Funding Sources

Business growth strategies too often are stymied by the limitations of bank financing. CEOs and CFOs seldom are aware of the existence of financing resources that can help to supplement bank borrowings in order to more fully-fund their strategic initiatives. L. R. Nathan Associates is thoroughly familiar with the requirements, features and temperaments of these non-bank money sources and, in many cases, know the decision-makers personally. As a consequence, our most common referral source is commercial bankers who are seeking help to complete transactions that require funding beyond their own lending products. The following is a brief description of how the various financing sources compare and can complement one another --

Commercial Banks

Bank loans are the least expensive source of working capital borrowings and intermediate term business debt. Lines of credit can be drawn down and repaid to match seasonal business cycles. Commercial banks also are eager to lend for new equipment purchases and, to a lesser extent, are willing to extend mortgages on owner-occupied real estate. Bankers take pride in “relationship” lending and often are active in their communities. At the same time, commercial banks are the most risk-averse lenders on a company’s balance sheet. They lend only to companies that already are in business and have established a reasonable track record. They never lend to startup ventures without a strong third party guarantor. Moreover, bank loans always are in the senior-most position on a company’s balance sheet, which gives them priority rights to be repaid before all other creditors. Bank loans usually are secured by a first lien on all business assets, although unsecured loans may be made to large companies with investment grade credit ratings.

The lending appetite of commercial banks is dictated largely by the fact that they are Federal or State chartered financial institutions that are closely regulated and monitored by their chartering agencies. As such, they are constrained as to their lending criteria and generally are compelled by their regulators to exit loan situations in which a borrower's credit worthiness has deteriorated below a certain risk level. In short, commercial banks strive to make loans only to businesses with good quality, “bankable” credit profiles. Consequently, banks have limited flexibility in situation where total leverage exceeds a certain relationship to demonstrated cash flow, or where there is significant unsecured exposure. In such instances, bank financing is unable to fully fund aggressive business growth plans, strategic acquisitions or management buyouts.

Asset Based Lenders

Asset based lenders (“ABL”) also provide working capital to business borrowers. They tend to be less credit-sensitive than are commercial banks and instead focus on the collateral value of business assets as their primary protection. ABL loans are structured as a revolving credit facility where actual borrowings are based on a formula of advances against accounts receivable and inventories. Advances typically are in the range of 75-85% of the borrower's good quality A/Rs, plus some percentage of their raw and finished goods inventory that can range from 20-60% depending upon the salability of the inventory. This combination of advances against A/Rs and inventories represent the total borrowing availability at any point in time. Unlike banks which monitor their collateral on a monthly basis, ABLs check their loan balances vs. collateral on a daily basis. In addition to revolving credit loans for working capital, most ABLs also will extend term loans for 3-7 years that are secured by a borrower’s equipment. Orderly liquidation value appraisals are ordered to determine a worst case recovery in a troubled situation. The loan amount then is set at 70-80% of this amount. ABLs are very reluctant to advance funds against the value of owner-occupied real estate, such as a manufacturing plant or distribution facility. This is consistent with their short-term orientation. Real estate loans, if any, usually are limited to a small part of their overall loan package with a short ten-year payback period.

Asset Based Lenders are most useful to business borrowers that have had credit issues in their performance, such as periodic losses or a high degree of leverage on their balance sheets. They also can be helpful to good companies in highly seasonal businesses where closely monitored working capital borrowings can be a useful cash management tool. Because ABLs are less concerned with credit strength, and most focused on their collateral which they monitor very diligently, they are able to lend in situations that may be unattractive to commercial banks. However, the cost of their money is somewhat higher than commercial banks. It also is notable that ABLs are less forgiving than commercial banks and are more prepared to liquidate their collateral in the event of a deteriorating financial situation.

Asset Based Lenders range in size from small finance companies that will make loans as small as a few hundred thousand dollars to very large national institutions that can lend upwards of $100 million. Increasingly over the years, the larger ABLs have been acquired by commercial banks.

