Equity vs. Debt … There is a difference

 

Over the past year, Revitalization Partners has been asked by several our clients to assist them in raising additional debt for their companies.

In most of these cases they have either outgrown their current debt facilities or the company has hit a roadblock and needs funds for restructuring.

In any case, the current lender has declined to lend additional funds.

 

Borrow or Dilute Equity?
As some of these companies are owned by or have large investments from private equity funds and these funds have often added to their original investment through bridge loans or additional equity, they would like to see the company borrow the additional money needed.

In other cases, the board of directors prefers debt to equity as they do not want to see their equity positions in the company diluted.

 

A Failure To Understand …

What equity holders often fail to understand is how differently they see the company and its prospects from that of a banker.

Equity holders invested in a company to benefit from that company’s long-term growth.

They believe in the future of the company and even in the case of a downturn or hiccup, they believe that they can make the changes that will, in the end, bring a benefit that will increase the value of their investment.

 

Same Situation … Seen Differently

Lenders view a company very differently.

Their return consists of getting their money back along with the agreed upon interest payment.

Unlike investors, they only look at the historical performance of the company to determine if, based on that history, the company will be able to pay back the loan in the future.

No matter how well the company does in the future or how much the value of the equity becomes, unlike equity investors, a lender is only entitled to repayment of principal and interest.

 

When Something Goes Wrong …

In many cases, the company may have a senior secured lender already in place.

A senior secured lender has a lien on the assets of the company; in most cases it is receivables and inventory.

In some, it is equipment and real estate.

But should something go wrong and the company is unable to make the agreed-on loan payments, the senior lender can seize the collateral and sell it to recoup its loan.

 

Dependent On Cash Flow …

In other cases, the company needs funds in addition to those supported by the assets or collateral.

This is where we hear the term subordinated or mezzanine debt.

These are lenders that will loan a company money that is only secured by any assets of the company beyond those that the senior lender might have to sell to recoup its loan.

In many cases, there are not assets to cover the loan, so the lender is totally dependent on the cash flow of the company that is above its operating expenses and existing debt.

These loans are more expensive than secured debt and the due diligence of the lender is greater.

 

Upside vs. Risk …

The problem often arises when the investor believes it has dealt with the problems of the company and now needs to borrow the money to execute the company’s plan.

The company puts together a plan, the investor believes in that plan, but the execution of the plan hasn’t happened yet.

The lender looks at the performance of the company, the amount of secured debt the company has and the historical and current cash flow.

The investor sees the upside, the lender sees the risk.

The investor wants to have the lender view the future the way that it does, while the lender would like the investor to see the risk that it sees.

 

Do You Speak “Bankanese?

What is needed here is the ability to speak, as the title of a webinar we did a few months ago, “Bankanese”.

The role of the third party such as Revitalization Partners is to make sure that investors and the company are understanding the lender’s issues and that the prospective lender understands why the investor believes in the future as strongly as it does.

 

Are We A Good Match?

Matching lenders, companies and investors is also critical.

Lenders, especially Mezzanine or subordinated lenders often have industries that they understand better than others.

Some have both lower and upper limits as to the amount of a single loan.

It does no good to focus on a presentation to a lender whose interest starts at 5 million dollars, if you can only support a two-million-dollar loan.

 

Successful Relationships Matter!

The exception to the above is where the party approaching the lender has relationship with the lender and has brought them successful loans.

Like any other part of business, successful relationships count.

Whether you’re an investor looking for a loan or a lender looking at a loan, being willing to listen to and understand the other parties thinking is critical to success.

And speaking “Bankanese” doesn’t hurt.

 

 

Revitalization Partners is a Northwest business advisory and restructuring management firm with a demonstrated track record of achieving the best possible outcomes for our clients. And now, we’ve written a book to help our readers understand the issues facing their businesses. You can find this compilation of our business thoughts at:
https://revitalizationpartners.com/we-could-write-a-book/ or on Amazon.

We specialize in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations.

Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

What Does It Mean For Your Business If You Panic?

 

rp-panicA Number of years ago, a group of us were on a sailboat trip in Southern California.  The weather had been good and we had spent the weekend at Catalina Island. 

On the way home, across 26 miles of open ocean, a dense fog had come in.  All of the boats in our small group had sufficient navigation equipment to find our way in the fog, so, with no wind; we were just motoring our way home.

imagesSuddenly, out of the fog came a small boat with two adults and two children. They hailed us with a panicked cry: “What is the way to Marina Del Rey?”    

We took a compass bearing and gave them a course. They thanked us and disappeared into the fog.   A few minutes later we heard them asking another boat in our group the same question.  And then another.   Finally, we could no longer hear them.

And that’s what panic sounds like.

We recently became involved …

We recently became involved with a company that has been in the construction business since the 1950’s as a large subcontractor.  A family business that has been successful doing large commercial projects, they recently experienced a number of setbacks: Several of their bids were significantly underbid and they were unable to make sufficient margin.

1In one case, their crew misread the job instructions and they had to undo a large amount of work that had been performed.

And due to a more than doubling the size of the company in one year, they installed a new computer system that screwed up their job costing and accounting.

And while all of this was happening, their bank line of credit was far too small to support the growth of the company.

So They Financed By Using …

So they financed the company the way that they knew how; out of payables.  And as payables to subcontractors became stretched, they added federal and state payroll taxes to the list of things that didn’t get paid in a timely manner.

Finally, as construction liens threatened the large commercial projects, the general contractors began pay with joint checks, insuring that anyone who might lien a project was paid in a timely manner, but significantly reducing the company’s ability to control and manage their cash flow. IRS

At the same time, both the state and IRS were escalating collection efforts, reaching the point of seizure notices from both entities.

This, the result of a payment plan they had negotiated on their own, but due to not understanding their cash flow, had been unable to meet.

They Asked Everyone They Knew …

imagesHow did the company react while all of this was happening?   They asked everyone they knew: What should we do

And since they asked people with vastly different frames of reference, they received vastly different answers.

An accounting firm told them that they could get them an SBA loan. This for a company where debt exceeded assets by over $1 million. 

After some time went by, the accounting firm told them they couldn’t help them.  Someone else told them that they really needed a tax lawyer.  But they felt they couldn’t afford one, even though the officers of the company are personally liable for trust taxes and cannot discharge this liability, even in bankruptcy.  

You Should Be Able To …

And finally, another “friend” who the CEO of the company considers a mentor, told them that they really didn’t need help, they should be able to handle this themselves.

Eventually, a group that they approached for a loan told them that they could not get a loan without a detailed financial plan and referred them to Revitalization Partners.   After six weeks of delay, they retained RP to help them get a loan. 

With Accurate Financial Information …

After a quick review of their current financial situation, we told them that getting a loan that would be sufficient to pay off past liabilities would not be possible, due to the level of current cash flow, level of debt, and the potential IRS and state actions.   However, we did believe that given the now accurate financial information we might be able to negotiate a workout plan.

Clearly this company was not prepared for the growth they experienced.  And because of a lack of preparation for both increased management and financial needs, as the business got larger, the problems got larger as well.  The problems got larger and so did the panic about what was happening.

Green-Action-Plan-2010-1After a lot of internal discussion and talking with one of their largest customers, the company has decided to work with RP to develop and execute a plan that will provide for both current operations and begin working down the past debt. 

While nothing is certain, a positive definable action should provide reassurance to customers, creditors and taxing authorities that the company is serious about meeting its obligations and continuing its business as well as demonstrating viable management practices.

And that’s a lot better than panic.