Financing sales growth typically involves assessing projections due to geographic expansion, capital investment in new equipment, expanded services or investment in talent. No matter what the combination of factors that will drive a company’s expansion, the risk in financing sales growth is consistent across all Borrowers. The funds needed are likely more than what can be supported with a Borrower’s historical cash flow. So how can loan structure support growth and reduce credit risk?
Understanding the drivers of sales growth
Abacus was underwriting a $250,000 loan to a specialty bread bakery. The bakery had outgrown its existing location. The bakery was turning away business because they didn’t have the capacity to meet orders. The Borrower identified a new, larger location to lease. The new location would allow for a more efficient production process with an investment in new equipment of approximately $175,000. The rest of the loan proceeds were for working capital and leasehold improvements to the new space. The growth of the company was based upon the ability to produce more orders to satisfy unmet demand.
What were the risks in financing sales growth?
In this case, the historical cash flow was not sufficient to support debt service on an amortizing $250,000 loan. We needed to understand what was the primary risk to these projections. From a projections perspective the Borrower’s ability to market itself to additional points of sale, specifically grocery stores, was subject to several barriers to entry.
- First, the Borrower did not have sufficient cash on hand to pay slotting fees to grocery store chains to obtain optimal shelf-space.
- Second, profit margins for grocery store locations is 2% to 3% in the Borrower’s footprint. Grocery stores are reticent to use shelf space on products that won’t sell.
- Finally, the Borrower would be required to buy back any unsold inventory. This is another possible drain on cash flow.
How did loan structure reduce these risks?
First, our recommendation was to split the loan in two. There was a line of credit for working capital and an amortizing loan for the equipment purchase and leasehold improvements. We recommended that line advances be subject to review of new customer orders and monthly monitoring of sales and the AR conversion process. Second, the lender secured the loan with all business assets and real estate collateral. The real estate collateral was a three-story retail and multi-family row house under common ownership. This collateral was important because break-even cash flow coverage was 125% of the historical three-year average cash flow for the bakery. In other words, if cash flow didn’t grow by more than 25%, the cash flow coverage would be below 1.0x. The real estate collateral, even when discounted, was enough to secure the full $250,000 loan.
With our recommended structure, the Lender was able to sufficiently reduce credit risk with a structure that balanced the Borrower’s need for debt capital and the Bank’s need to reduce the risk of loss.