I came across this refreshing page a few years ago and was reminder of it recently by a friend. Its nice to see venture firm laugh at itself. Its rare thing!
http://www.bvp.com/Portfolio/AntiPortfolio.aspx
Wednesday, February 18, 2009
US IPOs on ICU
Back in the late 1980’s and all of the 1990’s promising growth companies could raise $20-$30 million in equity capital and go public with well recognized names like Prudential Securities, Alex Brown, Salomon Smith Barney and many others. Since then the number of IPOs has slowed considerably particularly for companies seeking to raise less than $50 million. I, like many financial pundits, have blamed increased regulation which drove up the cost of IPOs. However, this white paper suggest it’s was a confluence of many factors (the perfect storm) that did it in and most important was the growth of online, discount trading. I found this article fascinating and a reminder that most causes for significant change are rarely one dimensional.
http://www.cfo.com/whitepapers/index.cfm/displaywhitepaper/12793037?f=search
http://www.cfo.com/whitepapers/index.cfm/displaywhitepaper/12793037?f=search
Tuesday, September 16, 2008
Refinancing Corporate Debt
Abstract: Shocking headlines from major financial institutions like Merrill Lynch to Fannie Mae, underscore the liquidity shortage that now faces banks and thus operating companies. Many quality companies will get caught in the middle. Detailed below is a fast track process for finding financing alternatives and added peace of mind during these uncertain times.
Author: Chris Risey, President, Lantern Capital Advisors, Atlanta
---------------------
Let’s be clear the financial shake-up appears far from over. Talking with investors, business owners, bankers and other finance professionals, the headlines only tap the surface of what’s actually happening in the capital markets. Lending parameters available just a few months ago are being scaled back. Companies believing they have adequate liquidity are getting caught short. As more companies seek to take down lines or proactively shelter themselves from future risks, the problem is likely to only get worse.
For business owners and CFOs needing added capital, it pays handsomely to think ahead. The best way to do that is understand your financing needs, articulate that to numerous funding sources, adjust based on their feedback, and then select and vet the best solutions for your company. As suggested by our Fast Track methodology, companies can assess their financing options and make informed choices about other financing alternatives within a period of a month and look to have financing in place in as little as 60 days. The key is being prepared, thinking ahead and have access to numerous possible funding sources.
STEP ONE: Understand the problem and the risks – The real risk in today’s credit market is less that your loan will be called and more that the future capital you were expecting (and even paid for) may not be there. Not having access to even small amounts of capital can jeopardize your business and create frustrating interruptions.
STEP TWO: Identify your specific financing needs– Given the risks, it’s critical companies accurately identify their future financing needs. The best way to do that is create detailed financial statement projections. Detailed financial projections should include monthly or quarterly income statements, balance sheets and cash flow statements for a period of three to five years, with five years being ideal. (Five years is important because most subordinated investors price their warrants off the fifth year. If you don’t give them the projections, they will calculate their own projections, and their projections are never as high as your own.) If this work seems daunting, hire a firm to help you on an outsourced basis. Firms with experience, like ours, can often complete this work much faster than accountants or internal personnel. While the temptation is to create summarized financials, detailed statements are a superior format because they also give the clearest picture of the financing need and provide institutions an opportunity to offer the best terms for your situation. Better financing terms may mean higher advance rates on debt, or valuable over-advance features during upcoming seasonal periods.
STEP THREE: Entertain other lenders – Not all financial institutions are struggling. While some are looking to cut their losses or scale back, many institutions are picking up market share. The trick is to talk to lots of groups and play the numbers. In these shaky markets, the institution’s own internal ‘story’ is a bigger driver of your loan process than is your company’s story.
STEP FOUR: Consider non-bank sources for financing – Right now many new financings are getting done by non-bank financing institutions, such as hedge funds, subordinated debt funds, insurance companies, etc. These funds have already raised their needed capital and many of them are filling the void of the traditional lender. As the market improves, both the company and the institutions expect that their loans will be reduced with cheaper forms of capital.
STEP FIVE: Give the prospective financing sources more information - Once receiving proposals and before committing to a bank or financial institution, allow as many as three or four prospective sources of capital to review detailed information and start some limited due diligence. This is often accomplished by setting up a data room with files that show information commonly requested by financing institutions. By advancing discussions beyond the initial term sheets (i.e. proposals), both the company and the prospective financing institutions are able to further assess one another and avoid future surprises or let downs. Equally important, this step shortens the overall due diligence period, because sticking points can be dealt with while the company is making its final decision or deciding whether it needs a new financing institution.
