RAISING CAPITAL
A Survey of Non-Bank Sources of Capital
by Dave Vance, MBA, CPA, JD Rutgers University School of Business Camden
What is Capital?
Capital is how assets are financed
Assets = Liabilities + Owners Equity
Assets are all the toys we have to build a business Liabilities are other people’s money used in the business Owners’ Equity is our money in the business
Capital can be either debt or equity
(We will call ALL suppliers of capital investors, even banks)
Why is Capital Needed?
Capital is needed because of timing differences.
- Capital is required to finance a product or service between the time it is produced and it is paid for.
- Capital is required to finance long term assets such as plant & equipment from the time of acquisition until they generate cash. - Capital is required to finance R&D, product development, plant start-up & marketing campaigns until they generate cash.
Raising Capital
There are many non-bank sources of capital
This is important because banks: - Are highly risk averse due to heavy regulation and low margins
- Change Lending Criteria all the time shift industry preference loosen and tighten lending rules
Without Notice!
- Tie borrowers up with loan covenants/gotcha clauses - Are not always responsive. Even to say No!
Control Your Destiny
If you want to take control of your destiny, you should actively seek non-bank sources of financing. 1. Banks review their credit commitments annually, and monitor them monthly, searching for covenant violations, vigilant for a reason to cut off credit. Having an alternative will give you much more leverage with your bank. Having an alternative will give you a fall back position when your bank lets you down, delays or tries to overreach. Many companies simply don’t fit the narrow historical profile that banks require.
2. 3. 4.
Risk / Reward / Size / Time
To close a deal for capital:
- The entrepreneur’s or company’s risk / reward / size / time profile must match that of the capital source
- The capital source’s risk tolerance and reward demand profile must match that of the company seeking funding
The higher the risk, the greater the reward demanded. The reward of the capital source is the cost to the entrepreneur
- Size of transaction is a factor in selecting a capital source.
- The length of time you need the money must match the source’s willingness to be patient.
Risk / Reward / Size / Time Space
REWARD TIME
SIZE
Entrepreneur / Smaller Companies
Financial Condition / Larger Companies
RISK
Stage of Development
Stage of Development
- Start-up: Concept company, no sales
- Early Stage: Some capital, a product, but the product has not
been commercialized, no sales
- Expansion: Shipping product, generating revenue, but not enough to expand, or for steady profits enough profit to grow
- Later Stage: Company is shipping product and generating - Mature:
The company is large and profitable and is looking for the best sources of capital
- Decline:
A once healthy company finds itself in trouble and in need of capital
Time to Exit
Funding sources have expectations about when they will get their money back. Sources call this the Time to Exit. - Bank terms loans usually exit in 3 years - Bank line of credit exit in one year - Mortgages exit in 10 to 30 years - Stock is permanent financing because an investor never expects to get his or her money back from the company, on the other hand - Commercial paper may exit in a day A company must match its need for funds with the source’s exit expectations.
Transaction Size / Deal Size
Different capital sources work best over a given size range. - The fixed costs of some types of capital are too high for smaller companies
- The deal may not be large enough to attract certain sorts of capital.
- If you want to close a deal, you’ve got use a source that is willing to handle your size deal economically.
Deal Size vs. Company Size
Deal size is often driven by company size. For purposes of discussion we will consider four size ranges. ----- Revenue Range ----Entrepreneurial / Start-up $0 to $5 million
Small Businesses
Medium Businesses Large Businesses
$5 million to $50 million
$50 million to $500 million $500 million and over.
Entrepreneurial/Start-up $0 to $5 million
Bank loans require some kind of financial tract record. The problem is getting that track record without capital. The Entrepreneurs best sources are: ---Typical Deal Size--- Personal Savings $1,000’s to $100,000 - Credit Cards $1,000’s to $100,000 - Home Equity Loans $10,000 to $200,000 - Vendors & Suppliers based on credit purchases - Customers based on customer advances - Leases $1,000’s to $100,000 - Friends & Family $1,000’s to $100,000
Small Businesses: $5 to $50 million
For a company with a low risk profile bank loans are probably the least expensive, but they are risky. Non-bank Sources include: ---Typical Deal Size--- Angel Investors $25,000 to $250,000 - Factors $50,000 to $500,000 - Angel Investor Groups $250,000 to $1,000,000 - Small Business Investment Corp.s $600,000 to $2,700,000 - Asset based lenders $100,000 to $50,000,000 - Commercial credit companies $500,000 to $100,000,000 - Small Public Offering $1,000,000 and up.
Medium Businesses $50 to $500 million
Non-bank sources of capital include:
-Asset Based Lenders -Tranche B Lenders -Bridge Loans -PIPES -Venture Capital -Mezzanine Financing -Initial Public Offering (IPO) -Junk Bonds
---- Typical Deal Size ----$1 million to $50 million $1 million to $50 million $1 million to $50 million $5 million to $50 million $5 million to $100 million $10 million to $150 million $50 million to $1 billion $100 million to $1 billion
Large Businesses $500 million and over
Non-bank sources of financing:
- Securitization - Commercial Paper
-----Typical Deal Size----$40 million to a few billion
$50 million to a few billion
- IPO
- Syndicated Bank Loans
$100 million to a few billion
$150 million to a few billion
- Bonds (Investment Grade)
$200 million to a few billion
Federal & State Regulation
- Raising Capital is one of the most regulated aspects of business - Federal Regulation is primarily through the Securities Act of 1933 & the Securities Exchange Act of 1934 - Only registered securities can be sold, unless there is a statutory exception - Every state regulates securities. - Unless there is there is federal pre-emption, a company must comply with both state and federal securities regulation.
