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Facing narrowing funding options, some successful small businesses hit an inventory-financing wall when they're about to grow. One new-old solution: venture merchant financing.
Marie Leone, CFO.com | US
March 3, 2005
Growth is hard on small companies, particularly when it comes to financing inventory. “When I first started,” recounts Jordan Lederman, “I would wait for my first customer to pay before I could buy products to sell to my second customer.”
Lederman is president and chief executive officer of The Kosher Depot, a $1.3-million specialty-food distributor in Westbury, N.Y. Like many small-business owners, he finds that growth spurts can involve some pain. For instance, Lederman says, he nearly crippled his business last year when he bought $40,000 worth of kosher artichokes from Spain.
To be sure, The Kosher Depot is a thriving business, selling exotic kosher foods to restaurants, supermarkets, caterers, universities, and such celebrity chefs as Jeffrey Nathan. Lederman had enough purchase orders in hand to cover the artichoke order. But the Spanish suppliers wanted cash in advance of shipment, and the bulk purchase consumed every bit of cash he could scrape together. The result was that the company was drained of its working capital.
The food distributor had fallen prey to his own success. He had hit a wall in terms of amassing enough excess cash to buy the additional inventory needed to boost sales. Growing his business beyond its current revenue ceiling seemed a daunting, if not impossible, task.
Help, however, was on the way in the form of 400-year-old solution that hasn't reached the radar screens of most small-business executives: venture merchant financing. By entering into such a deal with merchant bank Capstone Business Credit LLC, The Kosher Depot received a cash infusion big enough to get the company past its growth dilemma.
Before the solution presented itself, though, Lederman's company was in a far from unique situation. With significant sources of financing for small-business growth drying up over the last few years, inventory-funding crises seem to be growing more common. For one thing, bigger banks focusing on large corporate customers have gobbled up local and regional banks once friendly to small companies. The larger banks have reportedly been tightening lending criteria for smaller clients.
Globalization compounds the problem. The modernization of manufacturing facilities in China, India, and other Asian nations has increased the chances that finished goods are imported and not manufactured domestically. Foreign suppliers often insist that small companies pay upfront, before shipments leave factories and warehouses. Such payment terms leave small-business owners with little operating flexibility, forcing them to either cobble together cash quickly or cancel orders.
Further, funding sources for small businesses— those with under $50 million in sales, say—are intrinsically limited. The private entities among them are shut out of the capital markets, for instance. Often, they don’t generate enough investment return to attract private capital. Rarely do they have the balance-sheet strength or asset base needed to secure commercial loans or letters of credit.
The erosion of other capital sources makes venture merchant financing particularly alluring. Besides being a more available than other funding sources, it can serve as a financial proving ground for small business by enabling them to grow big enough to take part in more traditional capital raising.
Despite its long history, few small-business owners have heard of venture merchant financing and fewer still are using it. During the 17th century, groups of investors would pool their money and bankroll the merchant voyages of Dutch ship captains. The investors, and the trading posts they set up and ran, were precursors to modern-day shareholders and corporations.
Although the upfront costs of the voyages were hefty, the captains and investors could count on a steady stream of buyers willing to pay a premium for exotic and hard-to-get goods.
Venture merchant deals are rooted in this process. Merchant bankers raise funds and act as temporary chief financial officers, running their client’s trade and taking control of the order-to-cash cycle for a period of about 18 months to three years.
For their efforts, merchant bankers take about a third of their client’s profits, which includes a growing percentage of the accounts receivable they collect as the receivables age. (The banker's cut of the receivables usually starts at about 2 percent.) In such factoring arrangements, a merchant banker or other intermediary typically buys a company’s receivables at a discount, providing the company with immediate cash.
Venture merchant financing is, however, costly in comparison to other forms of small business capital. For instance, Small Business Administration loans carry interest rates pegged to the prime rate (about 5.5 percent currently) plus a premium, while personal credit cards carry 18 percent to 21 percent interest rates.
