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Factoring
is a financing method that is usually much more expensive than
conventional bank financing. Yet it is an important option for SME’s
who may not have access to conventional bank financing, usually
because of lack of appropriate credit history.
This
article will provide a definition of factoring and discuss the
circumstances in which factoring might be appropriate, before
concluding with some pointers on types of structures for factoring
agreements.
What
is factoring?
Factoring
is a financial transaction whereby a business sells its accounts
receivable accounts (money owed to the firm by clients) to a third
party, called a factor, at a discount in exchange for immediate money
with which to finance continued business. It differs from a bank loan
in three key ways. First, the emphasis is on the value of the
receivables, not the firm’s credit worthiness. Secondly, factoring
is not a loan - it is the purchase of a financial asset (the
receivable). Finally, a bank loan involves two parties, whereas
factoring involves three – the firm, the client and the third party
or factor.
When
is a good time to use factoring?
In
most circumstances, where a bank can finance its receivables via a
conventional bank loan, this is preferable, as a significantly less
expensive form of financing. A revolving line of credit backed by
receivables that is offered by a bank may have an interest cost that
is a fraction of the discount applied by a factor. However, where a
business is a start-up, with insufficient credit history, or if a
firm has developed a poor credit history, it may need to resort to
factoring. This may be possible where its clients (the parties
issuing the invoices) have a strong credit history, hence the factor
can look to the strong credit history of the clients to provide
assurance of payment.
Given
the generally higher cost of factoring, only businesses that are
projected to be highly profitable and cash flow positive should
consider factoring. In other words, if the business can generate a
return on capital that is higher than the cost of capital, adjusted
for risk, factoring may make sense. If an illiquid business resorts
to factoring out of desperation in order to provide some short-term
liquidity, without the ability to generate a higher return than its
cost of capital, it will only dig itself into a deeper hole.
Given
the general reluctance of banks to lend to SME’s in today’s
environment unless there is relative strong security (e.g. real
estate or a personal guarantee), factoring may also be a way for a
business to be self-standing in its financing, without resorting to
collateral or guarantees.
What
to look for in structuring factoring agreements?
There
are numerous types of factoring agreements. Some of them are what I
would call “classical” factoring agreements, where the factor
literally buys the receivable at a discount, which means it has no
remedy against the business if there is a default on the receivable.
Others may be called factoring agreements in name, but in many ways
resemble loans. For example, one variation involves the factor
advancing approximately 80 percent of the invoice amount at the
outset. The balance of approximately 20 percent is kept in a kind of
notional reserve pool, paid out when the receivable is paid to the
factor, if there is a default on the receivable, or more than 90 days
goes by without payment, the factor may deduct it from the reserve
pool.
But
the devil of any factoring agreement is in the details. What events
constitute a default? What are the consequences of default? What are
notice and cure provisions? Is there any minimum amount per month or
quarter that must be factored? And most factors will insist on the
receivables flowing directly from the client to them.
As
a result factoring is definitely not appropriate for every SME, but
in certain particular circumstances, where bank financing is not
available, or the owner wishes to avoid guarantees or collateral, and
the business generates a return that is higher than the cost of
capital, factoring is a viable option worthy of some consideration.
It has been a week of hell in financial markets: S&P downgrades
US Treasuries, the Dow plunges below 11,000, stock markets all over
the world give up trillions of dollars in value. Riots from the UK to
Israel. Safe haven investments such as the Swiss franc and gold reach
new highs … Where does this leave the average SME (small or
medium-sized enterprise) owner? Consider the following five likely
outcomes:
1. Revenue stagnation
What has happened in the past week or two is a sea change in the
outlook of financial markets. Whereas two weeks ago financial markets
seemed to reflect a cautious optimism that a slow global recovery was
under way, markets now reflect a scenario of stagnation, in some
countries potentially even a double dip recession. So unless you are
in one of those fortunate niches that can’t keep up with demand
(for example the entire supply chain of Boeing and Airbus is
struggling to keep up with a five year backlog on aircraft orders),
your revenue outlook may be considerably less optimistic today than
two weeks ago.
2. Ongoing volatility
The best prognosis is that markets will continue to lurch from crisis
to crisis. There is no credible solution yet in place for the debt
problems of the peripheral European economies. The US will lurch
between between slamming on the fiscal brakes (the Tea Party’s
desire to reduce the size of government spending) and stimulus, in
the form of new forms of quantitative easing and job creation
programs – each with its own set of problems. Even China teeters on
the edge of a contraction, according to some market watchers.