- Raising capital from banks, commercial credit companies, factors and large institutions generally isn’t regulated.
Characteristics of a Few Capital Sources
Angel Investors
- Tend to invest in start-up & early stage companies - In amount of $25,000 to $250,000 - Often demand yields of 30%
Venture Capitalists
- Tend to invest in later stage & expansion companies - In amounts of $5 million to $100 million - Demand yields of 30% to 60% These capital sources only make sense for very high growth companies
Four Sources for Companies $5 to $50 M
- Commercial Credit Companies - Tranche B Lenders & Mezzanine Financing Companies - Small Business Investment Companies (SBICs) - Small Public Offerings
Commercial Credit Companies
Commercial Credit Companies lend to companies with a less than perfect profit history. They look for assets to secure loans and often value assets higher than banks
Have fewer restrictive covenants than banks
Often don’t require personal guarantees Interest costs are generally higher than for bank loans.
Tranche B Lenders & Mezzanine Financing
- There is an overlap between Tranche B lenders and Mezzanine Financing, but generally: - These lenders supplement bank lending when banks contract during recessions or because of risk aversion. - These lenders deal in debt subordinated to senior debt, usually bank debt. - They usually value assets higher than banks and lend on the difference between bank values and their values. - Because their debt is subordinated to bank debt it is more expensive. - On the other hand, they provide levels of capital banks won’t
Small Business Investment Companies SBICs
Small Business Investment Corporations (SBICs) are private companies chartered by the Small Business Administration They act somewhat like Venture Capital firms, with the following exceptions: - They invest in early stage companies as well as later stage and expansion companies - They don’t demand as high a yield as Venture Capital firms do because their cost of funds is lower - They favor smaller deal size: $0.6 to $2.7M vs. $6 to $100M - Directories of SBICs by state are available on www.sba.gov
Small Public Offering v. Traditional IPO
Small Public Offering Traditional IPO
Typical Amount:
Cost: Stock Sold To:
$1M to $20 M
$40 to $500 K Public
$100 M to $B’s
~ 5% to 7% Institutional Investors
Exempt from State Regulation
Most suited to:
Not usually
Company with retail brand name
Usually
Any profitable company 3 years
Audited Financials? 2 years or less
Small Public Offering v. Private Placement
Small Public Offering Advertise? Who can invest? Yes w/disclosure Anyone Private Placement No Accredited investors & limited # of others No. Resale restricted Little liquidity No.
Stock Resalable? Liquidity? Can be listed
Yes Fair Yes
“Problems” With Small Public Offering
- Must comply with state law in every state where offered, but Most small public offerings are sold in limited number of states States coordinate their review NASAA has guidelines to facilitate review - Offering company must take substantial responsibility to sell the stock This is less of a problem for retail firm with a good brand name There are companies & brokers who will help you sell
Small Public Offering Advantages
- Less dependence on banks, who tie firms up with restrictive covenants; change lending rules; and re-evaluate risk annually. - Less dependent on private equity investors who demand high returns which translates into a substantial portion of a firm’s equity.
- Liquidity for the owner / entrepreneur.
- Customers who invest see themselves as stakeholders & there is some evidence that they buy more.
But.. A small public offering won’t work unless a company is growing and profitable.
What About Companies In Trouble?
Not every company is sweetness and light. Some are in such serious trouble they can forget banks and some are in so much trouble that… Commercial lenders won’t go near them. So what’s a company to do?
Four Options for Troubled Companies
Asset Based Lenders
Debtor in Possession Super Priority Loan Securitization and Private Investment in Public Entities (PIPES)
Asset Based Lenders
Lend against the value of a company’s assets.
Unlike banks, they don’t: - care about profitability or cash flow. - tie a company up with restrictive covenants, and - require personal guarantees.
They do care about: - the quality of assets - Maintaining the assets in good and marketable condition
Debtor in Possession Super Priority Loan
When a company files for Chapter 11 bankruptcy (reorganization), that doesn’t mean that all financing is cut off. Courts recognize that new capital may be necessary for a company to reorganize.
A bankrupt company can apply to the court for a debtor in possession loan, and if approved, the lender will get a superpriority over other unsecured creditors.
There are companies that specialize in such super-priority loans.
Securitization
Securitization is a way for a company with a troubled credit history to raise capital at the same cost as A rated companies. For securitization to work, a company must have a large block of assets that will produce cash flow over a period of years. Examples include: installment sales contracts, leases, mortgages or credit card accounts. Assets are sold to a Special Purpose Vehicle (SPV), an independent corporation set up by the company.
Securitization - continued
The SPV then sells bonds, backed by the cash generating assets, to pay off the company originating the assets. Because the SPV is independent of the company generating the assets, its credit rating is solely dependent on the quality of its assets, not any liabilities or other trouble the asset generating company may have. With an excellent credit rating the SPV can access bond and securities markets for capital at low cost. It passes that savings back to the company that originated the assets by paying close to face value for them.
Private Investment in Public Entities
(PIPES)
A PIPE only works for a listed, publicly traded company with stock price above about $3 per share. PIPE investors make private equity investments in publicly traded companies. Such investments don’t have to be registered with the SEC, and paperwork is minimal.
The PIPE investor negotiates a conversion feature to the company’s publicly traded stock at less than market rates.
The stock resulting from the conversion is then registered and the PIPE investor exits their investment by selling the stock they acquired at less than market price at market price. The difference becomes their fee.
“There are more things in heaven and earth than are dreamt of in your philosophies.”
~ Hamlet, Act I, scene i
What we’ve seen is a small sample of the alternatives to banks.
There is a strategy for finding, capturing and making the most out of each of these sources
The key is to find the right capital source for your company’s risk, reward, size and time to exit.
That’s All Folks!