Business bankers aren’t what they used to be. In generations past, bankers served as trusted financial partners. They had an interest in their clients’ success, and they had the experience to guide wise decisions. True banking partners are a rare breed these days, but they do still exist—at Pacific Mercantile Bank.
Our business bankers are experts at analyzing contingencies and planning for the future of small to medium sized companies, especially privately held companies, using a financial tool we call Horizon Analytics.
Private companies, no matter how well positioned and skillfully managed, are disadvantaged by lack of information available to their publicly traded competitors. At Pacific Mercantile Bank, we specialize in the application of modern portfolio theory to small and medium sized private companies, using a proprietary private company database and financial analysis techniques typically available only to large, public companies. We developed Horizon Analytics to further our Bank’s Mission: We help companies succeed.
Let’s look at how Horizon Analytics works for our clients.
We have a client who acquired a business several years ago and has nearly tripled its sales in the last five years. While sales have taken off, demand for working capital has exceeded sales growth, as additional inventory must be held to adequately service increasingly larger and demanding clients. This capital requirement has strained cash flow and reduced returns on capital, which constrains future growth. We are working with the company to identify those customers who add value to the operations, as distinguished from those that diminish it. Not all revenue growth increases enterprise value. In fact, some growth ought to be avoided if returns do not meet the cost of capital.
We have a deposit-only client for whom we continue to do contingency and capital structure planning. We began the relationship when they encountered reluctance from their existing lender to renew a credit facility. We stepped in, provided the loan, and worked with the company to support their efforts to identify an enhanced capital structure and operational funding plan. Not only did their operations completely turn around, they are no longer a borrower of the Bank, as their funding requirements have dissipated. However, the company has strong expansion objectives and, borrower or not, they continue to receive our full attention and best advice as they plan and build for their future.
Both clients grew their companies in the past by virtue of dedication and hard work. Both companies are moving confidently toward their visions for the future with the help of Horizon Analytics.
Team Up With A True Banking Partner
A true banking partner will offer valuable financial insight into the current state and potential future of your business. Above all else, a true banking partner is able to analyze a range of contingencies in a business’s lifecycle and help the owner plan and prepare for events down the road. That’s the role of Horizon Analytics.
In finance, the definition of risk is uncertainty. One of the worst things a business can encounter is a surprise, and so the banker’s role is to help business owners anticipate those speed bumps and plan accordingly. Contingency planning is about navigating challenges as well as capitalizing on opportunities, looking into the future, far beyond a company’s day-to-day activities. Horizon Analytics serves as a compass for your success, providing guideposts for progress along the road to reaching your vision.
Stop Worrying and Start Dreaming
Many entrepreneurs lie awake at night worrying about what might happen. That is wasted anxiety. Better to articulate your vision, delineate your concerns, test the upside and downside financial impact, and determine what you can do about it while you still have the luxury of time. If you can dream it, or worry about it, we can model it with Horizon Analytics. Stop worrying and start dreaming.
How It Works
Horizon Analytics begins with a thorough review of your company’s operating history. We identify the characteristics that have framed your company’s performance so far.
- How does it compete?
- What makes it special?
- How does it fit within the competitive environment?
- What are management’s objectives?
We then consider the overall market environment and micro-market expectations.
At Pacific Mercantile Bank, we work with management to assess your company’s competitive advantages, weaknesses, and goals. It is important to note that capital requirements, risk profile and the level of planning required, vary significantly depending on management’s objectives.
The goal of Horizon Analytics is to establish a compass for success and guideposts for progress along the road to reaching your vision. We start with a five-year forecast guided by general industry and company constraints. With a focus on free cash flow, we look to establish a reasonable value for the enterprise. A more precise forecast can be developed after a general direction has been set. Once a base forecast has been established with management’s input, and the key variables have been identified, we can test alternative scenarios inside this analytical framework to determine their impact. While the forecast may not be perfectly precise, it will establish the fundamentals that determine the company’s performance and, more importantly, the impact of the performance on the company’s value. Then each variable can be deconstructed to determine what influence management has over each.
With that overview, let’s look more closely at the Horizon Analytics approach.
We develop a multi-year pro-forma forecast of sufficient duration to measure the impact of today’s plans and amend the plan, as needed. The tenure is also long enough to identify a complete re-investment cycle.
Free Cash Flow
The primary purpose of the forecast is to identify the company’s capacity to produce Free Cash Flow (FCF). FCF is everything left over (in cash) after bills are paid and re-investment is made to sustain operations. Ultimately all companies with a positive valuation must produce FCF at some point. The question is when and how much.
Forecasted FCF is discounted for the time it takes to receive it, as well as the risk of its not developing. The discount rate, often referred to as the Cost of Capital, is established by weighting the cost and sources of capital by their respective proportions in the capital structure (basically, debt and equity and any derivative thereof). We weight the debt times its cost (adjusted for its tax deductibility) plus the equity times its respective weight and cost. We use a target debt/capital ratio close to industry standard to accommodate the shifting capital structure over time.
The Cost of Equity is a little more challenging. Nobel Prizes have been awarded to researchers trying to determine what rate of return equity investors are demanding. Even more confusing, there is little agreement regarding what the cost of equity is, or should be, for a non-diversified investor--namely the entrepreneur.
The only consensus in the literature for private companies is that they should earn an additional return premium over exchange-traded stocks, to compensate for the additional risk of size, lack of liquidity, and concentration of risk. The amount of premium is still subject to debate. In fact, so is the question of a premium at all. We use the capital asset pricing model, with an industry beta adjusted for leverage, and add an additional risk premium.
Benchmarking vs. Private Companies
Once we have forecast the company’s expected performance over time, we compare that to a proprietary private company database. This relative ranking procedure provides great insight into the condition of the industry, as well as the individual competitors. If a company is growing faster than its market, it is taking share from someone. Knowing the cost and debt structures of the competitors can help gauge what type of competitive response could be expected.
Macro and Micro Trends
Additionally, we put everything in context by considering macro (US economic) and micro (industry) trends and market performance.
Value Proposition / Takeaways
The takeaway for our client is the pro-forma multi-year forecast and written company analysis. Additionally, we include several proprietary reports, (for example, Industry Financial Data and Ratios Report, Industry Common Size Comparison, and Company Narrative, all with ratios, charts and analysis) to assist with managing your business. We also use the model to establish new metrics identified as critical in the creation of company value.
Why Horizon Analytics
We developed Horizon Analytics to further our Bank’s Mission: We help companies succeed. Our Bank grows as you grow and succeeds as you succeed. We believe the private market is informationally disadvantaged compared to your public competitors. We look to level the playing field for you--and for ourselves at the same time.
Contact us today to learn more about Horizon Analytics and Pacific Mercantile Bank’s commitment to helping your company succeed.
- Tom Wagner, EVP/Corporate Finance, Pacific Mercantile Bank
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- Chris Lieber, VP/Corporate Finance Director, Pacific Mercantile Bank