Asset-based lending: the lowdown on an alternative approach for capital-starved companies.

With the advent of deregulation, which allowed banks to cross state lines and resulted in large-scale bank acquisitions and mergers, the credit approval landscape of commercial banks has become much more homogenous for middle-market companies. Bankers have become more oriented towards risk adversity vs. risk opportunistic lending, causing more limited commercial banking access by companies with weakened balance sheets from the last economic recession. For many undercapitalized companies, this has been equivalent to navigating through a pop-up financing obstacle course while voyaging through the banking minefield.

While a banking paleontologist might refer to this continuing consolidation trend as evidence of the mass extinction of creative bank financing, your business financing fate need not be terminally sealed. When the commercial banker says "No!" to your loan request, it's time to broaden your vision and look at alternative debt sourcing. Asset-based lending is one of your options.

What exactly is asset-based lending?

As its name implies, asset-based lending focuses more on collateral asset values for structuring loan availability, flexibility and even financing creativity for middle-market companies that historically relied on more traditional commercial bank financing. The latter relies on the lender's prudent analysis of financial ratios such as working capital (liquidity), debt-to-equity (leverage) and debt capacity (debt serviceability) for meeting maturing debt obligations. Asset-based lenders look more aggressively at freeing up "hidden" balance sheet values of account receivables (including certain accounts over 90 days and selected foreign customer accounts), inventories (including "work in progress," referred to as WIP), more aggressive formula-based borrowing availability on fixed assets (as high as 90 percent orderly liquidation sale values) and relying more on fair market real estate values of land and building that, through accumulated depreciation, may show little in the way of book value, effectively undervaluing the net worth on the balance sheet. The asset-based lender structure increases debt availability for the business and is able to overcome traditional commercial banking concerns of high leverage, often caused by seasonal bulges in inventories and receivables, and a short profitable operating history. The typical commercial banking request of relying on second or third mortgages on the owner's residence frequently is also eliminated.

When is it appropriate to seek out an asset-based lender?

Often this is a direct outcome of triggering loan covenant(s) and sustaining several years of consecutive losses with your existing banking institution. This can cause "lender fatigue" when the borrower promises profitability improvements, but with unachievable results. The tired lender recommends (requires) moving the borrowing relationship, often suggesting an asset-based lender to take over the perceived additional lender risk. However, approaching an asset-based lender need not be a reactive debt refinancing step, but rather a proactive one to effectively manage your sales growth, bring suppliers current, purchase needed capital equipment to achieve increased productivity, and remove onerous financial covenant constraints in the process.

Consider asset-based lending when:

* Outside injection of shareholder capital is not feasible (such as early 401k withdrawal causing penalties or requiring second or third mortgages on a residence).

* Seeking greater lender flexibility of principal and interest payments (principal repayment grace periods of 6 to 12 months) for new term loan financing of capital expenditures to improve productivity/quality, structured on increased collateral availability and debt serviceability vs. the company's existing financial leverage.

* Financing an acquisition to lower economies of scale and improve margins--in spite of prior year loss or losses.

* Creating WIP financing backed by solid customer purchase orders and acceptable inventory turnover.

* Avoiding other alternative high-cost debt financing such as factoring or purchase order financing.

* Avoiding the commercial banker's requirement of compensating deposit balances, which are needed to finance your company's growth.

Asset-based lending should not, however, be used to finance entrepreneurial "visionary sales growth" based on ill-conceived gross margin assumptions.

When seeking an asset-based lender, look for:

* Ability to look at creative debt financing structures to meet your company's growth needs.

* Fewer and less restrictive financial loan covenants, ability to concentrate on cash flow and debt serviceability. Simplification and understandability of loan covenants geared toward your financial projections.

* Understanding your particular industry's technological changes, and being comfortable with seasonality issues impacting your business's operating cycle.

Sourcing of bank financing, whether it is from a commercial lender or an asset-based lender, is unequivocally a subjective process. But seeking out a knowledgeable banker, willing to pursue a creative and innovative approach consistent with a company's corporate turnaround, growth phase and the business cycle, will make the difference.

And remember Donald Trump's admonition: "Cash is king!"

RELATED ARTICLE: Asset-based lending: 4 key tips

1. Pricing considerations vs. loan availability: Be more concerned over funding availability and timing than absolute best interest rate. Don't get bogged down chasing banks for lower interest rates you were accustomed to paying. By focusing less on rates and more on availability and proper loan structuring, you will have greater success improving the financial prospects of growing your business.

2. Borrowing formula advance ratio: These vary widely among asset-based lending institutions. Be selective, and determine if the lender uses net orderly liquidation values (NOLV) vs. forced sale values (FSV). The former allows for a sale of inventories, for example, over a longer period of time vs. at a bulk sale auction. Demonstrating proper physical year-end inventories, interim inventory cycle counts and SKU-indicated item turnover allows the lender to focus on a higher inventory valuation percentage.

3. Machinery and equipment (M & E) appraisal values: Because asset-based lending relies on "comfortable" asset values, with M & E make sure the asset-based lender has on its list of approved appraisers one who is thoroughly familiar with your specialized industry. Additionally, much used equipment has made its way into foreign markets, bringing higher market values than domestically in a still distressed valuation state from two to three years ago. Check to see that the bank's professional appraiser is also familiar with M & E values in foreign markets for determining fixed asset borrowing formula availability.

4. Be wary of hefty upfront due diligence fees prior to the lender issuing its commitment letter disclosing to your surprise:

* Amount of "excess collateral availability" at time of funding that may run for 30 to 45 days.

* All trade payables must be within terms (typically around 60 days).

* Salary compensation caps.

* Potentially costly opinion letter from outside attorney to close the loan. Understand the lender's legal documentation costs upfront going into the transaction as these can be very costly in terms of the true financing costs.

* Understand upfront that asset-based lending requires increased financial reporting to the lender and increased collateral monitoring by the lender.

Lawrence Gardner is president of Troy-based Lawrence Gardner Associates, Managerial and Financial Consultants, a member of the Detroit Regional Chamber.

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