Putting Capital Back to Work the Receivables Exchange Creates a New Way for Small and Midsize Business to Manage Cash Flow

Nicolas Perkin

Putting Capital Back to Work The Receivables Exchange Creates a New Way for Small and Midsize Business to Manage Cash Flow

Innovations Case Narrative: The Receivables Exchange

I have always had a fascination with disruptive technologies, an inclination that has often led me to think about how we might disrupt the status quo or provide an innovation that favors a more efficient or convenient arrangement of the marketplace. In the last 20 years, we have seen numerous disruptions that have forever transformed businesses and lifestyles—cell phones and computers are the most obvious examples. Despite these advances, the way small and midsize businesses (SMBs) secure capital has changed very little for many decades. My vision for modernizing accounts receivable and getting working capital into the hands of small and midsize businesses, together with my partner Justin Brownhill’s idea for an exchange and his experience with electronic trading technology, led to the establishment in 2007 of The Receivables Exchange, and the launch in November 2008 of the world’s first online capital marketplace for buying and selling accounts receivable. In doing so, we succeeded in providing a new solution to the age-old problem of cash flow that almost all businesses face. Moreover, by establishing our headquarters in New Orleans, we also have had the opportunity to play a central role in building the dynamic and entrepreneurial city that has emerged since Hurricane Katrina. The credit crisis of 2008 and 2009 made it nearly impossible for a business of any size to get access to capital, much less the millions of SMBs that took the brunt of the financial fallout. Given that our launch occurred in the midst of the crisis, people sometimes assume that we developed The Receivables Exchange in response to it. However, the idea for the Exchange was born out of a fundamental belief that SMBs should have unfettered access to capital in the same way that large companies have access to the stock exchanges and the commercial paper market.

Nicolas Perkin is the Co-Founder and President of the Receivables Exchange.

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Most businesses that transact with other businesses sell their products or services with the expectation of receiving payment at a later date, and as such, all experience the frustrating problem at some point of having great sales on paper but no money in the bank. Given the importance of having cash to pay bills and buy raw material for new orders, financial products have emerged throughout the years to satisfy businesses’ need for cash. However, barriers to accessing this capital, such as exorbitantly high interest rates, excessive guarantees demanded from the borrow- er, or drawn-out approval processes by banks, all but eliminate SMBs’ financial incentive to take advantage of these options. The Receivables Exchange has disrupted the status quo by making the process by which SMBs access working capital more efficient, fair, and transparent. We are helping small businesses meet their funding needs at the same rapid pace of business today. The process starts when an SMB, the Seller, sends an invoice to a business, the account debtor, that has received a good or service from the Seller and has to pay within a given period of time, say 30 or 90 days. During this period, the Seller still needs capital to buy supplies for new orders, pay employees, or pay its own bills. So, instead of waiting for the debtor to pay up, the Seller—whose business has already gone through the due diligence review process to become an approved Seller on the Exchange—uploads the receivables it wants to sell onto the Exchange trading platform. Once we’ve verified the invoices and the Seller has set its auction parameters, such as the minimum advance amount (the amount of funds it wants to receive at the close of the auction from the Buyer), the maximum discount (the amount they are willing to pay for the sale), and the maximum dura- tion of the auction, the auction can begin. In our online auction-based marketplace, accredited institutional investors, Buyers, compete in real time to purchase the receivables, bidding against other Buyers or choosing to pay a buyout price—optimal terms set by the Seller which automatically closes the auction. Generally lasting one or two days, some auctions close in only a few minutes. The advance amount plus the Buyer transaction closing fees is then sent via reverse wire from the Buyer to the Exchange, and on the next business day, The Receivables Exchange wires the advance amount, minus the Seller transaction closing fees (% of auction value), into the Seller’s operating account. When the account debtor pays the Seller’s invoice, The Receivables Exchange reconciles funds and disburses net amounts: Buyers receive the advance amount plus accrued discount fees, and Sellers receive the remaining amount. By using the Exchange, the Buyer diversifies its investment portfolio and gains access to a previously untapped asset class, a $17 trillion receivables market. In addition, through transparency and standardization of information on The Receivables Exchange, Buyers are able to perform risk assessments and place com- petitive bids to meet their investment strategy. This represents a departure from traditional financing, where a Seller’s credit risk is often based solely on historical revenues rather than the strength of its cash generation and high-quality account debtors. A further enhancement is that as Buyers become more familiar with indi- vidual Sellers, their auctions, and the payment activity of their account debtors,

