RAISING CAPITAL A Survey of NonBank Sources of Capital

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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
  business
• ? Liabilities are other peoples money used in
  the business
• Owners Equity is our money in the business
• Capital 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 RD, product
  development, plant start-up marketing campaigns
  until they generate cash.

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Raising Capital

• There are many non-bank sources of capital
• This 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 actively seek non-bank sources of
  financing.
• Banks review their credit commitments annually,
  and monitor them monthly, searching for covenant
  violations, vigilant for a reason to cut off
  credit.
• Having an alternative will give you much more
  leverage with your bank.
• Having an alternative will give you a fall back
  position when your bank lets you down, delays or
  tries to overreach.
• 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 / time profile must match that of the
  capital source
• - The capital sources risk tolerance and
  reward demand profile must 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 sources willingness 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 not
• been 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 is
• looking for the best
  sources of capital
• - Decline A once healthy company finds
  itself in trouble
• and in need of capital

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Time to Exit

• Funding sources have expectations about when they
  will 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
  investor never 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 the
  sources 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 million
• Large 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. The problem 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 the least 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 of 1933 the Securities Exchange
  Act of 1934
• Only registered securities can be sold, unless
  there is a statutory exception
• Every state regulates securities.
• Unless there is there is federal pre-emption, a
  company must comply 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
  high growth 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 profitable
• retail 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 good
• brand 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
  restrictive covenants change lending rules and
  re-evaluate risk annually.
• Less dependent on private equity investors who
  demand high returns 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 a
  company 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
  banks and 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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Asset Based Lenders

• Lend against the value of a companys assets.
• Unlike banks, they dont
• - care about profitability or cash flow.
• - tie a company up with restrictive covenants,
  and
• - require personal guarantees.
• They do care about
• the quality of assets
• Maintaining the assets in good and marketable
  condition

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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 its assets,
  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 savings back 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 with stock price above about 3 per
  share.
• PIPE investors make private equity investments in
  publicly traded companies. Such investments
  dont have to be registered with the SEC, and
  paperwork is minimal.
• The PIPE investor negotiates a conversion feature
  to the companys publicly traded stock at less
  than market rates.
• The stock resulting from the conversion is then
  registered and the PIPE investor exits their
  investment by selling the stock they acquired at
  less than market price at market price. The
  difference 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!