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) companyexploring its financing options are no different than those for a company in any otherindustry.

As an industry, VMS remains fragmented. It is not fixed asset capital intensive. Bettermanaged VMS companies continue to grow larger and, recently, three largepharmaceutical/branded consumer product companies have entered the industry. The Internethas begun to play a role, particularly in the direct selling area, threatening to competemost directly with catalog selling. Variations in the quality of products from companieswithin the industry remain an issue. Questions about industry regulation and the Food andDrug Administration's (FDA) ambitions always seem to be there. Acceptance of herbalmedicine, on the other hand, is gaining ground, albeit slowly, both by consumers andtraditional medicine.

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

Before zeroing in on its financing options, a company should know what it is trying toaccomplish. 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 forexpansion, renovation or simply reshuffling what it now has. The reasons for reshufflingwould include changing the debt equity mix, extending or lowering its debt repaymentschedule, or lowering its cost of capital.

A key consideration must always be the return that additional funds sought willgenerate when invested by the company. The return generated must exceed the cost ofcapital to add economic value to the enterprise. Either a company must add to its economicvalue 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 becomfortable with the amount of maximum debt it can service. A common ratio employed togauge how much debt a company can put on its balance sheet is known as cash flow coverageof interest and fixed charges. So, if a company is losing money because it is involved ina development mode and would not be cash flow positive in the short-term, then debtfinancing is not a viable option. Equity or equity-based financing would seem moreappropriate. From the point of view of maximizing value of a firm, maximum but prudentleverage almost always helps, provided that a company has adequate tax capacity to absorbthe resulting deduction. In deciding what is prudent, a company should allow for errorsand unforeseen adverse events beyond the control of the management. For a publicly-heldcompany, equity often has a lower cost of capital than debt. For example, a public companymay find its stock a better currency than debt for making acquisitions, not to mention thebenefits of an accounting gimmick called "pooling of interests" that it can thenemploy, not otherwise available. Acquisition of Nutrition Headquarters by NBTY was such anexample. 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 mightbe appropriate to address the financing issue from the perspective of a privately-heldcompany. The first order of business for a company should be to brainstorm and documentits three-to-five-year strategic and operating plan, including a financial projection forthat period, as well as explanations and basis as to how it proposes to achieve each lineof the projections. For example, if the company is projecting sales growth, exactly how isit 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 acquiringanother company? If an improvement in gross margins is projected, how does itoccur--efficiencies in manufacturing, better raw materials sourcing or relying on externalsources for products? Does the company have manufacturing capacity to accommodate largersales; if not, how does it get additional products to sell? A discussion of this kindwould lead to various resources a company would require to accomplish what it projects inits plan. One such resource would most likely be capital.

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

The most common source of borrowed funds for midsize and small private companies isbanks. Banks, based on a company's present and projected cash flow, decide on minimuminterest coverage to determine the most they can lend a company, as secured or unsecuredloan and its terms. Any company, public or private, could do a private placement oflong-term debt with institutional investors such as insurance companies if it has thenecessary size and it is willing to go through the hassle and expense of issuing publicdebt. However, a private company may not comply with SEC's registration requirements forissuance of public debt or may be reluctant to put information about itself in publicdomain. It may not want to continue compliance with regulatory requirements imposed on acompany with public securities outstanding. Lease financing is another option. Leasefinancing is fixed asset specific and is worthy of consideration for a company that doesnot have adequate tax capacity to take full advantage of accelerated depreciation on itsfixed 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 upwith 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 companymay have in place, if terms allow it. The balance must either be borrowed or come fromadditional equity. Sources of additional equity include mezzanine lenders, existingshareholders and private equity providers. Raising additional equity involves new issuessuch as valuation, possible dilution and governance.

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

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

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