STEP SIX: Be a contrarian: Look for new opportunities to create value – Just like when the stock market is down, now is the time to be a buyer if you have the capability. The market always turns around and most will look back and acknowledge those that went after new opportunities realized the benefits for years to come. Initiatives that commonly build value in a down market include acquisitions, buyouts and even growth. (Consider Bank of America buying Merrill Lynch.)
Following these steps, CFOs and business owners can make decisive moves to take the future of their business and value into their own hands, and possibly create much greater value for years to come.
Author: Chris Risey, President, Lantern Capital Advisors, Atlanta
---------------------
Let’s be clear the financial shake-up appears far from over. Talking with investors, business owners, bankers and other finance professionals, the headlines only tap the surface of what’s actually happening in the capital markets. Lending parameters available just a few months ago are being scaled back. Companies believing they have adequate liquidity are getting caught short. As more companies seek to take down lines or proactively shelter themselves from future risks, the problem is likely to only get worse.
For business owners and CFOs needing added capital, it pays handsomely to think ahead. The best way to do that is understand your financing needs, articulate that to numerous funding sources, adjust based on their feedback, and then select and vet the best solutions for your company. As suggested by our Fast Track methodology, companies can assess their financing options and make informed choices about other financing alternatives within a period of a month and look to have financing in place in as little as 60 days. The key is being prepared, thinking ahead and have access to numerous possible funding sources.
STEP ONE: Understand the problem and the risks – The real risk in today’s credit market is less that your loan will be called and more that the future capital you were expecting (and even paid for) may not be there. Not having access to even small amounts of capital can jeopardize your business and create frustrating interruptions.
STEP TWO: Identify your specific financing needs– Given the risks, it’s critical companies accurately identify their future financing needs. The best way to do that is create detailed financial statement projections. Detailed financial projections should include monthly or quarterly income statements, balance sheets and cash flow statements for a period of three to five years, with five years being ideal. (Five years is important because most subordinated investors price their warrants off the fifth year. If you don’t give them the projections, they will calculate their own projections, and their projections are never as high as your own.) If this work seems daunting, hire a firm to help you on an outsourced basis. Firms with experience, like ours, can often complete this work much faster than accountants or internal personnel. While the temptation is to create summarized financials, detailed statements are a superior format because they also give the clearest picture of the financing need and provide institutions an opportunity to offer the best terms for your situation. Better financing terms may mean higher advance rates on debt, or valuable over-advance features during upcoming seasonal periods.
STEP THREE: Entertain other lenders – Not all financial institutions are struggling. While some are looking to cut their losses or scale back, many institutions are picking up market share. The trick is to talk to lots of groups and play the numbers. In these shaky markets, the institution’s own internal ‘story’ is a bigger driver of your loan process than is your company’s story.
STEP FOUR: Consider non-bank sources for financing – Right now many new financings are getting done by non-bank financing institutions, such as hedge funds, subordinated debt funds, insurance companies, etc. These funds have already raised their needed capital and many of them are filling the void of the traditional lender. As the market improves, both the company and the institutions expect that their loans will be reduced with cheaper forms of capital.
STEP FIVE: Give the prospective financing sources more information - Once receiving proposals and before committing to a bank or financial institution, allow as many as three or four prospective sources of capital to review detailed information and start some limited due diligence. This is often accomplished by setting up a data room with files that show information commonly requested by financing institutions. By advancing discussions beyond the initial term sheets (i.e. proposals), both the company and the prospective financing institutions are able to further assess one another and avoid future surprises or let downs. Equally important, this step shortens the overall due diligence period, because sticking points can be dealt with while the company is making its final decision or deciding whether it needs a new financing institution.
STEP SIX: Be a contrarian: Look for new opportunities to create value – Just like when the stock market is down, now is the time to be a buyer if you have the capability. The market always turns around and most will look back and acknowledge those that went after new opportunities realized the benefits for years to come. Initiatives that commonly build value in a down market include acquisitions, buyouts and even growth. (Consider Bank of America buying Merrill Lynch.)
Following these steps, CFOs and business owners can make decisive moves to take the future of their business and value into their own hands, and possibly create much greater value for years to come.
Friday, May 23, 2008
Deciding on Debt vs. Equity
For entrepreneurs with profitable growing businesses, they often have the opportunity of raising debt or equity capital. I have found that most of the time, companies are led to consider equity more so than debt for the following reasons:
1) Entrepreneurs associate business finance with personal finance. As such they look at higher interest debt as risky. This is particularly true if the entrepreneur struggled financially at some point and never wants to go back to that again. Unfortunately, what most entrepreneurs don’t know is that higher interest debt such as asset based loans and subordinated debt are often less risky to the entrepreneur than their existing debt with the local bank. That is because these lesser known types of financing typically come with limited or no personal guarantees leaving the lender little negotiating power to force the borrower to make difficult decisions in the short term. Conversely, local banks which offer low interest loans typically have tighter covenants and full personal guarantees in order to minimize their financial exposure.
