Unlocking Capital

While there seems to be some light at the end of the tunnel for emerging growth and middle-market companies with regard to capital availability, it likely is going to be awhile before we return to what we hope are “normal” market conditions. So where do you get the funds to support growth in today’s market? This question is being asked by many CEOs, CFOs, board members and their advisors who are seeking money to support strategic initiatives. Many operating companies with revenues from a few million to several hundred million dollars (emerging growth and middle-market) experienced tough business conditions throughout 2008 and 2009.

Some businesses may have had losses or diminished revenues with minimal profits, resulting in a weaker balance sheet. Further, many firms may have trimmed costs and become more efficient and are now ready to rebuild in 2010. Yet their banks have likely tightened the reins on available credit and taken a more conservative posture. While augmenting a company’s capital or equity base might be an option, numerous private and institutional investors have pulled back on funding commitments as they have seen their sources of liquidity dry up and as they focus on their existing portfolios. Alas, there is hope!

Finding the right capital depends on having a solid, well-thought-out strategy and operating plan and a strong management team. With the fundamentals in place, you can find investors or lenders that align with the type and horizon of funding required to implement your strategic initiatives.

Four sources of capital for emerging growth and middle-market companies that leadership teams should consider are:

1. Asset Based Lenders (ABLs). There is a wide range of ABLs, starting with commercial bank-owned lenders that lightly monitor collateral to very aggressive loan-to-own privately held financiers. Most likely, bank ABLs are going to be nearly as tight as their corporate finance counterparts given that they have some of the same regulatory pressures and risk aversion. Non-bank, non-regulated asset-based lenders are a more likely source of capital, as they can tolerate higher debt leverage ratios and an inconsistent earnings history. They typically provide working capital based on accounts receivable, inventory and, in some cases, customer contracts or purchase orders. In the past, some ABLs would tolerate current operating losses in the short-run or even slightly negative cash flow—but not in today’s market. Most of these ABLs have credit facilities that are lines of credit with daily or weekly monitoring.

In addition to traditional factors, there are hybrid factors that provide working capital in a line-of-credit-type facility, making these solutions less intrusive.

Lastly, there is now the ability to directly and selectively auction accounts receivable via an online exchange. While more expensive than traditional bank debt, ABLs avoid equity dilution and provide cash availability for short- and mid-term working capital needs.

Barry Yelton, senior vice president of Federal National Payables, Bethesda, Md., offers the following advice to executives: “Keep in mind that there are far fewer non-bank ABLs today than just a few years ago. If a borrower is turned down by a bank, he may have problems obtaining financing from a non-bank ABL as well, particularly in the funding bracket under $5 million.”

He adds, “Borrowers need to present as complete and positive picture of their companies to new lenders as possible. This includes providing full financial and collateral information, including a believable forecast of revenue and cash flow for the coming year.

“ABLs, like their banking cousins, are being more selective and requiring more from borrowers than in recent years. As a result of the current market environment, borrowers can expect to pay higher interest rates and obtain lower advance rates than historically,” Yelton concludes.

2. Growth Equity. For initiatives requiring permanent capital, growth equity may be an appropriate alternative for your company. Growth equity funds comprise a minor percentage of the total population of private equity investors. You can think of growth equity investors as being at the intersection of venture capital and non-control private equity funds in their appetite for risk balanced with cash flow and control.

Unlike a venture capitalist whose interests extend to start-up or early stage opportunities, growth equity investors do not make investments expecting many to fail, so their risk tolerance is lower. These investors look for operating companies that have revenues, a proven technology or service and proven market demand.

As Ed McCarthy of River Cities Capital Funds, Cincinnati, says, growth equity investors “look to avoid concept risk, preferring to invest in execution.”

Growth equity investors will fund operating losses if the company is in a growth or expansion mode and where the losses are an investment in capturing market share or long-term customers. In some cases, growth equity investors may be willing to fund a partial recapitalization or minority shareholder buyout.

3. Mezzanine Capital. Mezzanine funds are similar in their positioning in the world of private equity relative to growth equity. However, their investments are primarily in the form of subordinated debt with an equity kicker (warrants to purchase stock) that allows them to participate in the value growth of the business. As debt, they have a defined repayment period to recapture their initial investment (usually four to seven years). In some cases you will find that mezzanine funds will make a portion of their investments in the form of pure equity.

Mezzanine is thought of as a hybrid type of financing providing a lower cost of capital while having some characteristics of equity, given that it is subordinated to any bank or senior debt and that most banks will exclude subordinated debt in the total debt calculation for testing leverage ratios. Repayment is typically interest only with the principal due at maturity.

Keep in mind that mezzanine capital only works if your company is generating positive cash flow, which will likely need to be at least $1 million in EBITDA (earnings before interest, taxes, depreciation and amortization).

Typical uses of funds include an acquisition, major new initiatives like product launches or business unit start-ups and partner buyouts or recapitalization.

4. Key Partners. In almost a counter-intuitive move, strategic supplier and key partner relationships are providing capital as many companies seek to stabilize revenues and earnings. The capital provided usually is not in the form of direct investment but rather in the form of providing services, resources or new business on increasingly favorable terms to lock-in or secure sales and margins. This technique of obtaining working capital may be the most inexpensive and quickest form of fundraising for many companies.

A company’s executives are encouraged to look at their customers and suppliers to determine who has the most to gain by their company’s success. They should seek creative deals or relationships that provide value to both parties.

You will find that there are no silver bullets in fundraising, especially in difficult times. But it helps to understand the overall financing environment, clearly align your funding needs with the lender or investor and its priorities and to seek out financing before you actually need it, or proactively manage your capital structure as you would any other aspect of your business.

The author is managing partner of High Rock Partners, Raleigh, N.C. He is the lead author of the Handbook of Financing Growth. More information can be found at www.HandbookofFinancingGrowth.com or by e-mailing khmarks@HighRockPartners.com.