Financing a Business Playbook

As a business owner, the many considerations and choices that come with financing your company can seem daunting. However when we take a step back and look at the overall picture, funding a business becomes much simpler.

There are two primary ways to finance a company: raising debt and raising equity. In this playbook we’ll present an overview these two general categories, walk you through the primary components of your capital structure, and your primary financing options.

Part I: Understanding Debt Financing

Every company has some form of debt whether it’s a credit card, a bank loan or a mortgage on a piece of property. The question isn’t whether or not you should use debt, but rather which bets you’re willing to make when you’re raising this debt.

Benefits

Debt can be extremely helpful in allowing you to grow without giving away any ownership. By taking a bank loan to finance your business, you’ll pay more upfront in order to grow with much stricter conditions, but once the debt is paid off you’ll own all of the larger and more valuable business. In addition, loans are a great way to finance business improvements. By purchasing a large piece of equipment with a loan, you can get use the increased productivity to pay down the loan faster. If you can generate revenue at a faster rate, or even a nearly even rate as the interest on the loan, then the investment can end up paying for itself.

Revolving debt, like a credit card, can also be used as a great way to smooth out your working capital. If you have large swings in your accounts receivables, with contracts coming seasonally or in lumps, loans between seasons can help you cover payroll and daily expenses until the next accounts receivables are paid.

Risks

While debt does allow you to keep ownership of your company, that’s only true if the business stays afloat. Debts have to be paid back eventually and many banks require strong covenants in order to loan you money in the first place. They’ll often have access to your full financials and will be able to mandate that you do different things in your business or be in breach of contract on the loan. If your growth doesn’t match the expectations you had when you got the loan, the bank doesn’t really care. They have no ownership in your business and are thinking only of the least risky way to get a return on their capital.

In the same vein of your business being viewed as a risk rather than a growth opportunity, banks tend to look only at the risk profile of your company. The riskier you appear to be, the less likely they are to give you money. The old joke is always that banks want to give you money when you have plenty of it and won’t give you a loan when you actually need it.

Best Fit

Most companies find debt the best solution to help buy certain types of large assets, to smooth working capital and to grow faster than they could organically when the risks of failure are low. Debt is also used to make acquisitions, especially in layers. Often businesses will get part of the debt they need from a bank, part from an asset based lender, and another part from a mezzanine lender (more below).

• Balancing Debt and Equity in a Growing Business

• Two Alternative Loans to Bridge the Gap

• Why Small Businesses Aren’t Getting Loans

Part II: Understanding Private Equity Financing

While private equity has come into the spotlight for being associated with Mitt Romney in recent years, the concept is actually a lot larger than simple ‘private equity groups.’ The concept of private equity is any equity owned by anyone privately. Most often the reference means someone who is purchasing the equity of a private company in a private transaction, which is anything from friends and family investing in your business to a venture capitalist funding a startup or a private equity group buying a large company.

Benefits

If you fund your business growth with private equity, you don’t pay back the investment over time like you would with debt. Instead, you’ve exchanged a percentage of ownership in your company for the capital invested. And, since the investor is now a significant owner, they’ll want to be involved in the running of the business or at least be an advisor as you continue to run it. From a regulation perspective, as compared with public equity, since the transaction happens between private parties there are significantly less regulations and a lot less public disclosure.

Private equity, primarily in the form of venture capital, is a great way to fund early stage and pre-revenues businesses with great potential, high risks of failure and large capital needs. Because the investors are expecting high growth and potential failure, and are working with you as an advisor, the conditions can help you invest much faster than possible otherwise. This can actually allow you to build a business that would otherwise not be possible or get to the points of scale required to be profitable. Many startups also use equity, usually in the form of options, as a way to help recruit amazing people to work at the company. While companies are small or less profitable, augmenting pay with ownership in the business can help bridge the gap between your offer and other job offers.

Risks

While you never have to pay back the money that investors give you to grow the business, they keep the equity you gave up in exchange. Often this is a great deal in an early stage business, if you give up 20% equity for 10x or 100x growth, but if you don’t hit growth targets to get to profitability fast enough you can end up giving away most of your business to investors. Also, provisions in the contracts negotiated to exchange the equity often give investors ‘preference’ in the winding down or sale of a business – meaning they’ll get 1x or 2x their investment before anyone else gets any of the proceeds.

Best Fit

Equity investments are used all the time in different stages of businesses. Some companies start with partners who have different ownership shares in the business, other companies raise money from friends and family. Private equity also enters the equation often in helping more mature businesses grow by buying a stake in the business – as small as 10% and as much as 100% – before advising and adding other resources.

