The New Economy & How to Borrow
After recent volatility, global financial markets steadied last week with investors’ nerves soothed by positive economic data from both China and India, together with reassuring noises from US Federal Reserve chief, Ben Bernanke.
Not that there weren’t some surprises and concerns however. BP’s share price plunged to a 14-year low at one point as Obama launched a scathing attack on the company’s chief executive, Tony Hayward, leaving investors fearful that BP would bow to political pressure and cut its dividend.
Such a move would hurt many pension funds – both here in the UK and in the US – as the company accounts for around 12% of all dividend income from the UK market according to The FT. On top, as a major part of the UK index, its share price fall, has accounted for around 250 points off the FTSE100’s recent decline.
At these levels the company is on our radar screen and I will be thinking about whether to take a material position. In my view however there’s no rush. The possibility of BP not paying a dividend is high and this may lead to further selling by American investors and UK income fund managers and if you’re buying for the long term a one off Dividend pass isn’t material.
What of the world economy though? Well, Chinese exports soared by almost 50% as consumers in Europe, the US and the ten largest emerging economies rediscovered their appetite for cheap clothes and steel.
RBS chief China economist said there was anecdotal evidence that the country is capturing market share from increasingly cost-conscious consumers, which is supporting its exports.
Whilst imports also rose 49.3%, China still managed to produce a huge rise in its trade surplus compared to April – $19.5bn versus $1.68bn – a point which won’t go unnoticed in Washington where there is pressure for legislative action against China.
At the same time, India reported industrial production rising 17.6% year on year, up from 13.9% in March. According to the World Bank, developing economies will expand by 5.7% to 6.2% a year over the next three years – growth last year was 1.7%. The Bank also forecast that global growth would be 3.3% this year and next, rising to 3.5% in 2012. So we need to look East!
Positive economic forecasts from the Chairman of the US Federal Reserve helped the Dow Jones last week to climb over 2%. Ben Bernanke told the House Budget Committee that the US economy appeared to be on track to continue to grow for the rest of this year and next, as consumer and business spending made up for the government stimulus measures that were tailing off.
The Times reported that the Fed expects the American economy to grow 3.5% this year although there is likely to be only a “slow reduction” in unemployment which currently stands at 9.7%.
Following on from Hungary’s comments last week that the possibility of the country defaulting should not be dismissed, Ben Bernanke used Europe’s troubles to press for a reduction in the vast US budget deficit. Failing to rein-in the deficit (estimated at $1.6 trillion next year) – will damage growth prospects.
In the UK, by contrast retail sales bounced back last month with sunny weather giving a boost to sales of clothing and also helping sales of DIY goods. But there’s still uncertainty and unease, which is making customers nervous about buying more expensive items.
The National Institute for Economic and Social Research warned that the economy still faced difficulty as a spill over of Greece’s debt crisis, which has taken the edge off some of the competitiveness of British exports as the euro has weakened. The industrial sector showed prices of imported materials fell between March and April though (partly due to imported deflation), which will go some way to off-setting the weakening of the Euro.
The current problems probably started back in 2000 when everybody started buying more debt: banks, consumers and more recently, Government.
The consequences are that the global balance sheet collapsed, so then did the financial system, which led to an extreme policy response – low, effectively zero interest rates and massive fiscal easing.
So where are we today?
The stimulus package has had little real impact on the economy and has largely stopped. The Government can’t afford to spend more on it, even if they were politically minded to do so, it just isn’t the Conservatives way, so we need to think about what happens next.
If GDP is unlikely to return to trend for a while then low growth of around 1% is a probable outcome.
First though, we have to understand what is creating the current volatility – I call it dashboard management ~ with the dials represented by the likes of sovereign debt, Chinese growth, changes in Libor and so on. Everyone knows what the problems are, but with a herd mentality, as the ball is kicked one way, everyone rushes after it, only to turn around and dash back again when the ball is returned.
The key component here is access to capital.
In the first phase of recovery it will be the small and medium sized businesses that are most at risk because as they seek to roll-over existing debt, the banks are only likely to agree to part of the requirement and the cost of provision will go up.