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their familiarity and understanding of Sellers and account debtors increases and is reflected in their bidding. As a result, most Sellers realize a significantly reduced cost of capital as they build their transaction history on the Exchange—30 percent, on average. The ease and transparency we provide at every step of the transaction for Buyers and Sellers has transformed a formerly underutilized asset into an affordable, secure, and mainstream business financing option that enables SMBs to improve liquidity and get access to the cash they need to keep growing—all on terms they set. The Receivables Exchange has grown much more quickly than we had expected, both in terms of revenue and the number and size of trades. In the first half of 2010, we reported growth over 200 percent, and we continue to see record double- digit growth month after month. Over a thousand Sellers from 49 states now sell their receivables on the Exchange, and we’ve already seen a higher volume of transactions in one month than eBay saw in its entire first year. When one considers that accounts receivable in the United States alone total $17 trillion, shared among nearly four million B2B companies, we’ve only barely scratched the surface of our potential. I’m proud that The Receivables Exchange counts itself among the first of the many start-up companies that have committed to New Orleans after Hurricane Katrina, and that continue to drive the city’s entrepreneurial rebirth. Basing our operations in New Orleans has made sense financially because of the affordability and tax incentives the city offers. New Orleans has a high profile throughout the world as a Great American City and boasts a strong historical association with trade and exchange. Like us, many are rooting for New Orleans to succeed. Since we arrived, like-minded entrepreneurs and other talented professionals have flocked to this city, which has undeniable electricity flowing through it right now. We have folks on our team from London, Barcelona, San Francisco, New York, Atlanta, and many other cities. We also have managed to attract many New Orleanians, who have always wanted to move back but couldn’t for lack of viable career options. Regardless of their origins, everyone at The Receivables Exchange has come here to take part in the birth of an entirely new capital marketplace for SMBs and the rebirth of New Orleans. The Receivables Exchange has turned the tables on small business financing. Never before have small and midsize businesses had the flexibility and control over their business financing that the Exchange provides. With Buyers competing to purchase their receivables and give them the best cost of capital, Sellers are able to gain access to affordable capital when they need it and how they need it. We are using the technology of today to bring cash flow management into the 21st century, thus providing business financing at the pace of today’s business.

THE NARRATIVE The original vision for The Receivables Exchange derives from one of the most unquestioned, fundamental economic activities. In most business-to-business

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transactions, the buyer of a product remits payment for a purchase according to an agreement between the buyer and seller. This relationship between businesses, called trade credit, lies at the heart of every business’s capital management, and sometimes amounts to a cash flow tug of war. Companies need cash to produce their goods and services, so they push out what they owe (payables) as far as they can and pull in as quickly as possible what other companies owe them (receivables). In doing so, they manage the amount of actual cash their business has, hopefully in a manner that allows for growth. Meanwhile, the business that sells the product may not have the cash it needs to pay for its own day-to-day operating expenses or to buy more raw materials to fill new orders. Whereas large corpo- rations can sell their receivables as an asset called commercial paper to satisfy cash flow needs, SMBs have far less access to such financing. As a result, SMBs have an average of 60 percent of the working capital that could be put toward growing their business tied up in accounts receivable, and they wait an average of 44 days for an invoice to be paid. My partner, Justin Brownhill, and I intended from the start to build a capital market in which SMBs could increase their access to working capital by selling their receivables electronically. The operation we envisioned would return the business of providing working capital to its most basic form, where Sellers who needed cash and had receivables to sell came together with Buyers who wanted to purchase them, and market competition would decide the best price. Sellers would have complete control of the process: they could sell only when they wanted to and only at terms they set, without having to rely on personal guarantees. Beginning in December 2006, Justin and I began exploring the viability of such a marketplace. I had most recently worked to build a company called Massive, which Microsoft had purchased. Having known firsthand the challenges a growing business faces in securing working capital, I wanted to invest what I had made through the sale of Massive in a way that supported the efforts of entrepreneurs. The idea for a central marketplace in which SMBs could access capital grew from there. I connected with my future partner Justin, whom I had met when a company I worked for, Kestrel Technologies, did business with a private equities trading company called Lava Trading. Justin had been one of that company’s top execu- tives, and he moved over to Citigroup when it bought Lava Trading. We brought in some additional experts who also liked the idea and wanted to move it forward, including the former CEOs of Lava Trading and Massive, two people who had a significant amount of experience in building early-stage, fast-growing companies into more mature businesses. No marketplace like the one we envisioned existed, nor had anyone used accounts receivable as an asset in the way we envisioned Buyers and Sellers would on the Exchange. By April 2007, we had begun to understand the size of the opportunity we had on our hands and the scope of what it would require to implement, and we decided to work to attract venture capital so we could get the product to market. Justin and I had provided the seed money for the first few months from our own pockets, but we knew we’d soon need to attract a round of investment from venture capital firms willing to take a chance on only

