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Financial Health Check for Reopening: 4 Instruments to Extend Your Runway

By Josh Burwick
May 21, 2020

In short:

  • How much time your company has before cash runs out is your runway. The longer that stretch of tarmac, the more room you have to maneuver.
  • The concept of factoring has come a long way and could bridge the gap between customers paying and supplier bills coming due.
  • VC firms are in triage mode. If you have a relationship and think your business reality warrants a cash infusion, speak up.

As the economy reopens, business leaders must navigate some difficult decisions: Managing cash burn while gauging staffing levels, balancing customer retention and acquisition efforts, deciding whether to chase new funding sources.

Our advice? Start with a gut check. Then gather the right data to inform your choices with the goal of building out as much runway as possible. That will give you the benefit of time as you steer the organization through whatever lies ahead.

The first step is an assiduous, realistic assessment of working capital constraints. Gather the most accurate snapshot of your accounts payable, accounts receivable and inventory possible. On the payables side, given the environment, we advise reaching out to vendors, asking them to extend payment terms.

Once these basics are covered, you have dials to turn to extend your runway even further. We’ve ordered four options below beginning with the most easily accessible and quickly implemented, then moving to actions that require a relationship with a venture capital backer and that will take more time but that are nonetheless worth the effort.

Dial 1: Receivables Financing

“Factoring” has historically carried a pejorative connotation. It implied a company was in trouble and desperate enough to take pennies on the dollar for assets. But over the past decade, the need to tap into accounts receivable has given birth to some well-backed and highly successful companies, like BlueVine and FundBox, that provide factoring in addition to conventional loans and lines of credit. Traditional banks may also be funding sources.

What’s driving demand?

A recent trend, even before the coronavirus pandemic, was for well-established companies to extend their payment terms from net 60 to net 90 or even 120 days. That puts smaller companies in a bind because they’re generally unable to demand those same favorable terms from their own suppliers.

When you pay your vendors on a net-30 basis and then must wait an additional 60-plus days for payments to come in, you’re left with a mismatch in cash flow timing.

Working-capital financing companies acquire either certain segments of a customer’s accounts receivable or the entirety in exchange for a fee that’s based on the payment terms and the credit standing of the company whose name is on the payee line.

What to Know About Working Capital Models

Accounts receivable loans:

  • With customer invoices as collateral, the lender gives the borrower cash or a line of credit, normally 70% to 90% of the value of the accounts receivable.
  • The borrower pays interest on the amount loaned. The rate depends on the lender and other factors and can vary widely, from 5% to 20%.
  • It’s the credit standing of the end customer, not the borrowing company, that determines the rate.
  • The borrower collects payments from customers directly and uses that cash to repay the loan.

Invoice factoring:

  • Differs from an accounts receivable loan in that a company sells its receivable invoices outright.
  • Companies can expect between 70% and 85% of the value of the invoices but may need to pay fees that cut into that amount.
  • The factor then collects the invoiced amounts directly from your customers, which removes the need to chase and process payments but may have a negative effect on relationships.

Typical users of working capital financing are product-based companies and advertising technology firms. Software providers largely avoid the cash flow timing mismatch because they typically are paid monthly on a subscription basis.

Accounts receivable (A/R) financing charges vary and depend on two main factors: the company’s size and the quality of its customers. Banks typically charge a premium on top of the U.S. prime rate or EU LIBOR, usually 50 to 100 basis points, or 5% to 6% total APR, while non-banks charge an annualized rate of 10% to 20%, on average, for smaller firms.

This financing does not require a preexisting relationship because these lenders do thorough checks through the Uniform Commercial Code (UCC) system, which lists liens on certain assets. UCC-1 forms are filed by lenders stating they have a lien on certain asset(s) of a lendee, and lenders search UCCs before lending any money against the assets of a company.

In addition, credit analysis is largely focused on the financial health of end customers.

Cash upfront can extend the runway of a company by a month or two, which can mean the difference between making it to the next round of investment or influx of payables or becoming insolvent.

Dial 2: Revolving Lines of Credit

Bank revolving lines of credit are similar to credit cards in that they offer a maximum borrowing amount. These loans, usually for small and midsize businesses, are secured against an easily quantifiable asset, such as your accounts receivable, or, if you are a product company, inventory.

Banks typically offer credit against accounts receivable at 80% of “eligible A/R,” determined after accounting for various “ineligibles:”

  1. Customer concentration; companies that have a few, large accounts should know that the maximum loan amount for each customer is usually 25% of outstanding A/R.
  2. Amounts that are already past due.
  3. A/R from non-U.S.-based customers.
  4. Accounts for which a certain percentage of invoices (typically 50%) are cross-aged, meaning they are 90 days past due.
  5. Contra and customer offset accounts.

Let’s walk through a quick example. If ABC Toys has $5 million in A/R, but 50% of that amount is due from Target, only $1.25 million is deemed eligible. Further, if another customer is 90 days late in paying $500,000 of its invoices, that entire amount is excluded; the bank would view that as unlikely to be collected.

Foreign A/R is generally excluded entirely. Depending on the country, monitoring of secured loans may not be as strict as it is in the United States, with the UCC system we previously mentioned.

A company will need to update its A/R balances with its lending bank monthly for the bank to determine the borrowing base. Once a company engages with a bank for A/R financing, all A/R payments by customers will be paid into a separate lockbox account that the bank monitors to either reduce the credit balance or transfer to the main operating account, depending on a short-term credit ratio, typically known as an Adjusted Quick Ratio (AQR).

The AQR is computed as:

unrestricted cash + net A/R ÷ current liabilities – deferred revenue = AQR

The higher the AQR ratio, the better the company’s credit standing and the less the bank will require in escrow.

For a product company, inventory can also be included, either in isolation or in addition to A/R, to determine the borrowing base. A bank will involve a third party to appraise the inventory and determine a Net Orderly Liquidation Value (NOLV); that is, the amount that the inventory could be sold for in a managed liquidation process in a downside scenario.

Once the NOLV is determined, the bank will apply a percentage to determine the borrowing base to lend against. Appraisals will often be conducted semi-annually or annually, at the borrower’s expense.

Dial 3: Equity Round

Under normal circumstances, a private company sets out to raise an equity round three to six months before it will need the funds, with the expectation that these funds will carry the company for 18 to 24 months, when it will usually reach the next milestone, justifying a higher equity valuation.

Clearly, these are not normal times. The playbook has changed, and timing is of the essence.

Venture capital firms are currently doing triage. They’re taking a hard look at the most critically ill companies in their portfolios, the ones that have seen their businesses damaged severely during the pandemic. VCs are then making the call: Has this business been irreparably harmed, or does its status justify injecting more capital to get it through?

As a private company, whatever the valuation on your last round — whether it was six months, one year or 18 months ago — if your business has not deteriorated, use that figure as a base to start negotiations with existing investors. It’s better to get additional funding quickly at a lower equity valuation than to spend months haggling over valuation and terms that may prove moot when the deal settles, because the range of possible outcomes is as divergent as at any time in modern economic history.

Dial 4: Venture Debt

Venture debt — loans offered to VC-backed companies — is another growing source of capital, having doubled to $10 billion in 2019, according to a study conducted by Kruze Consulting. Some of the leading firms include Hercules Capital, Trinity Ventures, Orix and East West Bank.

Venture debt typically sits subordinate to senior bank debt and, as a result, requires a higher return rate to compensate for the additional risk.

While banks charge a modest 50 to 150 basis point premium to a benchmark rate, prime rate or LIBOR, venture debt firms charge multiples of that — usually 400 to 600 basis points, with a minimum threshold rate. In addition, venture debt firms will want equity warrants, usually around 10% of their credit facility, and they will impose covenants that allow them to take back funds and/or stop future funding.

Venture debt interest rates are in the low double digits now, depending on the nature and stage of the company being funded. These firms will normally grant an extended interest-only period before the term-loan amortization begins.

Venture debt issuers rely on the due diligence and backing of the venture capital firms. A recent equity investment goes a long way in supporting a venture debt investment.

Bottom Line

Markets are rallying, optimism is increasing and economies have started the process of re-opening. Still, there’s little consensus on the economic recovery’s trajectory, so start now, explore all avenues and rank time efficiency over specific deal terms.

What matters is lengthening your cash runway to ensure your company lands safely in the new economic normal.

Josh Burwick is an active private technology investor with a particular focus on software, Blockchain, e-commerce and sports betting technology. He has served as an interim CFO and advised on strategic fundraising for a variety of technology companies, ranging from Series A to Series D rounds.

Mark Bianco

For more helpful information from the Brainyard and our friends at Grow Wire and the NetSuite Blog, visit the Business Now Resource Guide.

  
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