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Because of a deteriorating commercial lending environment, some of our earlier advice is now likely to be especially relevant for many businesses. Banks are currently saying “no” more frequently than they have in decades, and we provided advice a few years ago about what actions business owners should consider if their bank rejected a small business financing request.

As described in this article, while a bank saying “no” is not an outcome that any business owner would hope for, it can eventually lead to an overall improvement in commercial financing options under many circumstances. Small business owners are increasingly hearing their bank say “no” to requests for needed business financing and working capital. Most commercial borrowers are often not sure what to do next since such an awkward situation represents uncharted waters for them.

Banks are routinely saying “no” to small businesses which are both profitable and long-term customers. It is now common to hear phrases such as “thinking outside the bank” and “business loans without banks” when talking about strategies small business owners might need to analyze because this has become such a widespread commercial lending problem.

There are two financing situations that businesses should especially be prepared for banks saying “no”. One of these involves commercial real estate loans and the other working capital financing (including business lines of credit). While a small number of banks are still proving to be reliable sources for some business financing options, recent nationwide commercial lending reports clearly show a drastic reduction in commercial loans for commercial real estate financing and working capital loans.

Small businesses have only rarely pursued the option of replacing their bank. However, an astute business owner will quickly realize that they have little recourse but to pursue such a path when their bank says “no” to routine requests for business financing. Improvements to the overall financial health of a business will be achieved in a pleasantly surprising number of cases even though this search for new commercial finance alternatives is undertaken under protest by most commercial borrowers. Keep in mind that in many cities and communities, one or two banks frequently operate in a near monopoly environment. When small business owners have literally been forced to find new business finance options, they are often pleased to discover that they can not only replace existing bank financing satisfactorily but also improve their bottom line in the transition.

A prudent starting point for commercial borrowers to adequately evaluate how to get working capital and other business loans when their bank says “no” is likely to be a lengthy conversation with a small business financing expert. Finding and selecting such an expert will not be a quick or easy task for business owners, but this step is likely to be critical to eventual success in formulating a strategy for obtaining new sources of effective commercial finance funding. Ensuring that the commercial financing expert chosen is totally independent and not affiliated in any way with the bank which said “no” is an especially crucial aspect not to be overlooked in locating a reliable expert to help.

Introduction

A venture financing can be structured using one or more of several types of securities ranging from straight debt-to-debt with equity features (e.g., convertible debt or debt with warrants) to common stock. Each type of security offers certain advantages and disadvantages to both the entrepreneur and the investor. The characteristcs of your situation and current market forces will impact the type and mix of security package that is right for you.

Types of Securities
Senior debt: Which is usually for long-term financing for high-risk companies or special situations such as bridge financing. Bridge financing is designed as temporary financing in cases where the company has obtained a commitment for financing at a future date, which funds will be used to retire the debt. It is used in construction, acquisitions, anticipation of a public sale of securities, etc.
Subordinated debt: Which is subordinated to financing from other financial institutions, and is usually convertible to common stock or accompanied by warrants to purchase common stock. Senior lenders consider subordinated debt as equity. This increases the amount of funds that can be borrowed, thus allowing greater leverage.
Preferred stock: Which is usually convertible to common stock. The venture’s cash flow is helped because no fixed loan or interest payments need to be made unless the preferred stock is redeemable or dividends are mandatory. Preferred stock improves the company’s debt to equity ratio. The disadvantage is that dividends are not tax deductible.
Common stock: Which is usually the most expensive in terms of the percent of ownership given to the venture capitalist. However, sale of common stock may be the only feasible alternative if cash flow and collateral limits the amount of debt the company can carry.

While each of these securities has unique characteristics, they can be grouped into two categories: debt or equity. In structuring a venture financing, the primary question is whether the financing should be in the form of debt or equity.

Disadvantages of Debt to a Company

From a company’s viewpoint, there are two potential disadvantages to debt.

An excessive amount of debt can strain a company’s credit standing, thereby reducing its flexibility in meeting future long-term financing requirements on a favorable basis. It can also negatively affect a company’s ability to obtain short-term credit. Of course, the form of debt the venture financing takes makes a difference. For example, subordinated debt will have less impact on borrowing capacity than senior debt.
The venture capitalist has the option of calling his loan if the company is in default of the loan agreement. This remedy, which is not available to him under other financing agreements, puts him in a better position to influence the company’s affairs when it is in default.
Advantages of Debt to a Venture Capitalist

From the venture capitalist’s viewpoint, there are three principal advantages to debt.

