Sources of Credit

7/31/2019 Sources of Credit

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RAISING CAPITALA Survey of Non-Bank Sources of Capital

by Dave Vance, MBA, CPA, JD

Rutgers University School of Business

Camden


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What is Capital?

Capital is how assets are financed

Assets = Liabilities + Owners Equity

Assets are all the toys we have to build a businessLiabilities are other peoples money used in the business

Owners Equity is our money in the businessCapital can be either debt or equity

(We will call ALL suppliers of capital investors, even banks)


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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.


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Raising Capital

There are many non-bank sources of capitalThis 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- Tie borrowers up with loan covenants/gotcha clauses

- Are not always responsive. Even to say No!

Without

Notice!


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Control Your Destiny

If you want to take control of your destiny, you should activelyseek non-bank sources of financing.

1. Banks review their credit commitments annually, and monitorthem monthly, searching for covenant violations, vigilant fora reason to cut off credit.

2. Having an alternative will give you much more leverage withyour bank.

3. Having an alternative will give you a fall back position when

your bank lets you down, delays or tries to overreach.4. Many companies simply dont fit the narrow historical profile

that banks require.


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Risk / Reward / Size / Time

To close a deal for capital:

- The entrepreneurs or companys risk / reward / size / timeprofile must match that of the capital source

- The capital sources risk tolerance and reward demand profilemust 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 sourceswillingness to be patient.


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Risk / Reward / Size / Time Space

REWARD TIME

SIZE

Entrepreneur / Smaller Companies

Financial Condition / Larger Companies

RISK

Stage of Development


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Stage of Development- Start-up: Concept company, no sales

- Early Stage: Some capital, a product, but the product has notbeen commercialized, no sales

- Expansion: Shipping product, generating revenue, but not

enough to expand, or for steady profits- Later Stage: Company is shipping product and generating

enough profit to grow

- Mature: The company is large and profitable and islooking for the best sources of capital

- Decline: A once healthy company finds itself in troubleand in need of capital


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Time to Exit

Funding sources have expectations about when theywill 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 investornever 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 thesources exit expectations.


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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, youve got use a source

that is willing to handle your size deal economically.


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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 $5 million to $50 million

Medium Businesses $50 million to $500 millionLarge Businesses $500 million and over.


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Entrepreneurial/Start-up $0 to $5 million

Bank loans require some kind of financial tract record. Theproblem is getting that track record without capital. The

Entrepreneurs best sources are:

---Typical Deal Size---

- Personal Savings $1,000s to $100,000- Credit Cards $1,000s to $100,000

- Home Equity Loans $10,000 to $200,000

- Vendors & Suppliers based on credit purchases

- Customers based on customer advances- Leases $1,000s to $100,000

- Friends & Family $1,000s to $100,000


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Small Businesses: $5 to $50 million

For a company with a low risk profile bank loans are probably theleast 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.


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Medium Businesses $50 to $500 million

Non-bank sources of capital include:---- Typical Deal Size -----

-Asset Based Lenders $1 million to $50 million

-Tranche B Lenders $1 million to $50 million

-Bridge Loans $1 million to $50 million-PIPES $5 million to $50 million

-Venture Capital $5 million to $100 million

-Mezzanine Financing $10 million to $150 million

-Initial Public Offering (IPO) $50 million to $1 billion-Junk Bonds $100 million to $1 billion


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Large Businesses $500 million and over

Non-bank sources of financing:

-----Typical Deal Size-----

- Securitization $40 million to a few billion

- Commercial Paper $50 million to a few billion

- IPO $100 million to a few billion

- Syndicated Bank Loans $150 million to a few billion

- Bonds (Investment Grade) $200 million to a few billion


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Federal & State Regulation

- Raising Capital is one of the most regulated aspects of business

- Federal Regulation is primarily through the Securities Act of1933 & the Securities Exchange Act of 1934

- Only registered securities can be sold, unless there is a statutoryexception

- Every state regulates securities.

- Unless there is there is federal pre-emption, a company mustcomply with both state and federal securities regulation.

- Raising capital from banks, commercial credit companies,factors and large institutions generally isnt regulated.


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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 highgrowth companies


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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


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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 dont require personal guarantees

Interest costs are generally higher than for bank loans.


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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 wont


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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 dont 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


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Small Public Offering v. Traditional IPO

Small Public Offering Traditional IPO

Typical Amount: $1M to $20 M $100 M to $Bs

Cost: $40 to $500 K ~ 5% to 7%

Stock Sold To: Public Institutional Investors

Exempt from State Not usually Usually

Regulation

Most suited to: Company with Any profitableretail brand name company

Audited Financials? 2 years or less 3 years


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Small Public Offering v. Private Placement

Small Public Offering Private Placement

Advertise? Yes w/disclosure No

Who can invest? Anyone Accredited investors& limited # of others

Stock Resalable? Yes No. Resale restricted

Liquidity? Fair Little liquidity

Can be listed Yes No.


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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 goodbrand name

There are companies & brokers who will help you sell


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Small Public Offering Advantages

- Less dependence on banks, who tie firms up with restrictivecovenants; change lending rules; and re-evaluate risk annually.

- Less dependent on private equity investors who demand highreturns which translates into a substantial portion of a firms

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 wont work unless acompany is growing and profitable.


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What About Companies In Trouble?

Not every company is sweetness and light.

Some are in such serious trouble they can forget banksand some are in so much trouble that

Commercial lenders wont go near them.

So whats a company to do?


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Four Options for Troubled Companies

Asset Based Lenders

Debtor in Possession Super Priority Loan

Securitization and

Private Investment in Public Entities (PIPES)


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Debtor in Possession Super Priority Loan

When a company files for Chapter 11 bankruptcy (reorganization),

that doesnt 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 super-

priority over other unsecured creditors.

There are companies that specialize in such super-priority loans.


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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.


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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 itsassets, 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 savingsback to the company that originated the assets by paying close

to face value for them.


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Private Investment in Public Entities(PIPES)

A PIPE only works for a listed, publicly traded company withstock price above about $3 per share.

PIPE investors make private equity investments in publicly tradedcompanies. Such investments dont have to be registered with

the SEC, and paperwork is minimal.

The PIPE investor negotiates a conversion feature to thecompanys publicly traded stock at less than market rates.

The stock resulting from the conversion is then registered and thePIPE investor exits their investment by selling the stock theyacquired at less than market price at market price. Thedifference becomes their fee.


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There are more things in heaven and earth

than are dreamt of in your philosophies.~ Hamlet, Act I, scene i

What weve 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

companys risk, reward, size and time to exit.


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Thats All Folks!

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Sources of Credit