What happens when your bank stops lending?
Author: Nitasha Tiku Jul 1, 2009 from www.inc.com the daily resource for entrepreneurs
Kevin Semcken got the call in the first week of January. His loan officer had some bad news. The bank was changing the terms of the $2.5 million line of credit it provided to Able Planet, Semcken’s Wheat Ridge, Colorado-based audio-equipment business. Under the new terms, the bank would no longer front the cost of raw materials and manufacturing.
Semcken had been working with the bank for almost three years and had never missed a payment. And though Able Planet was not yet cash-flow positive, he was stunned. Without those funds, he would have no way to pay for inventory demanded by retailers such as Wal-Mart and Costco. “They waited until the last minute and dropped it on us,” Semcken says.
Until then, Able Planet’s business plan had been fairly simple. The company used the bank financing to fund the manufacturing of Linx Audio headphones. For more than a year, Semcken had been using the funds generated by the headphones, which retail for $24 to $299 a pair, to develop a promising new technology called Sound Fit — a listening device designed to fit snugly in the opening of the ear canal, eliminating nearly all ambient noise. Sound Fit, Semcken believed, could open entirely new industries for his business, including hearing aids and Bluetooth devices. Indeed, Semcken had secured nondisclosure agreements from 30 would-be customers interested in seeing more. But before Semcken could move forward with any of these negotiations, he needed funds to create production-quality prototypes, as well as operating cash for the headphone business.
After hanging up with his banker, Semcken took a quick inventory of his options. Like other manufacturers with orders on the books but no funds to produce them, he could try a factor. But factors, which lend against receivables, charge exorbitant interest. Perhaps he could find a less risk-averse bank. The company also had more than 20 angel investors who had recently kicked in $1.4 million. But that money was gone. Would those investors be willing to pony up again so soon?
This wasn’t the first time Able Planet found itself high on promise and low on capital. That was pretty much the condition in which Semcken found the company at a technology conference in Denver in 2004.
At the time, Semcken was the head of HealthTek Ventures, a venture capital firm in Evergreen, Colorado; Able Planet was a two-person start-up with a promising idea — headphones embedded with a magnetic coil to enhance sound quality — but a disaster of a balance sheet.
Semcken, who suffers from hearing loss in his left ear, was intrigued. When he listened to music, he had trouble identifying high-frequency sounds like those produced by cymbals. He asked Able Planet to give him two headsets — one with the coil and one without — and tested them by listening to Dean Martin’s “You’re Nobody ‘Til Somebody Loves You.” “When I switched to the Able Planet headphones, I could hear the cymbals,” says Semcken. “I was instantly a fan.”
Semcken invested in Able Planet — he also brought on family members as investors — and eventually took over as CEO and chairman. In 2006, Able Planet’s Linx headphones won an award for innovation at the Consumer Electronics Show. Soon, the calls began pouring in. By 2008, revenue had jumped more than 1,000 percent, to $2 million.
Semcken was pleased with the results. But he had his eye on something bigger — Sound Fit. Semcken had stumbled onto the idea in a previous venture deal. The company involved was developing a medical device, a balloonlike stent that expanded and contracted to prevent debris from blocking small arteries during heart surgery. Semcken thought something similar could work for the ear. He asked Able Planet’s audiologists to create an inflatable disk that could conform to the size of an individual’s ear canal. Unlike earbuds, these devices wouldn’t fall out during jogging or other activities. Unlike most Bluetooth headsets, they wouldn’t rest awkwardly against the ear. And unlike hearing aids, Sound Fit would not require a costly fitting procedure.
In the past, some of Sound Fit’s potential customers might have been willing to fund the development of prototypes in exchange for a sweeter deal in the event that the technology panned out. Five companies seemed particularly hot on the product. But in the midst of a deep recession, none were willing to take on any extra risk.
Making matters worse, the bad news from the bank came at a particularly inopportune time. The late-spring graduation season, one of the busiest times of the year, was approaching. On its heels were the four months from back-to-school to Christmas, which account for some 60 percent of annual sales. No money to fund production in January meant no significant revenue for almost the entire year.