There is a greater likelihood that the venture capitalist will get his principal back and, at least, a small return. Many of the companies in the average venture capitalist’s portfolio are referred to as “the living dead.” Needless to say, their performance has turned out to be disappointing. In some cases, these companies are able to repay principal with interest but have limited appeal to potential acquirers or the public. As a result, a venture capitalist with an investment in such a company’s common stock may be unable to recover his investment within a reasonable period, if at all.
As previously discussed, under certain circumstances the venture capitalist is in a better position to influence the company’s affairs.
The venture capitalist has a senior claim. However, it should be emphasized that the meaningfulness of a senior claim depends on the marketability of a company’s assets and the amount of equity it has to cushion its creditors’ position. For example, in the case of a start-Lip situation with little or no equity, a senior claim means little or nothing.
Percentage Ownership Needed

While the difference may not be great, depending on the particular circumstances of the company, a debt position involves less risk than an equity position for the venture capitalist. Accordingly, a company should not have to relinquish as much ownership when a financing is in the form of debt. However, this advantage must be weighed against the disadvantages of debt.

No matter how the venture financing is structured, it must be priced so that it is attractive to the venture capitalist. There is no clear-cut answer as to how much ownership a company will have to relinquish to make a financing attractive. Broadly speaking, the greater the potential return perceived by the venture capitalist, the less ownership he will demand. In other words, if a company has a patented product which a venture capitalist thinks is revolutionary and highly marketable, he will undoubtedly settle for less ownership than he would in the case of 4 company with a relatively less attractive product. Thus, his ultimate position will be a business judgment based on his potential return.

Before you enter negotiations with the venture capitalist, you should determine what your company is worth and how much of your company you want to sell. The following procedure can be used to get a rough idea of how much ownership you will have to give up to make the financing attractive.

Estimate the risk associated with the venture financing. If the investment is very risky, the venture capitalist may be looking for a return as high as 15 times his investment over five years. Conversely, if a relatively low degree of risk is involved, the venture capitalist may be satisfied with doubling or tripling his investment over five years.
Make a reasonable estimate of the price/earnings ratio applicable to comparable publicly held companies. The market value of the company can then be projected by multiplying forecasted annual earnings by the estimated price/earnings ratio for comparable companies.
Divide the estimate of the total dollar return the venture capitalist wants by the projected market value of the company. This yields the percentage ownership the venture capitalist will need, as oil the future date, to realize his desired return. It is important to note that any equity financing required during the interim period must be considered in making these calculations.


Case Study

Suppose XYZ Company, Inc., a start-up, needs 0,000. The company’s product appears to have excellent potential. However, because the product is new and unproven, an investment in the company would be extremely risky. Accordingly, it is reasonable to estimate that a venture capitalist would want a potential return of at least ten times his total investment in five years. Management estimates that the company should be able to “go public” at 20 times earnings in five years. Projected after-tax earnings for the fifth year is ,250,000. Additional long-term financing of 0,000 will be needed at the beginning of the third year.

Scenario I

In the calculations below it is assumed that the venture capitalist who provides the initial financing (0,000) also provides the subsequent financing (0,000), and that he wants a return equal to ten times both. However, it should be noted that if the company made satisfactory progress during the first two years, it would be reasonable to assume that the venture capitalist would be satisfied with a lower return on the subsequent financing since it would involve less risk.

Estimate of Total Dollar Return Required Total Investment $ 1,000,000 Estimate of Return Required X 10

,000,000

V. Projected Market Value in Fifth Year VI. VII. Projected Earnings ,250,000 VIII. Estimate of P/E Ratio x 20

,000,000

Percentage Ownership Needed in Fifth Year Estimate of Total Dollar Return quired ,000,000 Projected Market Value of Company in Fifth Year 25,000,000

40% Scenario II

In this set of calculations it is assumed that a second investor provides the subsequent financing (0,000). The calculations show that the venture capitalist who provides the initial financing (0,000) would need 20% ownership as of the fifth Year to realize the return he wants. However, since the ownership to be given up for the subsequent financing will reduce his ownership position, he will want more than 20% ownership initially. For example, if it is assumed that 15% ownership will have to be given up for the subsequent financing, the venture capitalist who provides the initial financing would need 23% ownership initially to end up with 20% ownership in the fifth year.

Assume the same facts as Case I, except a second investor provides the subsequent financing for 15% ownership.

Estimate of Total Dollar Return Required Total Investment $ 500,000 Estimate of Return Required X 10

,000,000

Projected Market Value in Fifth Year Projected Earnings ,250,000 Estimate of P/E Ratio x 20

,000,000

Percentage Ownership Needed in Fifth Year Estimate of Total Dollar Return required ,000,000 Projected Market Value of Company in Fifth Year 25,000,000

20%

Thus, it appears that the investment (0,000) may be attractive to an interested venture capitalist if the principals of XYZ Company, Inc. are willing to give up approximately 23% ownership.

