It is commonly accepted that banks can’t finance small to medium sized enterprises (SME’s) 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 here in Alberta and inadvertently selling off our ‘family silver’ at pennies in the dollar to the United States, or other more technology savvy nations.
But there is a solution to this problem and it starts by identifying and properly handling a company’s intangible assets. Let me give you an example of how capitalizing intangibles helped an SME to successfully gain banking financing for its new product line.
I once consulted to a small company that designed and developed software-based access-control security systems. This company had developed a cost effective access control system and relied strongly on referrals to sell their products.
At the time of my involvement, the company was in the final stages of developing a new ‘high end’ security system to take the company to the next level. They estimated that $3 million would be needed to launch the product into the market.
The management had originally approached their existing bank for a loan. Unfortunately the bank refused their loan application and so the company was forced to raise additional resources in the equity markets.
They produced a business plan for the new product launch and were prepared to give up 33% of the company’s equity in exchange for the $3 million they needed. 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. It was at this point that I decided to call in accounting specialist Joe Batty CPA, C.A. to see if the company had alternatives to a highly dilutive equity investment. And sure enough Joe was able to assist.
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.
Joe asked the simple question, “Do you know what your assets are?”
They answered: “Certainly, they’re in our line of products.”
He then asked them: “Then why don’t your financial statements show these assets?”
Our recommendation, they needed to treat the intangibles in their product line as assets and capitalize them. They could now re-state their financial statements, showing these products as assets. Joe 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 R&D credits and tax considerations)
After huddling with their staff and the external auditors, we were able to adopt a series of policies that led to a change in their approach to accounting.
The external auditors agreed to a re-state their last 5 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 on their balance sheet.
- Improved Income Statement: as a result of capitalizing expenditures, the company’s financial statements showed strong and growing profits for the last 5 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 re-approached their existing bankers (the ones who had recently turn the down for financing). Upon review their bank manager approved a revolving line of credit for the $3 million they needed 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 SME in Alberta. 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.