Part III: Understanding Public Equity Financing

The idea of becoming a public company became pretty well understood after the IPO bubble in the late 90s, but since then the markets have cooled down a bit. Large companies are still going public and it’s still a great way to create liquidity for your business, but only a few hundred companies a year go public each year leaving the odds of public equity as a long-shot for most businesses.

Benefits

Going public can allow your business to raise significant amounts of money to use in growing your business and can raise the profile of your business. By selling shares on the open market, your valuation becomes less opaque and acquiring other companies with your stock can be much easier. Also, allowing your shares to be traded publicly also creates liquidity for all of your shareholders, including employees with small option or equity stakes. Since private companies are inherently hard to value, it’s extremely tricky for early employees to sell very small stakes in your business prior to your company being listed on a public exchange.

Risks

One major risk of being a public company, especially when you’re still small, is that it opens you up to significant oversight. Not only is there a fair amount of extra paperwork and laws (Sarbanes-Oxley for example), the act of writing 10-Ks and quarterly reports can give information not only to your investors but to savvy competitors as well. As a public company, it’s also very easy to get caught trying to make analysts happy by chasing this quarter’s earnings targets, whether or not that is actually the best use of your company’s resources.

Best Fit

While some companies IPO when they are very small, the average company going public has a multi-hundred million dollar or billion dollar valuation and high growth rates.

Part IV: Understanding the Capital Structure

A company’s capital structure is arguably one of its most important choices.

From a technical perspective, the capital structure is defined as the careful balance between equity and debt that a business uses to finance its assets, day-to-day operations, and future growth.

From a tactical perspective however, it influences everything from the firm’s risk profile, how easy it is to get funding, how expensive that funding is, the return its investors and lenders expect, and its degree of insulation from both microeconomic business decisions and macroeconomic downturns.

By design, the capital structure reflects all of the firm’s equity and debt obligations. It shows each type of obligation as a slice of the stack. This stack is ranked by increasing risk, increasing cost, and decreasing priority in a liquidation event (e.g., bankruptcy).

For large corporations, it typically consists of senior debt, subordinated debt, hybrid securities, preferred equity, and common equity. See exhibit A.

Any company’s capital structure serves several key purposes. First and foremost, it’s effectively an overview of all the claims that different players have on the business. The debt owners hold these claims in the form of a lump sum of cash owed to them (i.e., the principal) and accompanying interest payments. The equity owners hold these claims in the form of access to a certain percentage of that firm’s future profit.Secondly, it is heavily analyzed when determining how risky it is to invest in a business, and therefore, how expensive the financing should be. Specifically, capital providers look at the proportional weighting of different types of financing used to fund that company’s operations.

For example, a higher percentage of debt in the capital structure means increased fixed obligations. More fixed obligations result in less operating buffer and greater risk. And greater risk means higher financing costs to compensate lenders for that risk (e.g., 14% interest rate vs 11% interest rate).

Consequently, all else equal, getting additional funding for a business with a debt-heavy capital structure is more expensive than getting that same funding for a business with an equity-heavy capital structure.

Part V: Components of the Capital Structure

Senior Debt: A class of loans with priority on the repayment list if a company goes bankrupt. Holders of this form of financing have first dibs on a company’s assets. This means that in a liquidation event, lenders holding subordinated notes are not paid out until senior creditors are paid in full. Because of the minimal risk that accompanies this block of the capital structure, senior lenders loan money at lower rates (i.e., lower interest payments and less restrictive debt covenants) relative to more junior tiers.

Subordinated Debt: A class of loans that ranks below senior debt with regard to claims on assets. For this reason, this block of the capital structure is more risky than senior borrowings. However it also comes with commensurately higher returns, usually in the form of higher interest payments. For more, see our piece on drivers behind the rebounding popularity of subordinated debt.

Mezzanine Debt: A class of subordinated debt that blends equity and debt features. It therefore receives liquidation after senior capital and is generally used when traditional funding is insufficient or unavailable. Correspondingly, mezzanine firms lend at higher interest rates than traditional debt providers, and usually reserve the right to trade some of their debt for equity. Though mezzanine financing exhibits both equity- and debt-like characteristics, it’s usually classified as a category within subordinated debt. For more details, see our overview of mezzanine debt.

Hybrid Financing: A class of the capital structure in publicly-traded companies that also blends equity and debt features. By definition, hybrid securities are bought and sold through brokers on an exchange. Hybrid financing can come with fixed or floating returns, and can pay interest or dividends.

Convertible Debt: A class of hybrid financing. Convertible bonds are the most common type of hybrid financing, and usually take the form of a bonds that can be converted to equity. The conversion can only happen at certain points in the firm’s life, the equity amount is usually predetermined, and the act of converting is almost always up to the discretion of the debt holder.