Cash is still king then, in a capital constrained world where the strong companies keep getting stronger as their competitors fail or stumble. These businesses have pricing power and high margins, which underpin growth in their values.
So what does this mean for sme’s today?
As you expand out of recession, you will burn cash. Not necessarily because you are unprofitable, but because you will be expanding ahead of your sustainable growth curve. You can only expand at the same rate as your cash ROI unless you either alter payment terms or inject capital.
Where to find that elusive Capital?
We’ve all seen the headlines. In the current environment, many businesses have tried unsuccessfully to raise funding. Their experiences have varied with lots of “flat no”, some “protracted maybe” and very few “definite yes” responses from lenders. The financing prospect for many businesses looks bleak.
Banks continue to strengthen their balance sheets recovering from the crisis and in preparation for Basle III, although the latter is likely to be watered down to allow the Banks to meet it without choking off growth.
Lending is available, but is tougher to achieve with higher rates, more security required and more ‘setup’ or ‘consultancy’ fees than ever before. This is where Ian is getting his extra 20%!
Government loan schemes have had a very low take-up, with demanding information requirements. And as the new Coalition seeking to rein in costs, you can be sure this is a source that will be hit.
Private Equity and Venture Capital firms have focused on recovering lost value in their existing portfolios, their focus is maintaining what they have, not looking for new investments. Indeed many funds have dried up.
According to a recent survey by the Institute of Directors, nearly 60% of UK businesses were refused credit by their banks last year, despite the government’s efforts to boost lending. The survey found that a rather frightening 20% used credit cards to finance their business.
On the 19th of February, the Bank of England confirmed bank lending to businesses fell by a record 8.1% last year. It also said lending to businesses ‘fell across all the main sectors’ for the third successive quarter’.
Behind the headlines, the reality is that all the banks are desperate to lend more money to increase profits, BUT their credit departments have raised the bar on criteria and concurrently have increased their prices.
Better-presented business cases are essential.
So what can you do to maximise your chances of raising finance in the new landscape?
The general views of those in finance is that businesses need to get smarter about where they look for finance and how they ask for it.
The days of simply relying on your local bank are gone – you need to be prepared to look at other banks, other options. And whatever options you look at, they all have one thing in common – they are looking for solid business cases, with good data to support your case and evidence of having the right talent in place to achieve your goals.
A good, strong Business Plan is no longer enough. It has to contain all the elements that funders will want to see in order to feel comfortable that the Business and its Managers have what it will take to succeed.
To raise finance and to operate businesses, you require the strongest possible plans. And I set out below the headings I believe are essential.
company purpose
•define your company / business
~ in a single declarative sentence
• your elevator speech – on a business card!
problem
•describe the pain of the customer
(or the customer’s customer).
• outline how the customer addresses the issue today.
solution
• demonstrate your company’s value proposition
- to make the customer’s life better
• show where your product physically sits
• provide use cases
history
• set up the historical evolution of your category.
• define recent trends that make your solution possible.
market size
• identify/profile the customer you cater for
• calculate the TAM (total addressable market)
• calculate SOM (share of market)
competition
• list competitors
• list competitive advantages
• market map both
product or service
• product line-up
- form
- functionality
- features
- architecture
- intellectual property
• development road map ~ product or company
business model
• revenue model
• pricing
• average account size and/or lifetime value
• sales & distribution model
• customer/pipeline list
team
• founders & management / relationships
• board of directors / skill sets
financials
here data for a projected 5 years would be sensible,
3 years is a minimum:
• financial profile
• p&l
• balance sheet
•cash flow
exit
•how you’re going to get out
•when & to who – be specific
•utilising what resource
•WILL YOUR EXIT CHANGE YOUR OPS STRATEGY
But where to go for the money?
Family and Friend
Whatever the political rhetoric, at the coal face banks have less appetite for lending money to small and medium sized business and are looking for larger and larger contributions from shareholders to fund businesses. They also want you to provide security for debt financing. As a result businesses are looking to family or friends to provide funding.