2) Most entrepreneurs get their advice from their existing lender who is biased towards financing strategies that keep them from losing the account. For instance, I had a client that was told by their existing bank that they were being irresponsible and growing their business TOO FAST. The ‘responsible’ thing to do was slow down the growth of the business or raise equity capital. Of course, this ‘advice’ was from the point of view of the banker that wanted to keep the account and the only way to do that was to increase equity or cash flow to improve the debt to equity ratio of the business. Doing that though would have slowed down the company or diluted the ownership of a successful family business. Eventually, the company proactively shopped for capital and found another debt provider that offered a borrowing facility (3) three times the size of the existing bank (although at a higher interest rate) but most importantly WITHOUT any additional equity.
3) The industry standard for financial advisors and investment bankers is that they are paid more to raise equity than debt. Within the industry it is generally believed that raising equity is harder than raising debt and they should receive higher compensation for such efforts. It is true that equity investors are more selective and particularly for early stage businesses or companies currently losing money, raising capital can be very challenging. However, a significant percentage of businesses seeking capital are already profitable and growing. Unfortunately, many advisors use the same fee approach and charge twice as much for raising equity and debt even though those companies are much easier to finance. Advisors using this tactic are very likely to recommend and seek equity sources entirely in order to double their fee. Entrepreneurs go along with this because they see the advisor as the expert.
In the end, there is no ‘right answer’ in raising debt or equity capital. Equity can be an attractive form of financing if the valuation is good, dilution is significantly less than 50% and/or there is a likelihood the company may experience a period of time where servicing debt will be difficult. The most important objective is for the entrepreneur to know all their options so that they can make the best decision for their own situation and temperament.
Thursday, May 22, 2008
What is Creative Financing
Companies in search of capital are often looking for 'creative financing.' What does that really mean and how do you get it?
Creative financing is really just financing that is tailored to your business and your specific growth or funding needs. Practically every business has some unique wrinkle to their financing. We had a client that had taken a seller's note to buyout a portion of their business but the terms of the seller note didn't allow the company to have any bank debt with a maturity longer than one year. As a result, the company worked around this issue every year by creating new credit agreements for working capital. When we went to finance the business for future growth the company was given the option of totally paying off the seller note (to eliminate the clause) or continue automatically renewing their business loans before maturity. The company chose the later. There is no wrong or right answer, only preferences.
Shopping for financial capital is much like buying any other physical product. The provider of that product (the financial institution) likes to put all the clients in the same box. That is just human nature.
The way to get 'creative financing' though is to 1) know exactly what you need, 2) consider numerous sources of financing and 3) ask for it or demand it.
You find out what you need by creating thorough financial projections that are easily understood not wildly optimistic. You then seek financing from a wide variety of sources that go beyond the bank to include different types of specialty lenders, commercial finance companies and investment funds (i.pension funds, hedge funds etc). Most companies only talk to local banks. While these banks are often the least expensive financing option, they are typically the most risk averse and thus the least likely to do 'creative' or "outside the box' financing structures. Once you have cast a wide net, aggressively seek your ideal financing terms. Many financial institutions will say 'no' at first and then when they learn it is a competitive situation, they will give 'creative' terms. Many times they will come up with the creativity as a way to separate their product offering from another.
By clearly articulating your financial need, going to a wide audience and creating a competitive shopping environment, you can get customized financing covering the key issues of your business. Creative terms, we have seen include eliminating personal guarantees, securing over advances (i.e. the ability to borrow beyond your collateral limit) or changing or removing certain financial covenants during specific phases of your growth plan in order to not 'trip' a covenant or even worse create default. Negotiating these specific covenants on the front end of your agreement significantly changes (for the better) your future relationship with your banking partner(s) and greatly reduces management's stress.
Wednesday, May 21, 2008
CFO: How To Raise Capital Like The Pros
Challenges of a Private Company CFO
Most private company CFOs spend 95% of their time on internal accounting and operating issues. As such, most get their knowledge of the financial markets comes from a couple of bankers that finance or want to finance the business. These bankers usually do not know much about possible financing alternatives beyond the products their own bank provides.
To make matters worse, the financial markets are dynamic and always changing as financial institutions compete with one another to provide innovative capital solutions to desirable companies. CFOs are disadvantaged because much of the really valuable information on lending parameters, new products and innovations used on today’s financing transactions is confidential and limited to the players involved in those financings.
