Smart Financing

BioCycle February 2007, Vol. 48, No. 2, p. 23

Arranging financing for new composting facilities or expansions of existing ones can be easier when understanding how to raise the comfort level of the financing source.

Craig Coker

CONSTRUCTION or expansion of composting facilities normally requires significant amounts of capital financing. Even a relatively small composting facility can require $1 million or more, and a complex in-vessel (or enclosed) system can cost tens of millions. A basic understanding of financing principles, and terms and information desired by lenders, investors or government officials, can help improve the potential for obtaining financing.

Financing a private sector construction or expansion project is normally done with debt financing, although it may involve some equity financing. Debt financing is usually obtained after approval of a loan application to a commercial bank or credit union. Equity financing is obtained by an investment in the ownership of the underlying company (although government grants and the economic value of assets like land and equipment are often considered to be equity). Public sector (i.e. municipal government) construction projects are funded by issuing bonds that provide the needed capital.

Terms like bank, credit union, and savings institution may seem interchangeable today, but there are some distinct differences between them in terms of business purpose, ownership and governance. All three financial institutions offer basic banking services (checking and savings accounts, consumer loans, etc.) with larger ones offering a fuller range of services (credit cards, mortgages, foreign currencies, etc.). Each has some special features:

• Banks emphasize business and consumer accounts, and many provide trust services;
• Credit unions emphasize consumer deposit and loan services (including supporting farm-based accounts, which are significant in the composting industry);
• Savings institutions emphasize real estate financing.

Credit unions have been used by some composters for project financing and because they are more “local,” are reported to be somewhat easier to deal with than traditional banks.

All private debt financing sources want to see 20 to 30 percent owner’s equity in a project. This reassures the lender that you’re willing to take a risk with your own resources, not just with theirs. Equity can be cash, stocks, bonds or inventory, as well as land or equipment (but only to the extent that land or equipment is not already used as collateral on another loan). Equity contributions can also come from “angel” investors – individuals who invest in a business venture, providing capital for start-up or expansion. Their investment can be in the form of part-ownership of the company, or can be pledged collateral (stocks, bonds, land, etc.). Equity investments can also come from venture capitalists, some of whom try to specialize in environmentally-responsible businesses (like Sustainable Jobs Fund in Durham, North Carolina). However, few composting companies are of adequate size to attract investments from venture capitalists. For example, Sustainable Jobs Fund invests in expansion-stage companies, typically with revenues of $1 million to $10 million. They do not invest in commodity products and services, nor in companies that do not create substantial entry-level employment opportunities. Both of these constraints work against the composting industry.

In addition to the equity requirement, almost all financial institutions will require “personal” guarantees, where the principals of the business (officers and/or owners) will have to offer a signed guarantee that they will individually and collectively serve as a source of debt repayment in the event the borrowing company defaults on the obligation. These guarantees can take the form of second mortgages on your house, pledged assets, and the like.

A limited amount of government support is available in the forms of grants, tax credits for personal or real property, direct loans (through third-party intermediary financial institutions), and repayment guarantees of bank/credit union loans, as discussed below.

PROVING ECONOMIC VITALITY…AND OTHER INFORMATION NEEDS
The information needed for private sector debt financing was discussed in a November 1999 article in BioCycle by Noel Graydon (“Financing Composting Facilities”). Little has changed over the past eight years. Graydon noted the need for a well-prepared business plan, pro forma financial statements and construction-related documentation, among other items. “Your business plan must contain absolutely everything,” says Ken Newman of Royal Oak Farm LLC near Evington, Virginia, who has just completed a multimillion dollar refinancing of his composting facility for a planned expansion and upgrade. “You’ll need current references, Dun & Bradstreet credit ratings, a current appraisal, three years of personal and business tax returns, both personal and business financial statements, three-year financial projections and copies of signed contracts.”

Graydon went on to note that borrowers must have adequate cash flow to cover the debt, at a ratio of 1.5 times the loan. For example, if operating costs are $25,000 per month and debt service (repayment) is $10,000 per month, then monthly revenue needs to be at least $52,500 per month. In addition, banks will limit the amount of the loan to 75 to 80 percent of the value of the underlying loan collateral (property, equipment, assets, etc.). This limitation allows the bank to recover its loan if they have to auction off the collateral in the event of a default.

It is important to have existing contracts that have a proven track record of positive cash flow. If possible, they should be diversified among several customers. “That lack of existing paying contracts raises a real chicken-and-egg issue with respect to new facility start-ups,” notes Newman, “That’s where government support is needed most dearly.” One way around that problem may be to show very strong financial performance in an existing parallel business. That was the approach used by ERTH Products, LLC (Peachtree City, Georgia), which drew upon the financial strength of its compost sales company, Exceptional Products, Inc., to back its application for acquisition funding of an existing compost producer, according to Wayne King, Jr., ERTH Products’ Operations Manager.

