Heard It Through The Grapevine

They’re baaa…cckkk…!! Lehman Brothers is back in the news. The Wall Street Journal of 4 June 2008 and one of SAW’s favourites, the Naked Capitalism blog, are reporting that LEH’s appears to be on track to report a quarterly loss larger than the US$300 million predicted by analysts.

And they’re not the only ones making predictions. Investors have bet huge amounts on puts that LEH is gonna sink,sooner rather than later. Their debt rating was downgraded and their stock downgraded to “underperform”.

And what’s LEH said to be doing? Looking for US$3 - 4 Billion worth of new capital to shore up its Balance Sheet.

Effectively, a tsunami of rumour and predictions are driving perception and behaviour. At least the big boys have PR departments, press statements and the luxury of resorting to slick financial euphemisms.

LEH’s denials that it had funding problems and that it did not borrow money from the US Treasury, failed to convince the market and its shares closed down 10%. Let’s not forget that it was in March 2008 that LEH raised US$3 Billion from investors in order to refute reports that it was in the same predicament as Bear Stearns.

For SMEs, any rumour and predictions by outsiders, or insiders, on solvency, are potentially fatal. If cash flow is erratic, intermittent or eroded and debt ratings downgraded in the face of contracting credit, expect to be doing what some SMEs in the US are already doing – taking their goods to the pawnshop in an urgent attempt to raise capital. (Or, to use a Wall Street euphemism, “to shore up their Balance Sheet”).

The problem with rumour is that it takes on a life of its own. For SMEs, even at the best of times, it’s a delicate balance between Accounts Receivables and Accounts Payable. Inevitably, the worst aspect of any rumour reaches the SME’s most intransigent creditors first and encourages the SME’s debtors to delay payments to the last. But the phone calls demanding an explanation keep coming thick and fast.

What a bind. Crippled cash flow in a hurricane of innuendo. What’s an SME to do?

Factor the Receivables immediately if possible – even just a portion of them.

Ironically, shoring up the Balance Sheet through Off-Balance Sheet financing (another term for Factoring) is the quickest way to get cash flow, without giving up equity or sinking further into debt.

One more thing. The reputable Factoring companies are acutely sensitive to outsiders’ perceptions of Factoring and adopt the role of Receivables Managers. It’s all part of the Factoring service. Their ability to make it clear to the SME’s creditors and ultimate debtors that the SME is raising working capital through ongoing cash flow management, often goes a long way in assuaging potentially suspicious parties.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Stating The Obvious

“If you’re a smaller player, you need more capital to do business in tough times. They now need to show that they can keep churning profits in this environment”

David Hendler, CreditSights analyst, quoted in the Business News, South China Morning Post, 2 April 2008.

He might as well have been talking about SMEs. He was actually talking about Lehman Brothers having raised US$4Billion from a special offering of 4 million shares. The proceeds are slated to increase its capital base and provide greater financial flexibility.

Sounds familiar doesn’t it? Some of the best known names on Wall Street are scrambling to raise working capital and giving up equity to outside shareholders, despite the bravado.

Whilst this blog is not exclusively about Factoring, the pain on Wall Street is a nice contrast to Factoring, the potential benefits of which can be found by going to the Labels column on the Right Hand Side of this blog.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Lessons Learned

This blog has dealt extensively with sub-prime. But how does all that relate to private SMEs who are interested in improving their cash flow for the purposes of growth or survival? What lessons can be learned?

1. Surrender of Equity

Factoring does not involve going to foreign investors - Sovereign Wealth Funds in particular - and giving up, or issuing, equity in the company. Just ask Citigroup or Merrill Lynch.

2. Management Changes

The funding source will not demand management changes at Board level as a condition of funding (unless there’s suspected or actual fraud).

3. Debt-Free vs. Debt

Factoring is effectively debt-free growth for the company. It is based on the SALE of the commercial invoice to the factoring company. That invoice, which represents future cash, is a genuine asset. The factor buys it from the company at a discount from its face value and the company gets cash almost immediately. The factor then looks to the company’s ultimate debtor for payment of the full face value of the invoice.