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a team, an idea for a product, and a plan for marketing it. That round would help get us to the point of actually building the Exchange. Once we had committed to a plan, we had to decide where to locate our headquarters. We considered a lot of cities around the country for our future home, including Miami, Houston, Dallas, New York, and San Francisco. Then we looked at New Orleans, where I had attended Tulane University for my undergraduate degree. I had long had a yearning to return to what I consider one of the world’s most unique cities, and starting The Receivables Exchange there appeared to be a perfect opportunity. Once we began to list the benefits of starting and launching there, the decision was a no-brainer. In New Orleans we could procure office space at literally a fraction of what it would cost in New York, and because living costs in New Orleans are at least 50 percent lower than any other start-up hub in the country, we could pay start-up salaries to extremely qualified people. When launching a business, one obviously has to be extremely cost-sensitive in working with a finite initial investment, which made New Orleans extremely attractive from a financial standpoint. Furthermore, New Orleans and Louisiana offer so many benefits related to market regulation that my partner and I often tell each other that if we had not formed and launched the company in New Orleans, we probably would have had to move it here. Several aspects of Louisiana’s uniform commercial code (the set of laws that regulate commercial transactions) benefit our transaction structure in the same way that Delaware’s corporation law attracts so many institutional investors. The regulations put our Buyers in the strongest legal position possible, which lowers the cost of capital for our Sellers. Louisiana’s government has also made a significant effort to attract business to the state by offering a variety of tax breaks and grants, for which we qualified upon moving to New Orleans. Finally, New Orleans has a globally recognized name that we historically associate with trade. We hoped to curry that image into an association with commercial receivables trading in the same way we associate Chicago with commodities and New York City with stocks and bonds. While the city was enjoying its post-Katrina renaissance, we’d work in parallel to build the marketplace we envisioned. Once we had established ourselves in offices in New Orleans (please see text box for more about the offices and the community of which we are a part), we brought on staff to help us write a business plan. In the process, we got a sense of the sort of capital and resources we would need to build the Exchange. To help us map out what our potential customers would want from an exchange like ours, we brought on team members from the world of finance who had experience in both buy-side and sell-side sales, and we began to meet with participants within our target market of business-to-business enterprises and institutional investors. We also built an advisory board, which included market design experts to help us mine data on any similar products and help us identify some of the hurdles we might encounter. The actual building of the Exchange involved some enormous legal, operational, and technical complexities; we had to incorporate into our plan a substantial period of time to resolve these problems, which, despite our careful calcu-

