Financing Options for Dietary Supplement Companies

Financing Options for Dietary Supplement Companies
by Chance Badahur

Considerations that apply to a VMS (vitamins, minerals and supplements) company exploring its financing options are no different than those for a company in any other industry.

As an industry, VMS remains fragmented. It is not fixed asset capital intensive. Better managed VMS companies continue to grow larger and, recently, three large pharmaceutical/branded consumer product companies have entered the industry. The Internet has begun to play a role, particularly in the direct selling area, threatening to compete most directly with catalog selling. Variations in the quality of products from companies within the industry remain an issue. Questions about industry regulation and the Food and Drug Administration's (FDA) ambitions always seem to be there. Acceptance of herbal medicine, on the other hand, is gaining ground, albeit slowly, both by consumers and traditional medicine.

The nature of an industry and the size of a company are factors that determine available financing options. The growth rate of an industry, competitive landscape, concentration, outlook for raw materials and other operating costs--along with industry-specific regulatory and legal climates--are all relevant to a company's future performance. Future performance, to a degree, determines what financing options it has available.

Before zeroing in on its financing options, a company should know what it is trying to accomplish. In other words, why does it need financing? There could be several reasons, some more persuasive than others. The company may be seeking additional capital for expansion, renovation or simply reshuffling what it now has. The reasons for reshuffling would include changing the debt equity mix, extending or lowering its debt repayment schedule, or lowering its cost of capital.

A key consideration must always be the return that additional funds sought will generate when invested by the company. The return generated must exceed the cost of capital to add economic value to the enterprise. Either a company must add to its economic value over time or it should sell out to someone who can do so.

As far as an optimum capital structure is concerned, a company and its lenders must be comfortable with the amount of maximum debt it can service. A common ratio employed to gauge how much debt a company can put on its balance sheet is known as cash flow coverage of interest and fixed charges. So, if a company is losing money because it is involved in a development mode and would not be cash flow positive in the short-term, then debt financing is not a viable option. Equity or equity-based financing would seem more appropriate. From the point of view of maximizing value of a firm, maximum but prudent leverage almost always helps, provided that a company has adequate tax capacity to absorb the resulting deduction. In deciding what is prudent, a company should allow for errors and unforeseen adverse events beyond the control of the management. For a publicly-held company, equity often has a lower cost of capital than debt. For example, a public company may find its stock a better currency than debt for making acquisitions, not to mention the benefits of an accounting gimmick called "pooling of interests" that it can then employ, not otherwise available. Acquisition of Nutrition Headquarters by NBTY was such an example. And a high-tech company called Cisco has seemed to make a career out of it.

Since most of the midsize and small companies in the VMS industry are private, it might be appropriate to address the financing issue from the perspective of a privately-held company. The first order of business for a company should be to brainstorm and document its three-to-five-year strategic and operating plan, including a financial projection for that period, as well as explanations and basis as to how it proposes to achieve each line of the projections. For example, if the company is projecting sales growth, exactly how is it going to achieve it? Is it relying on its share of market growing at a certain rate, capturing a larger market share, going into new markets and/or products or acquiring another company? If an improvement in gross margins is projected, how does it occur--efficiencies in manufacturing, better raw materials sourcing or relying on external sources for products? Does the company have manufacturing capacity to accommodate larger sales; if not, how does it get additional products to sell? A discussion of this kind would lead to various resources a company would require to accomplish what it projects in its plan. One such resource would most likely be capital.

A company may need additional financing for expansion, acquisitions, modernization or development. First, let us discuss non-equity capital in this context. Non-equity capital would most likely be in the form of borrowings or capital leases.

The most common source of borrowed funds for midsize and small private companies is banks. Banks, based on a company's present and projected cash flow, decide on minimum interest coverage to determine the most they can lend a company, as secured or unsecured loan and its terms. Any company, public or private, could do a private placement of long-term debt with institutional investors such as insurance companies if it has the necessary size and it is willing to go through the hassle and expense of issuing public debt. However, a private company may not comply with SEC's registration requirements for issuance of public debt or may be reluctant to put information about itself in public domain. It may not want to continue compliance with regulatory requirements imposed on a company with public securities outstanding. Lease financing is another option. Lease financing is fixed asset specific and is worthy of consideration for a company that does not have adequate tax capacity to take full advantage of accelerated depreciation on its fixed assets. Being so specific, lease agreements often have lenient covenants.

If a company is seeking to finance purchase of another company, it will need to come up with pro-forma financial projections after the combination before going to a lender. Consideration should be given to retaining the borrowings and/or leases a target company may have in place, if terms allow it. The balance must either be borrowed or come from additional equity. Sources of additional equity include mezzanine lenders, existing shareholders and private equity providers. Raising additional equity involves new issues such as valuation, possible dilution and governance.

Finally, vendor financing should not be overlooked. Often, suppliers of materials and services, as a part of their marketing strategy, provide their customers financing in various forms. Terms and economics of such financing should be carefully considered to determine the attractiveness of this option.

Again, of paramount importance to an enterprise seeking infusion of additional capital must be a plan to derive additional economic value from that capital. Options available and utilized to obtain the capital should be the second consideration.

Chance Bahadur is president of The Bahadur Group Inc., based in Chicago.

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