The Company had been in business for three years providing tool and die cutting services for local engineering design firms. During that time, management had spent considerable time developing a cutting-edge product for the machine tooling industry and were ready to take the product to market. Initial customer orders could potentially bring in significant new revenues for the Company.
But, in order to fill the orders and manufacture the initial units, The Company required $750,000 in total: $500,000 for new equipment and $250,000 for working capital. The new product line had considerable upside potential and management decided to pursue the new line of business, expanding its cutting services to their customer base.
The Financing Issue
As a result of all the research and development required to develop the product, the Company had incurred significant losses over the years and the shareholders had reached their limit in terms of capacity to inject equity. They were looking for a financing solution to fund required equipment costs, and working capital for initial orders.The previous year’s losses made it difficult for the company to qualify for financing with its current lender.
After an initial financing assessment, Farber Business Financing came to the conclusion that the new product line was essentially a new business, and could qualify for significantly more financing if structured as such. With our assistance, management set up a new corporation (“Newco”), and separated the operations from the rest of their service offering. Newco could then be considered a start-up business, qualifying for start-up financing as a stand-alone company.
$350,000 Term Loan: As a start-up, businesses have many different financing options available as discussed in my last article Financing for Start-ups: There Are More Options Than You Think. For Newco, the first option was a Canadian Small Business Financing Loan (“CSBFL”) with a traditional bank for $350,000 to finance the equipment and associated leasehold improvements.
The CSBFL program is offered by traditional banks to a maximum of $350,000 per company. In this case, the Company had a CSBFL already in place, therefore establishing Newco enabled them to apply for and additional $350,000. CSBFLs cannot be used for working capital or inventory, but they are ideal for financing equipment and leasehold improvements. The percent financed is based on the purchase cost of the assets and/or completed leasehold improvements.
To be approved for a CSBFL, banks require personal guarantees from the owners, and the wherewithal to inject money into the business in the event the company requires it. Interest rates on the CSBFL are a maximum of prime plus 3% and repayment is typically over 60 months i.e., 5 years. A benefit to the borrower is that the owners have to personally guarantee 25% of the loan.
CSBFLs are far more accessible to businesses with higher risk profiles like start-ups. In the approval process, banks will follow their usual adjudication and due diligence procedures, but tend to be more aggressive in approving CSBFLs than traditional bank term loans because the Federal Government guarantees 75% of any loan loss suffered in the event of default i.e., after the bank has realized on all of its security. However, approvals are far from carte blanche, and the presentation of relevant details to the lender is critical. Furthermore, risk appetite varies from bank to bank, so successful navigation of the approval can be an issue.
$150,000 Subordinated Term Loan: The second solution for Newco was a $150,000 term loan for start-ups from a sub-debt lender to finance the remainder of equipment. In order to qualify for this loan, management needed to demonstrate a proven track record of running a successful business, have strong personal credit and sufficient personal net worth to invest in the business in the event the Company does not reach its sales targets in the first year. This type of loan is typically repaid over 60 months i.e., 5 years at an interest rate of prime plus 4% to 9%. The sub-debt lender was looking for a 2nd security position behind the bank on Newco, but a first charge over the specific equipment they were financing. The owner was required to personally guarantee 100 percent of the loan.
$250,000 Working Capital Loan: For working capital, a $250,000 factoring loan was arranged. The primary differentiator in a factoring solution is that credit adjudication depends primarily on the strength of the company’s customers, rather than the strength of the business borrower itself. In the case of a start-up business where the company has no credit history, the strength of the company’s intended customers is critical for approval. The lender did not require a personal guarantee from the business owner(s), and only required a first charge on the specific invoices being financed. A major benefit of factor financing is that it allows for the Company to collect on its receivables immediately after invoicing, which replenishes working capital and supports future orders enabling the business to grow. Interest rates can range from 12% to 24% per annum depending upon the lender, borrower and credit strength of its customers. The maximum limit for a factoring facility is only restricted to the maximum value of invoices allowing the limit to increase with sales, therefore can support future growth.
Structuring the borrower as a start-up enabled up to $500,000 in additional financing not necessarily available to the original Company. In this case, the owners were able to finance a profitable new line of business, and fill its initial customer orders immediately. The business was also able to bring their new product to market without any further owner’s equity, and still had the necessary working capital available to grow the business.
Eric Friedberg is a Senior Consultant with the Business Financing group at Farber. He focuses on arranging innovative financing solutions for small and medium-sized enterprises(SMEs) and early stage companies. Eric can be reached at 416.496.3078 and firstname.lastname@example.org.