3. Liquidity will be at a premium
Companies will likely stretch their payables even more, cash will be
at even more of a premium. Liquidity may become an even more
important source of competitive advantage.
4. It may become more difficult to raise financing
Banks may become even more cautious in lending. Private equity will
likely become even more cautious in cherry picking quality deals at
more conservative valuations. M&A markets may become even more of
a buyers’ market. Yet for business owners, it may be important to
seek financing to ensure liquidity, even survival, in the potentially
lean months ahead.
5. A shift in asset classes?
Many market observers are saying that now is a good time to buy
equities, taking advantage of current low valuations. They may be
right. But one must also ask the question: Is there a long-term shift
among asset classes here? Just as the decade leading up to 2008 was a
decade of soaring equity values and above-historical returns, the
subsequent decade may go down in financial history as a decade of
equity price stagnation, horizontal movement and volatility. Since
2008, an investment in commodities (e.g. gold) would have performed
better than most equity portfolios.
The two major financial markets in the world – the US and Europe –
each have their own sources of instability moving forward:
-
The
US highlighted its own political disfunctionality in not being able
to resolve an artificial, self-inflicted, problem – namely raising
the debt limit – until the eleventh hour. This does not bode well
for creating the political consensus to solve the real (and
infinitely more difficult!) issue, diminishing the vast imbalance
between projected revenues and expenditures.
-
Europe
continues to suffer from the lack of centralized institutions,
(giving it, for example, the ability to levy taxes, drive
expenditures and issue bonds at the European level), an advantage
that the United States enjoys vis-à-vis Europe. While the consensus
for further integration does not (at least yet) exist, the lack of
such centralized institutions makes it far more difficult for Europe
to respond credibly to financial crises.
Working through both of the last two issues is optimistically a
decade-long agenda for both Europe and the US. In the meantime,
markets may lurch from crisis to crisis, which will either help
create the incentive for political consensus to resolve the above
issues, failing both the US and Europe will see huge difficulties
ahead. Scenarios include the European Union losing members, or the US
dollar losing its status as reserve currency.
Given the developments of the past week in financial markets, the
worst approach by business owners would be to take the ostrich
approach: to stick one’s head in the sand and pretend that nothing
has changed. These are momentous changes. How does this change your
business?
One of the cornerstones of corporate finance is the concept of a risk-free interest rate. For many decades, US treasuries were considered risk-free. All other sovereign risks were priced off of US treasuries. After all, who could have a lower chance of default than the mighty US Government?
Corporations, in turn, in each country, could only have higher risk than the underlying government and currency in which they conduct business, their risk (and hence return) could only be at a premium to sovereign treasuries in their respective home countries.
This may no longer be axiomatic. The world is rapidly changing. Rating agencies, such as S&P and Moody’s, are now allowing for the very real possibility that US treasuries may lose their coveted AAA status. If the US government does not approve lifting the ceiling of its self-imposed $14.2 trillion borrowing limit, it is likely to cease making certain payments by August, 2011. While no one doubts that the US government is economically capable of servicing its debt in the short- to medium-term, a lack of political consensus to raise the ceiling would create a politically induced default.
Vicious circles
Long-term, if high deficits continue, the US may move into territory where it may even lose its ability to safely service its debt. The current ratio of federal government debt to GDP is upwards of 70%, and if current trends continue, could exceed 90% within the next few years. This is aggravated by the fact that total US debt (federal debt, plus state and municipal debt, corporate and individual debt) is already in the range of 300% of debt/GDP, and this does not include unfunded government obligations, (for example, those related to medical care, pensions, etc.).
When debt levels become this high, borrowers seek to pay down debt (to the detriment of investment and consumption), which creates an environment not conducive for growth. It is far less painful to reduce the debt/GDP ratio by growing GDP then by shrinking debt. But the higher the ratio becomes, the more likely it will require painful debt reduction (deleveraging) to bring the ratio down, rather than growing one’s way out of the problem. This risks creating a vicious circle, where debt contraction may trigger GDP contraction, creating a downward spiral.
There is another vicious circle potentially in the making. US treasuries have been at historically extremely low interest rates over the past years, as a result of quantitative easing. Yet despite near-zero interest rates, the US deficit continues to burgeon. If interest rates on treasuries were to increase by a mere percentage point, (for example, from approximately 3% to approximately 4%), this would raise by one third the cost of issuing new debt or refinancing old debt. This would further diminish the ability of the US government to service its debt, potentially triggering a downgrade by rating agencies, which could result in a further increase in borrowing costs.
