BUSINESS LAW; BUSINESS PLANNING: CREATIVE COMMERCIAL FINANCING USING MINORITY INTEREST WITH PUT AND CALL OPTIONS
Introduction
In recent years, privately held companies have had difficulty obtaining appropriate financing for startups or expansions. Many traditional banking channels refuse to make commercial loans. Others will not lend enough or will only provide a rigid set of unacceptable terms. In today’s economy an entrepreneur must shop nationally and internationally. An entrepreneur must offer creative borrowing terms, such as minority equity interests and notes convertible to equity coupled with put and call options, to entice institutions to lend money. This enables the entrepreneur to obtain greater financing at lower rates while still maintaining management and control of the business.
Possible Lenders
There are many possible lenders other than a local bank. Other lenders include national and international banks, insurance companies, private equity firms, private individuals, publicly traded markets, and governmental grants/small business funds. Each of these has their own characteristics and is perfect for different situations. Among the lenders, there is generally a tradeoff between flexibility and the amount of funds to be borrowed. For instance, publicly traded markets are not flexible but are sometimes the only market to raise hundreds of millions of dollars. Private equity, insurance companies, and banks are preferable for medium size loans of $50 million to $200 million, and vary in customization depending on the institution. Private lending is likely the most flexible, but may not provide the required amount.
Debt vs. Equity
Understanding the basic differences between and characteristics of debt and equity is important. However, the use of convertible loans coupled with put and call options blurs the line between the two.
Pure debt occurs when a borrower receives funds with a fixed or variable interest rate charge per payment period (usually monthly) during the life of the loan. The borrower must repay the outstanding balance at the end of the loan term.
Pure equity, on the other hand, occurs when the borrower transfers an ownership interest to the lender or equity holder in consideration for the funds. No payments are explicitly required during the ownership, and when the business or equity interest is sold, the equity holder generally receives a percentage of the sales price dependent on his ownership interest.
The key difference between the two is that debt requires continued payments with the borrower receiving all increases in value of the company above the debt payments. Equity, on the other hand, does not require continuing payments. All of the funds can be reinvested into the business; however, the equity holder has a right to a proportion of the sales price upon the sale of his interest. There is a tradeoff between the two. Due to the upside increase in value potential transferred to equity holders, debt is seen normally as a lower cost funding option. However, the transfer of equity is sometimes necessary to entice a lender to make a sizable loan.
Creative Financing Terms
The creative financing terms of convertible loans coupled with put and call options blend debt and equity. Such terms can entice lenders to make loans and enable the privately held business owner to acquire necessary financing. They add nontraditional features such as upside potential for lending, but the downside of transferring equity to a third party.
Puts and Calls:
For pure equity, the lending contract may include the transfer of a minority interest to the lender with a put and call provision. A put (call) is where one party has the right to force a counter party to buy (sell) the equity at a pre-agreed price and time. The pre-agreed price may be fixed or a formula based on sales, EBIDTA, industry/competitor multiples, or other indices. Further, the specified time may be exercisable any time up to expiration (an “American Option”) or within a 30 to 90 days after a specified time or event such as receiving a new level of funding (a “European Option”).
The debt with a minority interest for a bank or insurance company may provide the necessary sweetener of upside potential in the event of success to secure a $50 million loan. It allows the lender to receive extra upside earnings potential above its interest, which entices the lender to lend the money. In other words, it can be used as the necessary bargaining chip to induce a lender to lend necessary funds in hard economic times.
Puts and calls may be given to either party (borrower or lender), and set to expire at different periods and set with different prices. For instance, this office has been involved in different transactions where a bank will exercise its call option to purchase the entire company and where an entrepreneur has exercised his put option to sell his entire interest to the bank. The bank’s call provides a sweetener to induce the bank to lend whereby the bank has the possibility of a lucrative gain above its interest return. Meanwhile the entrepreneur has the option to sell his shares if he wants to leave after five years. Many times, experienced entrepreneurs are in it to enjoy the start-up challenge and, if successful, leave after five to seven years.
Another option it to place multiple puts and calls. Under this option, a bank may purchase an interest at increasing prices over a number of years while the entrepreneur can put his equity at higher prices to compensate the entrepreneur for his added time and management. The possible schemes are nearly endless and can be customized to the desires of the contracting parties.
Convertible Loans
A convertible loan is similar to the situation where a bank lends through debt with a put and call option. A debt holder will have a right to convert its debt, debenture or warrant to a specified minority equity interest foregoing the principal on the debt at any time after a three, five or seven year term. The debt holder’s conversion rights works to provide with the debt holder with periodic interest payments during the life of the loan, but gives the lender the option to convert its stock, warrant, or debenture to a 10% to 20% minority equity interest and receive a lucrative upside potential if the business is successful.
For example, a debt holder may lend $20 million to a business and convert the debt to own 20% of equity. This debt holder will receive periodic interest payments, and if the business’ value is above $100 million, it will likely convert for 20% equity at the end of the loan term to receive greater than $20 million in equity by way of a put option. Adding such a convertible feature may induce a lender to demand less equity, lower the interest rate, provide other favorable terms and provide the necessary funds.
Conclusion
As lending has tightened up and the world has become global in recent years, one has to become more creative to obtain favorable terms. With recent internet and mobile advances, it pays to contact multiple potential lenders, nationally and internationally, to obtain the best terms. This is not the same age where an entrepreneur or lender has to accept the same old plain vanilla contract at the standard terms of the local lender. The use of minority interests and convertible loans coupled with put and call options are great ways to induce lending and the shape the transaction to provide the necessary funds and return that each party desires.
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