" Yeah, but I don’t want to give up equity "
One of the most common statements from business owners is that they need capital (working capital, acquisitions, business growth, etc.) but they don’t want to give up equity or upside in their business. Although in some instances that isn’t possible, in a lot of circumstances there are alternatives for business owners to obtain capital without giving away equity (otherwise known as “non-dilutive” capital). Let’s review the various ways that can be accomplished:
First Lien Financing
Traditional Bank Financing - Most business executives and owners are familiar with traditional banking options. Examples might include lines of credit, equipment loans, or commercial real estate loans. Traditional banks evaluate/underwrite underlying collateral value, cash flow produced by the business (often referred to as EBITDA), and guarantor financial strength. Because banks are regulated, they all have to play by similar rules (advance rates on collateral, amortization of loans, etc.); however, the most important rule is that not all banks are created equal. Some banks care more about the financial strength of the guarantor. Some banks care more about the type of assets they are lending against. Others care more about how much cash flow will be generated relative to the debt. Some banks may have a concentration in an industry and because of that cannot do additional lending in that sector. Others may have had a loan go bad in that sector recently and their credit committee is unlikely to approve another deal in that sector. Some banks may be heavy on loans and need deposits, so they aren’t as aggressive on rates, fees and terms for loans. The best thing a business owner can do when considering bank financing is to talk to a few different lending institutions to make sure and uncover the best options available for their business.
Asset-Based Lending – Asset-based lenders (“ABLs”) are a form of first lien financing that allow for higher advance rates on underlying collateral (typically accounts receivable and inventory) and typically require less covenants than traditional lenders. There are far fewer ABLs in Oklahoma compared to traditional banks, but many ABLs from surrounding states are coming to the state to help fill that void. For inventory heavy businesses, ABLs provide a compelling alternative to traditional banks because they typically offer more competitive pricing and higher advance rates.
Factoring - Factoring occurs when a business sells invoices or a portion of accounts receivable to a factoring company. The selling company receives 80-90% of the value of the invoice immediately. Once the invoice is collected, the selling company receives the remainder less a fee paid to the factoring company. This fee (1-3% for every 30 days outstanding) is more expensive than a traditional line of credit; however, factoring allows businesses that may not be able to fit in traditional banking risk parameters in order to access growth capital for their businesses.
Subordinated debt is either an unsecured loan or a secured loan subordinate to a senior lender. Because subordinated debt lenders hold a riskier collateral position than traditional lenders, subordinated debt lenders have to charge a higher interest rate to offset the risk.
Subordinated debt is usually structured as an interest only loan with a balloon payment at maturity. The balloon payment is usually paid by refinancing out the subordinated debt lender with senior debt or another subordinated debt lender once the business either has more equity in its assets or a longer track record of financial performance. The maturity is often 2-3 years but terms can vary depending on a various factors.
There are hundreds, if not thousands, of subordinated debt lenders across the country and they all structure their offerings differently. Some will lend for 7-10% interest but will require a filed second lien behind the secured first lien holder. Others will charge 10-15% or more for a fully unsecured loan. Many will not require equity or warrants in a business while others will require that to be part of the transaction. Although the interest rate on subordinated debt may seem high, it is typically significantly cheaper than giving up equity to an investor.
A good example of a use for subordinated debt might be for a business with significant recurring monthly income like a pest control business, alarm business, software as a service business or similar where there are fewer hard assets for traditional lenders to lend against, leaving a gap in the capital need.
Unitranche debt is the type of debt provided when a lender comes in and provides both first lien financing and subordinated debt. This allows a lender to potentially collateralize all of its loan and lower the overall cost of capital to the business. For example, instead of a business owner needing a traditional lender at 4-6% interest on a $10MM term loan and 12% on a $5MM loan with a subordinated debt lender, the business may be able to obtain a $15MM loan from a unitranche lender for a blended 7%, which means the business will pay less overall.
Unitranche lenders are also occasionally willing to provide equity and take a more dynamic role in the business if desired by the business owners.
In a sale leaseback transaction, a company sells an asset (commonly real estate or equipment) to a third party in exchange for cash (typically fair market value or some discount to FMV). This is typically used to generate immediate cash for a business and have an off-balance sheet lease (often without a personal guarantee). The lease acts similar to a loan, but at the end of the lease term the business no longer owns the asset and must enter into a new lease or find an alternative piece of equipment or real estate for the business.
Although there are a myriad of options for business owners, and a daunting task to evaluate all of them, the task can be simplified with the right professional assisting you. If your business is in need of capital, and giving up equity is a concern, consider engaging an investment banker to help you think through your options to select the best non-dilutive capital providers who will provide the best possible solution for your business.
About Infinity Capital Partners
Infinity Capital Partners offers a full-suite of investment banking services for lower middle-market businesses, typically working with companies that have between $2 million to $50 million in EBITDA. Headquartered in Oklahoma City, the company has established a reputation working with businesses and institutional capital providers to expand operations, transition ownership or recapitalize the business. For more information about Infinity Capital Partners please visit InfinityCapPartners.com.