Convertible Equity: A class of hybrid financing. Convertible equity usually takes the form of convertible preferred shares, which is preferred equity that can be converted to common equity. Like convertible debt, convertible preferred shares convert into common shares at a predetermined fixed rate, and the decision to convert is typically at the owner’s discretion. Importantly, the value of a firm’s convertible preferred shares is usually dependent on the market performance of its common shares.

Preferred Equity: A class of financing representing ownership interest in a company. As opposed to fixed income assets (e.g., debt), equity is a variable return asset. However, preferred equity has both debt and equity characteristics in the form of fixed dividends (debt) and future earnings potential (equity). Correspondingly, it gives the holder upside and downside exposure. Its claims on the company’s assets and profits come behind those of debt holders and ahead those of common stock holders. Generally, preferred equity obligates management to pay its holders a predetermined dividend before paying dividends to common shareholders. On the flipside, preferred equity typically comes without voting rights.

Common Equity: Also a class of financing representing ownership interest. Common equity is the junior-most block of the capital structure and therefore represents ownership in an business after all other obligations have been paid off. For this reason, it comes with the highest risk and the highest potential returns of any tier in the capital structure.

• A Tutorial on Mezzanine Finance for Entrepreneurs

• Mezzanine Debt 101

• Six Keys to Writing Great Investment Teasers

Part VI: Selecting an Advisor

Choosing a qualified, experienced investment banker with relevant transaction experience to represent your company might be the most important decision you make to ensure a successful outcome. If you choose poorly, the downside is serious, as even well-meaning bankers can derail a deal with bad advice, poor judgment, or a misrepresentation of their skill-sets, the quality of their relationships, negotiating prowess, or overall transaction experience.

This article is the beginning of a running checklist we’re developing to help business owners go through the process of successfully identifying and selecting the right firm to represent their company. In this post, we specifically cover 6 key initial questions business owners / CEOs should ask when choosing an advisor, red flags they should watch out for, as well as the general answers they should be looking for.

As a business owner, the decision to sell is one of the most important events for your company and for you personally. Identifying several firms and then choosing the right one can be difficult and confusing, and you need to get it right given the downside of a failed sale.

You need to be confident that your advisor is going to be providing good guidance on how to present your financing, whom to market it to, how to proceed with any negotiations, how to manage exclusive solicitations, etc.

To make things more complicated, any advisors you evaluate will be providing you statistics, fancy presentations, impressive backgrounds, and success stories designed to make them look like the best advisor for you. Sifting through all this information can be overwhelming. Here are the top 6 questions to ask an advisor before hiring them to sell your company and what to look for in their answers.

Industry: What Comparable Financing Transactions Have You Completed in the Past 4 to 5 Years?

Look for completed transactions in your industry. When we say “industry”, we mean as close to your “specific niche” as possible. An advisor who has done deals in “manufacturing” is not necessarily good enough–they should have experience doing deals specifically in your industry niche. Retaining an advisor who has recently completed transactions in your industry helps ensure that they have fresh industry contacts and more importantly, deeper insight into who is actively making acquisitions. They will also be familiar with industry terminology and dynamics which is valuable in preparing marketing materials. Additionally, aggressively use Google to verify all the information advisors provide by searching for press releases of transactions the advisors claim they have completed.

Size: What Size Financings Have You Completed in My Industry?

Size is critical. An advisor who has raised funding for two $600M companies isn’t right for you if your company is one-tenth the size and is hoping to find a majority private equity partner instead of 100% sale to a strategic. Size is also important because it indicates who specifically from the advisory firm will be working day to day with your organization. Again, if the firm more often does $1 billion deals, and you run a company one-tenth the size, you’re likely not going to get the attention that you need from the senior professionals.

Broken Deals: On Your Engaged Financing Assignments in the Past 3 Years, How Many Did Not Close and Why?

This might be the most important question of all, particularly when your company is small to mid-sized. Have the advisor walk you through (on a no-names basis if they insist) the recent transactions they have taken on that were not consummated. This is critical due diligence. Ask to speak with several of the business owners they have worked with. When you connect with the business owner, ask how hard the Advisor worked, how long they stayed focused, and who were the individuals that really completed the work. If an advisor does not provide you several referrals, it’s a red flag and you should run for the hills.

Investor Research: What Is Your Process for Developing a Comprehensive Investor List?

With multi-billion dollar deals, the list of potential investors is usually a very short list. For example, when Gillette decided to put itself up for sale, there were only a few investors that make sense to approach (Procter & Gamble, Colgate Palmolive and several international multi-billion dollar personal products corporations).

