by Diane Taylor
All government contractors regardless of their size or maturity, are dependent on adequate working capital/cash flow to support growth. Commercial banks are interested in providing that working capital financing. Even more, banks also are available as financial advisor-partners to assist in developing a financial strategy designed to meet a company’s revenue and profit goals. Most important to the contractor, over the long term, bank financing provides the most stable and least expensive source of capital.
As with all business financing alternatives, not all banks are alike. It is important to look for a banking institution that offers a range of financing options that are appropriate to a company’s stage of development, and that has the flexibility to change the financing structure and increase the amount of credit as the business grows. Banking relationships, for example, which can provide an avenue to the Small Business Administration (“SBA”), economic development authorities and/or Exim Bank international financing programs can be of significant benefit to the contractor. Additionally, banks can provide access to non-traditional financing sources through the investment bank/capital markets that arrange private debt and equity placements.
Table of Contents
FINANCING WORKING CAPITAL NEEDS
The financing needs of government contractors range from start-up ventures requiring financing to support the up-front cost of an initial contract, to working capital lines of credit to support the receivables collection cycle of well-established contractors performing under numerous contracts. In addition, it is important to demonstrate to the government that a company has access to financing as an indication of ability to perform under government contracts, and often is a pre-requisite to contract award. The progression of financing naturally follows the development of the contractor.
Unlike a venture capital firm, banks are not equity suppliers of capital. Banks are regulated lenders of using depositors’ money and therefore have a consequent responsibility to operate at the lower risk (lower return) end of the spectrum. As such, the start-up venture is more appropriately handled by equity investors (in most cases, the owners themselves). Bank financing at this stage is most often based on the personal financial strength and resources of the owners.
As a company progresses and is able to demonstrate positive trends in performance and profitability (but is still inadequately capitalized), secured bank financing based on specific contracts may be an option. This is done through the Federal Assignment of Claims Act (“FACA”) which allows for the assignment of specific contracts, in addition to liens recorded under the Uniform Commercial Code on corporate assets.
Under this approach, invoices are submitted to the bank, and a certain percentage (generally 75% to 90%) is advanced against the invoice, with the specific advance repaid through the collection of the invoice directly from the government to the bank. Due to the time involved to assign contracts, it is not generally practical for a bank to take an assignment unless the contract spans at least 90 days and exceeds $100,000.
The feasibility of invoice lending is also a function of the type of contract. For example, an indefinite quantity contract funded on a task order basis may not be conducive to an invoice lending arrangement. Often each task order may need to be assigned separately. Also, by the time the task order assignment is perfected, the billing and collection cycle could already be complete. This type of monitoring is expensive and time consuming for the bank, and therefore requires the highest level of fees. Often, outside collateral is required, as well as owner guarantees.
For more established companies, contracts may be FACA assigned to the bank, with the financing managed through a borrowing base line of credit. In these cases, loan advances are usually made up to 85% – 90% against government and 75% 80% against commercial or subcontract accounts receivable, generally outstanding 90 days or less. Periodic audits by the bank of the customer’s systems are normal. Accounts receivable aging reports are provided to the bank to support the borrowing base certificate on which the advance rates are calculated and ineligible receivables are deducted (over 90 day accounts receivable, at risk work, etc.). On an exception basis, unbilled accounts receivable billable in the next billing cycle may be classified as eligible under the borrowing base, at lower advance rates and with limited exposure.
If applicable, inventory may be considered for inclusion in the borrowing base, usually at a limited exposure. Advance rates are generally based on the type of inventory and are set significantly lower than the level of advance against accounts receivable. As inventory is further removed than accounts receivable from conversion to cash, advancing against inventory is generally considered higher risk.
The frequency of providing the borrowing base certificate is a function of the type and nature of the contracts, frequency of billing under the contracts, the company’s line of business as well as its overall financial strength. For more diverse companies with a broader range of contracts, the bank may elect to take an assignment only on the larger contracts or those contracts which represent a concentration to the company.
