BORROWING FOR YOUR BUSINESS
Lessons learned over a decade
It is 1998, the eve of the Canada Small Business Financing Act. Most of the owners of the country’s 927,000 small businesses—those with fewer than 50 employees—are experiencing challenges in accessing the financing they need.
To launch their businesses, many of these entrepreneurs use their own money or that of family members and/or friends. Chartered banks, caisses populaires, credit unions, and trust companies are their other main source of financing—but reasonable terms and conditions are often difficult to obtain. 1
With the goal of increasing “the availability of financing for the establishment, expansion, modernization, and improvement of small businesses,” the federal government enacts the Canada Small Business Financing Act on March 31, 1999. The government will share risk with lenders by assuming 85% of their losses should an enterprise default on a loan. 2
Fast forward nearly 10 years. Businesses with fewer than 100 employees represent 98% of all businesses in Canada. 3 Following an extended period of unprecedented economic growth, a global credit crisis is sparked by the meltdown in the U.S. subprime mortgagemarket.
While personal savings still account for the bulk of funds entrepreneurs use to launch and grow their businesses today, banks continue to be their lender of choice. According to the Survey of Suppliers of Business Financing, in 2004 chartered banks were the SME credit supplier for 63% of loan applicants. 4 Being conservative funders that require extensive security backed by stringent covenants however, the banks are more reluctant than other lenders to take on risk—especially now.
So what is a small business owner to do? Fortunately, the past decade ushered in a range of new lenders, offering more options than there were in 1998.
Canada Small Business Financing Program
The Canada Small Business Financing Program has been helping many SMEs over the past decade. Businesses with estimated annual gross revenues of less than $5 million are eligible for this loan guarantee program. Funds of up to $250,000 are available to finance up to 90% of the cost of purchasing or improving buildings or equipment or buying land.
Between 1999 and 2004, the program made over 65,600 loans. 5 In the 2006/07 year alone, the value of loans made under the CSBF program exceeded $1 billion, with new businesses accounting for 60% of that total. 6
Business Development Bank Of Canada
The Business Development Bank of Canada has also expanded its support for small and mid-size enterprises over the years. In 1998, the BDC provided just over $5 billion in financing; 7 by 2007, that number had increased to $9.3 billion. 8
Moreover, today the BDC offers a wide range of financing options, such as term loans for purposes from buying a business to purchasing fixed assets; venture capital and quasi-equity venture loans for growth-oriented businesses; and working capital loans to top up short-term financing or lines of credit.
Scientific Research & Development Program
Determined to improve Canada’s competitiveness, the federal government continues to enhance its Scientific Research & Development Program. Maybe it is the intimidating name that causes many SMEs to overlook this generous source of financing, but the program offers billions of dollars in tax credits to encourage businesses of any size in any industry to conduct R&D that will produce new or improved products or processes.
The daily activities of many companies qualify for SR&ED incentives. Businesses receive valuable benefits: qualifying current and capital expenditures are fully deductible and are eligible for investment tax credits of 20% or 35%, depending upon a company’s level of taxable income and capital.
Asset-Based Loans
Once viewed as “last resort financing,” today asset-based loans are used to fund acquisitions, mergers, and growth. Since these loans are based on the value of assets rather than cash flow or business performance, they are particularly attractive to businesses experiencing slow periods of growth or those in cyclical industries.
The lender takes a security interest on a percentage of inventory or receivables and advances funds (up to 75% for accounts receivable and 60% for inventory) to the borrower. As inventory is sold or receivables paid, the borrower pays the lender, thereby reducing the balance of the loan. The lender recalculates every week or month the amount of money for which the borrower is eligible and when the company needs additional capital, the lender advances funds based on those calculations.
One caveat: asset-based lenders conduct extensive finan- cial monitoring of their borrowers, therefore financing costs can quickly add up. Despite this, asset-based loan volume in Canada was US$2.4 billion in 1998 and by 2004, it reached US$10.5 billion. 9 This trend is expected to continue as virtually any business with a reliable flow of accounts receivable, or that has inventory, equipment or real estate, can utilize asset-based lending.
Factoring
The use of factoring, accounting for about $4 billion in Canada today is also increasing. 10 Companies that sell to other businesses on credit can sell accounts receivable to a factor in return for an advance of capital of up to 90% of the invoicexvalue.
The factor collects on the invoices and when payment is received, this lender pays the borrower the rest of the amount owed, less a fee of about 1% to 2% per month. For businesses with delayed payments, or those whose earnings do not qualify for a traditional loan or an increase in their line of credit, they can use these funds for working capital or to finance growth.
Mezzanine Financing
The popularity of mezzanine financing has been fuelled by the busy mergers and acquisitions activity of the past few years. Along with buyouts and recapitalization, SMEs are increasingly using mezzanine to fund expansion. Borrowers must generally have a predictable flow of cash in order to qualify.
This type of financing is a hybrid of debt and equity financing and can be structured according to the borrower’s needs. Borrower and lender can create a mezzanine package that achieves an agreeable balance of equity, interest charges, and rates of return. These packages generally combine long-term subordinated debt at a fixed interest rate, with warrants or options to purchase equity at a later date. The value of these warrants is usually based on a multiple of earnings or a percentage of the company’s book value or enterprise value.
Private Equity
Many individual investors and companies had a successful run over the past few years and have cash and expertise to invest in return for a portion of the ownership of a business. These private equity investors often fund start-ups, facility expansions, new product lines, acquisitions, buyouts, and restructurings.
Lenders include “angels,” (affluent individuals), venture capital firms, institutional investors, and others. Private equity investors typically expect returns of at least 20% and therefore look for companies with ambitious growth plans. The larger lenders, which are usually funded by institutions, generally only work with companies that have at least $2 million EBITDA (earnings before interest, taxes, depreciation, and amortization) and predictable cash flow.
Conclusion
Whatever your capital requirements may be, today you have significantly more options than you did a decade ago. Since most lenders still look to a company’s balance sheet to assess the risk to their security however, you need to address any significant weaknesses in order to secure capital. Some of the balance sheet issues that most often lead to funding declines are:
- receivables or payables past 90 days;
- slow moving inventory;
- low ratio of current assets/current liabilities indicating that a company could have difficulty meeting short-term obligations; and
- high ratio of total debt/net worth suggesting that a company may be over-leveraged.
Having a clear strategy or business plan and the owner’s personal financial commitment to the business are two other criteria that are essential to securing capital. Perhaps the key lesson we have learned over the past decade is the importance of matching needs with the most appropriate form of financing. The right financing at the right cost for the right period of time is what ultimately enables small businesses to become successful businesses.
1) December 1997 Report of the Auditor General of Canada;
2) Canada Small Business Financing Program, Industry Canada;
3) Key Small Business Statistics, January 2008, Industry Canada;
4) Small Business Financing Profiles, September 2007, Government of Canada;
5) Evaluation of the Canada Small Business Financing Program, November 2004, Bearing Point;
6) Canada Small Business Financing Program, Industry Canada;
7) Small Business Financing Profiles, September 2007, Government of Canada;
8) 2007 Annual Report, Business Development Bank of Canada;
9) CapitalEyes, March 2006, Bank of America;
10) Financial Post, April 28, 2008
Clark McKeown, CA, CIRP, CFE, is a partner and Bruno Suppa, HBA, CA, is a manager with the transaction advisory services division of BDO Dunwoody Ltd. (www.bdo.ca), which provides corporate finance and mergers and acquisitions services. You can reach Clark at (416) 369-6126 or cmckeown@bdo.ca, and Bruno at (416) 865 0210 or bsuppa@BDO.ca.