Sub-prime was debt-ridden at all levels with catastrophic results. For the lenders, the “assets” of the individual debtors were either cars or plasma TV sets (which have no residual value) or the assumed ever-increasing value of a home which they knew fully well the debtor could not afford. The basis of sub-prime rested on loading credit challenged individuals with even more debt and then repackaging the “assets” as “safe” corporate investments for Wall Street and beyond.

4. Credit-Worthiness

Factoring is strongly dependent on the credit-worthiness of the company’s ultimate debtor. This is because the ultimate debtor remains liable to the funding source for the face value of the invoice. That is why factoring companies who are buying the invoices, demand to know details of a company’s debtors and run checks on them, including verifying that the invoice issued to the debtor is genuine. If the factor has doubts on the credit-worthiness of the ultimate debtor, funding for those invoices will be refused. Period.

One of the hallmarks of the sub-prime fiasco was that the credit-worthiness of the individual debtor, who often had a lousy credit rating to start with, was fudged or dishonestly recorded to make it appear better than it was. Everybody knew what was going on and simply turned a blind eye. Risk was compounded.

Factoring seeks to minimize uncertainty on 2 fronts: for the company seeking guaranteed predictable cash flow; and for the funding source that assumes the risk of repayment from the ultimate corporate debtor.

© 2008 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring & Bank Financing

The author has frequently said that factoring can be used in conjunction with traditional bank financing. What does this actually mean?

A business in the early stages of growth may not qualify for the best terms for bank loans since it doesn’t have a history. If a business line of credit or a loan is forthcoming, often it will be secured on the Receivables – in other words, every Invoice generated by the business acts as security for the loan. The problem with that, is those Invoices represent potential cash whose value is presently frozen – at least until they are finally paid by the debtor 30 plus days down the line.

For a start-up or early stage business, tying up the invoices to the bank and hoping the debtors will pay fast, is not the best strategy. It leaves the business without critical cash flow control and can hamper growth.

Since factoring requires creditworthy debtors more than it requires the operating history of the business, then (subject to good profit margins), factoring may be a better alternative.

Once cash flow has been stabilized and is predictable through factoring, the business will be in a better position to negotiate a bank loan – with the added advantage that its invoices have already been assigned to the factor and therefore out of reach of the bank.

Servicing the loan becomes that much easier since cash flow from factoring can already be calculated.

Remember also that banks tend to be conservative. Factoring companies are more flexible and forward looking in their assessment of the business prospects.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The First 3 Months Of The Year

It may come as a surprise to realize that January, February and March are difficult for businesses, even during good times. Why?

During these months, companies analyze and plan their objectives for the year. It might include expansion of product lines, production facilities, more employees, upgrading the marketing.

The company needs to project where the additional funding will be coming from, while still having cash on hand to pay expenses incurred at the end of the proceeding year. It is important to note that while the cost of expansion will be recovered at some point in the future, the costs of expansion are payable now.

It’s at this time of year that a company should be considering factoring. The cost of factoring will be offset by the additional revenue generated by their expansion plan. For example, if a business concludes that an expansion of its sales and marketing staff will generate more revenue in the coming 6 months, they could factor the revenue during those 6 months in order to have the cash resources to grow beyond that period.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring And Insolvency 2

The business is then required to obtain and unsecured loan. At first glance, it sounds paradoxical since the business is likely insolvent and lenders require collateral. Banks might not step up to the plate and the business will initially look to individuals or angel investors.

In reality, assuming that the business still has customers, the only tangible security it can offer are its new sales, evidenced by the invoices (which are technically, commercial paper).

For the purposes of Bankruptcy, factoring is not regarded as being in the ordinary course of business and the business must obtain the Court’s permission to factor its receivables. The Court will hear the factoring proposal and any objections from the creditors.

If the Order is made, the business will be allowed to factor the receivables which came into existence on or after the date of the filing of the Bankruptcy Petition. The factoring may be for a specific period of time (which can be extended by further order) and may require the factor to pay a portion of the advance into a designated account in favour of the creditors.

It is important to note that the Court’s Order is as good as a UCC filing.