Conclusion

It must be emphasized that the above procedure is highly subjective. And, you should remember that what really matters is how the venture capitalist views the relative attractiveness of a company. Typically, venture capitalists are satisfied with a minority interest. Although a venture capitalist may demand a majority interest, generally they are not interested in operating control. Some of them like to tie the amount of ownership they ultimately get to the performance of the company. For example, a venture capitalist who wants a majority interest initially may give the principals the opportunity to earn part of it back. Such an arrangement can be used to compromise on pricing when there is a significant disagreement between the principals and the venture capitalist.

To entrepreneurs unfamiliar with venture capital, it may appear that the venture capitalist is seeking an extraordinary high return on his investment. However, it is important to understand that, even under the best of circumstances, only a minority of the companies in which the venture capitalists invests will be successful. He is well aware of this, and must make a sufficient return of his successful investments to come out with an acceptable return overall.

Make or Break

Managing working capital is a critical component of financial management. It can make or break a company.

Inadequate working capital can put a company in jeopardy rather quickly due to liquidity problems. On the other hand, excessive working capital strains the companys finances.

Accounting Definition

Accounting defines working capital as Current Assets less Current Liabilities. It is also known as Net Current Assets. Current assets are those which are considered liquid and are convertible or expected to be realizable in cash within a period of 12 months from the date of the financial report. Common examples include cash, inventories, accounts receivables, prepayments and marketable securities. Current liabilities are those which are expected to be repaid within a period of 12 months. Examples include bank overdraft, short term borrowings, accounts payables and accrued expenses.

Operating Standpoint

Operationally, working capital indicates the ability of the company to finance its current operations and to meet obligations when they mature. It measures the companys ability to pay daily bills from a liquidity

standpoint.

When it is Inadequate

If there were more current liabilities than current assets, the result is called Net Current Liabilities, Working Capital Deficit or simply Negative Working Capital.

If all the liabilities were to become due and payable immediately, the company does not have sufficient liquid resources to pay them. This could potentially lead to a going concern problem, which means that the company may not have the ability to continue in operations if it could not successfully find sufficient liquid resources to settle its obligations quickly.

From a financial ratio perspective, a companys working capital position is also represented by its current ratio. Current ratio is calculated using current assets to divide by current liabilities. A current ratio of

less than one means that working capital is negative. For example, if current assets were 0 and current liabilities were 0, the working capital deficit calculated would be (). The current ratio is computed as 100/120, giving 0.83, which is less than one.

Remedial Strategies:

To relieve working capital deficit, the following strategies are commonly adopted:

a. Raise Equity

A company can issue more shares to existing or new investors to bring in fresh funds. This infusion of equity will help to raise cash. The side effect of this may be to dilute the interest of existing shareholders who do not wish to inject further equity into the company.

b. Selling Non-current Assets

Non-current assets are those which are not expected to be convertible into cash within a period of 12 months from the financial report date. These are typically fixed assets such as property, plant and equipment. Included

here are also long term investments in other companies. A company can sell its non-core assets to raise cash to enhance its working capital position.

The other way of liquefying its balance sheet may be to enter into a sales and leaseback transaction of its property. This would result in cash infusion into the company.

Ceasing further capital expenditure would be wise till the cash situation and working capital position improve.

When Having Too Much is Bad

On the other hand, having too much working capital may not be ideal either. This is particularly so if the expansion of working capital is due to the rise in inventories and trade debtors, especially when they are

rising faster than sales revenue.

Inventories

Excess inventories pose several problems for businesses. The first is that of obsolescence risk. It could mean physical deterioration as well as technical or market obsolescence.

The second problem is that inventories drain cash. Liquid cash is tied up until the products are sold and the money collected from customers.

The third problem is that inventories require storage facilities. This takes up valuable space and may cost a business in terms of rental expense or opportunity cost in terms of facilities tied up.

If a business has old inventories, it would be advisable to clear them out quickly and free up the cash so that it can be redeployed for better uses.

Trade Debtors

Trade debtors represent financing by the company to its customers. Most often, this is interest and collateral free. On the other hand, the company may need to obtain bank financing on which it incurs interest.

When trade debtors build up, it may also be an indication of lax credit policy and poor follow up on outstanding debts. It may be worthwhile to engage additional resources to recover these receivables more quickly than letting customers take their time to settle their invoices way beyond the credit limit given.