Tranche B Variations

"Tranche B" refers to a layer of debt that is situated immediately below the senior debt from a bank or ABL on the borrower's balance sheet. These loans usually do not comprise more than 20% of the entire capital structure. They enable a business to borrow more fully on its assets without incurring the higher cost of Mezzanine financing, which is described below. Tranche B can take several forms, the most common being the "b note" whereby the lender takes a second security interest in all company assets behind the senior lender in order to gain a limited degree of collateral protection. Another form of Tranche B is the "last out" structure, whereby the senior loan is expanded to include the additional funding by the Tranche B Lender, who agrees to be repaid only after the senior lender has been paid in full.

Because of the greater risk incurred, Tranche B Lenders charge more than senior lenders. Pricing typically is set at a variable rate of 8-10% above LIBOR – the London Interbank Offering Rate, which has become an increasingly used benchmark in U.S. financing. Tranche B financing has been provided by a number of specialized funds around the U.S., a few of which are publicly-traded. Some so-called hedge funds also have been in the business, and a few have been affiliated with banks.

Mezzanine Funds

The word "Mezzanine" refers to the balcony, or middle position on the liability side of the balance sheet between senior bank debt on the top floor and equity on the bottom floor. Mezzanine funding is structured as long-term debt with terms extending 5-7 years. It is very patient money, with principal amortization delayed for as long as five years. The most important feature of Mezzanine financing is that its rights are subordinated to the rights of all senior debt (and Tranche B, if any). That means that if the borrower's credit deteriorates, Mezzanine interest and principal payments could be suspended until the default is cured. All such understandings between senior and Mezzanine lenders are incorporated into a complex subordination and “standstill” agreement between the parties.

Mezzanine lenders are eager to identify new opportunities where their funding can energize the growth of operating cash flow (EBITDA).    Their loans can help borrowers to achieve business objectives that may require more capital than is available from internal operations and senior bank debt alone.  Mezzanine financing is designed to enable the full funding of a company’s growth plan, or to facilitate a strategic business acquisition, a management buyout, or as part of a recapitalization to enable shareholders to take some money “off the table” without losing control.  The interest-only feature can be especially helpful in preserving cash flow during the challenging early years of any worthwhile venture.

Collateral has minimal importance to Mezzanine lenders, but operating performance is critical. The key to attracting this form of capital is operating cash flow - that is, the demonstrated ability to generate EBITDA on a fairly consistent basis, plus having a plan to improve EBITDA further. As a general guideline, Mezzanine financing can bring total leverage – that is, senior plus subordinated debt - up to 4-5 times a company’s annual EBITDA (earnings before interest, taxes, depreciation & amortization) from the 2-1/2 to 3 times that represents a bank’s comfort zone.

Mezzanine financing should be considered only when the benefits of its uses are substantial to the borrower, since its pricing is much higher than bank debt. This is justified because of the risks inherent in being subordinated to all senior debt. Mezzanine lenders expect total annual returns in the range of the mid-teens or low 20s percent, depending upon market conditions, which they seek to achieve through one of the following structures:

  • Fixed Interest Rate: A current interest rate of 15% may be charged, for example. The cash flow impact of this high interest rate is partially offset by the fact that Mezzanine lenders may agree to long periods of deferred principal repayments.
  • PIK Interest Rate: The lender might agree to defer a portion of a higher interest rate in order to reduce the current-pay portion. For example, the rate might be increased to 18%, but 6% would be deferred in each year and accumulated in a note, or "payment in kind" (hence the term "PIK"). Therefore, the borrower would pay a fixed interest rate of 12% per year and be responsible for the deferred portion later - hopefully, once the cash flow from the successful use of proceeds has been realized.
  • Fixed Rate + Warrant: This is a structure through which the Mezzanine lender participates in a small portion of the value appreciation created by the use of his money. The fixed, current-pay interest rate might be reduced to 10-12%, for example. The Mezzanine lender also would receive a warrant, which is an option on common stock that is convertible into some non-controlling interest in the ownership of the business. Through this vehicle, the lender hopes to share in some part of the upside value to supplement his interest rate income. However, the warrant rarely is converted to common stock, unless the borrower goes public or is sold. Instead, L. R. Nathan Associates usually is able to negotiate the client’s buy-back of the warrant based on a formula of future value appreciation. The Mezzanine lender thereby achieves his target return by selling his position back to the borrower.

