A business has different needs during its start-up and a growth cycle.
Choosing how to correctly fund your business is fundamental to its prosperity and in a broader sense to those forming business relationships with your business and also the economy as a whole.
At present there appears to be confusion and a lack of true understanding of the options available to assist a business throughout its life cycle.
To try and make sense of the confusion we believe it important to consider three distinct basic funding categories none of which should be bundled together. Unfortunately bundling, especially of categories 1 and 3, seems to be the norm.
- Long term Funding: for example, seed money or start-up funding.
Possible sources of security from which to seek funding
- Mortgage against proprietors’ home.
- Proprietors’ savings.
- Third party/shareholder support.
- Equity or crowd funding.
It is important to note that if c. or d. are utilised then it would seem likely the investor will seek some form of shareholding.
If your seeking funding for a ‘start-up’ venture we suggest being very careful in any negotiations at this point in time, and where possible use a. and/or b. above. Later if necessary, once you have a “beta model” or a sustainable business, seek additional capital. This approach may save you equity and any ‘over’ dilution of your shareholding.
- Medium term funding: for example, fixed assets finance.
This class of funding is generally secured over the funded assets. Repayment is typically by equal instalments of principal and interest over a set term, usually 1 to 5 years.
Possible source of funding:
- Specialist asset funders and finance companies.
- Trading banks.
- Asset vendors and suppliers.
- Working capital.
Working capital is generally needed to bridge the gap between purchasing inputs and converting these into goods or the ability to provide services and getting paid for goods sold or services rendered.
Working capital is usually required for a 30 to 90-day cycle that continues at varying levels whilst the business is a going concern.
We believe working capital should be funded against the very assets for which the funding is provided; typically, that is stock, work in progress and debtors. Debtors being the result of allowing credit when sales are made.
Possible sources of 60-90 day working capital funding:
Invoice Factoring / Invoice Financing / Single invoice discounting.
- Bank funded business overdraft.
- Exploiting supplier payment terms.
There is a reluctance of many working capital providers, major trading banks included, to differentiate between the business proprietor’s own assets and the true assets of a business.
Most banks seem to have a propensity to rely solely on real property as collateral to secure a working capital facility. In reality this form of security is best used to fund start-up or in the provision of additional term capital to the business.
Most banks do not readily include the value of current assets such as accounts receivable and stock in their calculations. They seem to place little value in accounts receivable and stock.
Bank business overdraft interest rates are not as competitive as one might think.
In the absence of real property or plant and equipment as security the banks are inclined to treat working capital advances as unsecured and accordingly commonly charge at a higher rate of interest; rates that ought to be reserved for the riskier, truly unsecured loans.
Often ascertaining the true interest rate charged is not straight forward. The true interest rate must also include the banks rarely disclosed line fee, also known as an account management fee. The line fees are often between 1.00% and 1.80% per annum. As this fee is not readily disclosed it renders general rate comparison basically meaningless.
The trading banks pure working capital funding rates are rarely under 14.00% pa and do exceed 17.00% pa.
The Interest.co.nz endorsed Cashflow Funding Limited (CFF) funding calculator (www.cff.co.nz) demonstrates that using exactly the same parameters, not forgetting the line fee, CFF would provide considerable savings.
We estimate savings of between 3.5% pa and 5.00% pa. Even better is that a greater level of borrowing is typically possible too.
The approach taken by the banks tends to ignore the fundamental reasons why working capital is required.
Essentially working capital funds the business cycle from procurement of raw materials to receipt of cleared customer payments as mentioned above. Typically, each ‘borrow and repay’ cycle takes 60 to 90 days. We expect to see 4 to 6 revolutions per year.
It is the current assets - accounts receivable, work in progress and stock - that ought to be used as security for working capital funding, not other assets classes.