The main problem with family and friend investments is that the decisions and responsibilities are not just financial. Frequently a failed business can destroy a family and friendship overnight.
The reason is that many family and friend deals are not properly documented and are based on trust. Failure is never discussed and there is rarely a mechanism to mitigate the loss if failure does occur. When things do not go according to plan, what was intended, becomes more important than what was agreed (expressly or otherwise).
Short Term
Where the requirement is short term, the “investment” should be documented as a loan agreement with clear rules relating to interest due and what happens if the loan is not repaid on time ie. conversion to Shares etc.
Longer Term
If the investment is long term then an investment in shares is probably appropriate. There is only one thing all businesses must do at that time – make sure you have a shareholder’s agreement.
There is very likely to be a dispute at some stage in the business’s growth cycle and unless you have a shareholders’ agreement, the resolution will be very painful and almost certainly terminal for the relationship that existed before the investment.
Enterprise Investment Scheme
Businesses that are considering raising long term finance from friends or family should be using the enterprise investment scheme (‘EIS’) to maximise tax efficiency in the investment and to minimise the financial risk for the investor.
EIS are “unconnected” individuals that invest in ordinary shares of a business and own less than 30% so as a result can receive 20% of that investment back as a deduction from their income tax liability.
Gains on investments will be tax free. If the business fails then the investor can deduct his or her investment amount, less relief already taken, from his or her taxable income. There are other tax benefits (eg capital gains tax deferral), but these are the main benefits.
If you dispose of your shares within three years of claiming EIS relief, then the relief will be withdrawn as will any capital gains tax deferral claimed. This can be a significant issue if the company is sold in a share for share transaction to a UK non qualifying company or to an overseas company.”
Consult a professional who is experienced in this area ~ its complex!
Factoring
Whilst facilities can be tailored to meet the needs of an individual business, there are two main options of Invoice Finance available to sme’s; these are Factoring and Invoice Discounting.
Factoring can include a dedicated sales management service. Whereas Invoice Discounting is more suitable for businesses with an established credit management function.
Such is the climate, that speed, knowledge and contacts dramatically increase the chances of securing finance where I’ve a number of contacts if required.
One cautionary note here – this is SHORT TERM DEBT for ebbs and flows in cashflow – don’t mistake it as an alternative for a shortage in CAPITAL in a business and use it in that context. It will result in tears when the Bank will appear to take it away, just when you seem to need it most!
Invoice finance is not like securing a fixed loan or having a fixed overdraft level ~ or an appropriate capital structure. Therefore, it is important to understand the main variables that determine the funding you can access:
Overall Facility Limit:
Whilst the funding provided through invoice finance grows in line with the business’ turnover, the funder will set a facility limit as a review mechanism. Usually the funder will look to build in sufficient headroom to enable growth.
Levels between 60% and 90% are typical though tightening of late. The amount advanced is linked with the overall performance of the ledger therefore factors such as debtor credit worthiness, the sector trading in, previous payment history, the level of credit notes and the overall strength of the sales ledger, as the prime source of security, play a role in determining the % advanced.
Prepayment Level:
This is the % of the gross invoice amount a funder will advance against the invoice. Levels between 60% and 90% are typical. The amount advanced is linked with the overall performance of the ledger therefore factors such as debtor credit worthiness, the sector the client is trading in, previous payment history, the level of credit notes and the overall strength of the sales ledger, as the prime source of security, play a major role in lending levels.
Concentration levels:
It is prudent for any business to spread its risk to minimise the impact of potential debtor failure. This is good business practice for long-term sustainability and provides confidence to funders when they see a good debtor spread.
That said, sometimes due to factors such as seasonality or new start businesses, it is inevitable that there will be a higher concentration of one debtor on the ledger. In these cases, funders will look at the funding limit and/or credit insurance to enable funding where possible.
Typically, no more than 20% of your business in extremis or more normally 10-12% should be housed with one Client. A number of you breach this guideline and it exposes your businesses to failure when a Client fails…..as well as hindering your ability to raise funding.
Charges:
Whilst there are standard costs associated with invoice finance, it is worth noting that each provider will structure the facility slightly differently, according to sector, size of the business, service levels and debtor quality, amongst other things.
In my view it’s advisable to look beyond the headline figures to ensure that the facility will enable access to the right level of funding and service. Agreeing to pay a little more for the right service will pay dividends in the long term and provide profits for lenders, which will make them pre-disposed to further lending.
As with all forms of funding, there are operational requirements. That said, the right funder can structure a solution to suit even the most challenging of businesses or sectors.
Contractual Debts;
Where stage payments or monthly valuations are used. These are common in construction, electrical and mechanical engineering, phased IT projects.
Non standard products;
Where the product or service is a little out of the ordinary, Invoice Financiers rely on the ledger, funding can be raised where traditional banking lending would not be available and would be based on the financial performance of the core business.
Invoice finance remains an excellent funding option for companies of all sizes ~ even BAe use it, but especially now as the sales ledger is typically the most significant asset.
People often consider this to be an expensive option but in assessing its use, weigh up the cost versus the potential opportunities the additional funding will enable the business to access.
Raising Finance through Bank Funding
Banks lend short term and on secured debt ~ this is their business model so don’t complain when they won’t lend what they consider to be Equity / Capital!!
To succeed in raising finance from banks you have to remember that the “desire” to lend is based on a relationship of mutual respect you can create with your bank manager so regular updates and information to him will help even if you don’t yet want to borrow. Keep him in the loop!
The “decision” to lend however, is based entirely on the data that is presented by the bank manager to the person that approves the credit ~ the credit co-ordination committee.
Bank managers are just like any other supplier and negotiating with banks is really no different from negotiations with other suppliers. The product being negotiated is money and both parties have a list of requirements. As long as the business takes the time to understand the banks list of requirements, the negotiations go more smoothly and success is more predictable.
Again, it’s back to those Plans and the quality of the information contained where you’re in competition for funds with all the other business cases going before the CCC, so if your Manager knows you well, knows the business well and you’ve a great plan giving him everything he needs to present, you’ll win the day.
Bank requires five key things:-
1. Good quality management that have a track record of success and can demonstrate they can weather the odd storm.
2. Good quality financial information including historic financials and rolling future forecasts – and they LOVE Dashboards as they feel the business is analysing not just reporting the data….
Quality is measured over time and reflects both the information itself and the credibility of the team preparing the information. For this reason it is always worth providing quality information to your bank in case you need financial support quickly ~ keep them in the information loop ongoing.
3. Income from facilities. Bank managers are no different from any other salesman; they need to secure the best price. After CCC has approved a facility (that’s about risk and capital utilisation for the Bank), the “pricing” decision usually sits with the your bank manager and his director.
During 2009, most of the banks trained their managers to improve pricing of risk in the current climate. If you have no alternative, the negotiating position of the business is weak so keep someone / another institution in reserve wherever feasible.
4. Repayment of the loans. The CCC will review the financial information provided and the bank managers assessment of the management team and the provider of the financial information.
The financial information needs to clearly show how the facilities will be repaid and the assumptions made that underpin the proposed repayment. Frequently, credit teams will apply a sensitivity to the repayment proposal (eg what if sales are 50% of the forecast, can the debt still be repaid).
If as provider of the financial information you have already scaled back your forecasts, then SHOW this in your presentation to avoid CCC halving a forecast that has already been halved! Seems obvious, but you shouldn’t be surprise that this happens time and again!!!
5. Security in case repayment does not happen. This goes back to my previous point ~ many entrepreneurs think banks provide business finance. Unfortunately business finance falls into 2 categories: equity and debt.
Debt providers expect to be paid back whatever happens and the price of that finance reflects that risk. After all, banks are lending individuals and businesses money that has been placed on deposit by individuals and businesses.
Side-stepping the current difficulties, a bank has a duty to protect that capital and as a result, banks need to ensure they have sufficient security in the deal. The more risk the bank feels there is over repayment, the more they will focus on security ~ answer the questions early and convincingly and the price will reflect it.
