WHEN BANKS SAY“NO!” THE SMALL BUSINESS GUIDE TO FACTORING ENTREPRENEURIAL FINANCE Much has been written about entrepreneurs and their unique characteristics. A common fallacy regarding small business entrepreneurs is that they are driven to build immense empires. That is generally not the case. ENTREPRENEURIAL FINANCE The fact is, most true entrepreneurs start their businesses simply to generate a "living" and a steady stream of income. As true entrepreneurs, however, they must also be their own person, make their own decisions, and the business must run their way. Among their many characteristics, entrepreneurs..... ENTREPRENEURS • are risk takers and believe in themselves, their ideas, and their hunches. True entrepreneurs seldom give up and will never quit seeking a successful venture. • are competitive and strive to earn respect from both customers and competitors. They compete with themselves and believe they control their own destiny. ENTREPRENEURS • tend to be loners and thinkers who are often attracted to home-based businesses. They spend serious amounts of "alone time" analyzing problems and theorizing solutions and are always thinking up new ideas for beginning some new venture. ENTREPRENEURS • are goal oriented and once a goal is achieved, they may well replace it with an even loftier goal. • are multi-taskers. Once a new idea is envisioned, they will then quickly develop a sense of urgency towards its fruition. ENTREPRENEURS • tend to have a never ending sense of urgency to develop their new ideas. In fact, it is most often only their inability to finance their many ideas and projects that truly limits an entrepreneur's potential for success. ENTREPRENEURIAL FINANCE This presentation and its accompanying booklet, When Banks Say “No!”, is designed to assist small business entrepreneurs in understanding the world of Early Stage Financing Alternatives and in particular... • commercial accounts factoring • asset based lending • purchase order finance WHAT IS SMALL BUSINESS? The U.S. Office of Advocacy defines a small business as an independent for-profit business with fewer than 500 employees. When attempting to qualify for government contracts, the U.S. Small Business Administration furthers that definition by defining size requirements by business type. The complete listing is available at www.sba.gov/size. SMALL BUSINESS NUMBERS According to the most recent census data, the U.S. Department of Commerce estimates there were 27.2 million businesses in the United States of which 6 million had employees. Of those with employees, 99.9% were defined as "small business" (those firms with fewer than 500 employees). NEED FOR FINANCE Unfortunately, data also reveals that one third of all these small businesses started end up failing within the first two years of operation and less than 50% survive four years. One of the greatest causes of small business failure is their inability to secure adequate financing in their early stages of existence. ENGINE OF GROWTH Throughout the world, small business is recognized as the true engine of economic growth. According to the U.S. Small Business Administration (SBA), small business ventures make up nearly 99% of all known businesses in America with numbers now totaling over 22 million. STARTUP FINANCING Most small business ventures are initially launched with the personal savings or other assets of the founder. Sources of startup capital are most often bank savings accounts, investment accounts (stocks and bonds), loans collateralized by the family home or other real estate, credit cards, or personal loans from friends and family. STARTUP FINANCING Few new companies are ever started with funds from true "angel investors" or formal venture capital. Typically, entrepreneurs will actually be faced with the task of raising capital in two generic rounds, with... RAISING CAPITAL • round "A" being an initial start up round where savings and funds from friends and family are utilized. And... • round "B" being more traditional financing from banks and more formalized lenders. RAISING CAPITAL While the understanding of rounds "A" and "B" financing is acceptable, it paints the true picture of entrepreneurial finance with a much too simplistic brush. For a better understanding of the actual stages associated with types of business finance, the definitions commonly utilized in the professional venture capital industry are much more appropriate. Among these are: STAGES OF FINANCE • Seed: the concept or idea stage of a business where money is needed to research feasibility. • Startup: financing prior to initial operation. STAGES OF FINANCE • First Stage: an operating business with capital needs for equipment, payroll, and marketing. • Second Stage: growth capital now required with good First Stage results. • Bridge: temporary financing between other financing rounds. STAGES OF FINANCE • Mezzanine: equity financing that is prior to an initial public offering (IPO). • Franchise Funding: financing