OCTOBER 2011 NEWSLETTER

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1 OCTOBER 2011 NEWSLETTER POZZUOLO RODDEN, P.C. COUNSELORS AT LAW THE BYE-BENSON HOUSE 2033 WALNUT STREET, PHILADELPHIA, PA CREATIVE COMMERCIAL FINANCING USING MINORITY INTEREST WITH PUT AND CALL OPTIONS Before addressing this topic, Pozzuolo Rodden, P.C. are pleased to announce the following: A) PHILADELPHIA MAGAZINE FIVE STAR WEALTH MANAGER, BUSINESS PLANNING Pozzuolo Rodden, PC is pleased to announce that Joseph R. Pozzuolo was designated as a 2011 PHILADELPHIA FIVE STAR WEALTH MANAGER, BUSINESS PLANNING by Philadelphia Magazine. The award will appear in the November, 2011 edition of the magazine. Mr. Pozzuolo was selected after an independent survey was conducted by Philadelphia Magazine of 64,000 registered financial services professionals, high net worth households and subscribers of Philadelphia Magazine all of whom have an income of greater than $190,000. B) UPCOMING CLE SEMINAR WEDNESDAY OCTOBER 19 TH Joseph R. Pozzuolo, Esquire will be a speaker at a CPE seminar sponsored by the Montgomery County Society of CPA s on Wednesday October 19, 9:00 AM at the Cedarbrook Country Club, 180 Penllyn Blue Bell Pike, Blue Bell, PA Contact Diane McLeer at DMcLeer@Janney.com 1

2 C) UPCOMING SEMINAR THURSDAY OCTOBER 20 TH Employment Law in the New Technological Age Judith P. Rodden, Esquire and Lesley M. Ibanez, Esquire will be the instructors for the CLE/CPE seminar titled Employment Law in the New Technological Age on Thursday October 20, 1:00 PM to 5:00 PM at Penn State Abington Campus, 1282 Almshouse Road, Neshaminy Manor Center, Doylestown, PA Contact Theresa Bloom at (215) , or get more info and register at CREATIVE COMMERCIAL FINANCING Introduction In recent years, privately held companies have had difficulty obtaining appropriate financing for startups or expansions. Many traditional banking channels refuse to make commercial loans. Others will not lend enough or will only provide a rigid set of unacceptable terms. In today s economy an entrepreneur must shop nationally and internationally. An entrepreneur must offer creative borrowing terms, such as minority equity interests and notes convertible to equity coupled with put and call options, to entice institutions to lend money. This enables the entrepreneur to obtain greater financing at lower rates while still maintaining management and control of the business. Possible Lenders There are many possible lenders other than a local bank. Other lenders include national and international banks, insurance companies, private equity firms, private individuals, publicly traded markets, and governmental grants/small business funds. Each of these has their own characteristics and is perfect for different situations. Among the lenders, there is generally a tradeoff between flexibility and the amount of funds to be borrowed. For instance, publicly traded markets are not flexible but are sometimes the only market to raise hundreds of millions of dollars. Private equity, insurance companies, and banks are preferable for medium size loans of $50 million to $200 million, and vary in customization depending on the institution. Private lending is likely the most flexible, but may not provide the required amount. Debt vs. Equity Understanding the basic differences between and characteristics of debt and equity is important. However, the use of convertible loans coupled with put and call options blurs the line between the two. Pure debt occurs when a borrower receives funds with a fixed or variable interest rate charge per payment period (usually monthly) during the life of the loan. The borrower must repay the outstanding balance at the end of the loan term. 2

3 Pure equity, on the other hand, occurs when the borrower transfers an ownership interest to the lender or equity holder in consideration for the funds. No payments are explicitly required during the ownership, and when the business or equity interest is sold, the equity holder generally receives a percentage of the sales price dependent on his ownership interest. The key difference between the two is that debt requires continued payments with the borrower receiving all increases in value of the company above the debt payments. Equity, on the other hand, does not require continuing payments. All of the funds can be reinvested into the business; however, the equity holder has a right to a proportion of the sales price upon the sale of his interest. There is a tradeoff between the two. Due to the upside increase in value potential transferred to equity holders, debt is seen normally as a lower cost funding option. However, the transfer of equity is sometimes necessary to entice a lender to make a sizable loan. Creative Financing Terms The creative financing terms of convertible loans coupled with put and call options blend debt and equity. Such terms can entice lenders to make loans and enable the privately held business owner to acquire necessary financing. They add nontraditional features such as upside potential for lending, but the downside of transferring equity to a third party. Puts and Calls: For pure equity, the lending contract may include the transfer of a minority interest to the lender with a put and call provision. A put (call) is where one party has the right to force a counter party to buy (sell) the equity at a pre-agreed price and time. The pre-agreed price may be fixed or a formula based on sales, EBIDTA, industry/competitor multiples, or other indices. Further, the specified time may be exercisable any time up to expiration (an American Option ) or within a 30 to 90 days after a specified time or event such as receiving a new level of funding (a European Option ). The debt with a minority interest for a bank or insurance company may provide the necessary sweetener of upside potential in the event of success to secure a $50 million loan. It allows the lender to receive extra upside earnings potential above its interest, which entices the lender to lend the money. In other words, it can be used as the necessary bargaining chip to induce a lender to lend necessary funds in hard economic times. Puts and calls may be given to either party (borrower or lender), and set to expire at different periods and set with different prices. For instance, this office has been involved in different transactions where a bank will exercise its call option to purchase the entire company and where an entrepreneur has exercised his put option to sell his entire interest to the bank. The bank s call provides a sweetener to induce the bank to lend whereby the bank has the possibility of a lucrative gain above its interest return. Meanwhile the entrepreneur has the option to sell his shares if he wants to leave after five years. Many times, experienced entrepreneurs are in it to enjoy the start-up challenge and, if successful, leave after five to seven years. 3

4 Another option it to place multiple puts and calls. Under this option, a bank may purchase an interest at increasing prices over a number of years while the entrepreneur can put his equity at higher prices to compensate the entrepreneur for his added time and management. The possible schemes are nearly endless and can be customized to the desires of the contracting parties. Convertible Loans A convertible loan is similar to the situation where a bank lends through debt with a put and call option. A debt holder will have a right to convert its debt, debenture or warrant to a specified minority equity interest foregoing the principal on the debt at any time after a three, five or seven year term. The debt holder s conversion rights works to provide with the debt holder with periodic interest payments during the life of the loan, but gives the lender the option to convert its stock, warrant, or debenture to a 10% to 20% minority equity interest and receive a lucrative upside potential if the business is successful. For example, a debt holder may lend $20 million to a business and convert the debt to own 20% of equity. This debt holder will receive periodic interest payments, and if the business value is above $100 million, it will likely convert for 20% equity at the end of the loan term to receive greater than $20 million in equity by way of a put option. Adding such a convertible feature may induce a lender to demand less equity, lower the interest rate, provide other favorable terms and provide the necessary funds. Conclusion As lending has tightened up and the world has become global in recent years, one has to become more creative to obtain favorable terms. With recent internet and mobile advances, it pays to contact multiple potential lenders, nationally and internationally, to obtain the best terms. This is not the same age where an entrepreneur or lender has to accept the same old plain vanilla contract at the standard terms of the local lender. The use of minority interests and convertible loans coupled with put and call options are great ways to induce lending and the shape the transaction to provide the necessary funds and return that each party desires. Joseph R. Pozzuolo, Esquire Wednesday October 19 th 9am Please visit our web site: UPCOMING CLE and CPE SEMINARS A CPE Seminar Sponsored by the Montgomery County Society of CPAs The Cedarbrook Country Club 180 Penllyn Blue Bell Pike 4

5 Blue Bell, PA Judith P. Rodden, Esquire and Leslie M. Ibanez, Esquire Thursday October 20 th 1pm-5pm Employment Law in the New Technological Age Penn State University Cooperation Extension (Doylestown) 1282 Almshouse Road Neshaminy Manor Center Doylestown, PA Joseph R. Pozzuolo, Esquire and Jeffrey S. Pozzuolo, Esquire Wednesday December 7 th 8am-12pm The Privately Held Business Symposium for the General Practitioner and CPA Including Ethics Penn State University Cooperation Extension (Doylestown) 1282 Almshouse Road Neshaminy Manor Center Doylestown, PA Publications All of the following professional publications and past newsletters written bv attorneys of this office are available by clicking here: Articles.shtml Corporate/Tax Design Buy Sell Agreements For Maximum Utility Deferred Compensation Rewards And Retains Key Employees How To Use Non Qualified Deferred Compensation Arrangements As A Business, Retirement And Tax Planning Tool Protecting A Client's Business From Unfair Competition Using Restrictive Covenants Money Purchase Pension Plan Falls Out Of Favor Why An Employment Contract Is Mandatory 5

6 What Type of Qualified Corporate Retirement Plan Best Serves Your Business, Tax And Retirement Needs Structuring Loans From Qualified Plans How To Handle The Strict Tax Rules How An S Corporation Avoids The Double Taxation Incurred When Excessive Compensation Is Treated As A Dividend Bankruptcy How To Prevent It And How To Cope With It Should It Happen To Your Business How To Look, Act And Sound Like A Professional Corporation How Mortgage Lenders Should Draft Broker Agreements To Avoid RESPA Violations How to Structure a Suitable Buy Sell Agreement Estate Planning Estate Planning For Pet Owners The Limited Liability Company A Sophisticated Tool For Estate Planning Diversify Strategies For An Effective Estate Plan Use Wills To Maximize Family Protection And Minimize Tax Six Proven Estate Planning Techniques Divorce Raises The Need For Performing An Estate Planning Review Divorce and Estate Planning Remarriage Situations Can Raise Special Estate Planning Considerations College Funding Tool Offers Estate Planning Advantage Drafting The Durable Power Of Attorney For Wealth Protection Purposes Why Living Wills Advance Directives Are An Essential Part Of Estate Planning Special Needs Trust An Estate Planning Tool For The Disabled Adapt Estate Planning Strategies to Fit the Needs of Same Sex Couples Actual resolution of legal issues depends upon many factors, including variations of facts and state laws. This newsletter is not intended to provide legal advice on specific subjects. It is to provide insight into legal developments and issues. You should always consult with legal counsel before taking any action on matters covered in our updates. This newsletter is courtesy of Pozzuolo Rodden, P.C. To subscribe, unsubscribe, or for any questions, please contact us at INFO@POZZUOLO.COM. 6