The EQ Journal Blog

An Increasingly Important Source of Bootstrap Capital

In 2009, trade credit (or supplier credit) has surpassed bank lending as a source of finance for business in the US. TC amounted to $2.15 trillion this year versus $1.5 trillion in bank lending (which was down more than 6.5%, year over year) according to data from the US Federal Reserve.

For startups, trade credit or supplier credit is a key source of funding. For a nascent homebuilder, say, suppliers may extend credit for everything from concrete foundation work to trusses, lumber and drywall. Even lawyers, architects, structural engineers, surveyors, soils engineers and other professionals may extend credit for their services until completion of a sales transaction.

Now why would they do that?

• First of all, they do it because they trust the business they are providing credit to, to eventually pay them.
• Secondly, they want to expand the market and their market share—one of their key weapons for doing that is to provide credit to the firms that buy from them.
• Thirdly, this tends to lock clients into their business eco-system—once the client has been approved for trade credit, they tend to buy from the same source over and over again using their approved credit facility on a revolving basis.
• Fourthly, once the client establishes good credit, they can always apply for a higher credit limit and expand their business further using OPM—Other People’s Money, i.e., credit extended by their supplier or suppliers.
• Fifthly, suppliers expect to be paid not by their clients but by their clients’ clients—in the case of the homebuilder, for example, cashflow is actually coming from homebuyers. So the supplier is actually funding (indirectly) the credit rating of their client’s homebuyers.
• Sixthly, suppliers want their clients to stick around for a long time. They will often go out of their way to help out a loyal client who perhaps gets into financial difficulties by giving them better terms on their financing, forgiving portions of their debt or even trading debt for equity. If a bank hears you are in trouble, they’ll more than likely call your loan. Most suppliers will remain supportive (to a point).

The homebuilder may be able to get credit from not only suppliers of construction materials and professional services but also from landowners. Landowners might sell the homebuilder some lots and take back financing on the lots so again they get paid when the homes sell. This greatly reduces the amount of capital a startup homebuilder would need. They might also be able to source startup capital from their clients in the form of deposits on each home sold.

Let’s look at another business—the promotional products business. We’ll call the business Acme Promotional Products. Again, Acme’s clients will be a prime source of capital if the business takes, say, deposits of 50% on each order, up front. The business might also arrange trade credit with suppliers—maybe they pay 1/3 down with each order and the balance 30 days after delivery.

Let’s look at Acme’s cashflow. Let’s assume that they do only one transaction in their financial year in the amount of $300 and their cost of goods sold is $200. They pay 1/3 of the order up front to their supplier (i.e., $66.67) but they get a deposit of 50% from the client or $150.

A good indicator of what their cashflow will look like is to calculate their Cash Conversion Cycle (CCC)?

The CCC is an important tool for entrepreneurs to use—if it is 0 or negative, then entrepreneurs can probably grow their businesses without the need for outside funding.

You can determine your CCC as follows:

CCC = ART + INVT – APT,

Where:

CCC* is Cash Conversion Cycle,
ART is Accounts Receivable at Year End,
INVT is Inventory at Year End,
APT is Accounts Payable at Year End.

(* To make it easy for you, you can download a spreadsheet in .xls format from our server at: http://www.dramatispersonae.org/BusinessModels/CashConversionCycleMeasurement.xls. You simply insert the figures for ART, INVT and APT and the spreadsheet will automatically give you your CCC number.

You may prefer using our CCC calculators in your browser, so we also put them up for you at: http://sheet.zoho.com/public/profbruce/cashconversioncyclemeasurement.)

For Acme, we can figure out their CCC as shown in postscript 2 below. In this simple model, their Cash Conversion Cycle is a healthy -61 days. What this tells you is that the faster that Acme grows the more cash they will have on hand.

This is a non-trivial advantage for them. If they had to rely on their Bank to fund their AR, they are vulnerable to a change in Bank policy, the appointment of a new Account Manager, rumors spread by a competitor that might frighten their Bank into calling their loan and lines of credit or an overall downturn in the economy that results in a decrease in Bank lending. In this case, Acme is relying instead on their customers and their suppliers to provide them with their financing.

What if Acme, instead of asking for half down from their clients only got paid when the order was delivered? What happens to their CCC? It becomes a horrible +122 days. So even though they are only giving their suppliers 1/3 down on each order, waiting to get paid by their customers means that they have to find outside financing for each order and now they are in hock to and reliant on their Bank, with all the attendant downsides I described above.