Not only does this situation make it difficult for the CFO to make good decisions, it also makes the CFO appear indecisive or unknowledgeable on the things that a CFO ‘should’ know based to their job title.
How the Pros Do It
Thankfully, the challenges of a private company CFO can be overcome by using the same strategies the pros use. CFOs looking to raise capital for growth, acquisitions or buyouts should know the fundamentals of good decision making which is based on understanding the company’s primary financing alternatives and aggressively shopping for the best possible terms from numerous sources. This paper illustrates those alternatives, how they work, and how much of an impact they can have on the financing process and ultimately the value of the company.
Understand Primary Financing Alternatives
There are literally thousands of potential funding sources for established, successful businesses. These institutions span from well known banks and investment houses to divisions of large operating companies to a small funds with less than 20 employees yet capable of writing $100 million checks. While there are a countless number of providers, the financial instruments or products they provide typically represent one or more (i.e. combination often called ‘hybrid”) of the following:
Table 1: Overview of Primary Financing Alternatives
Most companies, particularly those able to support a full time CFO,can be financed with more than one financial product. As a general rule, the higher the cost, the greater the amount potential financing and the less risk assumed by the company. An example from a recent engagement illustrates this point:
Table 2: Comparison of Senior Debt Terms
As the table suggests the decision to choose one institution over the other is not solely dependent on the cost (i.e. interest rate). In this case, the CFO needs to help the entrepreneur figure out the incremental growth potential of utilizing the additional $4.5 million offered by the commercial bank as well as the importance of limiting the entrepreneur’s personal financial risk and guarantees balanced with increased efforts on asset monitoring of the working capital assets (i.e. accounts receivable and inventory).
While it is true that pricing can vary substantially between the same institutions, the structure and covenants differences can be more significant. By shopping all available types and sources of capital, the CFO and entrepreneur are armed with the information necessary to make the best possible decision. Ideally, the goal is to source not just the least expensive financing (as many do) but the financing alternative that offers the best opportunity to create the greatest value with the least risk.
Know Subordinated Debt: The Pros Product
Most CFOs are familiar with the first three products in Table 1. Arguably the most exotic of the instruments is subordinated debt. While not a household name, subordinated debt has been around for over 25 years. Entrepreneurs often shy away from these types of instruments because of the high interest rates and increased complexity.
The pros, however, use these financial instruments extensively to finance buyouts, growth or acquisitions - often on an all debt basis. By fully utilizing available debt financing, the pros can often make spectacular returns for their investors and shareholders. Companies have the opportunity to do the same.
How Subordinated Debt Works
Most subordinated debt providers seek a target annual return of approximately 20%. Statutorily these providers can not charge above a 14% current interest rate over the term of the note (typically 5 to 7 years). To make up the difference these funds seek added compensation through detachable warrants. Detachable warrants give the lender the right to acquire a certain percentage of the company’s stock either after the maturity of the note or upon a liquidity event such as a sale of the company or initial public offering. In practice, most warrants are repaid through a ‘put’ option where the lender proactively requests (or “puts”) to be paid out based on their percentage of warrants and the value of the company at the time of the put. Companies can be valued any number of ways, but most are valued based on a multiple of cash flow (often 5 or 6 times) at the time the put is exercised.
The intent of this instrument is to provide a flexible source of financing that can be paid off or refinanced with cheaper sources of capital, such as lines of credit and senior term debt, which become available as the company grows larger.
Illustration
Assume a company currently generating $2 million in EBITDA (cash flow) per year could grow by 30% per year over the next five years with $6 million of additional capital. Such a company would be a candidate for both equity and subordinated debt financing. Assuming the value of the business was equal to 6 times (X) EBITDA and each group wanted to hit their target return, their investment would be structured (more or less) as follows:
· Equity investor seeking a 30% annual return would require a 33%[1] ownership in the company.
· A subordinated debt investor seeking a 20% annual return and charging a 14% current interest rate would seek warrants equal to 8% of the total company stock.
These theoretical proposals are like ‘apples and oranges’ however the merits of each are more easily seen when calculating the costs of each instrument as follows:
Table 3: Cost Comparison of Subordinated Debt and Equity
As shown above in this simplistic example, the total cost of financing is $7.2 million for subordinated debt and $9 million. In addition to being a less expensive form of capital than equity, subordinated debt is easier to retire. Most companies that take significant equity investments are forced to sell or go public because it’s the only way to get the equity investor out and meet their return requirements. This is why so many equity investors want a control ownership position (51%). (They want to control when they get out!) Most successful entrepreneurs, however, want to remain in the driver’s seat and exit on their own terms. Subordinated debt allows that to happen easier than equity.