Mezzanine loans are provided by numerous specialized funds located around the country. These include SBICs, which are SBA-sponsored funds that will do deals in the range of about $1-5 million, as well as much larger privately-owned and publicly-traded funds that invest upwards of $100 million.

Mezzanine funds are flush with cash today and are eager to put their money out in situations that meet their lending criteria.

Equity Investors

Equity investors are far more willing to take risk than are lenders. If a company has exciting upside potential, but already is highly leveraged, or is too early stage in its development to attract debt, then Equity capital might represent the most realistic option. Investors know that they could lose everything if their bet does not pan out, so they require high potential returns on their money - in the range of 30-40% or more compounded annually once gains are realized. Equity capital usually does not have a repayment schedule like debt. Instead, the investor needs to await some event, such as the sale of the business, an initial public offering, or a recapitalization of the company, in order to recover his investment and realize a gain. It is not uncommon for Equity investors to negotiate a protective shareholder agreement which might include Board of Directors representation, rights to information, a put agreement after an agreed period of time, etc. Professional Equity investors usually have a 5-10 year investment time horizon.

It is essential that businesses seeking Equity capital first prepare a carefully constructed strategic business plan that explains in clear and persuasive terms why the proposed investment is attractive. This plan must include a thoughtful presentation of the company's special competitive advantage(s). What about the business, its products or services, is proprietary or can command a special market position? What will prevent competitors from entering the market? What kinds of returns can the investment capital expect to generate from its share of ownership? It is important to show precisely how the new capital will be used to increase the enterprise value of the business. Equally important is the track record of management in achieving its historic business objectives. Equity sources will consider financing for any legitimate business purpose, while focusing on the ability of the company to provide the desired return in a reasonable manner and time frame. Uses of Equity capital most often center upon strategies that are expansive of the business, such as growth, acquisitions or any other plan that increase the value of the enterprise.

There are several different types of Equity Investors in the marketplace actively seeking new opportunities. These range from individual "angels" to multi-billion dollar professional funds. Equity investors might be grouped into four broad categories, as follows:

Angel Investors: Individual investors are found in most communities. They consist of wealthy people or groups that typically seek to invest from $50,000 to $l million in local businesses. Some larger angel groups can be found on the Internet.

Venture Capital: Venture firms invest in early stage or developing businesses that have a proprietary (i.e., patented, copyrighted, etc.) product with the potential to revolutionize its market and make a great deal of money. Venture investor compound annual return objectives often exceed 40%. No track record of earnings is required, but these investors must be convinced that the potential gain is huge. Venture Capital that is used for product development, marketing, etc. usually is invested in stages, rather than all upfront. Venture capitalists usually take a dominant ownership position in early stage companies, but often negotiate performance based incentives for management.

Private Equity Funds: These are professionally-run funds that seek to purchase existing businesses in partnership with experienced management. The management team should have a good track record and a clear vision for how they would further increase the value of the business, given the opportunity for ownership. These management teams usually are rewarded with some level of "sweat equity" in the vicinity of 20% ownership going forward, or higher if they have capital to co-invest with the fund. The Fund puts up or raises all of the rest of the money, plus working capital, to buy and operate the business. In exchange, they will hold a majority of the ownership shares. Sometimes a successful management team can operate the business for several years and then recapitalize the company, purchase the Fund's ownership position with the proceeds, and end up in a controlling position.

Minority Equity Investors: Some Equity Investors will consider a minority (less-than-controlling) ownership position in a company with a profitable track record that needs capital to fund a strategic business plan that promises to further enhance value. In most cases, these companies already are fully leveraged with debt and therefore need the additional capital to take the form of Equity. Most often, the Equity investor will provide the money in the form of preferred stock, which will have some dividend yield and will be convertible to minority ownership interest upon the occurrence of an agreed upon event. An agreed event can include an Initial Public Offering, sale of the company, or a sale of some or all of the investor's position to a third party. Because this is a more conservative investment than start-up money, Equity Investors in this category seek returns of 30-35%.