Note: this posting is in general terms only and is not to be taken as containing specific or implied legal advice. A business must consult its lawyers and accountants where Chapter 11 is contemplated.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring And Insolvency 1

There is no doubt that factoring enhances cash flow for a business operating as a going concern. But what about a business that is unable to meet its current debt obligations and is facing insolvency?

In the US, a business may seek temporary protection from its creditors by filing a Chapter 11 Bankruptcy Petition in the Federal Bankruptcy Court. The effect of the Petition is to create an automatic stay that suspends the ability of any creditor, secured, or unsecured, to obtain payment from the company or to enforce the security.

Further, the Petition generally prevents the company’s future assets from being appropriated by creditors – notwithstanding any language to the contrary in any security agreement.

That means that a creditor who, in its agreement with the business, used typical language to secure “all the accounts receivables of the business whether currently existing, or hereafter arising, no longer holds an interest in those receivables which come into existence after the filing date of the Bankruptcy Petition.

Effectively, the business can make a fresh start with those receivables and negotiate with the creditors to formulate a Cash Collateral Order (which allows the business to use existing cash to meet at least a portion of ongoing obligations) and the Plan of Reorganization.

However, before Factoring can be implemented to assist the business, a few more steps are required. These are set out in the next post, entitled, Factoring & Insolvency 2.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring Flexibility 6

Invoice Batching

This is most commonly done where there are a series of invoices for small amounts. The invoices would be batched and treated as a single invoice. Once enough invoices from that batch are collected to cover the advance and the factoring fees, the batch is deemed “closed”. Thereafter every invoice of that batch which is collected from the debtor, is paid over in full to the client.

The effect is that the client is charged a lower discount fee, normally reserved for larger invoices, instead of being charged a higher discount fee normally charged on small invoices.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring Flexibility 5

Invoice Splitting

In order to save the client some fees, the factoring company might split an invoice i.e. notionally splitting it into sub-invoices. This is usually done where the debtor makes partial payment on the invoice over a period of time, instead of paying it all off at once.

The effect of splitting the invoice is that higher fees are charged only on the later partial portions, instead of the full face value of the invoice.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring Flexibility 4

Partial Funding Of Invoice

Since factoring is all about generating predictable cash flow for the client, it sometimes happens that the client wants to control the amount of cash flowing in. For example, a client may have factored a large invoice, but the present cash flow needs of the business are sufficient.

In order to save the client from paying unnecessary factoring fees on the full amount of the invoice, a factoring company may agree to partially fund that invoice for an amount set by the client. Factoring fees will be paid on the partial amount only.

Once the full amount of the invoice is paid by the debtor, the factoring company will keep the advance and its fees, calculated on the partial amount, and remit the unfactored amount to the client.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring Flexibility 3

Discounts On Fees

If a debtor takes a long time to pay on an invoice, the factoring company might give a discount on the fees to the client, for the sake of the business relationship. There might not be a contractual obligation to do so, but it could be done.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring Flexibility 2

Buyback Or Replacement Of Invoices

The cost of Factoring is paid by factoring fees. These are determined by how long an invoice remains unpaid. Factoring companies will allow the client to buy back an ageing invoice; or substitute it with a fresh invoice. This stops further fees on the previous invoice or prevents the old invoice from exceeding the ageing limit imposed by the factoring company.

Buyback - the client pays cash to cover the advance and the factoring fees on that invoice;

Replacement – the client replaces the ageing invoice with a fresh invoice of a suitable amount so that the advance on the fresh invoice covers both the advance and factoring fees on the old invoice.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring Flexibility 1

Fast Payment Of Reserve

From the factoring company’s view, each invoice that is factored, is an individual transaction. Therefore, once the full face value of the invoice has been recovered from the debtor, the Reserve is theoretically payable to the client immediately.

Some factoring companies will pay the Reserve to the client the same day. For smaller amounts, daily payments of the Reserve might not be administratively practical. In such cases a factoring company might pay the Reserve amount to a client weekly.

That’s not necessarily a bad thing. It could be agreed beforehand that if Reserve payments are made weekly, then they must be paid before payroll is due,

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved