Guide to Sources of Financing for Companies

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1 Guide to Sources of Financing for Companies By John A. Leonard Director, Fairfield and Woods, P.C. Below is a short guide to sources of financing for companies. Twenty-two sources of financing are listed, along with typical sources of financing, whether the financing is typically available to start-up companies and a typical range of interest rates applicable to the financing. While reviewing the sources, I think it is helpful to keep the following points in mind: 1. Successful companies combine various sources of financing. You don t just pick one source the goal is to match appropriate sources with particular needs. You don t incur long-term debt to purchase an asset with a short life. You combine debt and equity to maximize your rate of return to investors. 2. Successful companies focus on management. Anybody you approach for debt or equity is more interested in the company s management than the goods or services the company sells. 3. Successful companies establish important relationships early. Successful companies maintain a good relationship with a banker, lawyer, accountant, investment banker, insurance broker, and various consultants. Talk to them regularly so that they can be your eyes and ears. Talk to them about your business from time-to-time. In short, have a relationship with your important outside team members. 4. Successful companies learn to segregate their collateral. Pledging all of a company s assets for a loan restricts a company s ability to grow. Successful companies work with their lawyer, accountant, and CFO to negotiate with lenders certain carve-outs or limit security interests in collateral to certain assets. 5. Successful companies learn from past ebbs and flows in financing. When the angel/venture capital market was flourishing in the 90s and 2000s, many companies pursued those sources of financing. In other times, like the early 80s, companies raised money themselves using private placement memorandum, or sold common stock subject to puts and calls that could be exercised in two or three years. Times change and sources of funding change as well. You need to be nimble, and the check list below will help guide you through different types of financing that can be used. Page 1

2 Estimated Minimal Annual Revenue to be Eligible for a Particular Investment Type (in millions) $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 Common Stock Boot Strapping SBIR Grants Preferred Stock? JV? Factoring SBA Loan P.O. Financining Inventory Financing Sale/ Lease Back Preferred Stock Line of Credit Term Loan Mezzanine Majority Recap Minority Recap ESOP Page 2

3 A. FINANCING WITHOUT DEBT OR EQUITY Type of Financing Boot Strapping Joint Venture or Strategic Alliance Use of Financing Most start-up companies use boot strapping techniques in order to form an entity, protect their intellectual property (patents, copyrights, trademarks and trade secrets), explore market potential and identify potential customers. Source of Financing: Boot strapping techniques range from supplier and vendor financing to loans from friends and family, deferred employee compensation, customer prepayments and accounts receivable discounting. Range of interest rates: Not applicable. There are two general types of joint ventures: (i) The Off-Balance Sheet JV. For example, a large distributor employs 20 people in a marketing department to work with its resellers and coordinate marketing with manufacturers. In order to improve its balance sheet, the distributor can terminate its marketing staff and outsource the marketing department to a single purpose entity where half of the equity is owned by the distributor and half of the equity is owned by a professional marketing company. The single purpose entity is staffed by some, but not all, of the former marketing employees of the distributor. This is done when the cost of outsourcing is lower than the cost of performing the marketing function within the distributor s company. (ii) The M&A Alternative JV. When credit is more expensive, companies that were expanding through M&As form JVs to increase geographic presence or to match capabilities (i.e. a manufacturer forming a JV with a distributor in lieu of performing its own distribution or buying a distributor). Range of interest rates: Not applicable. Page 3

4 B. DEBT OR DEBT-LIKE Type of Financing Factoring Accounts Receivable Financing Inventory Financing Use of Financing Generally used for working capital by start-up companies or companies with a weak balance sheet. A factoring company purchases the company s accounts receivable at a discount. Because of the discount, the company must have a significant gross margin or low overhead costs. In a factoring situation, it is the creditworthiness of the paying customer, rather than the company, that is of most importance to the factoring company. Source of Financing: Specialized factoring companies. Range of interest rates: There can be four fees. A discount fee charged on each invoice up to 3%, an interest rate charged on the face value of an invoice ranging from 2% to 4%, a factoring fee commission, and a monthly fee. Generally used for working capital and not used to purchase real property, plant, or equipment. Typically, a borrowing base is established based upon the then-current value of a company s accounts receivables. The lender usually takes a security interest lien in the accounts receivables to ensure repayment of the loan advance. Receivables financing is usually combined with inventory financing. bank or commercial finance company. Generally used for working capital and not used to purchase real property, plant, or equipment. Typically, a borrowing base is established based upon the then-current value of a company s inventory. The lender usually takes a security interest lien in the inventory to ensure repayment of the loan advance. Inventory financing is usually combined with receivables financing. Page 4

5 bank or commercial finance company. Sale-Leaseback Generally used to provide working capital. Many established companies have real estate, plant and equipment that can be sold to specialized companies and leased back in order to create a source of capital. There are also venture leasing firms that can provide sale and leaseback arrangements with early stage companies that own appropriate assets. This can be used in lieu of bridge financing between preferred stock rounds from VCs or in lieu of venture backed equity investments. Source of Financing: Specialized finance company. Available to start-ups? Depends if company owns equipment or real estate it can sell and leaseback. Range of interest rates: Highly dependent on size of company and nature of equipment. Equipment Leasing Purchase Order Financing Companies of all sizes may choose to lease equipment to preserve capital for other uses. Many manufacturers have programs or relationships to provide leased equipment. Source of Financing: Sources could be specialized financing companies (e.g. GE Capital), specialized bank divisions, specialized manufacturer divisions. Available to start-ups? Some very specialized venture capital companies or companies that lease to venture-backed companies are active in this market. For start-ups, warrants or preferred stock are also part of the transaction. Range of interest rates: Usually expressed as a cap rate these rates are very dependent on the size of company and nature of equipment. Used to finance specific goods that have already been sold. Proceeds are used to pay third party suppliers for goods, raw materials, direct labor. Frequently used by importers and exporters of finished goods, out-sourced manufacturing, assemblers, and distributors. Page 5

6 Source of Financing: Specialized financing companies. Available to start-ups? Only those with production. Range of interest rates: Typically negotiable. Line of Credit Generally used for working capital. May be secured or unsecured by either company assets or personal assets. The specific payment schedule collateral used for security (if any) differ from case to case. Generally not used to purchase real property, plant, or equipment. Source of Financing: Generally commercial banks. Revolving Loan / Revolver Generally used for working capital. A maximum loan amount is established based upon a percentage of assets (cash, accounts receivable, inventory, etc.) owned by a company. Generally not used to purchase real property, plant, or equipment. bank or commercial finance company. Royalty Financing Term Loan Mining companies, drug companies, companies that license their intellectual property with established track records can assign all or a portion of royalties due in order to finance working capital or, depending on the amount of royalties, retire debt and repurchase equity. Source of Financing: Specialized finance companies with knowledge of specific industries. Range of interest rates: Negotiable on the size of company, type of customer base, and estimated sales. Generally used to purchase hard assets such as real estate, computers, machinery, equipment and leasehold improvements. Page 6

7 Equipment loans tend to be for shorter terms (2 to 5 years). Heavy fixed equipment, real estate and significant lease improvements can have terms from 5 to 40 years. Term loans are generally not used for working capital or for equipment with a short lifespan. In any event, the term of a term loan generally should not last longer than the lifespan of the asset purchased. Term loans are an important method to segregate collateral for a specific purpose, (e.g. long-term financing). Some assets should be used for working capital collateral. Other assets, with longer lifespans, should be used as other types of collateral. bank or commercial finance company. Senior Debt Junior Debt or Mezzanine Debt Senior Debt refers to the place in line that a secured lien holder has on a company s assets. Companies that grow without outside equity investment from Angels, VCs and private equity firms rely on Revolvers, Term Loans, Receivables and Inventory Financing. These lenders take a Senior, or first priority security, interest in that collateral to ensure repayment of the loan. bank or commercial finance company. Junior Debt is a broad term that refers to either secured debt where the lender has taken a lien subordinate to a first lien holder or it refers to debt that may be unsecured. Because of the risk, it earns a higher interest rate and can be used as working capital for a start-up or growing company. It can also be used to finance business exits. For example, middle management could purchase the stock of a founder using Senior Debt (including a term loan guaranteed by the SBA), Junior Debt, and a Promissory Note held by the founder. Source of Financing: Specialized finance companies, private equity Page 7

8 firms, venture capital and mezzanine lenders. Range of interest rates: Highly negotiable and may include preferred stock warrants or options. May also include royalty on future income. SBA Guaranteed Loan Bridge Loan Generally a term loan that is guaranteed by the Small Business Administration. Start-ups and other small companies can use an SBA guaranteed term loan to start operations, grow and facilitate an exit strategy. bank or commercial finance company. A short-term loan used by a company in anticipation of receiving additional financing or other liquidity event. For example, a company raising $2,000,000 in a private placement of Series B Preferred Stock may obtain a 3-month Bridge Loan while the preferred stock is being sold. The Bridge Loan is repaid out of the proceeds of the preferred stock sale or may be converted into the Series B Stock. Source of Financing: Specialized finance companies, private equity firms, venture capital and mezzanine lenders. Range of interest rates: Highly negotiable and may include preferred stock, warrants for options. May also include royalty on future income. C. EQUITY Type of Financing Common Stock Use of Financing The proceeds are used for and in lieu of all or some of the foregoing debt. Debt is expensive. Debt must be repaid. In contrast, Common stock is equity ownership in the company and is exchanged for cash by founders and other investors. It is not secured by any assets and may never be repaid. Every company has at least one class of Page 8

9 common stock. Many companies only have one class of common stock and no preferred stock. Recently, companies that have had difficulty obtaining a line of credit, or a company that has lost its line of credit with a commercial bank, have issued common stock to investors and have entered into simultaneous agreements to put or call the common stock within a short period of time (e.g., two years) at a pre-determined purchase price. For example, a company might issue $500,000 of common stock to investors with rights that permit the company to call the common stock and permit the investors to put the stock back to the company for a purchase price of $500,000 plus free stated interest rate (e.g., 10%). This way, the investors have a mechanism to get their investment out of the company, and the company s founders have a mechanism to buy back a portion of the company. Source of Financing: Founders and other company owners. Range of interest rates: No interest. Preferred Stock Angel / VC Financing Preferred Stock or Common Stock Raising Money on Your Own w/o a VC or Angel Preferred stock is the primary vehicle used by angel investors, VC investors and many private equity firms. Preferred stock usually has rights and privileges superior to a company s common stock. Preferred stock is convertible to common stock either voluntarily or upon the occurrence (or non-occurrence) of certain funding events. Prior to conversion, a preferred stockholder may be entitled to certain rights such as board representation, the right to vote as if a common stock holder and other rights. Proceeds from preferred stock are typically used for start-up and growing companies to fund prerevenue and early revenue operations. Preferred stock is sometimes used by early stage companies that do not desire to grow organically and do not have the financial strength to borrow from banks and other institutions. Source of Financing: Angel investors, venture capital investors, private equity investors, and mezzanine lenders. Range of coupon rates: Highly negotiable, typically 10% or less. Companies can raise equity themselves and bypass Angels/VCs/Private Equity companies. The cable industry in Denver was built this way. Projects (such as real estate development) and companies that will have long-term lifespan use this source of capital. Page 9

10 It is important to understand how the capital raised will be structured (common and/or preferred stock, shareholder s rights, liquidity events, etc). It is also vitally important to understand state and federal securities laws. Frequently the use of a private placement memorandum (PPM) is prudent in order to adequately disclose the nature of the transaction and risks. Minority Recapitalization (used as part of an exit or diversification strategy for significant shareholders) Majority Recapitalization (used as part of an exit or diversification strategy for significant shareholders) Used by established companies to create liquidity. Specialized private equity firms loan money to a company as mezzanine debt and/or purchase preferred stock. The proceeds are then used by the company directly or indirectly by other shareholders to purchase a portion of the shares held by a company s founder or significant shareholder. In this way, a founder can partially liquidate his investment as part of a planned exit and/or method to diversify his wealth. Source of Financing: Specialized private equity firms. A majority recapitalization can either be at a sale by the holders of a substantial majority of the stock (typically 60% or more) to a private equity firm. The private equity firm then either sells-off a company division by division as its exit or grows the company so that it becomes an attractive target for a strategic investor, is merged into the strategic investor and sold at a premium within three to five years. A majority recapitalization can also be accomplished by a private equity firm using mezzanine debt and/or preferred stock to inject funds into a company, which in turn, redeems a significant amount of the founder s stock or pays an extraordinary dividend to the founders. Companies that have strong management, are profitable and have strong growth opportunities may find that a majority recapitalization is a way to take the company to a higher level of growth that cannot be financed organically through sales. Thus, an established company might use a majority recapitalization to redeem the stock of angels and other early investors, partially liquidate the founder s stock and create funds for plant, equipment, R&D and other activities needed to significantly expand a company and groom it for a merger and acquisition by a strategic investor in three to five years. Source of Financing: Specialized private equity firms. Page 10

11 Employee Stock Ownership Plan (ESOP) For established small to medium-sized companies, an ESOP provides a buyer for the founder s stock. The principal benefit of ESOPs is they are very flexible and can provide a buyer of a closelyheld company where a buyer might not otherwise exist. Two drawbacks of an ESOP are that: first, the company essentially purchases the stock twice once from the founder and then from the employees as they retire or leave the company; and second, an ESOP is subject to administrative costs that many small companies cannot justify. This guide is for general informational purposes only, not legal advice. No one should act upon information contained in this guide without obtaining professional advice. No attorney-client relationship is created between you and Fairfield and Woods, P.C., as a result of your viewing this information or as a result of any or other communications you may send to us. Unless we have previously reached an agreement with you to represent you, any communication from you to us by or otherwise may not be treated as confidential or privileged. John Leonard heads up the corporate practice group at Fairfield and Woods, P.C. He specializes in the legal aspects of financing, running and selling businesses. He can be reached at or Page 11

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