before finalizing your plans.

Do not talk to them only when you need something
Your relationship with most of your stakeholders probably started when you had a need for capital. That is completely acceptable. However, for that initial “transaction” to become a “relationship” you need to communicate with your stakeholders regularly. The easiest way to do that is to treat them as advisors, even if they aren’t a formal advisor. If you only communicate with your stakeholders when you need something, you are showing great disrespect and eventually they won’t be there when you need them.

Address problems early so you will have more options
If a stakeholder receives a call telling them the company needs money by the end of the week to make payroll, or avoid defaulting on a contract, or any other bad situation, the stakeholder will have a hard time helping. First of all, most investors and lenders do not have the ability to react quickly to those situations. Second, a call like that is a red flag to stakeholders alerting them to poor management or someone who is trying to pull the wool over their eyes. With little notice, stakeholders have few options other than saying no to the request. However, if they had been alerted to the possible need a month or more earlier, they could have explored different ways to help, run the request through their established internal processes, or made appropriate recommendations or introductions. More time always results in more options.

Effective communication with your stakeholders after the deal is done is essential for building relationships and making sure your stakeholders continue to support you and your company. If you simply make a habit of openly and regularly touching base with your stakeholders you will build strong relationships that will serve you well in good times and bad.

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