Tuesday, 7 October 2014

THE MISSING FACTOR(ING) - How Debtor Financing can help you in buying (or running) a business?

Factoring, or debtor financing, as it relates to business acquisitions is one of those mysterious parts of the Finance Industry that not much of us know a lot about.....

So here's an overview for you...

First things first - What is debtor financing?

Debtor finance is a generic description of a particular funding process, based on the value of a business' accounts receivable ledger. 

Debtor finance is also marketed under the guise of invoice discounting, factoring, cash-flow finance, asset finance, invoice finance and working capital finance.

Basically, debtor financing Is the process by which a business owner assigns/sells their debtor book to a Debtor Finance Company who then pay the business owner within 2 to 3 days of the invoice is being issued.   The Debtor Finance Company then collect the invoices on behalf of the business owner.   

This means that rather than having to wait between 30 to 90 days for payment of their invoice, a business owner can be paid effectively immediately and sells the risk of the potential bad debts onto the Debtor Finance Company.

This is an excellent way for the business owner to manage their cash flow, particularly if their business model incorporates large amounts of debtors who pay on regular intervals.

So then, how can it help you buy a business?

When people are buying businesses they often spend most of their capital buying the business. The traditional banks will usually be happy provide the funds for purchasing the business assets (Plant & Equipment, Stock, and Goodwill) so long as you have enough equity behind you.

However the working capital component (debtors and work-in-progress) is unlikely to be funded by the banks and we often find that business purchasers have overcommitted themselves and their physical assets to purchase the business assets and have not accounted for working capital requirements.

Debtor financing is an excellent way for the business purchaser to get cash flowing quickly into the business immediately after settlement, of the business to help fund working capital, by way of assigning/selling the debtor book to a Debtor Finance Company who then pay the business owner within 2 to 3 days of the invoice is being issued. 

The Debtor Finance Company then collects the invoices on behalf of the business owner. This is an excellent way for the business owner to manage their cash flow, particularly if their business model incorporates large amounts of debtors who pay on regular intervals.

How does the process work? Here's an example:

Lets assume that a business owner (or new business purchaser) approaches a D.F.C with a debtor book of approximately $1 million. 

Firstly, in order to begin assessing the possibility of debtor financing, the D.F.C will require the business owner to make an upfront financial commitment (approximately 1% of the total value of the debtor book), of which 50% is paid immediately and the remaining 50% is paid upon the successful setup of the facility.  If the facility cannot be set up (e.g. due to poor credit history or other issues) the financial commitment is refunded to the business owner less The D.F.C’s costs to investigate setting up a facility.

The D.F.C will then ask for a detailed debtor and creditor ledger from the business owner as well as the financials and any interim financials. 

The D.F.C is less concerned with the business profitability and is more concerned with the management of the debtor book. They will look to see how the debtor's are spread. E.g. if there is 100 individual debtors for a $1 million debtor book, they will be viewed more favorably than only three debtors over a $1 million debtor book. Note also that they will consider the quality of the debtors (e.g. publicly listed companies) when assessing the debtor book.

After they have looked at the debtor book and have determined the ageing (or debt turns) of the book (e.g. 30 days, 60 days, 90 days) they will be able to issue an indicative proposal to the business owner.

(It's important to note that if your existing bank already has a charge over your debtors under the terms of your existing loans, they will need to agree to a release of these debtors before you can set up a separate debtor finance agreement with a D.F.C)

The D.F.C will then either setup a confidential facility (whereby the debtors are not aware that The D.F.C have purchased their invoices from the parent company) or a disclosed facility (whereby the debtors are made aware that the business owner has assigned the invoices to a debtor financing company).

The D.F.C open a bank trust account in the name of the subject business and all invoices of the company are paid into this bank account. Charges vary, but typically D.F.C's take 80% of the invoice value (since they are already given this amount to the business owner) plus they also deduct their interest and their service fees, and the remainder of the invoice value is passed back to the business owner which then can be drawn down.

Some of the typical conditions that The D.F.C will usually put in place:
  •  They will finance between 50% up to 80% of the value of the debtor book;
  • The amount of financing offered will depend on the quality of the debtor book.  For example if there are two or three major clients they will be unlikely to risk financing at 80% since there is a larger risk of loss due to one debtor falling over;
  • They only deal with business to business invoices and do not deal with business to consumer debtor books;
  • Their minimum facility size is typically around $200,000, which is traditionally the amount of debtors held by a company turning over a minimum of $2.4 million per annum.   Their sweet spot is generally between $1 million up to $4 million of the debtor book financing;
  • Most D.F.C's will not deal with the construction industry. Unfair you say? Here's why... builders are notoriously hard to follow up for payment of invoices. They also have the problem of progress payments.  The D.F.C want to see clean invoices where products or services are exchanged which can be clearly defined e.g. 100 computers at $10,000, or 60 billable hours at $200 per hour etc.  The construction industry has a lot of grey areas in it and as such most D.F.C's generally avoid debtor financing to the construction industry.
  • Interest rate on the facility varies, but is usually around 12.5% calculate daily paid monthly on the balance outstanding;
  • There is also a service fee per invoice, which varies from 0.3% up to 3% of the invoice value depending on the amount of turnover, the industry, the company etc;  for example, assuming a business is turning over $2.4 million and is incurring a service fee of .9% the yearly service fees would be approximately $21,000 per annum in addition to the interest payable. The higher the business turnover, the lower the service fee.
  • Benefits to the customer's mean that they are not having to leverage their houses to afford the working capital.
  • Often the company will require the business owner to take debtors insurance as a means of protecting the D.F.C against bad or defaulting debts.
  • If someone is purchasing a business that they will look at the business purchase contracts as well as the experience that the purchaser has in running that particular type of business before offering a debtor finance facility to the prospective purchaser. 


How are bad debts dealt with?

Example: say there is $1 million "out the door" (ie paid out by The D.F.C to the business owner for the assigned debtors), and a company owing $200,000 to the business goes down. This becomes a loss of $200,000 to the D.F.C, and as a means of recovering this the D.F.C will typically hold back monies from the bank trust account until this outstanding amount of $200,000 has been repaid through the ongoing trading of the business.

If a debt exceeds 90 days The D.F.C will often stop funding that particular debtor and it then becomes the responsibility of the business owner to collect that bad debt.  The D.F.C is usually not interested or involved with debt collection.  

For example if there is $30,000 “out the door” The D.F.C will approach the business owner and tell them that they are reducing their online limit (in the bank trust account) by $30,000 until such time as the trading activities of the business have covered that $30,000 shortfall.

Fraud Management

The D.F.C does random calls with the business clients to check that invoices have been issued for genuine transactions, to check on "fresh air" invoices. 



So, factoring just me be that missing "factor" in getting your cashflow up and running.  The facility is expensive, but if it allows you the peace of mind of not having to chase debtors it may be worth it.

Also it may allow you to buy into a business that may be slightly bigger than what you can currently afford now through traditional financing means.

Thanks for reading.

Contact Me:
Blair R Macdonald
0433 149 144

Tuesday, 9 September 2014

CONFIDENCE TRICK? - The role of confidence in business sales

Guilty!!... Until Proven Innocent ...

... That's the reality for a business owner looking to sell their business.

Business buyers (and their accountants, financiers, advisers) view the information they receive from business owners, and their brokers, with a healthy dose of skepticism.

There have been many horror stories of naive buyers being duped by unscrupulous business sellers, and as such buyers these days are very cautious and fearful about committing to buy a business.

"If this business is so good, why are they selling?"

That's probably the #1 question I receive as a business broker from buyers.  Therefore, It's important for a business seller to have a credible and logical answer for this question. The seller needs to be completely honest, because at some point in the sale process the buyer will confirm the true reason they are selling and this has to match with the original reason told by the seller.

Most sellers have legitimate reasons for selling a business. E.g. ill-health, relocating to the eastern states, or simply just being sick and tired of the business after 10 years of doing the same thing day in day out.

The trick for the business seller, the confidence trick as it were, is to clearly explain and convince the buyer that their reasons for selling are genuine and that the information provided about the business is true and correct.

If you're a business owner who is currently selling your business, or if you're advising a client in respect to the sale of their business, below are some simple steps you can take to help re-enforce and build confidence in a potential buyer and their advisers.

Step 1. Act Quickly! 
I consider this to be probably the most important step in the process and hence its first in the list.

Any request for information made to you from a business buyer or their accountant needs to be acted upon immediately and quickly.

Any delay in responding gets the buyer thinking "what are they trying to hide by delaying giving me this information?" These 'communication delays' sap confidence, and cause buyers to think there is something wrong with the business, if the information isn't immediately at hand.

If you need time to prepare the information they have requested, be in regular contact with the buyer (preferably every two days) to reassure them that you're working on getting the information they have requested as quickly as you possibly can.

If you are too busy to organise the information, I would strongly advise you engage the services of a business broker to undertake this on your behalf. Part of the role of a good business broker is to communicate regularly with all parties concerned. Acting quickly re-enforces confidence.

Step 2. Consider getting an Independent Valuation (blatant conflict of interest warning!!)
As a licensed business valuer, I have a conflict of interest in recommending this step, however the truth is that having an valuation/assessment conducted by an independent Business Valuer or an independent Business Coach is a valuable resource in providing assurance and confidence to the buyer.

Sure, there will be a cost to undertake this, however it will help reinforce your selling price and will act as a shield against buyers making ridiculously low offers. So long as the valuation or analysis is truly independent, this is a surefire tool for reinforcing confidence in a buyer.  

Step 3. Prepare a detailed and extensive Business Prospectus which outlines all the details of the business (without disclosing commercially sensitive information) so that buyer and their accountant have all of the information they need at their fingertips to make an informed decision on whether they wish to proceed further with the purchase of your business.

A good business broker should prepare a thorough Business Prospectus (not all do though).
I encourage potential business sellers who are planning to use a business broker to sell, to 'shop around' the different brokers to assess the quality of the Business Prospectuses they produce.  Take the time to find a Broker that understands your business, and has the systems and process in place to sell it.

Step 4. Direct Contact between Accountants
Give a buyer's accountant direct contact with your own accountant. A buyers accountants will feel a lot more comfortable advising their client if they have the opportunity to source information directly from your accountant.

There will be fees/costs to you associated with this so make sure that you only allow this the serious buyers.

It's important however that the sellers accountants react quickly to any request for information (see step 1 above).

Step 5. Enforce a "Due Diligence" Clause
In the event that a buyer makes a written offer on your business, be sure to enforce a Due Diligence clause in the contract.

A Due Diligence Clause states that you won't let a buyer purchase your business until their accountant has thoroughly checked your figures to ensure they are correctly prepared and genuine, and has given the all clear to the buyer.

By enforcing a due diligence clause in the contract, it demonstrates to the buyer that you are genuine in not wanting to hide any issues or incorrect financial figures in the business sale. 
This is a big confidence builder for a buyer since they know that if they make an offer on your business they will get an opportunity to thoroughly audit your books.

Also, don't agree to a Due Diligence until after a written offer is made! Why? A buyer can do a full due diligence and then offer you are ridiculously low price which you wouldn't accept anyway, which wastes a considerable amount of time and also potentially exposes you to the loss of commercially sensitive information.

A Due Diligence ultimately protects the business seller, since if there is any legal ramifications after the sale of the business you can point to the fact that the buyers' accountants independently checked the figures and they found no hidden issues with the business at the date of settlement.

These are a small selection of the ways a business seller can reinforce confidence in the business that they are selling.

Confidence is the key, and in my opinion it's the number one contributing factor of why businesses don't sell.

Contact Me:
Blair R Macdonald
0433 149 144