Prudently it makes sense to match the required 60-90-day use of the funding with a similarly structured 90-day funding source. An additional benefit of the utilisation of ‘90-day money’ is that as an undervalued source of funds it allows the borrower to gain access to very competitively priced funding.
From the banks’ perspective securing working capital funding against more tangible medium to long term assets certainly makes sense.
The banks are not administratively geared to secure the current assets. The model they employ doesn’t provide them with the required legislative protection. They rely on policy which dictates a “top down” approach to secure any advances. As a result, a business stakeholder will regularly be required to mortgage their personal property and along with the business itself they will also usually be asked to execute a general security agreement in favour of the bank; the latter restricts the ability to raise pure working capital funding without, ‘cap in hand’, seeking concessions from the bank.
This gives the banks security over all the assets and undertakings of the borrower and thereby affords them priority over most other creditors. Noted statue exceptions such as preferential creditor claims, voidable charge claims or any registered specific security interests interfere.
The banks approach, in these circumstances, significantly limits the ability of the business borrower to realise the maximum funding potential of the true asset base available to it.
The BNZ and Heartland Bank do offer current asset lending however the cost is significantly higher than that of a traditional overdraft facility. The rates offered suggest that they treat the lending as though it’s unsecured. For example, interest rates associated with current asset based working capital facilities offered by the BNZ and Heartland equate to annualised interest rates of somewhere between 18.50% pa and 22.74% pa and this does not take into consideration charges for other supplementary services.
These invoice finance facilities, based on annualised interest rates of between 18.50% pa and 22.74% pa seem to be expensive when compared to bank business overdraft interest rates which in turn, in our opinion, seem to be overpriced by at least 3.50% pa to 5.00% pa themselves. We have assumed a proprietor is managing their business using best practice.
The upshot is that small business is not getting true value from its asset base and is being required to pay a premium of between 7.00% pa and 10.00% pa for these invoice finance facilities.
At Cashflow Funding Limited (CFF) we specialise in the provision of working capital. Our model will enable access to working capital, regardless of size, provided debtors, stock and work in progress are verifiable. The cost of funds to the business will reflect the required funding term of 30-90 days and the cost we incur in procuring the required funding.
The Big Picture
The annualised combined New Zealand banking market for business lending is estimated at NZ$75 to NZ$80 billion dollars. Working capital loans account for approximately 45 % to 50% or between NZ $33.75 and NZ $40.00 billion of that sum.
Sixty percent of all SME (small to medium enterprise) working capital advances are secured by real property and little account of business assets is taken when the loan quantum is set.
The funding is based solely on the value of the secured real property. This can dramatically impair the ability of a business to grow as the loan is fixed to the value of the secured property and the assets of the business are largely ignored.
In effect the trading banks are bundling the business and proprietor’s assets to secure their position. This essentially denies the business the ability to raise funds against two distinct asset classes (2 & 3 above). CFF sees this as unnecessarily prohibitive.
CFF believes all asset classes should be available to a business to potentially fund against rather than ring fenced with no apparent value placed on them and what’s more being of no use to the secured creditor if the business is liquidated.
The CFF funding calculator (www.cff.co.nz) shows the downside of the trading banks bundling policy and conversely highlights the upside of unbundling the asset classes.
The affect technology is having on traditional business methods, including those of the trading banks and the opportunities which arise should not only reduce the costs of providing the likes of overdraft and working capital facilities, but also lead to the ability to better secure the borrowers’ assets. In short technological advancements should see businesses have access to greater funding at a lower cost.
Resistance to change from traditional methods is hard to overcome at the best of times and the fact that the trading banks have essentially been able to monopolise the business funding sector for decades makes convincing the market all the more difficult.
The perception that the banks are always the right and the best option is proving to be a difficult obstacle to negotiate.
Legislative innovation together with the forward thinking approach taken by the FMA has allowed Cashflow Funding, to develop a “New Zealand solution to a New Zealand problem”.
The problem and solution both being the provision of working capital to New Zealand businesses.