Inquiring minds might wonder what happens in a loan guarantee deal at the end of the loan. After all, in our hypothetical example, the underlying $1 million loan was payable at the end of 12 months. To go from a standing start to $1 million in after-tax, liquid, unencumbered, unneeded profits is a mighty, if near impossible, feat for most companies.
"The object of the deal is not to pay off the loan, per se," says Lipper. More accurately, the company would, at the end of the loan period, be in a position to pay off the loan with either another loan that it was able to negotiate without a guarantee or with an equity investment from another investor. (It would cost you less equity at the end of the loan period than it would have initially.) Presumably, says Lipper, with the growth the company demonstrated and the potential it holds, one of these two alternatives becomes viable.
Looked at this way, a loan guarantee is for companies that can make a go of it with interim financing as opposed to permanent financing. It's also for companies that have high profit margins. For instance, if a company's operating margin is 10 percent, and the investor's share of the revenues is 5 percent, there's not much left over. In fact, the remaining interest expense might convert a slim profit into a loss. "These kinds of financings tend to work best for technology companies where there is some form of intellectual property that gives them a protected profit margin," Lipper says.
In addition, loan guarantee financing tends to work best in situations where the price of the company's product or service is elastic--that is, where the price can be increased to cover the cost of the financing without driving off customers. For instance, a retail store could not do this, but a database management company probably could.
Finally, loan guarantees should be contemplated only by entrepreneurs whose companies can generate predictable sales and earnings. "The nightmare for the company occurs when it makes the revenue projection but doesn't hit the earnings projection," says Lipper. "Then it's left with very high financing costs and little or no profit."
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