Receivership News, Winter/Spring 2016 Issue 57

Business Capital takes a deeper look at the relationship between risk and
cost of capital, and the delicate equilibrium in
creating the optimal loan structure.

Equity or Debt?
Although the actual failure rate of the average small business
is unknown, business consultants generally consider 33% a close
approximation and, based on Small Business Administration
statistics, this failure rate goes up to 66% for companies younger
than 2 years old. With these kinds of statistics, it is more than
likely a business will face liquidity constraints at some point–
even if this is due to the flipside of success, hyper-growth or
scaling the business.

So is it better to seek equity or a non-dilutive debt-based
capital option? Obviously, that answer depends on the specifics.
Each individual situation and option carry varying types of risk
for the business owner.

Equity Investors
Generally speaking, opting to give up a stake in the business
– to a private equity investor, venture capitalist, angel investor,
friends, family or fools – is not for the faint of heart. Like most
marriages, the beginning is fantastic and like most divorces, the
breaking-up can be painful. Investors are taking a big risk and
want to be compensated accordingly. Seeking equity investors
requires having a well-written business plan, solid financial
projections and, in the modern era, even a checkable digital
footprint – along with a lot of confidence to convince investors
to give you their money. In return, they will expect a piece of
your pie and/or returns in excess of 20%, in most cases much
higher. Debt providers will also expect repayment at an agreed
future point in time that could either be opportune for all parties
or possibly detrimental to both the borrower and lender.
Doesn’t scare you? Consider that, according to Harvard
research (Shikhar Ghosh, WSJ 2012), 75% of venture-backed
firms in the U.S. have never provided returns to investors and,
in fact, 40% end up in liquidation leaving their investors with
nothing. If the business does succeed, be prepared to give up not
only cash flow, but also varying degrees of decision making and
control, and live within the limits of the equity or loan
agreement.

Debt Providers
Unlike equity investors, debt providers securitize their risk up
front and lend money to companies at rates that are
commensurate with the perceived risk of the specific situation
and transaction. It is important to note that all debt providers
fully intend to get their capital back and may go to extreme
measures to do so including loan documentation that provides
for the appointment of a receiver. Money has to be paid back
within a designated amount of time and with interest. A nondilutive
approach to accessing capital requires a greater focus on
cash flow and payments due, regardless of success or failure. Debt
providers look for an established model, revenue stream,
sustainable cash flow, and tangible assets and collateral (i.e. real
estate, equipment, AR, etc…) as a collective basis for offering a
loan.

On the upside, with a debt provider, it won’t be necessary to
share company profits, give away ownership percentage, or deal
with someone who wants to make different strategic decisions on
the direction of the company. Be it equity or debt, receivers are
tasked with preserving the value for all stakeholders involved as
well as the court.

Non-Dilutive Capital Options
Let’s take a look at the primary kinds of debt providers to
Small and Mid-Size Businesses (“SMB’s”). We will list these in
order of most to least risk averse, which directly correlates to
lowest to highest cost of capital.

1. Banks typically offer the lowest cost of capital, but are
also the most conservative, lending primarily to the
most creditworthy businesses. Traditionally, banks view
small business as the riskiest, based on their historical
rates of failure mentioned earlier. Banks are also limited
by regulation, so cannot be as flexible or creative in
providing financing solutions as they must protect their
depositors from unnecessary credit risk.

2. Finance Companies and /or Asset based lenders are
typically formula based senior debt providers and lend
on a percentage of collateral value, i.e. A/R, inventory,
machinery & equipment, real estate, trademarks,
intellectual property and even goodwill. Unlike banks,
they are not controlled by federal regulation, but are
credit constrained mainly by customer leverage. They
offer a higher cost of capital and assume the risk of asset
prices softening – which is likely to happen during the
next recession.

Risk in this type of financing is mitigated with the
(most often) first position securitization of collateral
and assets which can – and will – be liquidated to
recoup any financial losses in the event of a business
failure or loan default.
3. Mezzanine / Sub-Debt Lenders provide capital in a
subordinate – and therefore more risky – position to the
senior debt mentioned above. This sub-debt is,
however, senior to equity in its liquidation preference
(in bankruptcy). It is a credit product that sits between
equity and senior debt on the capital stack. In case of
“fire,” equity gets burned first and that is why credit
providers will look to see a sufficient amount that can
be torched before it reaches debt in that capital stack.
That risk is proportional to reward; upside potential is
most substantial for investors. Sub-debt lenders
demand a higher return for their capital commensurate
with their 2nd position lien rights and often totally
unsecured status. They focus on providing capital for
profitable companies and seldom, if ever, provide junior
capital for distressed businesses.

The benefits of the second and third financing types
listed above are in the structure. Because alternative
lenders usually are not bound by federal regulations and
government oversight, financing solutions can be “outof-
the-box,” or more creative, to meet the needs and
challenges of each borrower. The drawback vs. more
traditional institutional lenders, such as the first option
above, is in the cost of capital. Usually – though not
always – the money will be more expensive. Again, the
cost is related to the actual risk to the lender in each
situation.

