Debt Versus Equity
In the world of commercial finance there are only two types of funds available, debt or equity. Equity financing involves investors who invest money into a company and in return get some percentage ownership of the company. The exact amount of ownership would typically be a function of how much they are investing versus how much the company is worth at the time of investment.
Debt financing, on the other hand, involves a lender who loans money to a company and receives a predetermined interest rate paid by the borrower as well as having the principal (the original amount of the loan) paid back over time.
Investors don’t lend money and lenders don’t invest money. Investors invest and lenders lend.
We are primarily involved with debt financing even though occasionally we may be able to help with equity or some form of a hybrid facility involving guarantees that include a combination of debt and equity.
With straight equity requests we do work with a group that has a particular interest in investing in companies that have some form of patented technology.
With straight debt financing there are essentially two categories, secured and unsecured.
Secured financing involves loans being made against specific collateral of the borrowing company. The four major categories of collateral are accounts receivable (monies due from the borrowers commercial customers for services already rendered or goods already sold and delivered against which the advance is generally around 80% of non-disputed less than 90 day old accounts), inventory (lenders typically advance 50% against either the cost of raw and finished goods inventory, excluding work in process or 50% against the liquidation value of same), equipment (most secured lenders will advance anywhere from 50 to 80% against the liquidation value of marketable machinery and equipment), and real estate (most secured lenders will advance anywhere from 50% to 80% against the current value of commercial real estate depending on varying factors).
When a secured loan is made the lender will ‘perfect’ their interest in the collateral by filing a UCC-1 lien through the Secretary of State in the state in which the borrowers collateral is located. This Uniform Commercial Code legal filing enables the lender to have to enjoy specific rights against the collateral and the borrower in the event of default on the loan. If the collateral to be borrowed against already has liens against it the new lender may be able to lend more (a higher advance rate than the previous lender) and pay off the existing lien and substitute their own UCC-1 lien. Only one lender can be in first position with all the rights that infers. Occasionally on certain types of collateral a lender will make a loan as a junior lender (taking a second position behind the Senior Secured lender who holds the first lien position). This is sometimes referred to as a mezzanine position or sub debt (subordinate to the senior or first lien holder. When this occurs the junior or mezzanine will always get a higher interest rate (often double the cost of senior debt) because obviously there is more risk. In the event of default on the loan when the collateral is liquidated the senior lender is paid first and then the junior or sub debt lender is paid. If the collateral value comes up short, the junior lender may not get all of the principal and thus, the higher cost to the borrower associated with the higher risk.
Besides the lenders concern over collateral, which is paramount in any secured loan, next comes their concern over the borrower’s ability to cover the monthly payments. Most conventional lenders will require the borrower to demonstrate through an examination of historical performance the ability to cover the debt service on a new loan. It is not enough to show forward ability but rather the borrower must demonstrate historical performance. There are a couple of exceptions to this rule but even there the lender will have a higher interest rate because of the possible risk that the borrowers projections will not actually work out.
The other type of debt is unsecured also known as junior debt or sub debt, mezzanine debt or subordinated debt.
As earlier discussed this type of debt could be a second position behind the first lien holder but more often is totally unsecured and based on some multiple of historical net income or EBIDTA (earnings before interest expense, depreciation, income taxes and amortization). For example if a company has net income (the amount of money made after all expenses and taxes are paid) of $2,000,000 then they might qualify for an $8,000,000 cash flow loan which would be 4 times net income. To qualify for a cash flow or mezzanine loan the borrower must have at least review quality financial statements. There are three types of accountant prepared financial statements 1] compiled which are the least desirable from a lenders standpoint as they are simply a compilation of the numbers given to the accountant by the borrower, 2] reviewed where the accountant performs certain tests to verify the accuracy of the numbers presented and 3] audited statements where full due diligence is performed verifying the accuracy of the statements.
A financial statement is comprised of two parts, the balance sheet and the income statement also known as a profit and loss statement or P&L statement. The balance sheet lists the company’s assets and liabilities, as of a certain date and shows whether the company has a positive or negative net worth (the difference between asset value and offsetting liabilities). A company can have a positive net worth, meaning if the assets where to be liquidated and the liabilities paid off there would be money left over and still have what is known a a liquidity problem. That is to say the company is not liquid (has money problems) because their current assets (cash and accounts receivable for example) are less than there current liabilities (current bank debt and accounts payable as example).
The income and expense statement demonstrates whether the company has made or lost money over a period of time up to a certain date. If the expenses are more than the income, there is a loss or vice a versa. Sometimes a company that has a loss can still qualify for a loan if we look at the amount of payments being made for example under interest expense and substitute a less expensive lender who will thus reduce that interest expense. We always must therefore carefully examine the P&L statement to determine the borrowers ability to cover debt service on a new loan.
In summary we are involved in securing loans otherwise known as debt financing and of the two types of debt we are most often involved with secured loans using the collateral of troubled or developmental stage companies. When asked whether we can make a particular type of loan for a particular type of company the subject always needs to be directed back to the basics of collateral and cash flow. Simply put the borrower either has collateral to secure the loan (again assets already pledged as collateral can in many cases be refinanced to provide a larger amount of financing) or if not historical cash flow or net income performance over a period of at least two years to qualify for a cash flow loan.
In some instances we may be able to provide an unsecured loan based on the principals or a co guarantors personal credit score. This mechanism can work but only if the borrowing company is in business a minimum of one year.
We can also provide purchase order financing for certain companies which involves providing money through a purchase order finance company specifically earmarked to pay for labor or material costs associated with a specific purchase order. A purchase order is an order from a customer for goods or services. Let’s say a company has an order from Walmart for 10,000 dresses but does not have the money to pay for the labor and material to fill the order. The purchase order finance company will provide the needed funds subject to a review of the request and due diligence performed on the borrowing entity.