When Joe Assell's company, GolfTEC, was ready to tee up for its next level
of market penetration, he was looking for a tailor-made financing
solution to fuel its growth. Poised to secure GolfTEC's
position in the $62 billion golf industry, Assell needed a
million-dollar influx of cash to expand his market-leading,
high-tech, golf instruction business—he wanted to double the
number of company-owned stores and expand the company's
franchise operation.
"This investment was critical for us as we entered a new
phase of the business," said Assell, president of the
Greenwood Village, Colorado, company. "GolfTEC is a
high-growth company and a market leader. We needed an investment
structure that worked for us and our shareholders."
That investment structure ended up being in the form of
subordinated debt, a solution that allowed Assell and GolfTEC to
rapidly increase the company's growth.
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For Barvista Homes, a leading off-site residential
construction company in Johnstown, Colorado, equity financing was a
perfect fit for their financial needs. Specializing in new home
construction, Barvista offers customers a choice of more than 50
different home designs that are constructed off site and then
transported to the home site for final assembly. The company
received a $2 million first round of funding from private and
institutional investors and plans to use it to expand its customer
base beyond its current seven-state reach.
"In our first year of business, Barvista reached more than
$9 million in sales," said Mick Barker, the company's CEO.
"In our second year, we're targeting to increase that
amount by 50 percent. This investment will help us continue to
capitalize on the high growth we're experiencing."
Finding a source of capital to finance company growth can be a
major challenge, particularly for small and midsized businesses in
such sectors as recreation and residential construction.
Sadly, a great business is often only as good as its financing,
and without the right kind, you may just end up flapping around
like a turkey before ever getting the chance to soar like an eagle.
If your business is literally hanging by the slender, golden thread
of cash flow, it's crucial for savvy business owners to develop
a broad understanding of the different financing options available
to them. But sorting out the options to find the right financing
fit can be difficult.
Equity financing, the capital source that most often comes to
mind first for many business owners, is a good option for those who
have a compelling enough business to attract investors. The catch
with equity financing is that it can dilute the ownership of the
company for the shareholders, potentially resulting in a loss of
control.
Equity financing is generally recommended for a business
that's experiencing very high growth with high investment risk.
For example, an early-stage, high-growth company with limited
revenues and prospects for negative operating income for the next
few years would find this to be a good option.
GolfTEC's Assell used a lesser-known option, subordinated
debt, which enables business owners to retain more ownership of
their company while still receiving the capital they need.
Subordinated debt financing is recommended for businesses that are
in a high-growth sector with established revenues and are on a path
toward positive operating income within a year. One example of this
would be a retail company whose owners need capital to increase the
number of company-owned stores, yet who don't wish to give up
significant ownership in the company.
Subordinated debt enables a business owner to raise capital by
relying on the company's potential income combined with the
strength of the specific industry and its assets, rather than
having lenders look solely at a company's tangible assets.
Subordinated debt offers business owners access to capital they may
be unable to obtain from a bank due to a lack of tangible assets to
offer as collateral. This type of debt may also be more flexible
than conventional loans, where a lower risk-threshold often exists,
especially for young businesses.
Sub-debt, as subordinated debt's often referred to, is debt
that ranks behind the main debt, known as senior debt, in priority
of payment. Senior debt principal and interest—usually in the
form of a bank loan—is paid off first while the subordinated
debt principal and interest is paid off second.
This type of financing is not only a creative, flexible way to
raise capital, but it may also improve a company's equity
position. This is because bankers may consider it part of the
"equity cushion" that supports the senior bank debt. For
example, a project with 70 percent bank debt, 10 percent
subordinated debt and 20 percent equity, could be viewed by the
senior lender as a project having roughly 70 percent bank debt and
30 percent equity.
Other major advantages of this type of financing include putting
dollars back on a company's bottom line because interest
payments are tax-deductible, which lowers the company's taxable
income. Finally, using sub-debt financing can lower the cost of
capital for the firm.
With a clear idea of what to expect from subordinated debt as a
financing option, what type of lender would an interested business
owner look to? Typically, subordinated debt funds are the source
for this type of financing. These lenders want to work with
companies that have experienced management, strong industry growth
potential and financial strength. They may also rely strongly on
the existing or prospective cash flow of the business.
There are pros and cons with both equity and sub-debt financing.
We've already identified the loss of ownership as a major
drawback to the equity option. The primary drawbacks of sub-debt
financing include the fact that (1) interest and principal payments
are contractual and must be met regardless of the firm's
financial position; (2) the loan may place restrictions on the
company and its management; and (3) the use of debt may reduce the
value of the equity.
When considering sub-debt versus equity financing, the following
information should help you compare the two options:
Equity
- There's a distinct loss of ownership.
- It's the most expensive financing option with the highest
cost of capital.
- The capital stays in the business for the long term; dividends
are taxable.
- The valuation of the company is a huge issue in landing the
capital.
- Investors will want a say in how the business is run and may
elect to take seat(s) on the board of directors.
Sub-Debt
- There's relatively less loss of ownership through
warrants.
- It's a less-expensive financing option: it costs more than
senior bank debt but less than equity.
- The loan must be repaid and includes interest charges, but the
interest is tax deductible.
- The company needs to provide security on the loan, perhaps even
personal guarantees.
- It's unlikely there'll be management advisors, but
financial disciplines and controls may be imposed by the
lender.
If you're seriously considering sub-debt financing, ask
yourself the following questions to determine if it's the right
choice for you and your business:
1. Does your business have some type of asset(s) that can be
financed, such as invoices, accounts receivable, contracts or
compelling intellectual property/patents?
2. Is your company's current cash flow or prospects for cash
flow strong?
3. Is your earnings history strong (that is, is your company
profitable)?
4. Is your company a high-growth company?
5. Do you have solid books, records and financial controls?
6. Is your company free from any current performance
obligations?
7. Is there modeling and forecasting already in place?
8. Are you willing to be a financial guarantor for the loan?
9. Are you willing to possibly have financial covenants and
reporting disciplines imposed by a lender?
10. Do you need relatively short-term capital—between one
to four years—for various company initiatives such as
acquisitions or growth financing?
If you answered "yes" to the majority of the above
questions, then sub-debt financing may be the right choice for you
and your company. If not, it may be in your best interests to
investigate equity financing.
As the managing director for Enhanced Capital
Partners LLC, is responsible for overseeing investment activity in
Colorado. He has more than 14 years' experience in venture
capital, investment banking and strategic consulting, and has
managed numerous private equity investments.