Loan guarantees don't come cheaply. In fact, when you add it all up, it can be darned expensive financing. Here, Lipper details some of the costs the entrepreneur would be expected to pay in such a transaction:
- Guarantee fee. Remember, in addition to depositing funds into the bank, the investor had to pay his or her bank a fee to get it to issue the letter of credit. "The way the investor would tend to think," says Lipper, "is `It's the entrepreneur's loan that is getting guaranteed, not mine,' therefore he or she should pay the fees."
- Investor fee. Next, Lipper says he typically collects a fee of 5 percent of the guaranteed amount for putting the deal together. For our hypothetical $1 million deal, that's another $50,000.
- Bank interest. For deals such as this, banks typically charge the prime rate plus 1 percent (known as a premium), says Lipper. "It's outrageous for them to charge a premium," he says, "since there is absolutely no risk to the bank whatsoever." Moreover, he says, to avoid any possibility of default, the bank issuing the letter of credit will probably stipulate that the interest on the loan be taken out of the proceeds upfront.
It's important to note that the effect of all these fees coming off the top of the loan ratchets up the interest rate the company pays for the loan. In our example, the guarantee fee is, say, $20,000, Lipper's 5 percent fee is another $50,000, and the bank's interest upfront of perhaps 8 percent is another $80,000, for a whopping total of $150,000.
Looked at differently, the entrepreneur is really paying $150,000 for the use of $850,000 ($1 million loan proceeds minus $150,000 fees and interest). The true rate of interest is then 17.6 percent.
But it doesn't stop there. The pièce de résistance comes in the form of a "carried interest" in the company paid to the investor. Lipper says the carried interest is either a percentage of the company's revenues going forward or a hunk of the company's equity, perhaps 3 percent to 5 percent.
This equity, by the way, can often be structured as warrants, which are options to purchase equity at a specified price for a specified period of time. "For the company, the advantage of warrants," says Lipper, "is that it doesn't surrender any equity immediately, and when the warrants are exercised, the company gets an additional infusion of capital."