for the purchase of a franchise. • Leveraged Buyout: financing to purchase another established company using the combined assets for purchase. STAGES OF FINANCE • Recapitalization: financing revolving around the restructuring of a company's balance sheet and increasing or decreasing the company's debt. • Bankruptcy: financing to acquire another company operating under a filing of bankruptcy in Federal Court DEBT vs. EQUITY FINANCING In order to grow their businesses, it is crucial for all entrepreneurs to have access to "ready" capital. Commercial banks and other depository institutions have historically been the largest providers of financing for small business, accounting for approximately 65% of all financing through commercial loans (including those for non-residential mortgages, vehicles, equipment, and leases). DEBT vs. EQUITY FINANCING Though a variety of resources for commercial financing are available worldwide, actual providers of business capital can be broken down into two very broad categories. Those that provide equity investment alternatives, and those that financing through debt. EQUITY FINANCING Equity Financing...can be described as the exchange of money for a percentage of ownership in a business. Equity financing allows a business owner to acquire funds without the expense of servicing debt. It typically does not encumber assets such as equipment, inventory, and accounts receivable and is normally accessed through venture capital companies. DEBT FINANCING Debt Financing...refers to borrowed money that is paid back over time. Debt financing is flexible and can be for varied periods of time (short term or long term). The lender does not gain an ownership interest and the obligation of the business owner is simply to repay the loan as set forth in the lending agreement. DEBT vs. EQUITY Debt and equity financing offer significantly different opportunities / responsibilities when raising capital. Some of the many advantages and disadvantages of both methods include: DEBT FINANCING • Does not dilute an owner's interest in the company. • Other than variable rate loans, repayment is fixed. • Interest expense is deductible on tax returns. • No shareholder servicing requirements. EQUITY FINANCING • Requires no periodic payment of interest. • Will not affect a company's cash flow. • Does not encumber assets. • Does not require budgeting for principal repayment. ACCESS to FINANCING A common source of frustration to virtually all small business entrepreneurs is their inability to access credit through the traditional banking system as they attempt to grow their businesses. Banks and traditional lenders are severely regulated and covenant restricted when attempting to provide truly accessible financing and small business loans to startup entrepreneurs. ACCESS to FINANCING For most small business entrepreneurs, it is when their business is initially successful through its start up and first stage operation that the entrepreneur is confronted with his/her first cash flow problems. It is at this stage that the initial cash grub stake from savings, credit cards, and friends and family is "burned through" and immediate additional financing becomes necessary. ACCESS to FINANCING This is also when an understanding of the many financing options offered by such federal agencies as the Small Business Administration and the United States Export-Import Bank become highly important and when an in-depth understanding of the alternative commercial finance (ACF) industry may become critical. The SBA and EX-IM BANK The U.S. Small Business Administration (SBA) and the Export-Import Bank of the United States (Ex-Im Bank) are two independent federal agencies with powerful financing options for small business entrepreneurs. The SBA was created in 1953 for the purpose of aiding, counseling, assisting, and protecting the interest of small business concerns and free enterprise. The SBA and EX-IM BANK Export-Import Bank of the Unites States was empowered in 1934 as the official export credit agency of America. Both government agencies provide extensive financial services to small and mid-size businesses with a broad range of programs. FACTORING and ACF The global community of factoring and alternative commercial finance providers offer an extensive and powerful source of financing options for start up / first stage companies struggling in their early, formative years of operation as well as larger, seasoned companies in the various growth, expansion and operational stages of their existence. FACTORING and ACF The spectrum of factoring and ACF products directly addresses the problems faced by those entrepreneurs which, for a variety of reasons, are unable to access traditional bank financing and lines of credit and the early stage capital required to grow their ventures. ALTERNATIVE COMMERCIAL FINANCE Worldwide, there are literally dozens of unique financial product areas that join to make up the entirety of what is termed the alternative