The Art and Science of Financing Emerging Entrepreneurs

A major megatrend that is accelerating across the agricultural industry is the emergence of entrepreneurs. This vantage point has been gained by conducting approximately 20 young farmer and rancher programs annually for almost a decade and after reading a recent article in the Wall Street Journal. The “traditional” is now becoming nontraditional with the entry of the next generation of agriculturalists. Nonfarm income generated through a spouse's employment in teaching, nursing, or another profession in a rural town, while still important, is being transformed. The next generation is more likely to have a number of side gigs ranging from trucking, welding, and custom work to being livestock and crop consultants, agribusiness people, or agriculture lenders while operating a diversified stream of revenues on the farm and ranch. One of the farm business consultants from Minnesota coined the term “dimensional revenue” to describe this business model. Operations will include startups, cousins managing with cousins, boomerangers returning to their agriculture and rural heritage, or people just starting out in agriculture. Emerging entrepreneurs are frequently beginners with aspirations of business growth.

These aforementioned characteristics and attributes often do not fit nicely in the traditional analysis system for risk that relies on land equity with profitability, cash flow, and liquidity. Many of the Farm Financial Standards, of which I was a facilitator on the original task force, do not align with the opportunities and risks in this segment. Beyond the financial underwriting, or the science, there are many intangibles that connect the dots that are different from the traditional loan when it comes to the art of agriculture lending. Let's explore some of the elements of both the science, or the numbers, and the art, or the intangibles, in financing emerging entrepreneurs.

The Art

One of the critical elements of assessing risk in this group is that they are able to produce a written business plan. Requesting a written business plan will weed out those who lack the discipline and the process to think through their idea on paper. In this plan, a well-defined vision and specific goals, both short and long-term, will provide a glimpse of their focus. Of course, the plan will also include a SWOT analysis identifying the strengths, weaknesses, opportunities, and threats of the industry, the business, and the new enterprise being considered.

Another critical element for those with side gigs is an enterprise analysis. This requires entrepreneurs to think through the revenue streams and fixed and variable costs to determine the cost of production and possible profit scenarios. A word of caution is that it sometimes requires two to five years to break even in these new ventures. One must question where the resources are being utilized or where they are coming from to supplement the new operation. Be careful of commingling expenses and revenue streams between enterprises, which makes it difficult to determine the viability of the new enterprise.

Where will the resources come from to carry out operations? The operational plan of production, marketing, fixed and variable costs, and the timing of revenues and costs provides a roadmap that keeps the producer out of dead ends. A projected global cash flow that includes all sources of revenues and costs is a critical part of the plan. It usually comprises about 80 percent of the overall business plan since it is related to many other parts of the business plan as one thinks through cash inflows and outflows throughout the year. What are the five key performance indicators (KPIs) to monitor throughout the year? The top KPIs will vary between operations and could include breakeven points, percent use of credit lines, variance analysis of the cash flow projections, debt coverage ratio, and working capital as a percent of expenses.

One of the elements in the art of lending to entrepreneurial businesses is the component of time management. Generally speaking, if business owners exceed 2,500 to 3,000 hours per year globally in the business, the balance of business and lifestyle unravels. Analysis of the time commitment and the resources to draw upon to fill the gaps is often overlooked.

Any good business plan will have A, B, C, and D contingency plans and potential exit plans. This is a critical part of the analysis where the emotion and the reason often drive the business model to success.

The Science

The science of lending to the emerging agricultural entrepreneur combines some time-tested traditional ratios and possible new versions that can be useful to identify risk.

Relying on the standard debt service coverage ratio and land equity as collateral when financing these operations has its limitations. If the ratio appears to be less than125 percent, then a government guarantee can shore up the risk and provide attractive financing terms to the new or growing business.

These businesses often will be in the growth mode, which means that working capital becomes a pivot to block adversity and position the business for opportunity. One ratio that is fairly straightforward for growing operations is working capital divided by total debt service on existing and possible expansion financing. If this ratio exceeds 5:1, the business is in the green light area. If this ratio is between 2:1 and 5:1, working capital is sufficient, but the credit might exhibit increased risk, particularly on the lower end of the range. When the ratio is less than 2:1, while still viable, the business becomes vulnerable to variables that impact profits and cash flow in a negative manner.

The term debt to EBITDA* ratio works well when considering the long-term ability to service debt. The sum of all term debt, or non-operating debt, is divided by EBITDA. The ratio can be calculated for each enterprise and on a global basis. When this ratio is less than 2.5:1, there is not much risk and the business would be considered very strong. As the ratio increases, so does the risk level. When this ratio is greater than 6:1, with very little hard assets as collateral, the credit would be considered very risky.

The standard return on asset (ROA) and operating expense to revenue ratios are both metrics that can be used to examine profitability and financial efficiency. The business IQ, introduced in other articles, could round out the science of the analysis. A score above 32 would be considered high and will be critical for long-term success.

You may have noticed that some of the traditional ratios, such as the debt to asset ratio and the collateral coverage ratio, are not emphasized in the analysis. While they are still important, some of the risk can be mitigated by the financial and nonfinancial metrics, particularly regarding liquidity and profitability. Of course, character overrides many of these factors. Character is a metric that is not objectively defined and oftentimes takes judgment.

These types of credits may challenge some of the more vintage agricultural lenders. Assessing risk and opportunity of this new group of emerging agriculture entrepreneurs may require a little tweaking!

*EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization