The significant requirements for capital investment in this industry, and trends by customers to stretch out payments and require TDM firms to finance tooling, make it imperative that firms have access to funds to cover such financing requirements. There are different types of financial capital available for different purposes with a range of maturities, risk, and cost. Many TDM firms also have access to loan guarantees and diverse financing assistance through various Federal and State programs (available to all industries) that are identified in the “Government Programs” section of this chapter. The choice of whether to finance investment with debt or with equity is important
(historically, investment has been financed with roughly 40 percent debt and 60 percent equity49), because debt-financed corporate investment enjoys a tax advantage over equity-
financed corporate investment,50 and the tax advantage is heightened during periods of
inflation. But the risk is that the company may become over-leveraged, which exacerbates the effect of a downturn in revenue.
In response to a questionnaire request regarding sources of funds for all uses (not just capital expenditures), many firms indicated that they relied on a mix of financing sources. The vast majority (98 percent) stated that cash flow51 is a primary source; this was
followed by secured debt (70 percent), unsecured debt (24 percent), and the issuance of equity (6 percent). These responses are in line with an industry composed of small, privately held firms that are leveraged (e.g., see interest expense in table 3-6). With respect to secured and unsecured loans as a source of funding, there was the widespread perception, voiced by company executives at the Commission hearing, that the banking industry had figuratively turned its back on the TDM industry, although this
52 Braker, hearing transcript, p. 32; Baron, hearing transcript, p. 59; Coffey, hearing transcript,
p. 114; testimony of Michelle Cleveland, vice president, The Right Place Economic Development Program of Greater Grand Rapids; and vice president, CAMTI, hearing transcript, p. 125; Olav L. Bradley, chairman, Government Affairs, AMBA, hearing transcript, p. 126; and Rasmussen, hearing transcript, p. 128.
53 Cleveland, hearing transcript, p. 125.
54 Bradley; Belzer; and Rasmussen, hearing transcript, pp. 126-128.
55 It should be noted that many, if not the vast majority, of the firms in this industry do not have
the size or credit rating necessary to be an “investment-grade” borrower, that is to have access to the commercial paper or to the bond market, and, thus are dependent upon bank lending for short- term credit. A tightening of bank lending; starting in 2000, is expected to continue, even for large businesses. Andrew Osterland, “To Lend and Lend Not: Corporate Borrowers are Finding That an Investment-Grade Credit Rating Makes a Big Difference,” CFO Magazine, Dec. 1, 2001, found at wysiwyg://22/http:www.cfo.com, retrieved June 25, 2002.
56 Ibid.
57 Marie Leone, “Credit Squeeze: Turning the Screws on Borrowers,” CFO Magazine, May 1,
2002, found at wysiwyg://18/http://www.cfo.com, retrieved June 25, 2002.
impression may reflect broader trends in the banking industry.52 During the course of this
study, management personnel at several firms decried changed lending practices, as local, community-based banks have been taken over and incorporated into larger, often
nationwide, organizations. This shift has reportedly reduced the importance of long-term personal relationships in securing loans as local branches have less flexibility in making lending decisions.53
Some of the difficulties appear to be cyclical problems, as financial institutions become less willing to finance capital investment when economic conditions weaken. It appears that this has been the case for the industry since the end of 2000. However, financing for operating capital is just as important, and TDM firms appear to be encountering long- term problems with this type of financing. As customers stretch out payment schedules, firms need to be able to borrow against accounts receivable. However, banks reportedly will not lend on accounts receivable beyond 30 days, and payments in this industry typically are made well beyond 30 days from delivery.54
These industry-specific perceptions seem to reflect observations made at a more
aggregate level. Lending and credit have been affected by a number of factors in the past several years, including a general decline in the quality of borrowers’ balance sheets and increased default rates; consolidation in the banking industry; and tie-in of banks’ cash management services to secure short-term credit instruments. Many of the firms in the TDM industry are privately held or their creditworthiness has not been rated by one of the three major credit rating agencies, and the experience of other such non-investment- grade firms reportedly has been that banks have tightened the terms of extending credit to them, including shorter terms, higher rates, lower amounts, faster repayment, and
restricting the uses of the company’s cash flow to repay debt.55 Many non-investment-
grade borrowers rely on the syndicated loan market or bank lines of credit; following years of consolidation in the banking industry, commercial banks are fewer in number and tend to service existing clients. Also, with the increase in credit ratings on new loans, the riskier credits are squeezed out.56 Short-term credit has become more
expensive, in part due to the general decline in company credit ratings as well as pressure from banks to purchase high-margin cash-management services.57 Considering these
58 Walter Einhorn, CPA, “Are You Having a Credit Crisis?” Strategic Finance, July 2002,
found at http://www.strategicfinancemag.com/2002/07h.htm, retrieved Aug. 20, 2002. The author cites an estimate of the Commercial Finance Association that more than 24 percent of all
outstanding loans are short-term loans from asset-based lenders. Leasing is one such form of asset-based loan.
59 Rob Wright, “E&Y: It’s a Jungle Out There–Venture Capital May Be Back, But Start-Ups
Still Face an Uphill Battle,” VARbusiness, June 10, 2002, found at
http://proquest.umi.com/pqdweb, retrieved June 25, 2002. Companies may be ranked and
analyzed according to their growth rates, cash flow, and market share. See Michael E. Porter,
Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free
Press, 1980), p. 362.
60 Quite a few of the companies that responded to the Commission’s questionnaire stated they
were Subchapter S corporations. Subchapter S of the Internal Revenue Code defines the requirements of this limited liability form of business organization in which the income and certain deductibles flow through the entity to the partners to be included on the partners’ individual tax returns. Up to 75 individuals, including estates and certain trusts may form such a business entity. A subchapter S corporation may invest in a partnership (e.g., two S-corporations, each composed of 75 individuals, could form a partnership), but the reverse is not allowed. Theoretically, this should not stymie a venture capitalist from investing in the TDM industry, and the structure of a subchapter S corporation is to encourage individual investors; the declining returns in a fragmented mature industry with low market power appear to pose a greater hurdle.
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lending” in which a loan is collateralized by a company’s asset(s), including accounts receivable, inventory, or equipment.58
The TDM industry has not attracted venture capital because returns have not been commensurate with the risk of investment in what is perceived to be a mature and fragmented industry. Venture capital tends to flow to firms in industries expected to experience significant growth, as was the case in the late 1990's with Internet-oriented (e- commerce) companies, telecommunications, or other industry sectors.59 Also, very few
of the many firms that produce TDMs are public (i.e., have issued stock), or intend to go public, or possess a balance sheet and credit rating enabling them to tap into the
commercial paper market.60