Commercial real estate (CRE) transactions are complicated. There are a host of issues that can come back to bite you years after closing the financing. Acquisition, Development & Construction (ADC) financing transactions are the most challenging. The one thing that it all comes down to is working capital and computing how much working capital is being allocated. Working capital is the easiest money to spend, the hardest money to raise and comes with the biggest implied dilution hit to equity. It is the one thing in ADC transactions because insufficient working capital forecasts play out as potential bankruptcy and/or foreclosure events.
Recently I had a discussion with a company that is undertaking a securities private placement offering and was called to task because the INVIZEN platform utilizes a cash accounting approach for tabulating operating revenues and expenses, while using accrual accounting for the non-operating expense items. This is not consistent with GAAP was the complaint and accrual accounting is the only way to go, I was told. Both are interesting points that deserve a closer look.
While I am not an accountant, I sometimes play one on TV so I am not giving accounting advice. For the sake of argument let us take a look at this issue and see if we can find some wisdom.
Companies expend funds and receive sales in accordance with their response to market and business management demands. Start-up companies rarely have an easy time of things and sales go up and down during their spin-up period to becoming fully stabilized. The historical precedent on this issue is undeniable. When sales go up and down so do operating expenses, and that means the business manager has to have the liquidity at these points in time to sustain those operations. This is a fact of life and business we can all agree upon.
A simple explanation of how this plays out in reality will illustrate the point much clearer I think. Suppose you have a payroll estimated for the coming 12 months to be $1.2 million. Under accrual accounting this line item would be charged at the rate of $100,000 per month ($1,200,000÷12=$100,000). Each month the financial statements would record this fact. However, reality intrudes to make things hard. In the first month you may have only $60,000 in actual expense but a change in activities results in the second month having more than $150,000 in actual expense with no offset provided by revenues to support it. Under accrual budgeting you would now have a shortfall of $10,000 that has accumulated over that period (2 months @ $100,000=$200,000-$150,000-$60,000=-$10,000). That $10,000 has to come from somewhere or the business is now in real trouble because even though you budgeted the working capital for the whole year, the timing of its actual use versus the velocity of economic activity during that cycle created an actual shortfall.
Budgeting working capital has to be on a cash accounting basis and has to take into account the velocity of money in and out of the business over the accounting cycle (maybe I should be an accountant, that sure sounds like one talking). When undertaking a securities private placement offering it is considered bad form to go raise the funds and then have to come back a few months later and say you need more because the business operations are out of operating capital. My experience has shown these conversations are not generally well received and the consequences are not fun for anyone.