As you will see from the above, the quality of your relationship manager and his desire to work hard to secure you the funding you are looking for, is a crucial component in success. If you do not think the relationship is right you may need to do something about changing your relationship manager ~ it’s no different to changing another supplier or their account manager and don’t be afraid to consider or enact it.
Many sme’s are apprehensive to ask for new relationship managers, don’t be, they’d rather change one than lose the businesses, however they may present.
Venture Capital and Business Angels
You should not confuse private equity with venture capital.
Private equity firms tend to buy established businesses, invest in them and their management (adding their own prior expertise) with the objective of selling those businesses as fast as possible for the maximum return. This is changing, and increasingly PE’s are starting to become term investors but this is not their default position and you should plan accordingly!
Venture Capitalists on the other hand, invest in early stage and growth businesses to help them grow. There are few proper Venture Capitalists left in the market at present and as I say above, the lines between VC’s and PE’s is graying.
Business Angels work in a similar way to a proper venture capitalist and therefore I have grouped these together.
The most common complaints cited by entrepreneurs are:
• No investor is interested in my sector.
• The investor looked at the proposal and dismissed it out of hand without even explaining why.
• After an encouraging start, the meeting went badly and they lost interest.
• The deal proposed was so unattractive, it was not worth proceeding.
• The management team could not work with the VC/investor – they were on a different planet.
The underlying causes of these outcomes are often complex. However many entrepreneurs over-analyse the reasons and cite issues like:
• aligning the management team’s personal and business goals with those of the funder was not addressed during the discussions.
• the entrepreneur was unable to find the funder with investment criteria that matched the business.
• the entrepreneur failed to present the investment case to the funder concisely and in a manner that attracts their attention.
• the management team were worried about working with the investors team after the investment and this was plainly evident .
• there were fears that a hidden agenda existed.
• the documents sold the business content not the business.
Unfortunately entrepreneurs that are so good at selling their own products to their customers, lose their sales skills when it comes to raising equity finance where the process is really quite simple.
Angels and VC prefer to invest in businesses that fall into two broad categories:
Businesses with intellectual property / brands that can be exploited, thereby generating significant value with their help.
Businesses that have developed an offering and a business model that can be scaled quickly with their help.
Entrepreneurs have to be honest with themselves before they criticise funders:-
Firstly, you have to be committed to an exit within approximately 5 years. If this is not the case then it’s unlikely that a professional investor will be attracted to your plans however attractive they are ~ note the exit and its impact on your strategy in the content framework above and don’t under estimate it!
Also, does your business meet the criteria which attracts professional investors? i.e. does the business have IP that can be commercially exploited or an offering with a business model that can scale quickly?
They will score you in just the same way as a Banks CCC but with marginally different criteria, get used to they process and don’t feel its personal or directed at your business. If they can see a way to help, to correct a business model then they will. But it takes time and they will want to get to know you as unlike a Bank, this will be a Partnership so don’t “give up too soon in the process”…..
Consider having someone work with you from a corporate finance environment, who understands your business and knows exactly which VCs and angels are interested in that sector and sponsors the introduction. Again though, don’t expect it to be a fast Bank style turn-around, typically VCs and PEs will know your business for 12 months before investing.
When you meet a potential investor, they are looking for opportunities to make connections to their contacts that can immediately deliver added value to your business. This is a key trigger to investment and in order to know how to do this, they need to know your business ~ and that takes time. They make good business partners but only if they are given time to know you and invest for the right reasons.
What Finance?
The new economy, if it means anything, suggests that if traditional debt funding sources are available they are so, only in very economical amounts if indeed at all!
Woe betide anyone who’s business has gone out of favour for the financial markets (eg retail, construction, or recruitment!) and if you are displaying even the slimmest of declines in your performance, then prepare yourself for a fight to keep what you have, never mind acquiring new cash.