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The Decision to Locate in New Orleans When Justin and I first explored the option of making New Orleans our home, we went to dinner with one of the men who then worked, as he still does, at the forefront of entrepreneurship in that city: Sean Cummings. “If you guys pick New Orleans,” he told us, “you’ll effectively double the number of entrepreneurs here.” Shortly thereafter (and I hope we contributed something to this), companies began popping up left, right, and center in New Orleans. I can’t tell you how many start-ups now have a home here. New Orleans is in the midst of a renaissance. Once decades behind places like New York, San Francisco, and Los Angeles, New Orleans now has a feeling like that of Prague after the fall of the Berlin Wall, or today’s Shanghai with its constant construction. There is a mystique surrounding its distinctive culture, and it attracts people who wonder what living here is like. That’s particularly true of entrepreneurs—natural adventure seekers—and I think many have come to play a part in building something new and to live history in the making. As a result, New Orleans has been transformed into a regional hub, as demonstrated by the number of magazines (Entrepreneur among them) that have featured it as a great place for start-ups, with its extreme affordability, one of the lowest unem- ployment rates in the country, and Tulane University providing a great source of new talent. Moreover, the State of Louisiana offers a huge number of incentives to launch a business here, specifically in new media and technology, and as such it’s already become the third-largest film market after New York and Los Angeles. Entrepreneur’s Row, the offices where we work and an exciting project Sean and I spearheaded, has attracted even more entrepreneurs to the city. Far from just a business incubator, Entrepreneur’s Row houses some of the country’s fastest-growing and most innovative companies, and provides a great environment for networking and collaboration. As we begin to reach a critical mass of entrepreneurs here, we’ll no longer have to travel to New York or California in search of start-up capital, as we make the leap from start-up hub to the next Silicon Valley.

lations, took longer than we originally anticipated, as is usually the case. Some central questions at that point included what we would require from the technology, what we could anticipate having to pay to develop it, and how much we’d have to commit to make sure everything ran perfectly. After working from April to August of 2007 to build a business plan and come up with a more precise estimate of how much money we’d need, we felt prepared to approach the venture capital community. By November of that year, Prism VentureWorks and Fidelity Ventures had both partnered with us in separate investments to build the Exchange. We spent most of the period that followed taking what we thought we under- stood about our product and market and transferring it into an actual, working Exchange. The funding we’d received in November helped us attract some of the

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greatest minds in law, commercial finance, and financial technology, which we needed to make the transition from idea to reality. Many of our solutions required synchronizing some complicated stuff, which all had to happen seamlessly, and we knew that getting everything right at launch time mattered greatly in attracting people to the Exchange. Our business involves moving around a lot of cash that does not belong to us, as we act as an intermediary that connects the Sellers and Buyers. Our system would have to work as advertised and perform all the functions we said it would perform. As such, another major aspect of our problem-solving involved thinking of every possible eventuality that could occur in a transaction and developing a solution before it ever happened. That task was not easy, and we basically had to operate in a synthetic market environment to understand how everything would work. With our amazing team, we managed to solve some problems that no one had solved before and, ultimately, to launch an innovative, game- changing product. In the early months of 2008, we took the initiative to contact people who were unaware of our company and let them know what we were offering. At first we simply cold-called potential customers from lists of businesses or institutions that fit our target market, explained what we intended to do, and incorporated what they said they would need in order to trade. As soon as word began to get out, we started receiving calls from people interested in both buying and selling on the Exchange. The press coverage that grew around us happened through a similar process. We had called and e-mailed several publications and media outlets, explaining what we did and why receivables and working capital were such a rele- vant topic. A couple of stories that spread around Louisiana and appeared in USA Today early on begot further interest from other outlets that thought we had an interesting and unique product. Soon we had tremendous visibility, driven as much by our product as by the very real need among the thousands of SMBs in the country for just what we were offering. After months of technical planning and execution, Kestrel Technologies, which designed the New York Stock Exchange’s bond trading software, had built the pro- prietary trading platform our Buyers and Sellers would use to access the Exchange. Strategic partnerships with other companies specializing in electronic communi- cation, processing, and approval of commercial information ensured that the Exchange would provide a standardized, centralized, real-time auction marketplace fully capable of trading hundreds of millions of dollars per day. Additionally, because of the enormous effort our staff made to attract people to the Exchange, we had already signed up Sellers from a variety of industries and Buyers interested in the new, fairly liquid asset class they could trade by using our product. As these major pieces of the puzzle began to fall into place, the U.S. economy experienced some serious disruptions that would lead to the biggest economic crisis since the Great Depression. One of the most distressing results of the crisis was that financial institutions broke the unwritten bond they had with small and midsize businesses, an understanding that a hardworking, productive company would have access to capital based on the health of its operation alone. During the crisis,