Karl Scott, Vice-President for Corporate Development of Synagro Technologies, Inc. (Houston, Texas), noted that letters of intent – while not as valuable as existing contracts – are often critical in securing debt financing. They can serve as verifiable references for the bank on the claim of contract revenues as a source of repayment funds. Scott notes that composters should ensure that the terms of tipping fee material contracts be long enough (with renewal options as needed) to cover the loan amortization period and that they should realize that some bankers will require the contracts be assignable to the bank. “That way, in the event of a default, the bank can take control of the contract and assign it to someone else,” explains Scott.

Both King and Newman note that traditional banks don’t really understand composting technologies, nor the dual-revenue stream nature of many operations (i.e. tipping fee revenues on the front end to cover operating expenses and product sales revenues on the back end to provide profits). So business plans have to clearly explain both markets in terms of existing market share, growth potential, competition (within 50 to 75 miles) and how the applicant can/will position the company to have a significant advantage in both markets. An important component in the section of the business plan on compost sales is to show how cash flow will be maintained at adequate levels to repay debt during the slower-sale winter months. Scott believes the pro formas should be based solely on tipping fee revenues. “If you are trying to convince a lender that product sales are necessary to push you over the edge of profitability, I think they’re going to be real uncomfortable,” he notes.

Financing sources also have difficulties understanding that investing in composting facilities is not like investing in landfills or hazardous waste sites. The business plan should address the environmental liability issue and clearly explain the contingency plans in the event wastes have to be landfilled. It is usually very worthwhile to arrange for a bank loan officer (if not the entire credit committee) to visit an existing composting facility (ideally one of the applicant’s) where they can see the operation, learn about the in-place management protocols and appreciate the manufacturing nature of the business.

Acquiring equity investment in a composting facility is difficult, but one approach to consider is modeled after the methods New England Organics (Falmouth, Maine) uses to acquire capital from its publicly-traded parent company, Casella Waste Systems. “We use a multistep process,” explains Jamie Ecker, General Manager of New England Organics. “Step one is to develop accurate pro forma financial statements. Then we define the risk criteria and assess the risks: Is the volume of tipping fee material enough? Is that volume secured by contracts? Do we have firm estimates of construction costs? The next step is to accurately model the operations’ cost. The final step is to determine if we can hit an Internal Rate of Return (IRR) of 15 to 25 percent/year, which is an EBITDA target we have.” You can think of IRR as the rate of growth a project is expected to generate. EBITDA means Earnings Before Interest, Taxes, Depreciation and Amortization (see Glossary).

“STRINGS” AND OTHER ATTACHMENTS
The relationship between lender/investor and owner/borrower can take many different forms. Most private sources of debt financing will require routine reporting of financial performance, usually on a quarterly basis. Some angel or equity investors will want financial reporting on a monthly basis. While lenders often will ask for “audited” financial statements, they may be willing to accept “reviewed” statements instead (the difference has to do with the extent and depth of independent verification of financial review). In one recent compost facility financing, the lending bank asked for a detailed operating budget and required explanations of any significant variations from that budget.

Debt financing sources also will often ask for personal guarantees for the debt by the company’s officers and owners, even if the company’s assets put up for collateral are sufficient to cover the loan amount.

Equity investors (family, friends, angels and/or venture capitalists) obviously have widely differing requirements for involvement in the business. Most tend to fall into the category of “silent partner.” Venture capitalists have the most stringent requirements, often insisting on a majority ownership, a seat on the Board of Directors, and major involvement in company operations. However, very few venture capitalists are interested in the composting industry, as it doesn’t offer the stratospheric rates of return they can get in other industries.

GOVERNMENT FINANCING
Government support of the private sector composting industry’s capital needs takes the form of grants (in relatively few cases), tax credits for personal or real property, direct loans (through third-party intermediary financial institutions), and repayment guarantees of bank/credit union loans. Many of these types of programs are offered as mechanisms to stimulate the overall solid waste recycling industry, not just composting. As discussed above, public sector composting industry capital needs are handled through issuing bonds.

Most grant programs are state-sponsored, although there are a few Federal programs aimed at high-technology stimulus. Availability and size of grant programs vary widely from state to state. Many grant programs are not available for for-profit businesses. Older and more established grant programs can be found in Massachusetts, Minnesota, Pennsylvania and North Carolina. For the most part, grant programs are limited to smaller amounts of funding, cannot be used to acquire land or underwrite operating expenses, and require a substantial cash match (as much as 50 percent of the total needed). These programs, where available, are best used for equipment acquisition.

Recycling equipment tax credits are available in 25 states. These credits take different forms of application, from sales tax reductions and exemptions to personal income tax credits to property tax exemptions. As these tax credit programs were originally established to benefit the solid waste recycling industry, composters who process “nonsolid wastes” (i.e. manures, biosolids) may find the amount of available tax credit is reduced to the percentage of regulated solid wastes in the feedstocks.