Another benefit of subordinated debt relative to other forms of debt financing is it does not require personal guarantees. The practical implication is that should the company hit a bump in the road or even suffer losses, subordinated debt providers are often forced to help the entrepreneur ‘ride it out’ because they have little, if any, collateral and no personal guarantees.
Uses of Equity
Despite the lengthy discussion of subordinated debt, equity financing can be a very attractive form of financing, primarily because the amount of financing is unlimited and not based on the company’s ability to service debt. Another positive of equity is that the cost of capital is ultimately based on the company’s success. Those companies incurring a high cost of capital have evidently met or exceeded their financial goals.
Aggressively Shop Competing Institutions
Many entrepreneurs base their financing decisions on existing relationships. The pros base it on terms. It is not uncommon for a private equity firm doing a buyout to solicit over 100 institutions to get the best possible terms. Some even have competing banks attend meetings together. Companies should also solicit and talk with numerous potential financing sources (although ideally not all at the same meeting).
The reason for such a wide distribution and effort is simple. Over 80% are likely to say ‘no’ and of those interested the cost and terms can vary substantially from one institution to another. Whether a company does an IPO or private financing, it is proven time and again that competition significantly improves pricing and gives negotiating leverage to the borrower.
Some specific examples:
Table 4: Cost and Terms Comparison Senior Debt, Subordinated Debt and Equity
As the table suggests the implied cost differential can be staggering. Thus while companies may make selections based on factors other than cost, companies always select the lowest cost of capital assuming other terms and covenants are materially the same.
Other Advantages of shopping for financing
In addition to better terms, another less obvious benefit of shopping multiple sources is finding a back up lender. During the due diligence and closing process issues may surface at the last minute regarding covenants, control or liquidation. Having a backup allows the company to switch providers or at least threaten such action should a situation not be resolved adequately. Some buyout groups, if operating under a firm deadline, may sign two institutions to do due diligence and underwriting at the same time so they have a greater assurance of closing on time should an unforeseen problem emerge.
Another overlooked benefit is the company many learn something new. For instance, a recent client learned of a valuable election from a prospective funding source for S-corporations doing buyouts. While the company learned about it from a group courting their business, they ultimately chose another firm but utilized the idea and saved millions in taxes.
Be Aware of Conflicts of Interest
When seeking assistance, the pros know investment bankers and advisors often use a compensation structure where fees are paid based on a percentage of the capital raised. The amount of the fee can vary substantially based on the type of financing raised. For instance, most brokers charge twice as much to raise equity (5-10%) than debt (2-4%). This compensation structure creates a strong economic incentive that may work against the best interests of the company. Knowledgeable clients negotiate win-win terms or a fixed fee (as in our firm) so the company knows the advisor is acting in their best interest.
More subtle conflicts of interest may exist with other advisors such as accountants, attorneys and bankers that help companies with specialized services like ESOPs or insurance driven succession planning. While they may be excellent practitioners, they can often be biased towards recommending their resource or service as the answer to the company’s problems.
Create Wealth for Management
Management team members and CFOs are often promised ownership in their company when they join but the entrepreneur never formalizes it. A major financing event provides a new opportunity to get ownership. In fact, financial institutions will often require owners to create a 10% ownership or option pool so that management is rewarded for hitting its financial forecast.
Even more dramatic is when the management team does a buyout themselves. Few CFOs know they have an opportunity to finance leveraged buyouts using the same financing vehicles the pros use but without the equity firm involved. Such transactions can create substantial value for key management and give the owner an attractive exit that allows him or her to sell at premium price, get non-recourse liquidity and stay involved after the close of the buyout.
Management Buyout Illustration
As an example a recent client team comprised of the CFO and three managers borrowed $23.5 million of debt financing to purchase 80% of their company’s stock from the owner. Management liked it because they created an opportunity to secure $24 million of collective personal wealth by simply paying down the debt. The owner liked it because he was able to sell 80% of his business at 6 times cash flow, a price that exceeded an offer two years earlier at 5X cash flow. For the four key players in management this transaction became a life changing event. For the owner it is an opportunity to reward those that created the value while giving him an opportunity to stay involved and get much desired financial liquidity and peace of mind.
Summary
Despite some inherent challenges, CFOs are still ideally positioned to make a unique contribution to the success of their business by implementing these strategies when raising capital. CFOs that utilize them have the opportunity to grow their skill set, serve the best interests of their company and possibly enrich themselves in the process.
[1] Ownership % Calculated as follows:
EBITDA $2,00,000
Enterprise Multiple 6X
“Pre-Money Valuation $12,000,000
Investment Amount $6,000,000
“Post-Money” Valuation $18,000,000
Investment/Post Money Valuation 33%
Most private company CFOs spend 95% of their time on internal accounting and operating issues. As such, most get their knowledge of the financial markets comes from a couple of bankers that finance or want to finance the business. These bankers usually do not know much about possible financing alternatives beyond the products their own bank provides.
