Financing the Opportunities
You’ve decided to expand or diversify. Now, how do you pay for it?
The first part of this two-part series focused on business and investment alternatives to a core business of professional remodeling. This part features cash flow and funding options that might be available for diversification or expansion.
Many remodelers argue that the day-to-day operations of their business preclude them from branching into new ventures. The prospect of more of the same is ex-actly why you should give diversification careful consideration.
As remodeling companies typically are started with more labor than capital, many new remodelers usually don’t have significant capital or salaries at risk. But an established remodeling com-pany presents different circumstances: It is producing livelihood to the owner and company employees. Disrupting the company could affect regular paychecks for those people, as well as payments to subcontractors and vendors. So the dilemma a remodeling company faces once the decision is made to expand or diversify (and the terms are not synonymous) is how to pay for it.
Business cash flow
A successful remodeling company should not only generate sufficient cash to pay its bills, it should also yield profits to compensate the owner for entrepreneurial risk.
An owner should first turn to company-generated profit to fund diversification. If a remodeling com-pany is generating true profit (funds in excess of all business expenses, including an appropriate owner salary), those funds can serve multiple purposes. While they obviously can be used to reward the entrepreneur, they also can be used to expand the company. Using profits doesn’t put collateral at risk and doesn’t cause the owner to become indebted to others by borrowing money.
Remodelers who consider diversification have to make the distinction between investing back into the business to create a larger remodeling company and focusing some of their energies elsewhere. Examples of a growing remodeling company include adding sales staff, hiring more field employees to manage an increased number of projects and purchasing new equipment. Diversification, on the other hand, means taking profit dollars and investing them outside of the company’s primary function. While profits still may be used to make the company as a whole grow larger, they might be used to fund a new division or any other option discussed in Part I of this series.
Recognizing when cash from profits is truly discretionary (available for any purpose) is always difficult. A company owner should turn to a knowledgeable accounting or bookkeeping professional to assist in understanding current and past cash flow, and then make reliable projections before making an investment that might be difficult to recoup in the short term.
For example, Steve Taylor of Taylor Made Custom Contracting in Jarrettsville, Md., started a basement waterproofing company in 1987 that evolved into a $4 million business. He then used existing cash flow to purchase an Owens Corning Basement Finishing System franchise that would be used to cross-market finished basements to satisfied waterproofing customers. Why cash flow? “I’d be scared to death to borrow money,” Taylor says.
Deimler & Sons Construction in Harrisburg, Pa., has used cash flow to grow into a diverse company composed of three divisions: custom home building, residential remodeling and commercial renovations. Vice president Craig Deimler says the company uses deposits and positive cash flow from ongoing jobs to fund larger projects. “We’re not the bank,” he adds, and thus the need to stay ahead of every customer on cash flow.
When entrepreneurs start businesses, they seek funding from any source possible. For those who own a home, that asset becomes the first one to tap for cash. For remodelers looking to expand and grow a business, their home can still serve as a valuable asset.
The value of your home in excess of its mortgage represents liquidity that can be tapped through a homeowner’s line of credit. This second mortgage can be accessed two ways: through a fixed loan that is repaid with a variable or fixed rate of interest, or via a flexible credit line (with a variable interest rate) that can be used, repaid and used again.
But this approach comes with a caveat that needs to be understood by all parties involved, including spouses. Tapping into a line of credit secured by your home puts your home at risk. Failure to repay the loan in a timely fashion is a default that can damage your credit rating and cost you your home.
Alternatively, a business owner who has saved over the years and has a non-IRA brokerage account can tap the equity in that account through margin borrowing. This allows you to borrow a percentage of your portfolio in cash without selling any of the underlying assets.
As this is a fairly standard practice, brokerage houses typically give the account holder a checkbook that allows for checks to be written against a percentage of the account value. The interest rate to repay a margin loan typically varies with the prime rate, and the interest and any principal can be repaid monthly or with the use of yet more margin.
Remodelers who’ve used margin during the past two years know of one significant shortcoming with this method: The percentage of underlying assets available for use might stay constant, but the amount can vary widely. Fifty percent of $100,000 is substantially less than 50% of $200,000. If a portfolio drops in value and the portfolio holder has borrowed against it, he or she might get a margin call from the brokerage: Send us a check to cover the shortfall, or some of the underlying assets will be sold.
Remodelers who use personal assets to fund growth should do so only after careful, deliberate planning and consideration. Debt from personal assets, if used for business expansion, remains even after a business closes. Before tapping into personal assets, ask your spouse how he or she feels about putting a home or a college tuition account at risk. If we’ve learned anything after the stock market declines during the last two years, it’s that trees truly don’t grow to the sky (and neither do remodeling companies).
Bank financing is an obvious source of funds for business expansion or diversification. But expanding a remodeling business presents special problems.
