It’s commonly accepted that banks can’t finance small to medium-sized enterprises (SMEs) these days. Many SMEs lack the traditional collateral grade assets and/or reliable cash flow that banks need to write a commercial loan or extend a working line of credit.
Regrettably, lack of bank financing forces many emerging companies to turn to alternative capital sources like hard-to-access venture capital or angel investor networks for the resources they need to grow.
The results of these capital market inadequacies are tragic. We’re losing once-in-a-lifetime opportunities to develop a new economy in Alberta. And were inadvertently selling off our family silver at pennies on the dollar to the United States or other more technology-savvy nations.
But there’s a solution. It starts with identifying and properly handling a company’s intangible assets. Let me give you an example of how capitalizing intangibles helped an SME successfully gain banking financing for its new product line.
I once consulted to a small company that designed and developed a cost-effective software-based access-control security systems. They relied strongly on referrals to sell their products.
At the time of my involvement, they were in the final stages of developing a new high-end security system to take the company to the next level. They estimated $3 million would be needed to launch the product into the market.
The management approached their bank for a loan. The bank refused, so the company was forced to seek additional resources through the equity markets.
They produced a business plan for the new product launch and were prepared to give up 33 percent of the company’s equity in exchange for the $3 million.
However, it was clear that the reason the bank turned them down was improper handling of their intangible assets.
Not surprisingly, their financial statements were (as usual) prepared solely for tax purposes, expensing everything allowable. They had low profitability, few assets on the balance sheet and a massive accumulative deficit.
I called in accounting specialist Joe Batty, a Certified Public Accountant and Chartered Accountant. I asked him to see if the company had alternatives to a highly dilutive equity investment. Sure enough, he was able to help.
Despite the weak financial position, the company employed significant numbers of highly-skilled people, had satisfied customers and were excited about the launch of their new line. Optimism was running high in the boardroom when we went to discuss the financing issue.
Batty asked the simple question: “Do you know what your assets are?”
They answered: “Certainly, they’re in our line of products.”
He then asked: “Then why don’t your financial statements show these assets?”
Our recommendation was that they needed to treat the intangibles in their product line as assets and capitalize them. They could then restate their financial statements, showing these products as assets. Batty told them they should also re-examine their procedures for engineering and design, and then capitalize the costs associated with the development of these assets on a continuing basis (while still taking advantage of allowable research and development credits and tax considerations).
After huddling with their staff and the external auditors, adopted a series of policies were adopted that led to a change in their approach to accounting.
The external auditors agreed to a restate their last five years of financial statements and show the product line as assets on these statements. The change was dramatic:
- Stronger balance sheet: We added $4.5 million worth of assets to the balance sheet.
- Improved income statement: As a result of capitalizing expenditures, the company’s financial statements showed strong and growing profits for the last five years.
- Recent performance: In fact, the last two years showed a profit of approximately $1 million and $1.5 million respectively.
- The accumulated deficit was almost written off.
With these new statements in hand, the company approached their bankers again. Upon review, the bank approved a revolving line of credit for the $3 million to finance their expansion, saving the company’s owners considerable dilution in their equity.
Recognizing and capitalizing intangibles is the key to opening new financing opportunities for SMEs. The process begins with understanding modern value creation and then adapting new banking and accounting systems appropriately.
Doing so could radically improve and help diversify the Alberta economy.
Robert McGarvey is an economic historian and former managing director of Merlin Consulting, a London, U.K.-based consulting firm. Robert’s most recent book is Futuromics: A Guide to Thriving in Capitalism’s Third Wave.