John Lie-Nielsen, 28, is on the fast track. The San
Francisco-area company he and a partner started in 1999, Allied
Cash Advance, is growing right out of its britches. Happily, when
it came time to buy bigger britches, Lie-Nielsen knew right where
he could find the deep pockets he needed.
Lie-Nielsen has been luckier than most--he's nailed down
three rounds of angel capital that helped him open the first retail
locations for his short-term consumer-loan business. In three
years, the company has grown to more than 35 stores while doubling
revenues each year. But the business is consumer-driven, and Allied
Cash Advance growth is fueled predominantly by opening new
locations.
With its angel capital spent, the company needed to secure more
long-term financing if it wanted to continue its rapid rollout. As
the economy slowed in early 2002, however, angels and VCs were
growing reluctant to write checks--and Lie-Nielsen was equally
reluctant to sell stock at valuations that might not reflect the
company's significant prospects for growth.
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The answer? Subordinated debt. Sometimes called mezzanine
financing, or just sub debt, a subordinated loan is unsecured (not
backed by collateral), and therefore the claims of the lender in
such a loan are second in line--subordinate--to claims from banks
and other secured (asset-based) lenders.
Do the Math
"Of course, subordinated debt carries a higher interest
rate than a bank loan or other asset-based loan," explains
Barry Morganstern, a managing director at the Los Angeles-based
corporate finance advisory firm Glick Morganstern Capital Group.
"Typically, the rate is between 10 percent and 14 percent for
a five-year note."
It may seem like subordinated lenders are asking a high price,
but Lie-Nielsen, who previously worked as an investment banker,
quickly points out: "Fourteen percent interest is much cheaper
in the long run than the dilution or loss of control that would
come from another round of pure equity investment. Our current
shareholders could lose share value through dilution if we took in
another investor in these turbulent market times."
To evaluate different finance options you have to be able to
figure out the true cost of capital, often a tricky calculation.
There is no rule of thumb that works in all situations. It's
important to remember, however, that selling stock can work against
you if the cost (in terms of share of the company) is greater than
the growth you'll realize by investing that money.
Cash, Not Collateral
The key to subordinated debt financing is cash flow. Sub debt is
not secured by collateral like the typical loan you might get from
a bank. Much like a credit card company, a subordinated debt lender
is willing to take on the extra risk of an unsecured loan in
exchange for a higher return on its money. "Most sub debt
lenders are looking for a total of 25 percent to 30 percent
internal rate of return," explains Morganstern.
The difference between the 14 percent interest you pay and the
25 percent return that sub debt lenders hope to realize is made up
with stock warrants. Warrants give the holder the right to purchase
shares of stock in your company at a pre-determined price.
Essentially, owners of company stock warrants hold some of the
value of your company without actually becoming shareholders.
CapitalSouth Partners, a sub debt lender in the Southeast,
regularly lends companies from $2 million to $10 million for growth
and restructuring. Their typical borrower has greater than $10
million in revenue and between $1 million and $10 million in EBITDA
(earnings before interest, taxes, depreciation and amortization).
Joe Alala, president and CEO of CapitalSouth Partners, says the
company charges between 12 and 14 percent for the loan, and
receives "warrant coverage" equal to 10 to 20 percent of
the company's outstanding stock. (Alala warns, however, that
for companies with less than $1 million in EBITDA, warrant coverage
can be much more expensive.)
In some cases, the lender will convert those warrants into
marketable stock--and cash--if the company is sold or goes public.
Because few companies ever go public, however, CapitalSouth and
other sub debt lenders regularly sign a "put option" with
the company. This put option gives the lender the right to sell the
warrants back to the company at a future value. The sell-back price
is based on company valuation, which can be set as a multiple of
earnings or by a third-party appraisal.
One to Grow On
Subordinated debt is considered a long-term liability, and
therefore should be used for long-term projects. Sub debt can be
used to finance a variety of intangible growth-related expenses,
including marketing, IT projects, product development, R&D or,
as in the case of Allied Cash Advance, lease and build-out expenses
for new store locations. Subordinated debt is not generally
intended to cover short-term needs like payroll or inventory.
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"Half the borrowers use the money for growth, and half are
going through either an ownership change or restructuring,"
Alala estimates. Sub debt is often ideal for purchasing a company
or for rolling two companies together. Because cash is often tight
in these situations, CapitalSouth commonly structures loans with
interest-only payments.
Where to Find It
Despite--or perhaps due to--the decline in venture capital
investing lately, there are a growing number of financiers making
subordinated loans. As with most financial instruments, you can
find a lender through finance intermediaries--usually called
corporate finance advisors, like Glick Morganstern--or forge the
relationships yourself.
If you enlist an advisor or broker to help you work a deal, you
can be pretty sure they'll give you a clear understanding of
your options for both secured (traditional) and subordinated debt
instruments. Advisors can also assist you in putting together a
detailed presentation for your deal and shop it around directly to
the decision-makers at several sub debt lenders.
On the other hand, sub debt lenders are becoming more numerous
and easier to find. Many banks and credit unions have associations
with sub debt lenders. As Alala of CapitalSouth Partners puts it,
"Although it helps to be introduced by someone I know, anyone
can call me or send me a note from our Web page." Alala
estimates that he sees around 15 sub debt deals a week, only a
small fraction of which come through his network of agents and
acquaintances.
Putting It to Use
Back at Allied Cash Advance, John Lie-Nielsen has perfectly
matched his growth plans to the funding sources. The company
received a line of working capital from a traditional lender that
finances accounts receivable. Then a regional sub debt lender
stepped in to help with the money needed to open new
storefronts.
The stockholders in Allied Cash Advance couldn't be happier:
The subordinated debt lender has provided enough capital to
maintain strong growth for several more years and has taken only a
small piece of the equity to do it. The income from new storefronts
more than pays debt service on the loan, and the existing
shareholders were not penalized in the process.
| What's What |
A good
corporate finance advisor can help you evaluate various funding
sources. Choosing secured debt, subordinated debt or equity capital
depends on your willingness to give up ownership, the cost of the
capital and how you plan to use the money.- Secured
debt works if you have significant accounts receivable
or inventory that you can put up as collateral. The cost of the
loan is simply the interest rate, which may be only a few points
above the prime rate--usually 6 to 8 percent. If your business can
support it, this is almost always a good source of working capital,
but is not well-suited for investing in long-term
growth.
- Subordinated
debt is paid back solely from cash flow. The cost is the
interest rate plus the equity you'll give up in the form of
warrants. The interest rate can be from 10 to 14 percent, and the
warrants may be for as much as 20 percent of your company. Because
the loan is not backed by collateral, it's a good source of
growth funds.
- Equity
financing is simply selling stock. Although there is no
interest rate, the cost of capital can be significant. Weigh
carefully both the dilution your existing investors will experience
and the potential for loss of control of the company. Equity
capital can be used for whatever your business needs, but keep in
mind that you will only make all your stockholders happy by putting
the money to its highest purpose--strong growth! -D.W.
|
David Worrell is a
strategy and finance specialist in Charlotte, North
Carolina.
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Originally published in the September 2002 issue of Entrepreneur Magazine