4. Merchant Cash Advance Lenders are nonbank lenders
that thrive on subprime candidates. As these types of
borrowers usually have a poor credit history and
nowhere else to turn, the risk to the lender is most high
and therefore so is the cost of capital – sometimes in
excess of 50%. These lenders advance cash quickly in
return for a share of future sales, extracted from the
borrower’s credit card receipts or ACH, a digital
transfer of funds directly out of the borrower’s bank
account, on a daily, weekly or monthly basis. It is one of
most expensive forms of financing and only for those
with no other options.

In the recent boom of the digital age, another
“alternative to alternative” lender type has cropped up,
the Technology Based or Online Alternative Lender.
Online platforms have led to rapid escalation of new
entrants into small business lending. While this may
give greater options to businesses that won’t qualify for
a traditional bank or institutional loan – or perhaps
even a “traditional alternative” loan, this path requires
more diligence in researching potential lenders,
reputations and products. These lenders provide an
efficient on-line platform to a variety of lenders but,
one should remain mindful, that these lenders are
diligent and disciplined providers of credit.

It is critical that business owners fully vet and
understand the implications of these last two types of
financing. While there are legitimate, reputable lenders
in this group, some are just sharks out to take advantage
of desperate business owners. They will charge a fee just
to “qualify” for a loan and to have access to their
lenders. Also, most of these types of last-ditch options
come with unreasonable interest rates and terms.
All of this can be confusing to troubled business
owners. There are benefits to hiring a financial advisor
instead of tackling the process alone.

With so much at stake and so many possibilities to
weed through, it is often helpful to engage an objective
third party financial advisor to run the process. This
can help to ensure an informed, competitive process;
due diligence upfront to produce more, better and
vetted offers. This enables clients to negotiate from a
position of strength and results in the best structure and
optimal cost of capital for each particular business
situation.

Stabilizing Actual vs. Perceived Risk
There is no doubt of the relationship between risk and cost of
capital. It is a balancing act for lenders and borrowers alike.
How that risk is calculated, verified and plugged into the
equation is a critical piece in determining the final structure and
cost of a credit facility. On both sides of the deal, teams of credit
experts, accountants and lawyers pore over the financial and
business data on a very granular level; valuation teams assess and
verify assets. New technology tools give access to almost realtime
data flow, concurrently compressing and expanding the
due diligence cycle, making this evaluation process faster and
more accurate. The outcome still comes down to risk – both
actual and perceived.

So what’s the difference?
Actual data does not always tell the whole story. Perhaps a
business has a valid reason behind the challenges that produced a
not-so-clean balance sheet or, erratic sales and profits due to a
one-time weather, economic or management disruption, or an
unusual capital expenditure, for example. Hard data doesn’t give
the opportunity for explanation. Based on hard data alone, a bump
in the financial road can be viewed as a complete veer off course
by potential lenders and result in either outright rejection, or
overly painful loan terms. Actual hard data cannot be changed;
the perception of that data can be.
A good financial advisor will certainly collect and examine all
of the hard credit and collateral data, but will also gain a greater
level of detail and understanding for the story in each situation.
Most rapidly growing or distressed business owners cannot present
a squeaky clean P&L history and balance sheet. Many of them
have legitimate reasons for their financial plight. An advisor seeks
to get an understanding of each particular client’s situation. In
cases where there is an explanation, value, and a clear path to
profitability, an advisor can package this information together
with the financial data to present a complete picture to lenders
why the actual risk is much less than the perceived risk. This type
of presentation can produce a positive effect.

Win-win and win for Borrowers, Lenders and
the Future
When the entire picture is packaged, the result for the borrower
is an increase in the likelihood of accessing capital as well as
financing options. The cost and terms of capital are more favorable.
A financial advisor’s vetting and underwriting upfront mitigates the
risk to the lender on the back end by addressing the 5-C’s of
commercial lending. There are the quantifiable predictors of actual
risk – Capital, Collateral, Credit; and the more intangibles –
Character and Capacity. The latter two relate to perceived risk and
evaluating the likelihood the borrower will feel a moral obligation
to repay the loan and not take undue risk. A well-scrutinized
process maximizes the borrower’s chances of predictably qualifying
for a loan, future business success and the lender getting repaid. A
fully vetted client and financial strategy reduces the probability of
courts and receivers dealing with undervalued assets, false
securitization or litigation issues in the event of a business failure.

Finding Equilibrium in Financing
Every business needs a solid financial foundation of both equity
and debt capital to support a sound strategy. Business conditions
are fluid and can rapidly change, necessitating an alteration in the
capital structure to finance new funding requirements. The result
can be a shift in the overall cost of capital based on overall risks to
the business. Successful proprietors recognize the need to
constantly adapt to new business conditions and maintain
financial equilibrium to maximize growth in revenues and
earnings. Securing the best and most balanced capital structure is
critical to successfully compete in the marketplace.

It Takes a Team
At the end of the day, futures are won and lost taking risk. A
critical element to success is eliminating as much of that risk as
possible. In the case of a capital raise, it’s wise to get the best
possible advice. This is a process that doesn’t happen often in the
life of a business and can take anywhere from 30 days to over a year.
If, in that time, company executives are taking their eye off the ball
by talking and negotiating with lenders, they are not running the
business or focused on revenue generating activities. A team of
outside experts can augment the staff, juggle all of the moving
pieces to drive the best cost of capital, create the optimal loan
structure and customize a total solution that meets specific business
objectives.

Whatever the outcome, for every
business, a mitigated financial risk and a
well-balanced capital structure maximizes
and preserves value for all stakeholders.