The Financing Worked. Until It Didn’t

Too often, entrepreneurs and their advisors focus on completing the transaction and ignore the cash crunch that is likely to follow.

Over the past few weeks, I’ve been working with two very different companies. One bought an existing business about two years ago. The other is a manufacturing startup. Different entrepreneurs, different industries, and different financing structures. Yet both companies face almost the exact same problem. In both cases, the financing got the deal done, but it wasn’t designed for what came next.

The first entrepreneur purchased a business for $5 million, using the full Small Business Administration 7(a) loan limit available at the time. Every dollar of the financing went to the seller. The acquisition closed, the keys changed hands, and everyone moved on. Today, the business is doing well. It has roughly $1.5 million in accounts receivable, customers are paying, and demand is strong. The problem is that it doesn’t have enough cash to buy inventory.

The owner recently called me because he was considering a $500,000 short-term loan with a very high interest rate just to keep the business moving. I strongly advised against it. Instead, we’re looking at an asset-based line of credit secured by the company’s receivables. With about $1.5 million in accounts receivable, a lender should be willing to advance roughly 85 percent of eligible invoices, creating more than enough liquidity to support the business. Because there’s already an SBA lender in place, the two lenders would need to enter into an intercreditor agreement. It takes coordination, but it’s a very workable solution.

What strikes me is that this cash crunch shouldn’t have been unexpected. The business always needed working capital. The financing covered the acquisition, but nobody spent enough time thinking about what the balance sheet would need to look like after closing.

The second company has the opposite issue. This entrepreneur started a manufacturing business and financed approximately $2 million of equipment with an SBA loan. The lender also provided an $800,000 accounts receivable line of credit, and at the time, the structure seemed to make sense. Then the business exceeded everyone’s expectations. Today, accounts receivable have grown to roughly $1.6 million. Sales have increased, but so has the amount of cash tied up waiting to be collected. Normally, that’s a good problem to have.

Unfortunately, because the company hasn’t reached profitability yet, the lender isn’t willing to increase the line of credit, even though the collateral supporting that line has doubled. The business is healthy. The financing simply hasn’t kept up.

Again, there’s a solution. A lender that specializes in asset-based lending can pay off the existing line, establish a larger borrowing base against the receivables, and work alongside the SBA lender through an intercreditor agreement.

Both of these situations reminded me that building a balance sheet is a little like building a football team. Before the opening kickoff, you have to decide how you’re going to spend your salary cap. You need an offense. You need a defense. You need depth. And you need enough flexibility to adjust when the game doesn’t unfold the way you expected. You don’t want to realize halfway through the second quarter that maybe you should have invested in an offensive line. The same is true when financing a business. Too often, entrepreneurs—and sometimes their advisors—become so focused on getting the transaction closed that they don’t spend enough time designing the balance sheet the business will need over the coming years.

Will there be enough working capital if sales take off? What happens if customers start paying more slowly? How will the company finance additional inventory? What if growth requires more cash than anyone anticipated? Those questions are just as important as negotiating the purchase price or the interest rate.

The closing isn’t the finish line. It’s the opening kickoff for the business. If you don’t build enough flexibility into your balance sheet before the coin toss, you’ll spend the rest of the game fixing a problem that could have been avoided.