FINDING FUNDS

For many consulting engineers, it’s a toss-up as to which they dislike most, having a tooth pulled or going to the bank to ask for money.

Fortunately, in both the fields of dentistry and financing visits no longer have to be the painful ordeals of the past. While in dentistry this change can be attributed to advances in technology, in the capital markets it is due to a proliferation of new players.

A need for capital no longer requires a visit to your banker since alternative financing options for small and mid-size businesses are burgeoning in Canada. The alternative sources often provide more flexible arrangements in terms of security, repayment and financial covenants which are better suited to your business.

If you need new premises, equipment or a loan to sustain your consulting engineering firm while you undertake a new project, here’s the lowdown on some of the most popular new sources of expansion capital.

Small Business Deduction. For those with incorporated businesses, the small business deduction can provide you with capital to reinvest in your business.

If you operate a sole proprietorship or a partnership, you pay tax on your business income based on your combined federal and provincial personal tax rates. These can total more than 50%. If your company is incorporated, it is liable for a corporate tax rate of up to 46% depending upon the province in which you are located.

To encourage the development of the business sector, the federal and provincial governments offer a tax break to small businesses with taxable capital of less than $10 million. This small business deduction reduces the federal corporate rate from about 28% to about 13% on annual “active business income” — income you earn from business operations of less than $200,000.

The provinces further reduce the corporate tax for small businesses. Their rates vary, the highest being 9.5%. With the deduction, the small business rate can therefore be as low as 18% and no higher than 22.5%. That deduction can translate to savings of up to $47,000 of combined federal and provincial taxes on $200,000 of taxable income.

If you draw the money out of the business as salary or dividends, it becomes taxable and much of the benefit will be lost. That is why you have a great incentive to keep that nice chunk of after-tax income and reinvest it in your business to expand your operations.

Leasing. Leasing has become popular because for firms with limited or unsteady cash flow, this form of financing helps to protect cash reserves. Rather than providing one lump sum to purchase an asset, you pay a deposit plus regular installments for the use of the item. Leasing also gives you flexibility regarding the length of time you use assets which are subject to rapid depreciation, like cars and high tech equipment. Another benefit is that you can deduct all your lease payments as business expenses.

If you want to preserve your future borrowing power, then the type of lease you secure is important. A capital lease, for example, enables you to acquire the asset for a moderate price once the lease has expired. This type of arrangement is a long-term liability that may limit the amount of credit available to your business.

With an operating lease, you simply pay for the use of the equipment, therefore the lease costs do not appear on your firm’s balance sheet. However, this type of lease requires higher payments because you are financing the equipment for less than its useful life and the leasing company must be able to recoup the value of the equipment.

Corporate Loan. One of the benefits of incorporating your business is that you are allowed to borrow money for certain purposes from the company at low or no interest. You can, therefore, take out a corporate loan to purchase a company car, buy shares of the corporation or for personal needs. You have to include an interest rate in your personal income, which is Revenue Canada’s prescribed rate less the interest you pay on the loan. However, you will still be ahead in comparison to obtaining a personal bank loan.

To qualify for a corporate loan you need to prepare a written document specifying the amount of the loan, the rate of interest and the repayment deadline. The document has to be available for Revenue Canada should they want to review it. You also need to pay back this loan by the company’s year end of the following year; otherwise the amount will be included in your personal income and you will have to pay tax on it.

Supplier Financing. Your suppliers have a vested interest in your success, particularly key suppliers with whom you have a long, established relationship.

If you have substantial investment in supplies, inventory or equipment, you can try negotiating with these key suppliers for special deals. These might include extended payment terms, fast payment discounts, reduced prices, special lease arrangements, even an equity investment.

Many firm owners have found that their most productive financing comes from this very close, but infrequently considered, source.

Royalty financing. For firms with a reliable cash flow, royalty financing can help you acquire an advance on your revenue stream. Royalty financiers receive a percentage — generally up to 5% — of your firm’s revenue for a defined period of time. Your firm receives an “advance” on future sales, rather than a loan. You have a few months in which to put the capital to work in your business and then you begin sending “royalty payments” to the investors. Royalty financing can be arranged with institutions as well as with private investors.

Mezzanine financing. If your firm is established and has reliable earnings and cash flow but few tangible assets, mezzanine financing can enable you to raise funds without sacrificing ownership in your business. These high interest loans are not secured by assets; instead, projected cash flow serves as collateral.

Mezzanine financing is particularly helpful when you need funds for an acquisition, expansion or a management buyout. This form of financing is “subordinated debt,” i.e. unsecured, high risk lending that is subordinate to conventional financing because it has second claim behind secured lenders.

Mezzanine financiers offer a variety of arrangements: high interest loans, fees, participation in cash flow or conversion of debt into equity. Loans can range in size from $200,000 to multi-million dollar amounts and are generally offered from three to seven years. While interest rates are as high as 25%, the borrowing costs and fees are tax deductible.

Factoring. For those firms with lots of cash locked up in receivables, factoring can free it up. A factoring company, or invoice discounter, purchases a portion of your accounts receivable in exchange for a discount of up to 9% on those receivables.

You can benefit from this type of financing if you need to fund a large project, if your payroll or workload fluctuates through the year, or if your firm is growing quickly.

Angels. “Angels” are a type of informal venture capitalist. These are generally wealthy professionals or entrepreneurs who invest their own money, typically not less than $100,000, in return for partial ownership in a business. They help a firm grow by contributing their expertise and contacts. Sometimes angels form a group or “syndicate” in order to invest larger amounts up to several million dollars.

Angels look for young businesses with excellent short-term revenue growth potential — an annualized return of at least 30% over five to seven years. They also look for a management team with vision and skills, and products or services with a promising market.

Asset-based financing. If you are involved in an acquisition, turnaround or expansion, or you need to purchase capital assets, you might want to consider asset-based financing. This financing allows you to borrow against the value of a pledgeable asset, such as accounts receivable, inventory, equipment, furniture or computers.

Whereas traditional banks are concerned with debt
-to-equity ratios, asset-based lenders are interested in cash flow and the liquidation value of the security. Your firm is a good candidate for asset-based financing if it is growing rapidly or is highly leveraged. You can secure asset-based loans of as little as a few hundred thousand dollars or as much as several million dollars.

While it is always a good idea to maintain a productive relationship with a banker, you should think about some of these other financing sources as supplements or contingency strategies. But before you start knocking on these lenders’ doors, you should prepare a simple financing plan. Doing so will help you organize your capital requirements and assess your ability to repay the debt. Your accountant can help you put together this plan, advise you on your eligibility for the various types of financing options and match you up with the best sources.

Now go get the capital you need — without wincing in pain. CCE

Chris Joakim, CA, is a partner of Horwath Orenstein LLP, a Toronto-based chartered accounting firm and member of Horwath International. He can be reached at (416) 596-6767 or cjoakim@hto.com.