Banks loan money based on collateral. Expanding a service business poses problems because there are limited “hard” assets to collateralize. Thus, the owner of a remodeling company might have to secure a bank loan with property (business or home), equipment or receivables. Regardless of the source of the collateral, a personal guarantee is virtually always required, which again puts personal assets at risk.
While a bank considers whether to approve a loan, remodelers should be prepared to have their businesses scrutinized. Vendors and subcontractors might be called to determine whether invoices are paid in a timely fashion. Business and personal tax returns might be examined to determine whether all income is documented and to assess whether the company has sufficient free cash flow to pay down debt. And a business plan is usually essential. Loan officers want to see why additional funds are necessary and that the company owner has researched and planned how those dollars will be used.
U.S. Small Business Administration small-business loans present another opportunity for financing and are a likely option when a remodeling company is relatively small. While the SBA doesn’t loan directly to businesses, it does guarantee loans made by its lending partners (designated banks). The SBA can guarantee up to 85% of loans up to $150,000 and up to 75% of loans in excess of $150,000 (with a maximum guarantee of $1 million). A remodeler who might otherwise not get financing would be best served by applying to an SBA-approved bank; an SBA guarantee might be the difference between loan approval and denial.
The smallest remodeling companies should not assume they are ineligible for an SBA guarantee. The SBA has a MicroLoan Program that provides small loans to relatively new or established and growing small businesses in amounts up to $35,000. Regardless of the size of the loan or the SBA loan program ultimately used, collateral is still required.
Remodelers considering such costly endeavors as spec remodeling or residential rentals should con-sider seller financing, a method often used by home builders and land developers.
Seller financing entails the landowner’s or property owner’s acting as banker; he or she sells the property and then collects interest-only payments from the buyer until the buyer, in turn, sells the property. In the case of the purchase of a rental property, monthly payments to the seller might include interest as well as principal.
For example, the purchase of a property to rehabilitate and sell at a higher price might entail the owner’s selling the property with the contingency that the remodeler pay the balance owed after the remodeling project and subsequent sale are complete. In turn, the remodeler might obtain a loan commitment to refurbish the property, buy the property with little or no money down, pay monthly interest payments to the owner and the bank, rehab the house, sell the newly refurbished property, and then pay off the owner and the bank with the proceeds.
One big caveat: If a remodeler needs to secure bank financing for remodeling costs on a home to be bought, rehabbed and sold, the homeowner must take second position behind the bank in terms of his or her own home. Unless the remodeler has other collateral, banks typically loan money for refurbishment only if the property serves as collateral. For a seller, this increases the risk of losing money if the project is not completed and the bank ultimately has to dispose of it at a distressed price.
In the case of a property a remodeler wants to purchase, hold and rent, the remodeler could buy the property with the proviso that the owner will finance all or most of the selling price. Monthly rental payments to the remodeler then would be used to help defray the monthly payments to the seller. If the financing arrangement is for a fixed period of time (three years, for example), the buyer would be obliged to repay the entire loan at the end of that time (by securing a loan from a bank that could be justified based on monthly cash flow and, potentially, an increase in the value of the prop-erty). This so-called balloon payment at the end of a specified period limits a seller’s risk to a short, defined period.
One other cautionary note regarding seller financing: If the buyer defaults on the monthly payments, the seller probably will be able to take back the property along with any improvements made by the buyer. The buyer probably would be entitled to no compensation for any investment, labor or otherwise.
While professional remodelers know contracts should be written — and projects should be managed — to ensure positive cash flow from start to finish, occasionally a project might require upfront expenditures. Remodelers seeking to expand into light commercial renovation or handyman services might need to spend additional funds for equipment, staffing or marketing, resulting in a short-term cash flow shortfall. If a remodeling company has a successful partnership with vendors and subcontractors, it might be possible to enlist their assistance in company expansion by delaying or extending current payments.
You will need to present a well-conceived expansion plan to all vendor and subcontractor team members to convince them that expansion and/or diversification has a reasonable chance of success. Similar to a presentation to a bank, the plan should include upfront costs, cash flow, a marketing component and a time line.
Second, vendors and subcontractors must be convinced there is something in the plan for them. If they have been paid in a timely fashion in the past and have observed a well-organized company in operation, your words will carry more credibility. If a successful company is looking to expand, then the team that supports it should benefit from an increased amount of projects and more sales and profits down the road.
Third, as this is an unusual form of financing company expansion (vendors and suppliers are being asked to partner in the financing portion of the expansion, but not to share in the increased profits), vendors and suppliers should know a time frame during which they will be repaid all funds that have been delayed or postponed.
Fourth, a fairly concrete contingency plan should be offered in case of failure. Vendors and subcontractors are typically not in the business of loaning money, so they should be presented an option for their protection. They should know that if diversification or expansion fails, you can tap into an alternative source of funds to compensate them for funds they are owed.
Remodelers have a multitude of opportunities in terms of expanding and diversifying their businesses, as well as multiple paths to fund them. Regardless of which direction a remodeling company takes, following a well-conceived plan will ensure the best chance of success.
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