Commercial Lending / Financing

Philadelphia PA Commercial Lending and Financing Lawyer

In recent years, even with the markets beginning to open up and the national and global economy bouncing back, privately held companies have had difficulty obtaining appropriate financing for startups or expansions. Many traditional banking channels still refuse to make aggressive commercial loans or create unrealistic demands. Many times, the local banks that will make such loans do not have the capital to meet funding needs. Therefore, many times it is necessary for an entrepreneur to shop beyond traditional banks and explore other national and international options whereby an entrepreneur will offer creative borrowing terms, such as equity participation, convertible debt, and put or call options to entice financial institutions to lend money. This enables the entrepreneur to obtain greater financing beyond its usual reach at more favorable terms, retaining more of a greater upside potential and still maintain management and control of the business.

Alternatives to Traditional Lenders

There are many possible lenders other than a traditional bank. Other lenders include national and international lending institutions, insurance companies, private equity firms, private individuals, publicly traded markets, and governmental grants/small business development organizations. Each of these has its own characteristics and is perfect for different situations. Private equity, insurance companies, and traditional banks are preferable for small to medium size loans of $1 million to $100 million, and vary in customization depending on the institution. For anything larger, outside of the largest hedge funds or private equity firms, publicly traded financing would be necessary.

Among the lenders, there is generally a tradeoff between flexibility and the amount of funds to be borrowed. For instance, publicly traded markets have strict requirements including financial reporting, operating as a C-corporation, and certain standardization, however, sometimes they are only market to raise hundreds of millions of dollars. Private lending is likely the most flexible, but may not provide the required capital. An entrepreneur must know: 1) how much funding is necessary; and, 2) what types compensation it is willing to pay a lender/investor for use of his/its money in order to make a decision of where to obtain his/its funding.

Debt vs. Equity

To understand the types of compensation payable to lenders and investors, it is important to understand the characteristics of debt versus equity, and when to use a hybrid of each.

Pure debt is simply that the lender allows the borrower to use its money for payments of interest and principal for a finite, predetermined term. The lender receives the funds lent plus the interest/fees charged for the use of its money and no further amounts. The lenders depend on the business to be stable because if the business fails it loses the amount invested. If the business grows beyond expectations, the lender still receives the same set of payments with no additional bonus.

As a result, debt holders require borrowers to jump through many hoops to guarantee its stability including making periodic payments, meeting certain financial ratios and covenants and meeting certain other business covenants and requirements to help ensure the stability of their payments. In essence, lenders will continually look over the entrepreneur’s shoulders to ensure it will receive its funds back.

Last, in the case of bankruptcy, debt holders will have priority over equity holders. This means if a debt holder lends $10 million and the entrepreneur/equity holders invest another $10 million, if the business only has $15 million in assets, then the debt holder has a claim on the first $10 million whereas the equity holders will split the remaining $5 million among their various percentage ownership.

Pure equity, on the other hand, is where an investor provides funds to buy a portion of the business. The investor now owns a certain percentage of the value of the business and has a right to a percent of the profits of the business. Equity ownership is about taking a risk for a greater return on investment in that equity does not require periodic payments, jumping through banking hoops, or meeting various financial ratio and business covenants. The equity holder is generally not entitled to any return on its investment until: 1) the business elects to make distributions; 2) the equity holder sells the business to a third party for value; or, 3) the business is dissolved and the equity holder receives a final liquidating distribution. These may or may not happen and many equity holders are restricted from selling his/her interest. Last, as stated above, equity holders only receive the residuary after all debt has been paid.