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healthy and struggling companies alike had their lines of credit reduced or elimi- nated, or readjusted with prohibitive covenants. In the market, big buyers began to change the rules of the game, with larger companies telling smaller suppliers that they would unilaterally extend the due dates for their bills. (For example, Anheuser-Busch extended their payment terms another four months on invoices already due.) These extremes, however, resulted from the same inefficiencies in the financial markets that had existed for ages, which the financial crisis had only, unfortunately, made more apparent.

LAUNCH AMID CRISIS On November 17, 2008, we publicly launched The Receivables Exchange, amid a market and business environment that only a couple of months before had all but collapsed. The financial crisis highlighted the disparity between the financing options that small and midsize business owners needed to manage and grow their business and the options that they actually had. In an exceptionally rare event, we had identified a need in the marketplace that the financial crisis had made significantly more pressing. The combination of our idea and the time it appeared made what took place go far beyond anything we could have expected. We all had to work extremely hard in the next few months to continue to grow the business, especially given that we launched in a recession economy. On the other hand, the credit crisis expedited our penetration into the market by creating an even greater need for our product, which allowed us to demonstrate more broadly and across more industries in the SMB community that companies should and would use this product. Once we had launched, we began to gain traction in the market right away. We had raised our first round of venture capital to get us to the point of going live, and now that we had a proven product, we could use the evidence of a working exchange to attract more capital from another round of venture fund investment to gain market penetration. In February 2009, three months after we went live and in a market where few new businesses got funded, we received financing totaling $7.75 million from Redpoint Ventures, and a reinvestment from Prism VentureWorks. With the product already built, this round of funding went prima- rily toward bringing in more talent to expand the number of Exchange users and continue to grow the company. We still considered ourselves in the start-up phase, and demonstrating that our idea merited such significant investment helped us attract new people with the talent we needed. One of the challenges we faced early on in attracting business was the issue of trust. Any new idea faces scrutiny, and a lack of confidence was running rampant throughout the market at that time. From 2008 through 2009, people just didn’t trust each other, and they definitely didn’t trust financial institutions. Financial products, especially those in the mortgage market, had badly damaged confidence, and many blamed the credit crisis on convoluted fundamental assets used to build complicated financial products impossible to trace back to their source. In essence,

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the amount of information available to the Seller differed from that of the Buyer. As a result of these factors, we had to work hard to gain our customers’ trust if we wanted to succeed. We provided a system that worked consistently just as we had said it would, thus reducing a bit of the anxiety associated with taking a chance on a new product. Moreover, by providing an extremely transparent system, right down to what we call the electron level, we combated the mistrust in the marketplace. With the Exchange, when an investor buys a receivable, it can drill down to see precisely what asset it is buying and assess the risk. In our marketplace, everyone has access to the same information and knows precisely what they are buying or selling. During that first year, the credit market continued to freeze up and major financial institutions began to crumble. At this point, the millions of small and midsize companies that we had hoped to assist by providing an alternative source of credit needed capital even more. We had hoped to be an additional source, but suddenly these hardworking SMBs were almost completely shut out from main funding sources. The troubles and eventual failure of CIT, a commercial lending bank founded over one hundred years ago, dealt small and midsize businesses a major blow. The U.S. Small Business Administration had formerly turned to CIT, a bank holding company with more than $75 billion in assets, for a major portion of its small business loans, and many enterprises that couldn’t get financing else- where had found it at CIT. With the collapse of CIT, as well as its substantial fac- toring business (it had formerly ranked as the largest commercial factor in the U.S.), the 950,000 businesses to whom the bank had given loans now had even fewer options for acquiring short-term loans. But the most salient point in CIT’s collapse didn’t have to do with trusting the bank, but with another failure of commercial finance: businesses were relying on too few institutions to provide capital. Given the diversity and number of Buyers interested in bidding on receivables on the Exchange, SMBs began to flock to us after losing yet another option once CIT finally declared bankruptcy in November 2009 after months of uncertainty. Although we offered a centralized online trading platform, companies looking for funding on The Receivables Exchange didn’t have to worry that disruptions in one capital provider would affect their own ability to get capital, given the vast numbers of investors active on the Exchange. It appeared that we had arrived on the scene at precisely the right time. In November 2009, we celebrated one year of trading receivables on The Receivables Exchange. The previous few months had demonstrated to us just how much financial markets needed a solution like ours. Sellers with anywhere from $2 million to $500 million a year in revenue joined the Exchange, and within only 18 months we had more than a thousand sellers interested in posting invoices on the Exchange and a global network of Buyers with $20 billion in buying power. By October 2009, we did a higher volume of business in one month than eBay had done in its entire first year, and we ended up doing more business in our first year than eBay had done in its second year of operation.