Several states operate Recycling Loan Funds (RLF), which are hybrid public-private sources of capital. For example, the Massachusetts Recycling Loan Fund offers the RLF Fixed Rate program for Massachusetts companies that recycle construction and demolition debris or organic wastes. Fixed rates as low as 4 percent are available on loans from $50,000 to $500,000. Financing under this program is structured so that a conventional lender provides up to 50 percent of the total project costs. The RLF provides up to 40 percent (or $500,000, whichever is less) at a below-market rate and in a junior secured position (meaning in a default, the conventional lender gets paid first), with the recipient contributing at least 10 percent of the project cost as equity.

Loan guarantees, which are essentially deficiency guarantees, are offered by Federal agencies like the U.S. Small Business Administration (SBA) and the Rural Development Program of the U.S. Department of Agriculture (USDA). These are programs in which loans made by financial institutions are guaranteed by these government agencies, thus reducing the risks of default to the lender. There are usually extensive due diligence investigations needed to support these requests for support (appraisals, equipment evaluations, site environmental impact studies). An upfront loan placement fee of 2 percent of the loan amount is involved. In the event of loan default, the guarantee will cover up to 80 percent of the shortfall after liquidation of all assets.

Are government support programs worth it? For a new composting facility, they can certainly make project financing more likely. As King explains: “It’s a necessary evil, but as soon as you can get out from underneath it, you should. Government loans are very rigid in their reporting requirements. They usually require audited financials, which are a big expense. They also require your banker to provide endless forms and reports throughout the year that would not be required with traditional financing. As my banker stated, this is his first and last U.S. Department of Agriculture loan. He is working with us to convert this to a traditional loan at the end of the prepayment penalty period.”

King adds that another challenge with government lending programs is time. “The process in our case took over 1.5 years and was very inefficient and cumbersome. In addition, government guaranteed loans are more expensive than traditional financing in terms of both up front costs and interest rates charged. They typically require more assets to be pledged, including personal assets such as your home and the personal guarantees of the partners. All that said, I think the purpose behind the lending program is valid. The problem is the inefficiencies.”

“BE PERSISTENT”
Financing a composting business start-up or expansion, while potentially daunting, can be done. As Newman of Royal Oak Farm notes: “Be persistent. If one lender won’t work out, keep looking. If you can’t find funding on the East Coast, look on the West Coast. If you can’t find funding in this country, look overseas.” Newman speaks from experience, as he went to 11 different lenders before obtaining financing for his facility’s expansion.

As in any type of business borrowing situation, the basics of good financial history are critical. Banks will simply not lend money to companies who do not have strong, consistent financial results. “If you have an existing business with good financials, leverage it as much as you can,” says King of ERTH Products. Complicating this reality is that few banks understand the composting industry; they think of waste management in the same context as landfilling. It is important for loan applicants to distinguish that they are in the recycling and product manufacturing business; that they understand and have planned for the vagaries of both the waste management and product sales markets; and that they have adequate resources to repay the loan. “Remember the loan officer is a representative of the entire credit committee,” says Synagro’s Scott. “You have to be able to convince the credit committee, who is often just looking for a reason to say no.”

Craig Coker is a Principal in the firm of Coker Composting & Consulting in Roanoke, Virginia, who specializes in providing technical support to the composting industry in the areas of planning, permitting, design, operations and compost sales and marketing.

SIDEBAR:
Financing Glossary

Banks
Community, regional or national for-profit business corporations owned by private investors and governed by a board of directors chosen by the stockholders.

Collateral
Property that is offered to secure a loan or other credit and that becomes subject to seizure on default. (Also called security.)

Credit Unions
Nonprofit financial cooperatives owned by their members and governed by members elected to the board of directors. Usually there is a common bond among the members, such as belonging to the same organization or living in the same geographical area. Accept deposits from their members and use them to make short- and long-term loans. Deposits are regarded as purchases of shares, and all earnings of the credit union are paid out as dividends to members.

Debt Financing
Funds borrowed from a financial institution (bank, credit union, etc.) that is repaid in a fixed period of time at a fixed or variable interest rates.

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
An indicator of a company’s financial performance which is calculated as follows: EBITDA = Revenue — Expenses (excluding tax, interest, depreciation and amortization). EBITDA can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.

Equity Financing
Funds provided by existing owners (paid-in capital) or obtained from outsiders through sale of a portion of the company; these funds are not normally repaid unless the ownership share is bought by another.

General Obligation (GO) Municipal Bonds
Long-term debt instruments backed by the issuer’s ability to tax. General obligation bonds are issued to pay for projects such as schools and sewer systems.

Internal Rate of Return (IRR)
The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.

Municipal Bond
A debt security issued by a state, municipality, or county, in order to finance its capital expenditures; bonds can be redeemed for their face (issued) value when the bond matures (usually 10-30 years after issuance).

Pro forma Financial Statements

Projected cash flows and income statements.

Savings Institutions (also called savings and loans or savings banks)
Specialize in real estate financing. They can be either corporations or mutuals (a type of business where making a deposit is like purchasing stock in the organization). Savings institutions always have the letters SSB or FSB after the name to indicate whether they are a state savings bank or a federal savings bank, respectively. Both types are governed by an elected board of directors.

Related Posts Plugin for WordPress, Blogger...

Comments are closed.