Tiered Financing 

Corporate Finance

Tiered Financing

The small and medium-sized business financing landscape is changing as more and more niche lenders enter the marketplace.

FROM: MAY-JUN 2004 ISSUE | BY MARK EIKELAND

The client base of many public practitioners includes a number of entrepreneurs and small business owners. And when these clients need capital, their first thought is often, "the bank." But these days, the bank represents only one funding source out of many, as there are more financing options available than most entrepreneurs or even their accountants are aware of.

In fact, the Canadian small business financing landscape continues to open up to alternative sources of capital. Increasingly, it is a marketplace of niche lending, and the increased competition is bringing added specialization and innovative options. Today, lenders differentiate themselves with financing initiatives that focus and target services, industry, region, class, asset type, life cycle/growth stage, product, risk, sales, customer base, growth, leverage, the dollar size of the credit facility, and so on.

This growing list of options includes credit unions, factoring companies, and foreign banks such as Wells Fargo. Add to that merchant and investment banks, "near-banks" like GE Capital, leasing companies, venture capital companies, asset-based lenders, sub-debt lenders, boutique lenders, private companies, investment funds, federal and provincial government programs, mortgage and finance companies, enterprise centres, and government-sponsored specialty programs such as the Community Futures Development Corporation, Export Development Corporation, and Canadian Commercial Credit Corporation.

For the entrepreneur, gaining access to new financing sources can be like trying to navigate through uncharted waters without a guide. Entrepreneurs need to know exactly what their requirements are and what the lender's preferences are, as some lenders look for and do deals that other lenders avoid. Access to capital is one of the biggest issues facing entrepreneurs; it is also one of the biggest opportunities for CGAs to deliver valuable professional services to their small and medium-sized business clients.

A Tiered Approach to Financing

Using multiple funding sources is known as tiered financing. It is a well-used strategy common in big business financing, syndicating large loans, and spreading risk. A version of this strategy is being used more frequently by small businesses.

Gone are the days when one bank was the sole funding source and met all of the financing requirements of a business. Now even small operating lines of credit under $500,000 can be split between two different banks; one bank provides the secured funding and the other is in an unsecured position providing top-up financing.

A tiered financing approach can be a very desirable and successful strategy. Such an approach might include some or all of the following products:

1. Operating Line — Secured
A secured operating line of credit (LOC) is a cornerstone to any mature business financing program. Funded by the bank, it typically margins the facility on inventory and accounts receivable. Rates are low starting at prime.

2. Operating Line — Unsecured
There are many opportunities to top up a LOC, such as adding another unsecured facility, insuring accounts receivable balances for higher margining or factoring specific accounts receivable in excess of margining requirements.

A second lender comes in on an unsecured basis to "top up" working capital with an unsecured operating LOC to supplement the primary operating line. This works well when a business is experiencing a growth spurt or has seasonal cash flow swings. This is also an opportunity to introduce a second lender into the business. Rates can start at prime plus two percent.

3. Factoring
A factoring program turns a company's accounts receivable invoices into immediate cash. The factoring company buys the invoices and charges a fee. A carrying cost is charged until the customer pays the invoice, usually directly to the factoring company. For many businesses, a growth spurt has consumed the entire LOC, yet there may be excess margin available. A factoring company can work with the bank to purchase invoices over margin. Factoring is often a good alternative when a company is precluded from bank financing or when used in tandem with an existing operating line. Rates can start at two percent per month or one per cent for every 10-day period that the invoice remains unpaid.

4. Capital Term Loan — Secured
This is the traditional long-term capital asset financing program that is fully secured by capital assets. In the past, the bank providing the operating loan was expected to provide this financing product as well. Today this is an opportunity to introduce an alternative lender and reduce overall exposure to any one financial institution. And, in many cases, this can be achieved with better terms, rates, and conditions. Rates can start at prime plus one percent.

5. Capital Lease — Secured
Capital leases are commonly used for acquiring specialized equipment, in specialized industries or in cases where attractive terms such as 100% financing is available. Very often, in-house dealer programs make acquiring capital assets with a lease very easy. Sale lease-backs are often used to turn equity in equipment into cash. They are often a good alternative when conventional loan programs are not available, or the company has no other credit alternatives. Rates can vary significantly.

6. Working Capital Term Loan — Unsecured
Working capital loans are used in situations where sales are expanding and the company needs additional working capital to support the sales growth. In this case, the company assets are already fully secured with senior debt. As a result, this specialized type of financing is based on cash flow and debt serviceability, and is essentially unsecured. Rates are higher because of the unsecured risk. This specialized product might also include convertible instruments and warrants. Rates can range from prime plus four per cent to prime plus 14 per cent.

7. Operating Lease — Secured
The operating lease is easily available and is typically used to acquire small to mid-size equipment. It often comes with no money down options and is a very attractive financing alternative. With proper planning, larger equipment leases can be structured as operating leases for financial statement purposes. With the June 2001 tax changes, all leases, even capital leases, are treated as operating leases for tax purposes. This can present some significant tax planning opportunities when financing capital equipment.

The premises lease is included here and is how leasehold improvements are most appropriately financed. In most cases the landlord is willing, and is best able, to provide some financing on the project over and above negotiated tenant inducements. If applicable, the landlord can simply adjust the lease obligation to reflect the additional investment.

These products could be part of an overall financing program, and a different lender may supply each product. Here are some additional reasons to use the tiered approach:

• Reduce credit risk
  The best time to establish a new banking relationship is when you do not need one. Multiple banking relationships build in financial flexibility with future alternatives.
  
  
• Flexibility of niche lenders and products
  Speciality lenders can often provide financing programs with terms and conditions that are specific to the industry the business operates in.
  
  
• Access and ease of process
  New Web-based services provide instant access to a multiple range of lenders and financing products.
  
  
• Reduce cost of funds
  Refinancing is often a case of replacing existing debt with new terms and conditions, so that both cost and cash flow have been improved.
  
  
• Reduce impact of economic fluctuations
  Industry and economic fluctuations can affect banking relationships. When banks are overexposed in certain industries, everyone in that industry experiences a tightening of lending policies. Compare the "fast and furious" financing practices of the high- tech industry in 1999 to the challenges of financing a high-tech company today.

In the past, if the bank refused a loan, the business owner would likely be without a suitable financing alternative. But these days, there are many alternatives and solutions to successfully finance a business. CGAs can play a valuable role in guiding their clients through the ever-expanding maze of options to establish an effective, tiered financing strategy.

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Mark Eikeland, CGA, is president and founder of NetFinance.ca, an online full service corporate finance resource for accountants and accounting firms in BC and Alberta. Visit NetFinance.ca for more information. (This article appears courtesy of CGA-BC.)