When it comes to the different types of business loans available in the marketplace, business owners and entrepreneurs can be forgiven if they sometimes get a little confused. Different types of business financing are offered by different lenders and structured to meet different financing needs.
A bank is usually the first place business owners go when they need to borrow money, but not all businesses will qualify for a bank loan or line of credit. In particular, banks are hesitant to lend to new start-up companies that don’t have a history of profitability, to companies that are experiencing rapid growth, and to companies that may have experienced a loss in the recent past.
Where can businesses like these turn to get the financing they need? There are several options, including borrowing money from family members and friends, selling equity to venture capitalists, obtaining mezzanine financing, or obtaining an asset-based loan (ABL) from a commercial finance company.
Borrowing from family and friends is usually fraught with potential problems and complications, and has the potential to significantly damage close friendships and relationships. And the raising of venture capital or mezzanine financing can be time-consuming and expensive. Also, both of these options involve giving up equity in the company and perhaps even a controlling interest.
Balance Sheet vs. Cash Flow Lending
Often, the most attractive financing alternative for companies that don’t qualify for a traditional bank loan or line of credit is an asset-based loan from a commercial finance company. Unlike banks, commercial finance asset-based lenders look at a business’ balance sheet and assets — primarily, its accounts receivable and inventory — when analyzing financing requests. In other words, they are balance sheet lenders.
ABL lenders lend money based on the liquidity of the inventory and quality of the receivables, carefully evaluating the profile of the company’s debtors and their respective concentration levels. They will also look to the future to see what the potential impact is to accounts receivable from projected sales. It’s what we call “looking out the windshield.”
Banks, on the other hand, look primarily at a business’ income statement to determine if it can generate sufficient cash flow in the future to service the debt. In other words, banks are cash flow lenders, looking primarily at what a business has done financially in the past and using this to gauge what it can realistically be expected to do in the future. We call this “looking in the rearview mirror.”
An example helps illustrate the difference: Suppose ABC Company has just landed a $12 million contract that will pay out in equal installments over the next year, resulting in $1 million of revenue per month. It will take 12 months for the full contract amount to show up on the company’s income statement and for a bank to recognize it as cash flow available to service debt. However, an asset-based lender would view this as receivables sitting on the balance sheet and consider lending against them, depending on the creditworthiness of the debtor company.
In this scenario, a bank might lend on the margin generated from the contract. At a 10 percent margin, for example, a bank lending at 3x margin might loan the business $300,000. Because it looks at the trailing cash flow stream, an asset-based lender could potentially loan the business much more money — perhaps up to 80 percent of the receivables, or $800,000.
Comparing Apples and Oranges
As you can see, traditional bank lending and asset-based lending are really two different animals that are structured, underwritten and priced in totally different ways. Therefore, comparing banks and asset-based lenders is kind of like comparing apples and oranges.
For businesses that do not qualify for a traditional bank loan, the relevant comparison isn’t between ABL and a bank loan. Rather, it’s between ABL and one of the other financing options — friends and family, venture capital or mezzanine financing. Or, it might be between ABL and foregoing the opportunity.
For example, suppose XYZ Company has an opportunity for a $3 million sale, but it needs to borrow $1 million in order to fulfill the contract. The margin on the contract is 30 percent, resulting in a $900,000 profit. The company doesn’t qualify for a bank line of credit in this amount, but it can obtain an asset-based loan at a total cost of $200,000.
However, the owner tells his sales manager that he thinks the ABL is too expensive. “Expensive compared to what?” the sales manager asks him. “We can’t get a bank loan, so the alternative to ABL is not landing the contract. Are you saying it’s not worth paying $200,000 in order to earn $900,000?” In this instance, saying “no” to ABL would effectively cost the business $700,000 in profit.
Rodney Schansman serves as Ftrans’ CEO and member of the Board of Directors and is responsible for leadership and strategic direction of the company. He is a 25-year veteran of commercial finance, healthcare finance and private equity.