Unfortunately, it’s not that simple when you’re a small or mid-sized private company. The reality is that there are many potential investors and there is no chance that even the best advisory firms have every “relationship” needed to best ensure that the deal is closed properly. This means that the right advisor will have a process for researching, identifying and contacting additional investors. When selecting your investment banker, ask each one that you interview about the nitty-gritty details of their investor research and outreach process. They should have a very good answer for you, and it should include internet research, database research, contacting several specific industry experts they know, etc. Their research should culminate with a finished document that shows all the potential investors that they intend to approach initially on your behalf.

Tip: When an advisor mentions a great relationship they have with XYZ company, and claims that XYZ Company is a high-potential investor, always ask the follow-up question: “who do you know at XYZ firm?”.

Valuation: What Range of Valuations Is Reasonable to Expect? Why?

After years of work building a company, it’s important to know your business is being fairly valued. This is relevant mainly to an equity raise and much less of a factor in debt financing transactions.

The advisor should have a good feel for current market conditions and thus be able to provide guidance on their valuation expectations. Qualified advisors know that the price of any business is dictated by its future strategic value to the investors who are interested in the business. This means that an advisor can not give you total certainty until you actually go down the road and have final bidding bids from investors.

In fairness to advisors, it is important to go into a financing process with reasonable expectations about your company’s value. Remember that market conditions can weigh heavily on the outcome. If you purchased a home in 2001 and sold it in 2006, you likely made a handsome profit. If you purchased a home in 2005 and had to sell it in 2009, you likely lost money. Exogenous market conditions have important effects on price, no matter how good or bad your business is.

TIP: Compare the valuation expectations you hear from the different advisors you choose to interview. If there is significant variation among the advisors, drill down on their respective valuation estimates so you can understand what is specifically driving the differences. This might really help indicate which firms know what they’re doing.

Process: Please explain who from your team will be doing what for my company?

A typical sale process takes 6 to 9 months and qualified advisors will have reasonably similar stages: Business Review; Preparation of Marketing Materials; Launch; Due Diligence/Initial Offers; Meetings; Negotiations; and Closing. A key question to ask is: Who will be actually contacting the potential capital providers? Is it going to be the senior member of the Advisory team who has developed an understanding of your business, or is it going to be a junior person on their team working on multiple deals?

Depending on the size of your potential investor universe, it is reasonable for the advisor to enlist the help of junior people at their firm to call on lower-probability investors, but the answer you’re looking for is that the senior banker will be handling as much of the outreach as possible to key investors.

Your Takeaway:

A sale process is going to have ups-and-downs and there are going to be challenges. Capital providers are going to ask difficult questions, potentially disagree with your views of the market, and challenge your assumptions. Carefully researching and choosing an experienced advisor who can anticipate these challenges and proactively address issues will help put you in a better position as you begin meeting with and negotiating with potential investors. In addition, the best advisors are those that not only have experience, but also have demonstrated the ability to adapt to changing market conditions and apply refined techniques for the unique nuances of your sale process.

In the end, the right advisor must have unique a combination of transaction skills, relevant industry experience, trustworthiness, and commitment to your success. If you focus on the above questions, you have a better chance of choosing the right advisor to sell your company.

If you are a business owner that has gone through a sale process or an advisor that has represented business owners, we would appreciate your thoughts, comments, and/or stories below.

• Ten Questions to Ask When Choosing an Investment Banker (Part I of II)

• Ten Questions to Ask When Choosing an Investment Banker (Part II of II)

• Twelve Questions to Ask When Hiring an M&A Lawyer

Part VII: Other Types of Financing

Initial Public Offering (“IPO”): A private company’s first sale of equity ownership to the public. An enterprise traditionally ‘goes public’ in an effort to raise more capital for accelerated growth. IPOs are significant for a multitude of reasons, the most important probably being that it substantively broadens the shareholder base and brings meaningfully higher liquidity to the company’s securities. See our opinion piece on directional trends in the IPO market for more.

Recapitalization: The reorganization of a company’s capital structure to build a more sustainable business model or to return cash to a single shareholder. In a recapitalization, the company relevers and uses the proceeds from the new debt to pay large dividends to the equity holders. Recapitalization processes, or recaps, typically occur when the owner wants to partially monetize its investment and either (a) wants to retain potential upside gains in the company or (b) cannot hit the required company valuation as a consequence of unfavorable market conditions.

Growth Equity: A special type of equity financing. It is almost always issued in the earlier stages of a company’s life cycle. Growth equity is predominantly issued for the purposes of funding development and primary growth of a business.

Supply Chain Finance: A set of tools, techniques and products for financing different segments of a company’s supply chain. This category of financing is often used when a manufacturer offers financing to suppliers is requesting more favorable payment terms in order improve its working capital management. See our article on driving profit through supply chain finance for more.

• Supply Chain Financing

• Driving Profit through Supply Chain Finance

• Energy Efficiency Financing: When Being Green Improves Earnings