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After hitting our stride following an enormously successful first year, we began to develop more detailed metrics that we could use to track our performance more precisely and continue growing. We got into some detailed elements of our model and began to understand the numbers that drive our business, such as what it costs to acquire new customers, what Buyers will pay for transactions, and how much Sellers will sell for. We used that information to attract a third round of investment, and were able to choose Bain Capital Ventures as our new partner. In January 2010, we announced that Bain, one of the largest and most highly respect- ed venture capital firms in the world, had closed a deal with us for $17 million in new funding to continue expanding our business. Bain’s investment will help us increase our penetration in the buyer and seller communities, expand our operations, and scale to take full advantage of the market opportunity. When a marketplace is designed correctly and with scalability in mind, as ours is, adding additional volume doesn’t involve any significant additional overhead or structural changes. Accordingly, our next stage of expansion will center around enhancing the customer experience, as we continue to improve the support we provide to all Buyers and Sellers on the Exchange.

CONCLUSION In all of my years as an entrepreneur, I have never seen the kind of growth that our company has experienced. We now have between 50 percent and 100 percent increases in revenue month after month, even after we began to make millions of dollars a day. I don’t think anyone would expect to see the kind of growth we do over time, but we have still only scratched the surface. Even though we’ve attracted over one thousand SMBs to the Exchange, there are over four million SMBs with receivables to sell in our target market. The value of their receivables totals $17 trillion. Accordingly, we expect the volume of receivables traded on the Exchange to grow to many trillions of dollars from its current hundreds of millions. Given the changes in the U.S. economy and the business need that the Exchange addresses, I think that growth will happen at an increasingly rapid pace. Liquid capital has flooded the economy, but this hasn’t translated into an increase in lending for small and midsize businesses. Nor do I think we’ll return to the level of lending we could expect before the credit crisis. The market has simply found a new equilibrium, making what had previously posed a challenge to smaller enterprises even more difficult. But when I look back a few months and remember the hesitance with which a number of our Sellers approached the idea of using The Receivables Exchange, a large percentage of them thought they would participate only long enough to weather the financial crisis. Once they started using the Exchange, however, they began to see the value of selling receivables associated with growing their business. They see that the liquidity and control they’ve gained over cash flow allows them to build their businesses on their terms. For many of the Sellers we speak to, there is no going back to traditional financing methods.

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That, in a nutshell, describes what we intend to do with The Receivables Exchange. The credit crisis didn’t exist when we started, and we simply wanted to create a working capital solution that was synchronized with the velocity of money and business transactions in the 21st century. We’ve innovated by creating a transparent, liquid marketplace that has expanded markets, not taken them away. We operate an extremely standardized Exchange and contribute to rebuilding trust in the marketplace, mostly by delivering what we told people we’d deliver. By bringing on exceptional partners as investors and proving our product’s effectiveness, we’ve proven ourselves in the market and to our customers. We set out to change the way companies do business, and we believe we’re doing just that every day.

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