commercial finance community with some being more favorable than others in particular economies and geographic regions. ALTERNATIVE COMMERCIAL FINANCE For their ability to provide ready access of capital to entrepreneurs and to generally meet the working capital and cash flow problems of start up and early stage small business, several areas clearly stand out among the rest. These areas include... FACTORING Commercial Factoring...one of the oldest known forms of commercial finance, factoring is also characterized by its simplicity. It directly addresses those cash flow problems associated with accounts receivable of a business, slow paying customers upon those accounts, and the granting of terms of payment to customers in order to become more competitive and to secure more business. ASSET-BASED LENDING Asset-Based Lending...similar to factoring in some ways, asset-based lending solutions can be employed in a multitude of industries where financing of accounts receivable, inventories, and equipment is essential for growth. PURCHASE ORDER FINANCE Purchase Order Finance...simply put, purchase order finance involves the process of providing capital to business owners needing to purchase or to actually manufacture goods to fill large orders prior to shipment. It is often necessary to facilitate handling transactions involving major retailers. MERCHANT CASH ADVANCES Merchant Cash Advances...a relatively new area of small business finance but with broad availability, MCAs provide cash advances on future, anticipated credit card receipts of retailers which can be used for growth and expansion. BANKS vs. ACF For entrepreneurs in the early high-growth period of developing their business, ACF offers some significant advantages to traditional financing. One such advantage is the ability to finance each asset of a company separately. When banks provide financing, they will typically require all assets of the company as collateral and file a "blanket lien" when perfecting their loan. BANKS vs. ACF With such a blanket lien filing, the single loan will be secured (collateralized) by inventory, accounts receivable, machinery, equipment, patents, rents, and any other asset of the company. In such cases, bank loans are often significantly over collateralized. With ACF, collateral is typically taken separately. ACF EVOLUTION Alternative commercial finance is a community rich in history and legend. Factoring, for example, may well be the oldest form of commercial finance known to man though most know little of its extensive history and remarkable problem solving capabilities when compared to more traditional business financing methods. ACF EVOLUTION Factoring is literally centuries older than modern day banking and some of history's earliest recorded commercial transactions of both the ancient Egyptians and Phoenicians reference features similar to modern day factoring. ACF EVOLUTION Asset-Based Lending's earliest beginnings can be traced to a pair of encyclopedia salesman, Arthur Jones and John Little who started the first finance company, Mercantile Credit Company, in 1904 which offered accounts receivable financing. Asset-based lending has grown steadily since and now accounts for over 20% of all short term business credit in the U.S. TODAY’S ACF INDUSTRY Overall, today's alternative commercial finance industry is enormous with asset- based lending transactions alone accounting for over $545 billion in terms of outstanding loans annually. Factoring, known affectionately as the industry's "crown jewel", has grown to an annual volume of roughly $135 billion domestically. TODAY’S ACF INDUSTRY But as far as factoring is concerned, that is only the tip of the iceberg. Recent statistics compiled by the international factoring organization, Factors Chain International, quotes total global factoring now reaching an epic annual volume of nearly $1.3 trillion. TODAY’S ACF INDUSTRY Other areas are expanding just as rapidly. According to ELFA, the Equipment Leasing and Finance Association, the $650 billion leasing industry is adding nearly $6 billion in new equipment leases every month. TODAY’S ACF INDUSTRY When you additionally begin to include the many unique niche product areas such as forfaiting, purchase order finance, merchant cash advances, etc., the overall dollar volume of specialized, non-traditional bank financing done throughout the world is many trillions of dollars each and every year. ACCESSING ACF While many of the product areas, associated with the alternative commercial finance industry are well established throughout the world, some are relatively new. What has changed markedly in the past 10-15 years is the broad access to knowledge of alternative commercial finance products. This has occurred primarily due to two major influences: ACCESS TO ACF • The Internet....without question, the information superhighway now offers and imparts a broad array of knowledge to those who know where to look. • Industry Brokers....a unique vocation