For contractors with an established track record, a history of profitability, acceptable financial condition with positive trends, and good earnings potential as evidenced by the level and diversity of backlog, the bank may secure its lien on the company’s assets under the Uniform Commercial Code,, without requiring FACA assignments on the government contracts. In almost all cases, however, the bank reserves the right to take assignments.
For well capitalized companies with established, predictable and consistent earnings history, strong backlog, good diversification and excellent financial condition, the borrowing base requirement may be modified or even eliminated. In some cases, working capital financing may be considered on an unsecured basis. This, however, is the exception. These companies often have access to numerous alternative financing sources including private debt and equity placements, as well as the public market.
The loan structure and collateral requirements are based on examination of all facets of borrower including:
- Historical and projected profitability
- Nature of business
- Competition (performance compared with peer group)
- Financial condition (level of liquidity, debt relative to equity)
- Depth and predictability of earnings/cash flow
- Management depth and experience
- Accounting systems and controls
- Quality of financial reporting
There is no one correct structure or formula. Each financing arrangement and its structure should be tailored to meet each company’s specific financial situation. There are trade-offs and flexibility in structure and pricing alternatives.
IMPORTANT FACTORS IN A BANKING RELATIONSHIP
The most important factors in any banking relationship are good management and communication. Confidence in management will allow the bank to be more aggressive in its risk tolerance. Good communication is key. If the company is having a problem, the banker should not find out by reviewing the financial statement. The bank will be much more willing to be creative in dealing with the inevitable problems that businesses face, whether it is “ramping” up on a new contract or contract funding delays, if the bank is informed of the situation in advance.
It is a good idea to periodically prepare an overview for the banker of how the company has done, including financial performance, major issues, contract awards and the firm’s outlook. This will allow the banker to be proactive and add value to the process, offering suggestions as to how the bank can assist the company in achieving its financial goals.
Evidence of sufficient accounting support and systems to provide accurate and timely information are critical to the bank. This allows management, as well as the bank, to monitor financial performance and enables management to respond and plan accordingly.
HOW TO PACKAGE FOR BANK WORKING CAPITAL SUPPORT
It is important to have an understanding of your working capital needs, based on your company’s financial condition and projected cash flow. This can be impacted by the nature of contracts on which the firm is bidding, and the amount of up front expenses incurred prior to billing under the contracts. Cash flow analysis/projections are necessary to determine the amount and timing of credit need. Typically, a line of credit should be sufficient to cover at least three months of accounts receivable, plus a cushion for growth or unexpected delays.
The financing package should cover financial, operational and background information. Generally this information is available in some form for management’s use, or for inclusion in contract bids, or as a condition to participate in other programs such as the SBA. Such information may include:
- Business plan
- Overview of business strategy
- Corporate capabilities statement
- Breakdown of company ownership/organization chart
- Resumes of key management personnel
- Personal financial statement of principals (if guarantee)
Note: The principals of most small and medium sized businesses generally personally guarantee the full amount of the credit facility. However, this is a function of the overall financial status of the borrower.
- Financial statements or federal income tax returns for last three years and most recent interim financial statement
- Projections: cash flow/income statement and proforma balance sheet
- Accounts receivable aging report; breakdown of unbilled accounts receivable
- Inventory breakdown (if applicable)
- Contract backlog/status reports (total and funded contract amounts and performance period listed by contract, agency, contract type, with status as prime, subcontract, set aside or competitive)
- References
If not readily available, some of this information may be obtained through discussions with management. Positive trends in a company’s earnings and financial condition are important. if the business does not have a well established, profitable operating history, make sure the reasons are clear and demonstrate that the prospects for future profitability are strong.
CONCLUSION
For a successful banking relationship and adequate working capital support, the government contractor should seek a banking institution that has the expertise, experience, and a proven track record in the industry in providing the services and flexibility in financing that matches the company’s specific needs. Inquiry into a bank’s lending expertise and risk philosophies, as well as asking for contractor-customer references is suggested. The bank can be an effective long term partner in supporting the contractor growth cycles. it is important to have direct contact with experienced professionals to respond to the company’s needs.
Michael C. O’Grady, Senior Vice President, Crestar Bank, Technology and Government Group (703-902-9084)