Of course, if they don’t pay anything to their supplier until they get paid, then their CCC will be exactly 0 which is better than +122 but not as good as the payment plan, receivable plan and inventory management system we started with. Seemingly small changes in company policies can produce big changes in your CCC and cashflow so this is an area that needs more focus and attention.

Most entrepreneurs and many businesses do not give enough thought to this. We had one client of ours, a top notch advergaming firm, nearly go out of business despite: a. fantastic growth in their order book, b. a client list to die for (including several Fortune 50 and Fortune 500 companies) and c. having tremendous technology and creative resources within the business. Each time they signed a contract, they had to hire more, highly paid tech developers and build their ‘pipeline’ to deliver the product. They forgot to get any money up front from their clients and didn’t even receive progress payments when they hit certain project milestones. For complex projects that lasted a year or more, they had to wait until delivery plus 30 days to get paid—it was feast or famine for them.

As a result, they needed huge amounts of capital from their Bank, which predictably enough put them in a precarious position. I was called in when the Bank had called their loan and the firm was threatened with extinction. We got the Bank to agree to a 90-day standstill agreement and then we asked their client base for help. Practically all of them came to their assistance.

Now their biz model calls for 1/3 deposits up front with each new contract and progress payments that always put the firm out front in terms of cashflow. Only 10% is due upon final delivery. Their CCC went from over +300 days to a -40days and the firm went on to do really great things.

If you think this only applies to SMEEs, you’re wrong. Think about Dell for a minute. They don’t build computers until they have an order and they require that you pay 100% (and sometimes more than 100%) up front. Once they have your money, your PC is built by a Dell supplier who only gets paid, say, 30-days after delivery. I guesstimated Dell’s CCC at -45 days. In fact, it may be better than this—Dells tries to upsell you on ‘value added’ services like a full, multi-year extended warranty for parts and service that they hope you will never actually use or they will never actually have to deliver (remember ‘Dell Hell’?) The impact of Dell receiving > 100% of the price upfront on their cashflow is a big plus for them, not so much for you.

So one of the keys to Bootstrap Capital is to not need startup capital in the first place! You can help do that by looking for financing in the deal flow itself; i.e., start with a CCC that is negative. You can get capital from your clients and from your suppliers and you should try to get as much as you can (within reason) from both.

Prof Bruce

Postscript 1: Sometimes your suppliers can be coaxed into giving you not only trade credit but cash too. If you are an automotive company, for example, a good place to look for the cash you need to fund the required R&D for a new car line would be from your suppliers. They will ‘sponsor’ your efforts in the hopes of securing supply contracts for the new assembly line. Think this only applies to large firms? Think again. Many startups could find funding in sponsorships except that they just don’t think in those terms.

One of my students wants to start her own women’s fashion and design firm in Montréal and she isn’t sure where she will get her startup capital. Every VC and Angel Investor she has talked to has turned her down—not a field they are interested in.

Instead, we sketched out a program to ask perfume companies, jewellry firms, fashion magazines and bloggers, wineries, distilleries, breweries, sunglasses manufacturers and others to sponsor her first event in Montréal; after a successful launch there, she will go on tour of major cities in Canada, the US, Europe and Asia and her sponsors will go with her.

Why would they each contribute money to this? Again, first of all, because they trust her. Secondly, she is passionate about what she does. Thirdly, she has a very different approach to fashion and design which I can’t disclose here. And they want to be associated with something avant garde like this.

Postscript 2: We calculated Acme’s CCC as follows:

Dec. 22, 2009 CASH CONVERSION CYCLE (CCC*) MEASUREMENT

CCC Measurement- Promo Products Biz** Number Units

Accounts Receivable at Year End (AR) $150
Days Per Year 365.25 Days
AR x Days Per year $54,787.50 Dollar-Days/Annum
Annual Sales $300 Dollars/Annum
AR x Days Per year/Annual Sales 182.625 Days ART

Inventory at Year End (INV) $0
Days Per Year 365.25 Days
INV x Days Per Year $0.00 Dollar-Days/Annum
Cost of Goods Sold (COGS) $100 Dollars/Annum
INV x Days Per Year/Annual Sales 0 Days INVT

Accounts Payable at Year End (AP) $ 133.33
Days Per Year 365.25 Days
AP x Days Per year $48,700.00 Dollar-Days/Annum
Cost of Goods Sold (COGS) $200 Dollars/Annum
AP x Days Per year/Annual Sales 243.5 Days APT

CCC* -60.875 Days

* CCC = ART + INVT – APT
** For demonstration purposes only.

Payables Down 0.333333333 0.666667 In 30 days
One Sales Transaction