practiced by a select group of individuals that share their industry knowledge with small business entrepreneurs. THIS PRESENTATION With such an expansive and rich array of industry product areas, it is clearly well beyond the scope of any basic presentation (or most university courses for that matter) to provide a complete education in all of the fascinating areas of entrepreneurial and alternative commercial finance practiced throughout the world. THIS PRESENTATION The objective of this booklet, When Banks Say NO...the Small Business Guide to Factoring, is to impart an introductory knowledge of two of the most practiced and accessible areas of alternative commercial finance available to small and mid-size early stage business entrepreneurs....Factoring and Purchase Order Finance. ENTREPRENEURIAL FINANCE FACTORING FACTORING In simple terms, factoring or accounts receivable factoring is the sale of the accounts receivable of a business at a discount to a finance company known as the factor. Factoring is commonly employed by businesses that grant extended terms of payment to their customers for goods or services purchased, allowing those customers to delay payment upon invoices for 30, 45, 60 days or longer. FACTORING Factoring is commonly employed by businesses that grant extended terms of payment to their customers for goods or services purchased, allowing those customers to delay payment upon invoices for 30, 45, 60 days or longer. It is probably the oldest form of commercial finance known to man. FACTORING It is important to keep in mind as you develop your knowledge of this powerful financial tool, factoring differs dramatically from most other forms of commercial finance in that true factoring is never in the form of a loan. Factors actually purchase the accounts receivable of a business, a trait that sometimes gives factors certain advantages over more common commercial lenders. FACTORING For entrepreneurs in the early stages of developing their businesses, factoring represents one of the most powerful financial tools available. Factoring... • is available to businesses in the earliest "start up" stage of their existence. • requires little or no credit history for either the business or its owner. FACTORING • provides a financing facility that automatically increases as your business grows. • provides substantial operational support in addition to providing capital. • allows other business assets to be financed separately from accounts receivable. FACTORING Most factoring arrangements are sought out simply to provide a readily accessible method of financing a company’s terms of payment policy and to remedy the cash-flow problems a business often experiences by granting such attractive terms of payment to its customers. FACTORING At some point in time, as companies grow, they are almost required to initiate a terms of payment policy. Terms of payment are granted by sellers as an accommodation for a singular purpose…that is to attract more purchases from large (and sometimes not so large) creditworthy customers. FACTORING Many large, creditworthy customers, on the other hand, demand terms of payment for a singular purpose…..that is to benefit from the payment delay provided under the terms of payment policy and to allow time to sell products or provide their own services and to generate enough additional cash to subsequently pay their supplier's invoice within the normal payment terms. FACTORING For large corporations, the benefits of demanding extended terms of payment from vendors are very significant. When one business grants terms of payment to another, it is in effect, creating a short-term non-interest bearing business loan to that company. (See example page 18) FACTORING Because of the attractiveness to large companies of delayed invoice payments, it is not unusual to see contracts and large purchase orders granted to those vendors and suppliers that offer the most attractive payment terms, even if the prices for goods or services are slightly higher than from competitors. TRANSACTIONAL BASICS In a typical factoring transaction, a business owner (known as the client) will enter into a relationship with a commercial financing source (the factor) to which it periodically sells its invoices payable by its customers. In most modern factoring transactions, the invoices are initially purchased by the factor with an advance of cash (usually 75-85% of the invoice face value). TRANSACTIONAL BASICS By periodically purchasing a business's invoices, the factor provides immediate working capital for normal operations including timely payment of its bills due to suppliers and its periodic payroll obligations. FACTORING BENEFITS With a factoring arrangement in place, the customers of the seller still get to enjoy their 30, 45 or even 60 day credit terms while the factor, not the seller, patiently waits for the agreed payment. The factor will make collection calls on behalf of the seller, provide weekly accounting of all