While equity sounds great, the downside to this freedom to use another person’s money is the entrepreneur has to give away more of the upside potential of the business and potentially control. For example, receiving $20 million in debt on a $30 million fair market value business, if the business grows to $100 million and is sold, the entrepreneur gives the debt holders $20 million and walks with $80 million. To provide $20 million on a $30 million business, the equity holder will require anywhere up to 66.67% of the business (66.67% x $30 million = $20 million). If this same business grows to $100 million and is sold, the equity holder will receive up to $66.67 million of the value and the entrepreneur will receive $33.33 million. Additionally, the entrepreneur will be giving up control of the entity by selling more than 50% of the business. Therefore, entrepreneurs will prefer debt to equity and if it can jump through all of the bank’s demands including meeting periodic payments, meeting regular, reoccurring financial covenant, and other business covenants.

On the other side of the transaction from the debt holder’s point of view, if there are business risks due to rapid growth and expansion, the debt holders are taking the same risk as an equity holder without the reward. For example, if the above business fails, both the debt holder and equity holders lose $20 million. If the value of the business increases, the debt holder still only receives $20 million while the equity holder receives up to $66.67 million for the same risk. The debt holders realize the inequality and will either not lend or demand more financial incentives.

As a result, hybrid financing will be required where the debt holder is offered equity “sweeteners” to balance the financial risk with the appropriate financial reward, and the entrepreneur’s desire to retain as much upside potential as possible. If the debt holder was provided an additional 25% equity interest, the debt holder may decide to lend the $20 million. As a result, if the same business grows to $100 million and is sold, the lender receives $20 million to satisfy the debt leaving $80 million in equity. The debt holder will receive another $20 million financial sweeter due to its 25% equity interest leaving the entrepreneur with $60 million. Under this, the debt holder is satisfied in receiving $40 million vs. $20 million, and the entrepreneur is also satisfied with $60 million vs. $33.33 million by maintaining a 75% majority of the business. Creativity is a must with a lack of greed by all aprties.

Creative Hybrid Financing Options

To balance the lender’s interest in receiving a greater reward for the risk taken on an expanding business and to allow the entrepreneur to keep more of the upside potential, this section will discuss some of the sweeteners private equity and other such investors may require. These include providing: 1) income or capital participation; 2) put or call options; and/or, 3) adding a convertible debt feature. These allow the debt holder to share in a portion of the growth and help to balance the inherent risks involved with expanding businesses.

Income and Capital Participation

Participation is merely a more global term for having an equity or equity-like interest in a business. Income participation is that the lender shares in the entity’s profits distributions on top of interest and principal payment. Capital participation is that the lender shares in a portion of the asset value appreciation. Participation can take the form of formal ownership or phantom ownership where there is a contractual right to certain amounts of capital appreciation without voting rights. Using the example above, the 20% interest could be given through common stock, preferred stock, partnership interest, LLC membership interest,… or the debt holder could simply have a contractual right to 20% of all profits distributions, and/or the 20 % of the proceeds of any sale of the business to a third party or 20 % of the net proceeds of the business to a third party above a certain predetermined number.

Puts and Calls

A debt holder can also be provided what are called “options.” There are both “put” and “call” options. A put (call) is where one party has the right to force a counterparty to buy (sell) the equity at a pre-agreed price (called the “strike price”) at a set time or times. There are two times that these are very important to an entrepreneur: 1) if the entrepreneur is looking to exit the business after the business has gelled; or, 2) if the entrepreneur is looking to continue growing the business for the long haul.

If the entrepreneur has a knack for starting up businesses from scratch for financial moguls and is more interested in jumping from start up to start up, the debt holder may be provided a call option whereby the debt holder has the right to purchase equity at a future time at a predetermined discounted price. For the call option, the debt holder may have an option to purchase 85% of the equity at a predetermined substantial discount whereby the debt holder will be able to sell the entire business to a third party buyer at a substantial profit for the debt holder and entrepreneur. This extra reward may entice the debt holder into providing start up debt/capital, it allows the entrepreneur unfettered control in the initial stages to work his/her start up business magic , and if the business is successful the entrepreneur can walk with the value of his/her minority interest with little or no money invested before heading to the next venture. Additionally, the entrepreneur may have a put option whereby the entrepreneur may cash out by selling the minority interest at a pre-determined value at a predetermined date, 3, 5 or 7 years after start up.

