Question

I wanted to update you on my efforts to secure an increased line of credit for working capital. Despite my repeated efforts and the calls that both of you have made to our bank's senior officers, Miami Dade Merchant's Bank (MDM) continues to be inflexible. It refuses to increase our $3.2 million line of credit and says that it will not change its mind. It is also proposing tighter covenants. I have highlighted for MDM our improved EBIT and free cash flow over the last eighteen months and our concomitant success in reducing the use of our line of credit by almost $500,000. MDM argues-perversely-that this shows we do not require additional funding, especially given our recent lack of revenue growth. I have pointed out its flawed, catch-22 logic. It claims that we don't need additional working capital because we're not growing, while I counter that we can't grow without additional working capital.

Quite frankly, I think MDM now regards us as an unattractive account and is trying to fire us as a customer. It appears that it is pruning its account base after being acquired by Imperial Bank. Although our long-time account executive, Chris Mitchell, swears otherwise, he has cautioned me that the bank is adopting a very tough line with small business accounts that breach covenants. For all of MDM's rhetoric about supporting local businesses, they have shown little regard for our relationship.

In recent months, I have met with several other banks to gauge their interest in Sunflower as a new account. Unfortunately, those conversations have not been successful: It seems that most commercial banks in South Florida are retrenching. Also, in the unlikely case of another bank agreeing to replace MDM, we will probably have to start with a lower line of credit and tighter covenants as the new bank becomes more familiar with our business. Thus, the relationship capital we have built up with MDM will have to be rebuilt with a new bank. The smaller banks have very limited experience with or interest in providing services that are essential for us, like letters of credit to Chinese suppliers. So if we choose to rely on bank financing, we'll have to stick with MDM.

However, we do have some alternatives. I've been looking into some non-traditional sources of working capital, and I'm pleased to report on two interesting possibilities.

Fernando Flores (FF): I think you both know Flores through his business and philanthropic activities in Dade County. A successful investor in local real estate, FF wisely sold most of his properties several years ago before prices collapsed. While he has deployed the bulk of the proceeds in hedge funds, he has been searching for some angel investing opportunities close to home. He became interested in us because his wife, Ana Luisa, loves our Zen Blend herbal remedies. FF contacted me out of the blue several weeks ago. After extensive discussions, he has proposed providing us with a working capital credit line in exchange for an equity stake in Sunflower. Specifically, FF is prepared to replace our entire line of credit on MDM's current terms (i.e., $3.2 million at 8% interest) and provide us up to an additional $ 1.5 million in revolving credit. In exchange for this credit line, he is asking for 20% of our equity. To be clear, FF will get this equity "for free." His entire dollar investment will be in the form of senior debt (i.e., a $4.7 million line of credit). Thus, any amount we borrow from FF has to be paid back and will carry an interest rate of 8% while the loan is outstanding. FF firmly believes that Sunflower has substantial growth potential. He feels that we're at an inflection point and, in his words, it would be a "crying shame if we lost the opportunity to break out." I asked FF about his willingness to provide a $4.7 million line of credit on a more traditional basis - perhaps at a higher interest rate than MDM charges without any equity attached to the loan. I also tried to convince him to invest the same amount in convertible debt or preferred stock where he can choose to convert some or all of his investment from debt to equity. He said that he has no interest in "becoming a bank" and wants to share in the financial success that he is funding. At the same time, FF says that convertible debt and preferred equity wouldn't impose enough discipline on Sunflower management. He likes the strict covenants and close cash flow monitoring that he's accustomed to in the real estate business.
We may safely assume that FF, despite not wanting to become a bank, will impose covenants on us that are as tough as MDM's. FF has insisted on joining the three of us on Sunflower's board. In brief, while this opportunity can help us pursue aggressive growth, FF will have his cake and eat it too: his investment will always have the protection of debt if we do not earn a profit, but his equity position will allow him to share in our successful growth.

Averell & Tuttle (AT): AT is a boutique investment bank headquartered in Atlanta but with deep Miami roots, as indicated by the Tuttle name. Its portfolio includes a number of investments in the natural products and retailing sectors, including the Earth Life chain. AT's team has submitted an intriguing proposal that I believe warrants consideration. Like FF, AT is prepared to replace MDM and provide a line of credit, but it is offering terms that are novel in my experience. First, it is willing to provide us a line of credit of $ 3.7 million, which will allow us to undertake more initiatives compared to our current credit line of $3.2 million. However, this larger line of credit comes with many strings attached. First, our interest rate will be 10%, which is much higher compared to the 8% charged by MDM. Also our current line of credit is secured exclusively by the accounts receivables and inventory of Sunflower. AT is demanding the same security but, in addition, it is insisting that I provide a personal loan guarantee as well. As you know, when we started this company, MDM had insisted on similar personal guarantees. It took us over five years before MDM became comfortable with our business and released me from this personal liability. While I believe in Sunflower's potential, it is dismaying to face the prospect of having to take on this personal liability again. Finally, AT also wants what it calls a warrant sweetener to approve this deal. For every $100,000 we borrow beyond $3.2 million, we will need to issue enough stock warrants so that AT will own 2% of the equity for each $100,000 over the $3.2 million credit line. Thus, borrowing the entire $3.7 million (i.e., $500,000 more than the $3.2 million) entails giving up 10% of our equity. AT is insisting that these warrants be issued with a nominal strike price of $0.01. Thus, it can exercise these warrants for essentially no investment. This is equivalent to giving away our equity for free. To be clear, we would have to concede 2% of our stock for every additional $100,000 we draw over $3.2 million, even if it is only for one day. AT acknowledged that it has never done this type of transaction before, nor could it provide any third-party examples. Obviously, we can't ask Chris Mitchell for his opinion. If either of you have any experience with this sort of transaction, please let me know.
Like FF, AT believes in our growth potential. I explained that we have multiple growth opportunities and that our lack of top-line growth in recent years has been more a function of working capital constraints than market opportunities. AT will be entitled to a board seat if we borrow the entire $3.7 million.