All the high street lenders have rolled down their shutters to new lends, save for the historically conservative Co-Op and Clydesdale (Yorkshire) Banks, who are taking on some new business, albeit with tough covenants and high interest rates. Consider the long term and if this suits your corporate goals.
Where any lend is being considered protracted timescales are the norm right now, as credit committees cover their backs and more! Due Diligence is more thorough than ever with even seemingly robust deals being aborted at the last moment. The new economy therefore requires new thinking from the entrepreneur, to maximise available cash for growth.
Consider first what assets you have and how to exploit them better. Take your Debtor book; is it worth looking at early settlement discounts or pro-forma deals.
Have you looked at your stock levels? Can you sell some to release cash, would your suppliers provide consignment stock or “just in time” or even “paid when paid” which is gaining in popularity in the current climate.
What about the business creditors – not just trade, are there deals to be done on payment extensions? Don’t forget even if they charge higher than bank interest rates, this is unsecured lending and may provide additional working capital to fund expansion.
With all the businesses I’ve ever acquired, the first port of call has always been “how quickly do we pay vs how quickly do we get paid” – again, its back to the Dashboard and the balance between Debtors and Creditors.
Are there any assets you can sell and lease back from fixtures and fittings, to plant and equipment and of course, motor vehicles. There are specialist funders for all these deals .
Create cash by offering staff a pension holiday or even forsaking contribution payments for a period until business picks up. For most people this is far more attractive than salary cuts.
If you’ve milked your own assets and still need cash now what?
Watch the small print, negotiate hard on arrangement fees and the admin costs for facilities, these are much more onerous than the interest nowadays.
Also consider the exit provisions both in terms of costs and timings – take advice from your chosen Mentor.
There is a distinct likelihood that the less savvy entrepreneurs may be so thrilled to get funding, that they don’t consider these issues and then find they’re locked into an agreement that is ineffectual and expensive to exit.
From here to…?
2010 is going to be difficult for most businesses – those that survived the last 18 months have done so often due to the sacrifices made by their owners, their homes they have pledged, the salaries they have cut and the deals done with employees.
If this year requires you to take severe remedial action, many companies have no more resources to access and as such will fail not because they don’t have business but primarily because they have the trade and either too high a cost base or they can’t obtain or service their debt.
Raising Finance in The New Economy – Key Indicators:
Whatever your potential sources of business finance, the changes in our economy and business climate have forced several new common factors on all businesses:
You should explore several options in detail. The days of simply assuming that your current bank is the sensible source for your finance are gone.
Explore the short-term and long-term implications of your chosen finance route. Short-term cash gains might be very useful – sometimes essential, but do your homework on the longer term implications.
Shop around. Finance is like any other business service. The quality of service provided, the details and terms of the package offered and the full cost of the package do vary from lender to lender – don’t assume that all other offers will be the same.
Negotiate: Business finance is no different from other business services. Don’t accept terms immediately – negotiate. Look at the overall cost to your business and other factors such as seasonal cash flows. Demand better terms, payment holidays etc that suit your business. It’s your loan/finance – negotiate to get terms that favour your business.
Prepare your business case well. Have the group comment on it before going to your chosen lender. Include enough information in your plans, to give a lender everything they need to know to be able to make a decision.
If the lender comes back and requests further information, then you clearly have not enabled them to make the decision with the information you initially provided. Include information on risks and how you will mitigate these. Present your information clearly and back it up with key contracts/orders etc.
Provide regular, clear and complete updates to your bank/lender. Provide management accounts, trading updates ~ some good and some bad but always under promise and over deliver. Banks and other investors don’t like surprises. Keep them informed. If your information is clear and regular, the door will be open to finance discussions.
The last few years have created a new business landscape, with new challenges, new extremes and new business models that can change the rules of the game. Within this volatile environment, you may not be able to rely on the knowledge, experience and practices that got you here first time around. New, fresh thinking is needed.
eNABLE provides a trusted, confidential environment where the very latest business thinking can be applied to your business. In addition, your own answers and actions will be challenged in a way that is unique to eNABLE . So, you and your business will prosper in the new business landscape, supported by your group ~ use them!