What if treasury interest rates were to spike into the double digits? (It has been north of 16% in my living memory.) You get the picture.
A race to the bottom
The US government has nevertheless been spared a negative spiral, in part by the fact that there have been so many crises over the past years (Hungary, Dubai, Iceland, Greece, Ireland, the Jasmine revolutions, Portugal, now potentially Spain or Italy), that US treasuries appear relatively safe compared to other major currencies, given the sheer size of the US economy, and the status of the US dollar as a reserve currency. Ask not whether the dollar is stronger than the euro, or vice-versa. Ask which is less weak?! At times, over the past few years, it has appeared as though the dollar and the euro have been in a race to the bottom.
So, I come back to the question: Where does all this leave practitioners of corporate finance? Every valuation in the world using the most common methodology (Discounted Cash Flow) calculates a cost of capital that assumes that US treasuries are risk free. But how can US treasuries be risk free if they risk losing their AAA status? And if the US government risks defaulting on its debt?
In the same way as a compass loses its accuracy when a navigator approaches a magnetic pole, the riskier US treasuries become, the more corporate finance practitioners risk losing their compass or accuracy in valuations. Let me ask a question that illustrates the absurdity: If we are to value an asset or company that derives its cash flow in a country where treasuries have less risk of default than the US treasuries (that is, less risk of losing their AAA credit rating), it is intuitively wrong to add a risk premium or even to price treasuries at the same rate as US treasuries. Would not such an argument be even stronger if the US dollar actually lost its AAA status?
Thorny issues
These are thorny issues, with no easy answers. If I had to offer a prediction as to what were to happen if the US credit rating was downgraded a notch from AAA, it would be that the US treasuries would, at least for a while, continue to play the role of the “risk-free rate” for valuation purposes, because of the sheer size of the US economy, the status of the US dollar as the reserve currency, and the time necessary for a consensus to develop as to what might be an appropriate alternative.
If US treasuries lose their AAA status, how long they remain the “risk-free” rate for the sake of corporate finance valuations will depend on the seriousness of the credit degradation, the future outlook for treasury risk, a big dose of market psychology, and power politics—in other words, quite unpredictable.
Parties to a transaction do not always
realize the extent to which time is of the essence in closing a
transaction. I will give three cases which illustrate why time is so
much of the essence, then draw certain conclusions:
Case
#1: In 2001, I was working on a major telecom transaction, where
numerous offers arrived on the company we were selling. After a
process that had taken over half a year; the best offer was still $20
million short of our client’s expectations. After weeks of very
hard bargaining, the gap was reduced to $5 million. The momentum was
promising. And then something extraordinary happened: September 11.
As result of the Twin Towers disaster, financial markets were greatly
perturbed. The gap was back to $20 million. And the whole transaction
was called off.
Case #2: I also heard of a case where
the last of several signatories to a deal was to sign the papers on a
Friday. He was not feeling well and asked to defer until Monday. The
only problem was that the signatory passed away on the weekend. No
one else in the company was willing or able to take responsibility
and sign the deal. Once again, the deal fell through.
Case
#3: The due diligence of a particular deal dragged on months
longer than what was normal. Once the due diligence issues were
resolved, the purchaser of the company noted that there had been a
major fluctuation in currency which greatly diminished the value of
the company in question. While a compromise on valuation was
eventually reached, and price renegotiated (it was touch and go: the
deal could just as easily have fallen through), the delay and
renegotiation still cost the seller millions of dollars.
As
the above cases indicate, there are all kinds of uncertainties that
may affect a deal. The above cases all point to the same conclusion:
when there is an active negotiation on a transaction, negotiations
need to take place with maximum speed, and none of the parties should
rest until closure of the transaction. This is one of the reasons why
M&A transactions tend to be ‘round-the-clock marathons. (Or
perhaps a party has a vested interest in drawing out the time line,
to take advantage of such uncertainties?)
The above cases also
illustrate why sellers of companies need to be fully prepared before
going to market, whether to raise additional capital, find a
strategic or financial partner, sell a minority or majority interest.
