What Do You Know About Your Financing?
Barf: “I’m a mog: half man, half dog. I’m my own best friend! “– quote from Mel Brooks Spaceballs :The Movie
I continue to experience some confusion by owners as to the nature of their financing agreements. When I ask what form of financing they have, I get responses which remind me of this line by Barf. I realize it can be complex and bankers, lawyers and even accountants seem to revel in throwing around terms like springing liens, clean up period and covenants and I am sure for most owners, this just serves to make their hair hurt. They wonder if their advisors and bankers are talking about some strange animal, their son’s bedroom (which never has a cleanup – period) or the Old Testament. So, let’s spend a few minutes describing three basic types of financing. By design, I am leaving out equity and more complex instruments like commercial paper, subordinated notes and convertible debt in an attempt to keep the suicide rate down. Let’s stick to basic loans from financing (legitimate) sources.
The first is a cash flow loan sometimes called an unsecured loan. The banker or financing source looks to historical and projected cash flows and determines the amount they will lend, the period of the agreement and how and when they will get paid back. This is true borrowing off the cash flow of the business and usually has the most favorable rate. While personal guarantees are less prevalent now, they come and go based upon the overall economy. These loans also usually have covenants – financial benchmarks you will need to meet to prove you are still worthy of this type of loan. This loan is the most common instrument for providing working capital to a profitable business.
Next is a secured loan. It is modeled similar to a cash flow loan but you may not be as credit worthy so the financial institution will take a security interest in (put a lien on) your assets – principally receivables, inventory and fixed assets. Many of the concepts under cash flow loans apply here and the rate is usually a bit higher.
Finally, there are asset based loans or ABL’s. This type of loan is for those struggling a bit where the financing source wants to monitor the overall level of debt. It is also a secured loan as the security interest is present but it is more formulaic – the company prepares a periodic borrowing base certificate containing eligible assets and negotiates a formula – usually a certain percent on receivables and inventory with exclusions for aging, concentration and foreign accounts. The result is the amount of borrowings the financial institution will allow. As you can tell, it is a bit more complex but it does force a discipline which keeps your borrowings within a range your assets can support. This type of financing can be costly as it limits overall availability and there are a number of fees (in addition to a higher interest rate) to cover. I would not suggest getting into this type of arrangement without some internal or external qualified financial personnel. Dealing with an ABL can be a bit overwhelming.
While every loan does not fall directly into one of these categories the vast majority do, so as an owner, an awareness of the basics should make you more knowledgeable as to your alternatives and also provide you (based upon the type of loan you obtain) with a view as to how the outside financing world perceives your business.