collections and fees charged, and provide monthly statements of account to the seller's customers. FACTORING BNEFITS When payments upon purchased invoices are ultimately received from the customers, the factor deducts its fee for services (the factoring fee), repays itself for the earlier advance, and then rebates the balance to the seller (client). In most modern factoring arrangements, clients will sell their invoices to the factor on at least a weekly basis but sometimes as often as daily. FACTORING BENEFITS Though the circumstances that can trigger the critical need for a factoring arrangement can vary considerably, the common thread is always a need to speed up the payment from invoiced sales so the cash can be used for some immediate purpose. Such needs typically include… FACTORING BENEFITS • making timely payroll. • paying suppliers for parts or merchandise early to obtain volume discounts. • paying overdue tax obligations. • purchasing machinery and equipment. FACTORING BENEFITS • funding retirement plans and programs. • providing funds for acquisitions or expansion. • increasing sales and marketing operations. • buying out business partners. FACTORING BENEFITS The list of reasons for establishing a factoring arrangement go on and on. In most cases, the need for factoring is the result of the inability of a business to access bank lines of credit, a trait that is of even greater importance in today's credit impaired markets. It is no surprise that factoring is enjoying an increasing awareness by business owners today as more traditional methods of business finance prove difficult to obtain. FACTORING TRANSACTION CHARACTERISTICS Business-to-Business Invoiced Sales As a method of providing commercial finance, factoring only involves the purchase of invoices due for payment for goods delivered and for services performed on a business-to-business basis. Factors are not lenders and do not loan money regardless of collateral. FACTORING TRANSACTION CHARACTERISTICS Ability to Verify Invoiced Amounts Due Unlike banks that may lend against hard assets such as real estate and equipment, factors purchase a piece of paper (an invoice). Such invoices clearly must be verifiable. FACTORING TRANSACTION CHARACTERISTICS Unencumbered Invoices for Purchase Invoices purchased by a factor must be unencumbered. This means that the business owner selling the invoices cannot have a pre-existing loan from a bank or other lender that claims the invoices (accounts) as collateral for that loan. If such a pre-existing loan exists, the lender will be required to subordinate the collateral position. FACTORING TRANSACTION CHARACTERISTICS Assignable Invoices Factors require the ability to "notice" the customers of a client and to redirect payments from the client's address to that of the factor. While this is not an issue in most cases, some debtors, such as the Federal government, may refuse to pay the factor directly and will not recognize such notification, thus adding a level of risk that may be unacceptable to the factor. FACTORING TRANSACTION CHARACTERISTICS Acceptable Profit Margins From Sales Factors will look at the profit margin of a prospective client to make certain that enough profit exists to absorb the overall costs of factoring. Companies with15% profit margins or higher can easily absorb the fees of a factor. FACTORING TRANSACTION CHARACTERISTICS Federal Tax Liens Prospective factoring clients must have their payroll and corporate taxes current and cannot have a federal tax lien for delinquency in place. It is important to note however, factoring can be an important tool in dealing with tax liens, freeing up cash from invoices which can be used to satisfy liens In some cases. FACTORING TRANSACTION CHARACTERISTICS Continuous Need /Ongoing Basis As a prospective client for factoring, the business should exhibit a need for the service on an ongoing basis. Those entrepreneurs that only need additional working capital on an occasional or one time basis will find it much more difficult to interest a factor in accepting the arrangement. ELIGIBLE INVOICES For purposes of financing, factors and lenders will purchase normal trade invoices reflecting sales "without condition". Certain types of invoices and / or conditions of sale can disqualify invoices from factoring or other forms of accounts finance. Some of the most common of these characteristics include… ELIGIBLE INVOICES • Over 90-day receivables • Consignment invoices • Invoices Subject to Lien • Contras • Government / Foreign Accounts • Bill and Hold • Inter-Company Receivables • Contingent Invoices • Poor Credit Quality FACTORING CASE STUDIES Case Studies One of the best methods of understanding factoring is sometimes through examples or "Case Studies". See page 28. FACTORING FEES Fees Charged in Factoring Fees charged for factoring are usually calculated per period of time that the invoice remains outstanding and unpaid. Such periods are referred to as "windows" and are frequently