It Boils Down to Efficiency

The more efficient a business can manage its inventories and trade debtors, the better it is for liquidity. More cash would then be available for growing the business, reducing finance costs and paying shareholders

dividends.

Conclusion

As we can see, it takes prudent financial policies, management discipline and vigilant monitoring to ensure that a fine balance is maintained for working capital. But the effort will pay off handsomely for the business

with the will to do so.

An important tool companies adopt to send a message to the investors that the company means business is to cut capital expenditure and reduce non-core assets.  Usually this is met with more investment or better stock price from the market. What is the message that the investors are receiving that entices such a reaction?  Usually, the message means that the company is trying to reduce cost and become more efficient. They are indicating that the company is trying to get more assets available that they can use for operational expenses in the short term for their financial health. In financial metrics this means increasing the current assets or decreasing current liabilities.

A good measure to identify this is the Working Capital (WC).

Working Capital = current assets – current liabilities.

Current assets are cash and other assets that can be converted to cash within a year. Current liabilities are obligations that the company plans to pay off within the year. Working capital indicates the assets the company has at its disposal for current expenses. It can be thought as the circulating capital of a business. The process of managing the WC efficiently is called Working capital Management. It’s one of the important aspects of financial management. An excess of working capital many mean that the company is not managing its assets efficiently. It’s not using its assets to get a bigger return or better profit. An aggressive company may keep its working capital smaller. A very low working capital may mean the company may not be suited well enough to payoff its short term obligations.

This decision of how to manage the working capital of the company depends on the Working capital policy of the company. An important factor that determines the policy is the industry in which the company operates.  For Example, an IT service company may not have a lot of shot-debt in terms of inventory but it still needs to pay wages, insurances and other expenses like rent. The company needs to have a policy that makes sure it sets targets were it gets paid as the project progresses so it can keep paying its staff in time. The company has to manage its account receivables according to this policy. Some industries operate in a high profit margin that they can afford to have a longer term on the account receivables because the higher cash balance part of the current assets. A good example is a company like BP, which is able to survive till now after the big oil spill disaster in the Gulf.

The Collection Ratio helps project this aspect of a company

Collection Ratio = Accounts Receivable/ (Revenue/ 365)

Collection ratio tells us the average number of days it takes a company to collect unpaid invoices. A ratio which is very near to 30 days is very good since it means that the company is getting paid on a monthly basis.

Cutting costs and shedding non-essential assets to make the company leaner is one of the attributes of working capital management. But this strategy cannot be sustained. The company cannot keep cutting costs without sacrificing service. Once the company becomes lean enough cutting costs will become detrimental to its operations.

Another attribute that strongly impacts working capital is sales. It is the ability of a company to sell its products fast enough to get the money back to put back into operations or supplies for producing more materials. Moving inventory fast is always a good plan for a company. It also helps in reducing costs associated with holding and moving inventory. A good ratio that helps put the attribute in perspective is inventory turnover ratio.

Inventory turnover ratio= sales / inventory

Alternatively,

Inventory turnover ratio = Cost of goods sold / inventory

The ratio shows the efficiency the company has in selling its products. The higher the ratio the better the company is able to move the products. Again this could be dictated by the industry, for example, a daily products company is usually forced to sell its products fast enough or lose it. The ratio also provides a good insight into how a company is doing within an industry. The direct ratio of companies can be compared to see how well the company is able to sell the products in comparison to its competitors.

Financing is another attribute of Working Capital management. Companies tend to finance their way out of a need for short term expenses by taking loans. From the balance sheet it is clear that financing increases liabilities, so the only option companies have to increase Working capital is though long-term debts that have a smaller impact on current liabilities. This way their short term cash balance increases providing the cushion the company needs for its short-term operating needs. Since obtaining long term debt depends on the credit rating of the company it becomes difficult for smaller or newer companies to use this attribute of working capital management.

Debt-Asset ratio provides a good insight into how much of the company’s assets are being financed though debt

Debt-asset ratio = Total liabilities / Total assets

Financing for short term operations may not immediately signal an issue with the company, it may be that the company has realized an opportunity that it needs to act on immediately which would increase the prospects of the company in the long term. Companies that have an aggressive working capital management policy would be using this strategy. But this is always riskier since the company would accumulate a lot of long-term debt that could eat away at the profits or even become so big that the interest expense can impact the current liabilities.

Working capital management becomes a very important aspect for a company since it is the first line of defense against market downturn cycles and recession. A company with cash is usually in a good position to make better use of the opportunities the markets provide. Its can spend the money on R&D for coming up with better products. Increase in current assets, especially, increase in account receivables due to growth is sales have to be managed efficiently. Ability to control working capital plays a significant role in the survival of the company.