Financing unrated growth companies requires a strong stomach – and a strong balance sheet.

A man in San Francisco knows that his two-year-old software company already has a more powerful offering than any of his competitors; you can hear it in his restlessness and eagerness to begin winning business. Not far away, another man is racing to get his medical device into the hands of influential surgeons, sure that as soon as he does, his company will attract multiple bids from Fortune 500 companies. Both men could make millions for themselves and their investors in less than six years.

On the surface, these businesses have little in common. But both are hungry for capital, and both possess the potential for rapid revenue growth.

Specialty finance firms that can identify these opportunities will likely provide financing, because we devise customized equipment leasing and finance solutions for growing companies that we believe are well positioned for the future. In so doing, specialty finance firms take on considerable risk because few of these potential clients have attained credit ratings or achieved lengthy operating histories. And, few have audited statements or can demonstrate positive cash flow. Thus, banks and other funding sources have good reason to deny credit to these companies.
 
A Different Philosophy

Specialty finance firms serve this sector for several reasons. Most of us enjoy assessing and taking risk. We also enjoy the variety that comes from financing many types of companies and equipment, including equipment that may be expensive to recover or may have little resale value. Additionally, some of us find satisfaction crafting individual deals that address a client’s “hot buttons,” whether that sensitivity is cost of capital or a need to maximize availability of financing. At times, we may also be asked to provide a degree of flexibility or responsiveness that would be difficult for a regulated financial institution to offer. But by and large, we are not banks and our mission is to deliver value – not to provide “risk-free” pricing.

Even so, we’re often asked how we stay in business by financing firms that aren’t yet making money. We’re asked how we survived the recession when so many other credit providers did not.

Executives at any specialty finance firm worth its salt will tell you that each potential client presents an opportunity to understand its business, its capital needs and its equipment needs – both now and over time. But doing so takes a lot of work and requires a certain level of expertise. Specialty lenders often have broad and deep experience in credit analysis, equity analysis, financial operations and investing, and we use this experience to study the financial statements and projections of potential clients carefully to assess credit worthiness.

We may also offer prospects a chance to tell their story during a phone call or face-to-face meeting. Rarely can this process be reduced to a computer application, because many of the questions we ask depend on prior answers. In some cases, the prospect for funding may prove to be too premature for even a specialty finance firm. But in other cases, we may be able to offer terms immediately based on our understanding of the business.

However, specialty finance firms can spend only limited time with each prospect and as a result, may miss certain data or make errors in judgment. When this happens, we can certainly lose money. But if we are to remain in this business, we need to continue taking risks that others avoid. And to be successful, we must understand those risks and more often than not, be correct in our assessments.

One Client with Two Problems

“Company A” is a cloud computing firm that started operations in January 2006. Fountain Partners became acquainted with the company and its owners two months after start up. The business was already generating revenue with February billings totaling more than $25,000. The owners had invested $500,000 of their own money and were deferring salaries. The management team was complete and consisted of individuals who had managed a similar business.

The firm needed additional computer servers to meet growing demand, but there were meaningful risks. The company had an extremely limited history and lots of competition. There were no institutional financing partners, and we knew this type of business didn’t usually attract traditional venture capital funds. But, we liked the business model and management’s ability to sell its products. We executed a term sheet, visited the company and began our relationship. The company grew even through the recession and soon was able to get financing at lower rates. For a while, the company was on top.

But success often breeds risks of its own. In this case, a large competitor filed suit against Company A in what seemed a deliberate attempt to slow Company A’s progress. No matter what we thought about the facts of the case, we couldn’t predict what a judge would do or how long the case would continue. What’s more, the client’s legal costs were high and financing options were running out.

Ultimately, we provided more financing. We accepted the risk that a judge could stop our client from adding new customers, because we didn’t think it would happen. We thought that even in an adverse situation, a judge would find it commercially unreasonable to order a firm to stop serving its customers abruptly. And, if there were to be a transition, we believed we had a chance of being compensated for our leases.

Months passed while the case sat with a judge. Finally a deal was brokered when the largest shareholder of the plaintiff company decided to purchase Company A and put an end to the litigation. At sale closing, our leases were paid in full.

Taking Multiple Risks at Once

In this second example, we entered the negotiations facing multiple risks. In this case, we had equipment customized for a particular use and located on our client’s customer’s premises. Thus, we had an asset with little resale value that would be very expensive and difficult to recover.  Furthermore, the value of the equipment was now highly correlated to the performance of the company.  And, the client was still unrated and unprofitable. If the company failed at this point, we would lose significant capital.

But we liked the fact that the equipment was being used to support service contracts, and we liked the owner’s prior track record. The company had also demonstrated decent sales traction, and we could see the company’s business model was working. Even so, we knew we couldn’t help if we were not compensated fairly for assuming these risks. If specialty finance firms are to stay in business, they must maintain disciplined pricing.

A Deal Refused

“Company C” came to us for financing with a history of financing received from other equipment leasing firms. After reviewing Company C “on paper,” we asked the CFO about the other financing relationships. What was their payment experience, the condition of their balance sheet and the monthly payments?

We soon  learned that Company C was far behind in its obligations – owing $1.5 million to another leasing firm. Upon learning this, we asked to speak with the other leasing company and learned that the leasing firm was forbearing without financial consideration. We certainly didn’t want to have the same experience, nor did we wish to fund a company that stalled creditors when there were deep-pocketed equity investors who could have kept the obligations current. We explained to Company C that we would not become involved until they were in good standing on all current debt obligations.

What’s Ahead

There’s a consensus among lenders today that banks are hungry to lend to only the best credits and that consequently, opportunities to do so are highly competitive and won with low rates. The upshot: Businesses not meeting prime lending criteria – but still in need of  capital – won’t  have the ability to borrow at rates of 3% or 4%. But to attract and compensate non-bank lenders (including specialty lenders), projects undertaken for these businesses will have to generate much higher returns.

Eventually, banks and other regulated financial institutions will probably find ways to expand the range of risks they can tolerate. At the same time, the capital markets will enable unregulated financial services firms to satisfy loan demand. We  cannot foresee  which institutions will misprice risk on a large scale. We cannot predict when and to what extent other firms will follow these “volume leaders.” We can expect, at some point, for easy credit to return.

The key to success and longevity for specialty finance companies will be to maintain underwriting standards and pricing disciplines across cycles. Smart firms will endure by working with clients that understand and appreciate value – and are willing to pay for it accordingly.