To make matters worse, the financial markets are dynamic and always changing as financial institutions compete with one another to provide innovative capital solutions to desirable companies. CFOs are disadvantaged because much of the really valuable information on lending parameters, new products and innovations used on today’s financing transactions is confidential and limited to the players involved in those financings.
Not only does this situation make it difficult for the CFO to make good decisions, it also makes the CFO appear indecisive or unknowledgeable on the things that a CFO ‘should’ know based to their job title.
How the Pros Do It
Thankfully, the challenges of a private company CFO can be overcome by using the same strategies the pros use. CFOs looking to raise capital for growth, acquisitions or buyouts should know the fundamentals of good decision making which is based on understanding the company’s primary financing alternatives and aggressively shopping for the best possible terms from numerous sources. This paper illustrates those alternatives, how they work, and how much of an impact they can have on the financing process and ultimately the value of the company.
Understand Primary Financing Alternatives
There are literally thousands of potential funding sources for established, successful businesses. These institutions span from well known banks and investment houses to divisions of large operating companies to a small funds with less than 20 employees yet capable of writing $100 million checks. While there are a countless number of providers, the financial instruments or products they provide typically represent one or more (i.e. combination often called ‘hybrid”) of the following:
Table 1: Overview of Primary Financing Alternatives
Most companies, particularly those able to support a full time CFO,can be financed with more than one financial product. As a general rule, the higher the cost, the greater the amount potential financing and the less risk assumed by the company. An example from a recent engagement illustrates this point:
Table 2: Comparison of Senior Debt Terms
As the table suggests the decision to choose one institution over the other is not solely dependent on the cost (i.e. interest rate). In this case, the CFO needs to help the entrepreneur figure out the incremental growth potential of utilizing the additional $4.5 million offered by the commercial bank as well as the importance of limiting the entrepreneur’s personal financial risk and guarantees balanced with increased efforts on asset monitoring of the working capital assets (i.e. accounts receivable and inventory).
While it is true that pricing can vary substantially between the same institutions, the structure and covenants differences can be more significant. By shopping all available types and sources of capital, the CFO and entrepreneur are armed with the information necessary to make the best possible decision. Ideally, the goal is to source not just the least expensive financing (as many do) but the financing alternative that offers the best opportunity to create the greatest value with the least risk.
Know Subordinated Debt: The Pros Product
Most CFOs are familiar with the first three products in Table 1. Arguably the most exotic of the instruments is subordinated debt. While not a household name, subordinated debt has been around for over 25 years. Entrepreneurs often shy away from these types of instruments because of the high interest rates and increased complexity.
The pros, however, use these financial instruments extensively to finance buyouts, growth or acquisitions - often on an all debt basis. By fully utilizing available debt financing, the pros can often make spectacular returns for their investors and shareholders. Companies have the opportunity to do the same.
How Subordinated Debt Works
Most subordinated debt providers seek a target annual return of approximately 20%. Statutorily these providers can not charge above a 14% current interest rate over the term of the note (typically 5 to 7 years). To make up the difference these funds seek added compensation through detachable warrants. Detachable warrants give the lender the right to acquire a certain percentage of the company’s stock either after the maturity of the note or upon a liquidity event such as a sale of the company or initial public offering. In practice, most warrants are repaid through a ‘put’ option where the lender proactively requests (or “puts”) to be paid out based on their percentage of warrants and the value of the company at the time of the put. Companies can be valued any number of ways, but most are valued based on a multiple of cash flow (often 5 or 6 times) at the time the put is exercised.
The intent of this instrument is to provide a flexible source of financing that can be paid off or refinanced with cheaper sources of capital, such as lines of credit and senior term debt, which become available as the company grows larger.
Illustration
Assume a company currently generating $2 million in EBITDA (cash flow) per year could grow by 30% per year over the next five years with $6 million of additional capital. Such a company would be a candidate for both equity and subordinated debt financing. Assuming the value of the business was equal to 6 times (X) EBITDA and each group wanted to hit their target return, their investment would be structured (more or less) as follows:
· Equity investor seeking a 30% annual return would require a 33%[1] ownership in the company.
· A subordinated debt investor seeking a 20% annual return and charging a 14% current interest rate would seek warrants equal to 8% of the total company stock.