Semcken met with Able Planet’s two board members, Rob Cascella and Steve Parker, both investors in the business. They advised Semcken to put Sound Fit on hold and redouble his efforts on Linx Audio. “When you’re at the point where you’re not generating operating cash flow,” says Cascella, “you have to worry about today or you’re not even going to be there in three years.”
But Semcken wanted to continue negotiating with all 30 of Sound Fit’s prospects. “The way you get a partner committed is out of fear they’re going to lose it,” he says. He was open to pushing Linx harder, but without a way to finance production of the headphones, expanding the line and finding new accounts would be out of the question. When he told his advisers that he wanted to ask Able Planet’s other angel investors for a loan, they gave him the go-ahead.
His offer: For every $100,000 loan they guaranteed, investors would get warrants for 30,000 shares at $3 apiece. Within three days, Semcken had a dozen takers. A representative at U.S. Bank, where Semcken kept his personal account, offered to make the loans, but only up to a certain amount. Semcken was hoping to raise some $1.5 million this way.
All the while, Semcken had been hustling to find a replacement for the company’s $2.5 million line of credit. He traveled around the country to meet with 15 banks. But nothing was panning out.
The Decision In March, Semcken compromised with his board. He agreed to renew his efforts to bring in new business for Linx and narrow his focus on Sound Fit to the five most serious potential buyers. The change in focus toward Linx paid off. Semcken hit the road and began aggressively hawking the line. Within months, Best Buy and BJ’s placed orders, and a deal with Staples is in the works; all three are new Able Planet customers.
With no banks willing to lend, Semcken overcame his aversion to factors (often called Invoice Discount Facilities in Australia – and they tend to be closer to commercial rates of lending here as well). He is in negotiation with three, all of which are offering to lend at 18 percent — about five points higher than the company’s bank credit. U.S. Bank, meanwhile, went ahead with the loans but capped the amount at $500,000.
Still, Able Planet will have enough inventory for the holiday season. Everything hinges on whether consumers will buy specialty headphones and headphone accessories in a recession. But Semcken thinks they will, which would mean he would finally be able to build Sound Fit prototypes. In the meantime, to keep the interest of the five primary Sound Fit targets, Able Planet has offered each of them a limited exclusive license for a year, an idea the company had only toyed with before the bank changed its terms. Semcken hopes that once Sound Fit proves a success with those five clients, others will be motivated to embrace the technology.
Semcken remains more bullish than some of his investors. “In order to slow our burn rate, we might have to back off a little,” says investor Tom Stavros. “Kevin thinks he’s going to get cash flow quick enough that it’s not going to be an issue, but Kevin is an optimist.” Semcken makes no apologies, but he says he is glad he took the advice of his board. “I’m an endurance guy,” he says. “I’m going to run as fast as I can as long as I can, and I’ll take on as many projects as I can bear. Rob [Cascella] is more conservative — which makes him extremely valuable in a recession.”
THE EXPERTS WEIGH IN
It’s All About Sell-Through
In consumer products, the big risk is that the actual demand is not there. You can open distribution at Best Buy and BJ’s, but that does not mean much until you have measurable sell-through. Even if the sell-through is there, you need to make enough margin to cover your operating expenses and service your debt. Big-box businesses have a lot of power to push your margins. If you are not careful, retailers will quickly squeeze the profit out of the equation.
Semcken might consider a partner model that rewards the first-in with a percentage of subsequent deals. In other words, the first customer gets a 2 percent gross on sales to the next four customers, the second gets 1.5 percent of the next three, and so on. This rewards the believers and flips the fear of losing a deal into something positive.
G. Michael Maddock
Sweeten the deal for the Angels
Able Planet did the right thing by offering warrants in exchange for loan guarantees to give the investors an incentive to lend. But existing investors might also be open to helping the company factor its receivables, rather than paying the interest and fees to an outside firm. Finally, the reason the bank changed the terms of the credit line is that Able Planet didn’t have enough security or assets. Providing a bank with better evidence of repayment, like a term sheet for a future round of angel or venture capital financing, might change that.