Both of these proposals provide us with immediate relief from MDM and would allow us to focus our attention on growing our company. However, I want to make sure you realize that, with these proposals, there is no debt-to-equity conversion option: We would give up an equity stake in exchange for access to credit, but we would not receive any new equity capital. Both parties expect us to pay interest and meet standard loan covenants, and to repay the principal eventually.

I have communicated to both FF and AT our reservations about bringing in new equity partners to fund temporary cash flow requirements. While sympathetic, each is adamant that it requires substantial equity upside if it ties up its capital. While I like the certainty of FF's offer, AT's stair-step approach is a creative alternative.

As we debate these proposals, I'm guessing that you may wish to discuss the option of sticking with MDM and once again trying to raise a new equity round. Obviously, it would be better to have a cash cushion that didn't come with loan covenant strings attached. But I don't see much opportunity to raise equity. You'll recall that, over the past year, I've met with a broad range of venture capital and private equity firms to discuss this issue, and we have rejected the only two serious offers that we received. Fairwind low-balled its valuation. Red River offered a better valuation but insisted on a three-member board that excluded the two of you and teamed me on the board with a Venture Capitalist and an outsider-Red River's nominee who'd be subject to my approval. I continue to feel that reverting to these types of options puts us on a path toward losing control of the company.

At our upcoming board meeting on February 21, we will need to decide between sticking with the bank, as unpalatable as that may be, or turning to these new options. There are important provisions to finalize before then, most notably the duration of any commitment by FF or AT. On a happier note, our negotiations with Atlantic Wellness are nearing completion. Were we to proceed, Atlantic would represent our largest account and become a potentially important reference with other health food and natural products chains. I am also excited to report that a major mass merchant has just contacted us about a potential national rollout. (It is acutely sensitive to confidentiality; I will brief the board in person on February 21.) The volume from large new accounts could allow us to secure improved terms from our suppliers, based on conversations I had during my trip to India and China last month. Ayurveda Naturals is already preparing a proposal on new credit terms; Dynasty Enterprises is reluctant to revise its terms at our current volume.

Finally, I have also begun looking at online opportunities and opportunities in the Latin American market. I will present our plans for both at the board meeting

Which financial option is the best and why?

MDM Bank option

Debt	$3,200
Equity Dilution	0%
Interest Rate	8%

Flores debt plus free equity option

Debt	$4,700
Equity Dilution	20%
Interest Rate	8%

A&T option

Debt	$3,700
Equity Dilution	10%
Interest Rate	10%

Answer 1

So we have the following options at our disposal and the analysis for the same point by point which would help us narrow down to our best possible choice.

1. MDM appears quite restrictive in their stand. This would definitely hurt the company in terms of its growth. The very fact that the company has lowered its credit line by $500,000 on account of improved EBIT and cash flows shows that the company is all poised for growth ahead. The very fact and limitations imposed by MDM would limit the company's growth and hurt its future deals. Also the requirement of credit line in the event of any future deal and expansion, if not properly sanctioned and approved by MDM would prove to be fatal for the Sunflower's growth.

2. The FF proposal of offering $4.7 M in credit line seems good. But the very fact of taking a fifth i.e. 20% of equity in the company is a major pain point. While the company has already stated that it has reduced its credit line with MDM by $500,000 means that the company is taking the path of self sustenance. The requirement of working capital would definitely be there for the company. But such a heavy credit line i.e. $4.7M is unused would eventually prove to be a burden for the company in terms of the 8% interest. So effectively the company after reducing its credit limit is using up $3.2M - $0.5M = $2.7M. Any increase in the same would effectively be like a 30% increase so to speak for any major working capital requirement. This goes to $3.51M at max. Thus the company would have to give away a board seat, bear additional interest and also losening of control for a credit line limit which is not even used.

3. The A&T option has helps the company to stay afloat ideally and grow by using up a stable limit of $3.7M. This limit, as explained earlier seems good enough for the company given its recent financial performance. The fact that it would have to loosen 2% per $100,000 for additional credit line is the only pain point. However what the company should realise is that this would only arise when the need is there. The company can at best try and limit this which would prompt the company to perform better. Also with the loosening of the board seat only if they borrow the entire $3.7M. Pursuant to our discussion on FF we had tested a case of 30% additional requirement in the credit line which effectively made it $3.51M. Thus the A&T option seems slightly favorable.

Now effectively after having analysed the above cases we reach to a conclusion that A&T reposes its faith in Sunflower as a company and its growth. Thus we would be more comfortable with A&T as they provide flexibility in terms of our working capital requirements, repose their faith in our growth story.

Thus the A&T option would be the best.