These theoretical proposals are like ‘apples and oranges’ however the merits of each are more easily seen when calculating the costs of each instrument as follows:
Table 3: Cost Comparison of Subordinated Debt and Equity
As shown above in this simplistic example, the total cost of financing is $7.2 million for subordinated debt and $9 million. In addition to being a less expensive form of capital than equity, subordinated debt is easier to retire. Most companies that take significant equity investments are forced to sell or go public because it’s the only way to get the equity investor out and meet their return requirements. This is why so many equity investors want a control ownership position (51%). (They want to control when they get out!) Most successful entrepreneurs, however, want to remain in the driver’s seat and exit on their own terms. Subordinated debt allows that to happen easier than equity.
Another benefit of subordinated debt relative to other forms of debt financing is it does not require personal guarantees. The practical implication is that should the company hit a bump in the road or even suffer losses, subordinated debt providers are often forced to help the entrepreneur ‘ride it out’ because they have little, if any, collateral and no personal guarantees.
Uses of Equity
Despite the lengthy discussion of subordinated debt, equity financing can be a very attractive form of financing, primarily because the amount of financing is unlimited and not based on the company’s ability to service debt. Another positive of equity is that the cost of capital is ultimately based on the company’s success. Those companies incurring a high cost of capital have evidently met or exceeded their financial goals.
Aggressively Shop Competing Institutions
Many entrepreneurs base their financing decisions on existing relationships. The pros base it on terms. It is not uncommon for a private equity firm doing a buyout to solicit over 100 institutions to get the best possible terms. Some even have competing banks attend meetings together. Companies should also solicit and talk with numerous potential financing sources (although ideally not all at the same meeting).
The reason for such a wide distribution and effort is simple. Over 80% are likely to say ‘no’ and of those interested the cost and terms can vary substantially from one institution to another. Whether a company does an IPO or private financing, it is proven time and again that competition significantly improves pricing and gives negotiating leverage to the borrower.
Some specific examples:
Table 4: Cost and Terms Comparison Senior Debt, Subordinated Debt and Equity
As the table suggests the implied cost differential can be staggering. Thus while companies may make selections based on factors other than cost, companies always select the lowest cost of capital assuming other terms and covenants are materially the same.
Other Advantages of shopping for financing
In addition to better terms, another less obvious benefit of shopping multiple sources is finding a back up lender. During the due diligence and closing process issues may surface at the last minute regarding covenants, control or liquidation. Having a backup allows the company to switch providers or at least threaten such action should a situation not be resolved adequately. Some buyout groups, if operating under a firm deadline, may sign two institutions to do due diligence and underwriting at the same time so they have a greater assurance of closing on time should an unforeseen problem emerge.
Another overlooked benefit is the company many learn something new. For instance, a recent client learned of a valuable election from a prospective funding source for S-corporations doing buyouts. While the company learned about it from a group courting their business, they ultimately chose another firm but utilized the idea and saved millions in taxes.
Be Aware of Conflicts of Interest
When seeking assistance, the pros know investment bankers and advisors often use a compensation structure where fees are paid based on a percentage of the capital raised. The amount of the fee can vary substantially based on the type of financing raised. For instance, most brokers charge twice as much to raise equity (5-10%) than debt (2-4%). This compensation structure creates a strong economic incentive that may work against the best interests of the company. Knowledgeable clients negotiate win-win terms or a fixed fee (as in our firm) so the company knows the advisor is acting in their best interest.
More subtle conflicts of interest may exist with other advisors such as accountants, attorneys and bankers that help companies with specialized services like ESOPs or insurance driven succession planning. While they may be excellent practitioners, they can often be biased towards recommending their resource or service as the answer to the company’s problems.
Create Wealth for Management
Management team members and CFOs are often promised ownership in their company when they join but the entrepreneur never formalizes it. A major financing event provides a new opportunity to get ownership. In fact, financial institutions will often require owners to create a 10% ownership or option pool so that management is rewarded for hitting its financial forecast.
Even more dramatic is when the management team does a buyout themselves. Few CFOs know they have an opportunity to finance leveraged buyouts using the same financing vehicles the pros use but without the equity firm involved. Such transactions can create substantial value for key management and give the owner an attractive exit that allows him or her to sell at premium price, get non-recourse liquidity and stay involved after the close of the buyout.
Management Buyout Illustration
As an example a recent client team comprised of the CFO and three managers borrowed $23.5 million of debt financing to purchase 80% of their company’s stock from the owner. Management liked it because they created an opportunity to secure $24 million of collective personal wealth by simply paying down the debt. The owner liked it because he was able to sell 80% of his business at 6 times cash flow, a price that exceeded an offer two years earlier at 5X cash flow. For the four key players in management this transaction became a life changing event. For the owner it is an opportunity to reward those that created the value while giving him an opportunity to stay involved and get much desired financial liquidity and peace of mind.
