Accessing capital for business and professional services firms
INSIGHT ARTICLE |
Business and professional services (BPS) firms are generally low capital intensity businesses. Most of the asset base is tied up in the people, i.e. the assets arrive and leave each day via the elevator. However, as competition becomes more intensive, technological change continues to accelerate and services become more global, having access to capital provides competitive advantages in the professional services sector as it does across other industries.
Whether seeking capital to optimize current operations or for new business development and growth initiatives, identifying and understanding the options available are key to ensuring the capital is aligned to the business need for a BPS firm.
While many of the factors that need to be considered for a firm when accessing capital are the same as for any other business, such as the existing capital structure, cash flow, management expertise, profitable and defensible market position, there are some additional specific issues that capital providers to business and professional services firms consider.
1. Seasonality and unpredictable cash flow
Cash flow can be unpredictable, or at the very least seasonal, whether within the law sector, accountancy and taxation, engineering or creative services, with variable client billing timing, delays and discrepancies. The financial ups and downs are simply more manageable for larger, more diversified firms with a more diversified client base and hence generally access to more internal working capital.
Financiers will focus their due diligence on the working capital of a BPS firm when considering financing as this is the most significant asset. Those firms that have strong internal controls to manage their work-in-progress (WIP) and accounts receivable (AR) are those firms that will access better capital terms.
2. Quality of client base
The quality of the clients, and hence the quality of the WIP and AR, is very important for financiers to BPS firms given this is most generally the most significant assets of the company.
A diversified client base with no significant customer concentration will lead to higher financing, while ‘non-credit quality’ WIP and AR, due to historical payment issues or long term outstanding amounts, will be discounted or excluded from financing calculations.
Ensuring the partners or client-facing leaders are managing the business as well as their work deliverables, in partnership with the finance department, is key to ensuring a healthy base on which a financier will view the business.
3. Dedicated financial controls and management
BPS firms often have part-time or non-dedicated operations teams, preferring to maximize client-facing or ‘billable’ staff. While size and scale may not make it feasible for smaller firms, a dedicated finance team, including a controller and/or chief financial officer, sends a strong signal to a financial partner that the financial controls are a priority.
With these issues in mind and managed, the availability of capital can then allow a BPS firm to look at a number of financing alternatives.
1. Bank debt
As noted earlier, since most BPS firms have limited tangible assets, bank debt is generally extended either as a function of the firm’s cash flows or against its WIP and AR. Some banks provide more extensive partner loan capital programs that firms use to finance capital needs, however, generally is limited to the credit circumstances of the individual partners.
Since traditional commercial banks are relatively conservative in the amount of capital they are willing to lend, some BPS firms look at mezzanine debt. Mezzanine debt is ‘junior’ to the senior debt, meaning in the event of a liquidation, they are paid after the senior lender. While a mezzanine lender is willing to add to or extend beyond what a traditional bank might be willing to offer, it usually comes at a higher interest rate with potential equity warrants to compensate for the higher risk they are taking. Weighing the increased cost of capital against its use will determine whether such financing makes sense.
2. Private equity capital
Some BPS firms, such as law firms, have traditionally had to abide by regulations preventing outside investment. As a result, they have long been reliant on two main forms of financing: raising equity capital from partners or getting a loan from their bank.
Deregulation of ownership in these sectors have allowed more types of BPS firms to access third party equity capital. There are a lot of factors that determine whether the firm can access equity capital from outside investors, above regulatory points. This is chiefly related to how they are positioned in their market and how much of the goodwill of the business is tied to the brand/firm versus the individuals.
It is often viewed that under the traditional partnership structure, where the BPS firm’s partners are traditionally the owners of the firm, they do not have permanent equity. As the partners give up their ownership interest upon retirement, there is an inherent incentive to earn as much as possible during their productive working years, rather than re-investing into the firm to build up the long-term value of the firm as a business.
BPS firms seeking to access private equity capital should ensure the long-term goals of the business and existing partners/shareholders are aligned to those of equity providers early in the discussions.
3. Leasing or sale-leaseback of assets
While the ‘people’ assets of the business are funded over time, investment in technology and other assets may be able to be funded through other specialist financiers. Leasing assets rather than funding them upfront can help preserve cash in the business that can be invested to fuel growth and customer retention.
Established firms can look at sale-leaseback options to access the capital already deployed for existing assets in order to fuel other capital strategies.
As with any other business, ensuring the right capital for the right need is key when accessing capital for a BPS firm. Positioning the business correctly through pre-transaction work prior to going to market will ensure optimal terms and a smoother capital raising process that aligns the interests of all parties.