Nevertheless, venture merchant deals can be well suited to help small companies expand because they provide immediate capital that otherwise might not be available, contends Joseph Ingrassia, a managing member of Capstone. Further, since the deals don't involve any actual borrowing, they don't burden small-company balance sheets with debt.
By providing enough cash, venture merchant financing helped The Kosher Depot to buy enough inventory to enable the company to grow. Before his factoring company introduced him to Capstone a few months ago, Lederman, like many of the merchant bank’s clients, had never borrowed money directly or used any kind of third-party financing.
The hurdles to garner Capstone funding are high, however. The merchant banker vets businesses to make sure that: their finances are in order; management has a proven track record in a niche business; there's a strong demand for the company's products; customers are creditworthy; and the business's gross profit margins are between 25 percent and 30 percent.
Six weeks ago, Capstone accepted The Kosher Depot as a partner, and the two companies inked a two-year, $3.3 million venture merchant deal. Capstone agreed to advance cash to the Kosher Depot against customer invoices so the food distributor could buy more inventory. Based on current sales volume, and taking the infusion of capital from Capstone into consideration, Lederman projected that his revenues will climb to between $3 million and $5 million by year’s end.
The deal works like this: The Kosher Depot assigns its purchase orders to Capstone. Next, Capstone buys the pre-sold goods from manufacturers using part of the $3.3 million it had allocated to The Kosher Depot.
Capstone then imports, ships, and stores the goods in U.S.-based warehouses it controls. The warehouse fulfills the orders based on an approved release request generated by Kosher Depot and signed off on by Capstone.
Finally, Kosher Depot bills the customer and assigns the invoices to Capstone, which collects the receivables.
During the process, Capstone charges the client set fees that total about 30 percent of the final profit. The balance goes to The Kosher Depot, which books the income as a sale. The difference between the gross income and the advance made by Capstone is recorded as "due from factor" until the receivables are paid. As the receivables come in, Capstone remits the balance from each factoring transaction to the Kosher Depot, which credits its books and zeros out the transaction.
While Kosher Depot focuses on selling, Capstone works the order-to-cash cycle, and together the partners aim to improve the system—including sourcing, logistics, and collections. But it’s a short-term relationship, mainly because the financing is expensive.
Once a healthy level of working capital is established and the company’s asset base grows, the business is able to tap in to cheaper financing. The gauge of whether a company is ready to abandon the venture merchant model is that it "should have increased its gross revenue and net profit significantly," says Ingrassia.
As effective a springboard as the technique can represent to cash-strapped companies, it remains little known, however. Interestingly, Capstone's CFO John Beasty says he wasn’t familiar with venture merchant finance until 1995. In that year, he was hired as a finance executive at Khepra Beauty Group LP to help restructure the bankrupt health and beauty products distributor.
As a fragrance-industry veteran, Beasty knew that the ailing distributor, which imported such coveted brands as Dolce and Gabbana, Adrienne Vittadini, and Moschino, would not have enough capital to stay afloat during the industry’s spring and summer seasons, when cash is scarce. After September, however, cash flows spike.
Khepra’s funding problem was a Catch-22. The distributor had millions of dollars worth of unfilled back orders. But it wasn't generating any sales because it had no cash to buy inventory to fill the orders. At the same time, Khepra's strong product lines, high margins, and backlog of orders made it a good candidate for a venture merchant deal, says Beasty.
Khepra called in Capstone in 1998, the financing deal was approved by the bankruptcy court, and within a year, the company was generating $17 million in sales. After the turnaround lured a takeover bid from Canada’s Riviera Concepts Inc., Khepra was sold to the Toronto-based distributor in a 1999 deal that created a $68 million company, notes Beasty.
That year, Beasty joined Capstone. The CFO's contends that the straightforward, cash-on-the-barrelhead approach of traditional merchant banking is a “breath of fresh air” in a corporate finance world replete with off-balance-sheet financing and financial engineering.
The CFO's view is not without self-interest, of course. But the technique's direct approach and its mix of old and new financing tactics seem in tune with how small business owners like to operate. For some small companies that suffer 21st century growing pains, the 17th financing technique could indeed represent a Dutch treat.