either 10 or 15 days. Factoring fees have dropped markedly over the last twenty years with a typical 30 day factoring rate now being about the same as a credit card transaction (2%-3%). See page 32 INTERNATIONAL FACTORING INTERNATIONAL FACTORING As international trade continues to grow, so do the opportunities for international factoring or import-export factoring. It is becoming well established in many developing nations (especially those that are highly industrialized) and is often considered the financing method of choice for export trade between the United States and Europe. INTERNATIONAL FACTORING There are four parties involved in an import- export factoring transaction: ♦ the exporter ♦ the importer ♦ the export factor ♦ the import factor INTERNATIONAL FACTORING In most typical international factoring transactions, the export factor will be located in the same country as the exporter of goods and the import factor will be located in the same country as the importer of goods. The exporter will work with the export factor who has a relationship with the import factor. Usually, both will be members of Factors-Chain International ENTREPRENEURIAL FINANCE PURCHASE ORDER FINANCE PURCHASE ORDER FINANCE Purchase Order Finance (PO Finance) is a powerful financial tool commonly offered through factors and asset-based lenders. Though its capabilities are not limited to export-import trade, its use is so common in cross-border transactions that virtually any entrepreneur with international commerce in mind should become familiar with its capabilities. PURCHASE ORDER FINANCE Simply put, purchase order finance answers the needs of manufacturers and distributors when capital is necessary to fulfill an order. Whereas factoring is brought to bear after the delivery of merchandise or performance of a service, purchase order finance provides the necessary capital to manufacture the goods prior to delivery and invoicing. PURCHASE ORDER FINANCE Successful purchase order finance is based on three criteria: • a valid order from a creditworthy customer • performance capability of the client • is it a "firm" purchase order? PURCHASE ORDER FINANCE Purchase order finance is primarily utilized by two types of companies... distributors and manufacturers. It is generally not available for the service sector. As a rule, distributors do not manufacture or assemble their product although many intoday's markets are "contract manufacturers" and arrange for the manufacturing of a product overseas PURCHASE ORDER FINANCE Purchase order finance companies work directly with factors and asset-based lenders. Once an order is filled and delivered to the customer, the customer is invoiced by the client and an account receivable is created. At this point, the purchase order finance company must be "taken out" by the factor or lender. PURCHASE ORDER FINANCE As a general rule, most purchase order finance companies dislike working directly with lenders such as banks, much preferring the flexibility of the factors and asset-based community. PURCHASE ORDER FINANCE As mentioned, one of the most common transactions requiring purchase order finance is that of offshore contract manufacturing. When a foreign factory, for example, manufactures a product for a domestic company, they generally require full payment when the goods are delivered to the freight forwarder. PURCHASE ORDER FINANCE To accommodate the foreign factory, the domestic manufacturer will contact a purchase order finance company to: A. post a letter of credit for payment B. inspect the goods C. pay for the goods when required D. arrange for shipment to the customer PURCHASE ORDER FINANCE Once the goods are delivered to the client's customer, invoices can be generated which will be factored. Instead of advancing funds to the client, the factor first pays the purchase order finance company satisfying their lien. The balance of the advance is then given to the client. PURCHASE ORDER FINANCE It is important to understand that purchase order finance is a short-term transaction, usually lasting less than 60 days. As with factoring, it is never used to finance inventory. Goods generally must be delivered directly from the factory to the customer, bypassing the client altogether. PURCHASE ORDER FINANCE If the goods must be modified or repackaged by the client, this can often lead to a problem with purchase order financing. When purchase order finance is used to acquire inventory, an asset-based lender must agree to take out the purchase order finance company when the goods are delivered. SETTING UP A RELATIONSHIP In most cases, a business owner requiring purchase order finance will work directly with their factoror asset-based lender to secure such financing. In the cases where a direct relationship is first established with the purchase order finance company, that company will refer the business owner to an appropriate factor or asset-based lender. Alternative Commercial Finance Solutions When Banks Say... NO!