Jolly Hockey sticks?! – Understanding the underlying profitability profile of a growing business
by Gavin Harrison
During my early days in banking, while learning the signs of what a ‘good business’ looks like, something that I regularly heard from Credit departments and Senior Management was “Another Hockey Stick forecast! Seen a thousand of these, they’ll never achieve this, mark my word” followed swiftly by “I think it is too early in the cycle…!” Little did I realise at the time that what they really meant was “I really can’t be bothered to use my extensive experience to assess whether there is a good business here!”
Technically they were correct regarding the forecasts; even underpinned by the most accurate management information, no forecast can reasonably be expected to translate into a precise reality. However, it does present an educated estimate of where the business is likely to be heading, as well as the ambitions and expectations of management and shareholders (subject of course to this being presented by a credible management team).
My experience is one I hear echoed by management teams of SME and Mid-Market businesses. Many will at some stage have approached their longstanding bank ‘partner’ for lending, only to be offered a modest overdraft facility or even told that the funding requirement is ‘Equity risk’ (this is the same ‘partner’ that has sat happily on the company’s cash for the last few years).
In certain sectors (in particular Tech), the issue has been overcome to some extent, albeit the focus has jumped much further up the risk curve to the high-growth candidates. The Venture Debt market loves a growth profile and lenders can look beyond profit and focus on Investor quality and a viable product, alongside a pre-requisite of rapid revenue (or user) growth to bulk up the value of the business. This form of lending is certainly not cheap though!
In between the traditional lending market and Venture Debt, a gap therefore remains. This historically underserved section of the market is the ‘Growth Capital’ segment, and it is here that the challenge of the Hockey Stick profile becomes particularly relevant.
In an effort to work with this part of the market we have seen lenders creating mechanisms to rationalise (or in their terms ‘de-risk’) the credit analysis/decision-making process. For example, lending against a contracted level of ‘Annual Recurring Revenue’ (ARR) offers some structure to support the ability of a borrower to repay debt. Asset Based Lending (ABL) is also a common tool to protect repayment where a business has a valuable asset base.
My personal view is that irrespective of the nature of lending, if a lender ultimately does not truly understand a borrower, things are likely to end badly. It is positive therefore, to see an increasing number of specialist lenders coming to the market over recent years with a focus on employing quality structuring teams to look beyond the ‘challenges’ that cause a high-street lender to say no. With the appropriate work and analysis, the funding options are certainly widening, and as an added bonus, these structuring teams are much cheerier as they spend less of their time saying “sorry, its not one for us at this time!”
Borrowing money is naturally a risky business for both lender and borrower! Businesses are so different and even those that share a sector can have hugely differing ‘personalities’. I have always started from the beginning when setting out on a process to raise debt funding, it’s just easier in the long run! However, as a starter for ten, the four areas below are key considerations for me before I begin to work with a new businss. With a positive story around each you will have a strong base from which to build a case that lenders can use to see past some of the traditional lending ‘challenges’ that have become engrained in the minds of the banking sector.
1. A credible Management Team
This does not necessarily mean a collection of perfectly curated CV’s and Bios. A lender is putting their trust in the management team to a) look after their money, b) use it as they said they would and c) treat the lender as an important stakeholder in the business and its future success. A management team that comes across as open and honest and clearly understands the challenges and risks that the business faces, is far more likely to be successful raising debt than a lone CFO presenting the highlights and expecting a lender to fill in the blanks.
2. Appropriate and accurate management information
Another obvious requirement here, however the word ‘appropriate’ is key. Too much detail will naturally overcomplicate and stretch out a process, while too little will attract immediate follow up questions and immediately erode trust. Bankers are also naturally pessimistic so may assume missing information has been deliberately withheld! Also, to the extent that forecasts can be made as static as possible through a process this will help to build confidence in what is being presented (appreciate this is not an easy one).
3. A viable product & business model
This means being able to explain what the business actually does. It is generally very difficult to insult a banker by dumbing things down! Explaining, or even better showing, how revenue is generated, and then how and when this ultimately flows through in the future as cash, is what the lender needs to understand. Remember that very few lenders truly have a detailed sector focus, so ‘layman’s terms’ are always appreciated.
4. An appropriate use of funds
Being clear on the proposed ‘purpose of funds’ is often much more important to a lender than management teams may expect. The range of purposes that debt can be raised for is wide. M&A, Capex projects, balance sheet recapitalizations are a few of the more traditional uses. Venture debt is intended to extend the cash runway of growing businesses and in the Growth Capital segment, debt is being used to finance growth programs, underpinned by the ability of the existing core business to pay off the debt taken on. Lenders do understand that regardless of how much legal documentation there is to ensure funds are used ‘correctly’, the borrower is in control once a loan is drawn. The purpose is more a point of principle and trust, and this brings me straight back around to point 1) above – Credible Management!
In summary, raising a meaningful amount of debt is rarely a light touch process, despite how some lenders might pitch it. For the experienced management team with existing debt facilities, it is certainly not a complex undertaking, however for a business coming to the market for the first time in a while, focused preparation will significantly shorten and de-stress the process. Even if you do have the time to spare, in the current markets lenders themselves are stretched for resources, so they will place the more completely presented applications at the front of the queue. Ultimately, now more than ever, this is a time to raise debt the right way!
Gavin Harrison, Dow Schofield Watts Debt Advisory Partner
Get in touch with Gavin by calling 0207 076 3472 or email [email protected]