Summary
Despite some inherent challenges, CFOs are still ideally positioned to make a unique contribution to the success of their business by implementing these strategies when raising capital. CFOs that utilize them have the opportunity to grow their skill set, serve the best interests of their company and possibly enrich themselves in the process.
[1] Ownership % Calculated as follows:
EBITDA $2,00,000
Enterprise Multiple 6X
“Pre-Money Valuation $12,000,000
Investment Amount $6,000,000
“Post-Money” Valuation $18,000,000
Investment/Post Money Valuation 33%
Tuesday, May 20, 2008
Understanding Your Company's Growth Potential
Could you double, triple or quadruple your company’s revenues over the next five years? A study published by The National Commission on Entrepreneurship (NCOE) found that less than 5% of all companies generate annual growth of greater than 15% per year over a five-year period. The study also states “flying in the face of conventional wisdom . . . high-growth companies are not only found in high-technology sectors . . . fast growing, entrepreneurial companies are widely distributed across all industries.” This means that all industries including non-technology segments like retail, business services and manufacturing provide high growth opportunities but few companies actually generate substantial revenue growth. A key reason is that very few companies develop growth plans that effectively tap their real growth potential.
The typical planning mindset- The most common business planning approach for companies (particularly those in non-growth industries) is to develop a growth strategy under the following guiding questions: (1) “How much capital do we have?” (2) “What needs to be done?” and (3) “How do we allocate that capital across the different opportunities?” From the outset, this approach limits the company’s growth strategies to only those initiatives suited for the company’s current capital structure. That limitation can be significant especially for small and middle market private companies that have limited access to additional capital.
High growth planning- To plan like a high growth company, ask your management team, “What would we do if we had all the money necessary to grow our business to its full potential?” From this exercise management should uncover a whole list of new and exciting growth initiatives. New strategies not previously identified may include: (1) horizontal or vertical company acquisitions, (2) new product/service launches, and/or (3) broader, (possibly exclusive) supplier or customer relationships. During this part of the planning process any initiative that increases top-line revenues and profitability are fair game.
The typical planning mindset- The most common business planning approach for companies (particularly those in non-growth industries) is to develop a growth strategy under the following guiding questions: (1) “How much capital do we have?” (2) “What needs to be done?” and (3) “How do we allocate that capital across the different opportunities?” From the outset, this approach limits the company’s growth strategies to only those initiatives suited for the company’s current capital structure. That limitation can be significant especially for small and middle market private companies that have limited access to additional capital.
High growth planning- To plan like a high growth company, ask your management team, “What would we do if we had all the money necessary to grow our business to its full potential?” From this exercise management should uncover a whole list of new and exciting growth initiatives. New strategies not previously identified may include: (1) horizontal or vertical company acquisitions, (2) new product/service launches, and/or (3) broader, (possibly exclusive) supplier or customer relationships. During this part of the planning process any initiative that increases top-line revenues and profitability are fair game.
Prioritizing strategies- Once the brainstorming is complete and some very exciting, plausible growth opportunities have been identified, management should develop more detailed growth scenarios that quantify the anticipated revenue potential and resources required to launch these initiatives. In choosing its strategies management should also identify the long-term strategic advantage of each initiative. Ideally management should develop strategies that help to further differentiate the company’s product or service as well as improve the company’s defensible market position against competitors.
Planning reduces company risk- After identifying different scenarios management should then develop financial projections to determine if any additional financing is required to implement the growth plan. Many companies mistakenly believe it is less risky to use internal resources to implement their strategies. However, if the growth plan goes off track once launched, management could put the entire company at risk and find it very difficult to seek additional financing at favorable terms. By doing thorough up-front planning and seeking outside financing prior to launching the growth plan, management can effectively reduce the company’s overall business risk while also pursuing specific growth initiatives.
Outside financing- As stated at the outset, high growth companies exist in all businesses, not just select high growth industries. Recent financing transactions show that institutional investors and investment banks also support growth in diverse industries. Thus, despite the doldrums for traditional venture capitalists, the current capital markets for established businesses in even basic industries like business services and manufacturing are significantly more robust. Further, to provide attractive financing alternatives to these companies, professional investment firms are increasing their use of customized financing products like subordinated debt and mezzanine financing. These financial products provide greater liquidity than bank debt and are also far less dilutive to a company’s current ownership than traditional venture capital.
Putting it all together- If you and your management team have high growth ambitions, make sure you utilize a planning methodology that matches your growth aspirations. Companies that consider all strategic alternatives, refine their strategies with good prudent planning, and work diligently to realize their well-thought out plan will consistently build substantial value for all their stakeholders over the long-term.
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