On the other hand, if the entrepreneur is looking to stay in for the long haul, the lender may be provided a minority interest with a put option where it can sell its interest to the entrepreneur within a set time period at a predetermined price. The put option creates a minimum price for which the debt holder can sell its interest providing some security, but if the value is greater, then the debt holder can sell it at such higher value. For example, the debt holder may be given a 25% interest in the business and be able to force the entrepreneur to purchase this minority interest at $10 million in ten years. If the business is only worth $20 million in ten years, the debt holder will exercise such option and guarantee itself at least a $10 million return. If the business is worth $100 million, then the debt holder will exercise its put options and will simply sell its 25% interest for $25 million to the entrepreneur or third party after ten years.

Additionally, the debt holder’s put option may be coupled together with an entrepreneur’s call option and theoretically it may even be that the debt holder may exercise on even years and the entrepreneur may exercise his/her call option on odd years with the strike prices increasing every year or a variation of the same. The purpose of the call is to limit the debt holder’s potential return. Using the above example, the entrepreneur may have a call option to purchase the debt holder’s interest at $25 million. Therefore, the entrepreneur essentially retains 100% of the growth of the business above $100 million. If the value is greater than he/she will force the sale at $25 million since 25% of the business is worth more $25 million.

Therefore, puts and calls can be used creatively as a vehicle to grease the financial risk gears and can be the difference between obtaining the necessary financing for growth or being left behind without funding. Puts and calls, as illustrated above, can be engineered in many ways that can be tailored to the specific situation to ensure each party receives the proper financial incentives and rewards. Once again, creativity and experience is a must.

Convertible Loans

Another option is convertible loans. A convertible loan is where the bank provides a traditional loan, but is provided a right to forgo the remaining principal by converting such debt into an equity stake. Essentially, it is like a call option with a strike price for equity for forgoing the remaining principal amount. This option gives the bank the option to retain its first priority on the assets, periodic payments, controls and financial covenants usual for debt holders, however, if the business has financial success, the lender has the option to share in the growth of the business.

For example, if the bank lends $20 million, the lender may have an option to convert the debt into a 25% equity stake. If the business has only $16 million in assets, then as a debt holder it has a priority claim on all $16 million of assets versus only a claim to $4 million as a 25% equity holder. This protects the bank. If the business is successful and the asset valuation is less than $80 million in fair market value, the debt holder will prefer receiving the $20 million in debt as it would receive less in equity. If the value of the business grows to $100 million in assets, then the debt holder would forego the $20 million in debt owed in order to obtain a $25 million equity stake in the business. Further, this may be coupled with a put option where the debt holder may force the entrepreneur to purchase this 25% interest in immediate available funds or over a number of years or sell to a third party. As stated, essentially convertible loans are similar to the debt holder providing a loan and the entrepreneur providing a call option with a strike price set at the then outstanding principal.

Conclusion

Even with the markets beginning to open up, many traditional banks will be hesitant to invest in new ventures or aggressive expansions that it views as too risky for its portfolio. Therefore, many times it is important to realize that traditional banks may not be the best starting place for such projects, but private equity firms, insurance companies, or even the public markets may be best. To be compensated for the additional risk above a stable loan, these lenders may require equity-like sweeteners and rewards with some type of the debt-like security. This may provide a win-win where the debt holder now has a lucrative return if the business succeeds, and the entrepreneur does not give up all of the equity, and the subsequent growth in fair market value, to obtain that initial funding. Some examples of specific mechanisms to provide this equity-like reward is simple income and capital participation, the use of put and call options, and the use of convertible debt. In a deal where traditional financing does not work, these are the options that keep a project from being sidelined due to financing and allows an entrepreneur to grow his/her business into a huge financial success.

Contact a Philadelphia PA Commercial Lending and Financing Lawyer at Pozzuolo Rodden, P.C. today to answer any of your questions.