Where they are not fully prepared, the
companies are unnecessarily opening themselves to a
lengthier-than-necessary sale process. Better to have a thorough
information memorandum, data room, financial model and management
presentation fully prepared before going to market, thus minimizing
the amount of time that a company is actually on the market.
In
today’s financial market, and for the foreseeable future, there is
likely to be a huge amount of volatility and uncertainty.
Whether it’s the potential of the US
Congress not lifting the debt ceiling and the US defaulting on
payments, or the default of Greece, or any number of risks which
affect today’s financial markets, an event can happen tomorrow or
next week which may close your financing window, the same way 9/11
closed the financing window in the first case.
Today may not be the best financing
market – many people are putting off financing or transactions
until markets improve. But if you are counting on today’s financial
markets to raise cash, don’t take it for granted that markets will
improve. Until the agreements are signed and money changes hands,
virtually any deal can fall through.
In most cases company owners will be
best-served by taking a company to market only once preparations are
fully complete, and then close the transaction as quickly as
possible.
Only 8 percent of businesses offered
for sale are actually sold in the UK, and that statistic is likely
similar for other countries. There are probably three main reasons:
1) some businesses don’t have value; 2) in other situations, there
is a wide valuation gap between buyer and seller; 3) often there are
risks in a business that a buyer is unwilling to assume.
A
privately held business is perhaps the most illiquid form of
investment. It may take many months, even years, to sell a
company.
So how can one best maximize the chances of a
successful sale? I would suggest paying attention to the following
five areas:
1. Know thyself. Does the business owner
really want to sell? Particularly for those business owners facing
retirement, there is often deep psychological resistance to selling a
business. Giving up travel, an expense account and a life with a
mission can be difficult, especially if moving to retirement. Some
owners may get to the final phase of a negotiation, get cold feet,
and suddenly withdraw, without fully understanding the reasons
themselves. Bottom line: business owners need to understand their own
motivations, and when exiting to retire, need to plan and prepare
themselves for the subsequent phase in their lives.
2.
Understand your objectives. Is the objective to maximize
transaction revenues? Or reaching a predefined minimum price? Speed
of a transaction? Looking after future family generations? Often
objectives can be contradictory: maximizing speed, for example, tends
to reduce price. It helps to have a written definition of objectives.
Few things focus the mind like putting objectives in writing. Then
set a plan for achieving your objectives.
3. Build scale
and profitability. Most people intuitively understand that the
more profitable a business, the easier it is to sell. But it is
perhaps counter-intuitive to learn that selling a $10-$20 million
business is actually easier to sell than a $1-$2 million business.
Larger businesses typically have more critical mass, better systems,
better staffing and governance. Hence there are typically more
potential buyers for larger businesses. A small business often does
not “move the needle” for many buyers.
4. Build the
business from the perspective of an investor. Every now and then,
a business owner should be like a fly on the wall, and assess his or
her own business objectively, from the perspective of an investor.
(Or ask an objective outsider to do it.) Is this a business that
would be desirable for investors? Which investors? How much would the
business be worth?
I once advised a business owner that every
dollar generated in his fledgling online business generated eight
times as much value as in his conventional business. He immediately
postponed any plans for sale, and decided to work for a few years on
building up his online business.
Sometimes I find businesses
that are involved in too many incompatible business lines, hence not
of interest to any buyer. (For example, one of my clients had
businesses in construction, aviation-related manufacturing, and
non-core assets.) Such companies generally require restructuring
prior to sale.
Both of the above situations illustrate how a
business should be built from the perspective of investors. There is
often a paradigm shift involved when business owners who build a
business in their own image realizes the need to build a business
that will survive, most often via a sale, and hence be of interest to
investors. Neglecting this rule can result in a business that is
illiquid or unsaleable.
5. Begin exit planning as early as
possible. I am often asked when the best time to begin planning
an exit is. My answer: when you consider buying or founding a
business. It’s never too early. Too many business owners spend
decades building a business without planning for exit. It’s then
often too late to do estate planning or tax planning, let alone
applying all of the principles mentioned in this article. A
fundamental reason for the success of the private equity industry is
that they take a very hard look at exit before investing in a
business. You need also to take time to build your team, both
internal staff and external advisors (lawyer, accountant, financial
advisor) that will assist you with the transaction.
Think of
building and selling a business not as two separate acts, but as part
of the same continuum – in the same way that mountain climbers,
when planning an expedition, plan not just for the ascent, but also
for the descent. A business should be built with exit, or at least
succession, in mind.