What's It Worth?

Despite all the hoopla banks are making about the small-business market, in the final analysis, it's often a poor fit for them. There are many reasons for this: Banks are built to make large loans, not small ones. Because they are lending depositors' money, banks can only make loans where there is very little risk; there has to be plenty of cash flow and hard assets to back up a loan. And finally, banks almost always require monthly or quarterly payments on the loans.

All this is fine for the banks--it's just diametrically at odds with the experience of most small or early-stage businesses. Keeping the above in mind, consider that small businesses possess large amounts of risk and little cash flow, and they attract new business at a slow, if not random, pace.

There is another alternative, however--one most entrepreneurs probably haven't considered. "The needs of entrepreneurs and banks can be bridged by angel investors who are willing to provide loan guarantees," says Arthur Lipper III, chairman of Del Mar, California-based British Far East Holdings Ltd., a company that provides and arranges financing and offers advisory services.

"It's not cheap, and sometimes it's not easy," Lipper says, regarding the use of third-party guarantees, which he arranges for deals between $400,000 and $3 million. "But for companies with explosive growth opportunities, it can be the best way to go."

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David R. Evanson, a writer and consultant, is a principal of Financial Communications Associates in Ardmore, Pennsylvania. Art Beroff, a principal of Beroff Associates in Howard Beach, New York, helps companies raise capital and go public.

Let's Make A Deal

To get such a deal done, an entrepreneur needs three ingredients: two banks and one guarantor. Lipper says providing loan guarantees to high-growth companies is a very subjective undertaking for investors, and there are several ways a deal might be structured. However, he says a typical one-year loan for $1 million might be put together as follows:

First, the investor purchases a letter of credit from his or her bank. This letter of credit stipulates that the investor's bank will pay to the entrepreneur's bank $1 million one year from the date of the agreement.

For the bank to issue such a letter, it will charge 1 percent to 2 percent of the amount of funds being guaranteed--in this case $10,000 to $20,000--as a fee. But also, because it's a bank (and banks tend not to take risks), it will also require the investor to deposit $1 million in government securities or $2 million of marginable securities into the bank. (So-called "marginable" securities are those that can be borrowed against, a determination made by the Federal Reserve.) These assets collateralize the letter of credit the bank issues.

With a rock-solid letter of credit for $1 million protecting it, the entrepreneur's bank will then lend the entrepreneur the $1 million he or she needs to grow the business.

Pocketbook Blues

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."

Silver Linings

Despite the seemingly prohibitive cost of loan-guarantee financing, there's a compelling benefit that makes it hard to dismiss, especially for early-stage companies: By using guarantees to get a loan from a bank, a company can avoid surrendering any ownership in the company if they surrender revenue.

"When companies need capital very early in their development, equity investors must take a disproportionately large piece of the company to justify the risk they're taking," says Lipper. The net effect is that an entrepreneur can be left with little more than a grub stake before he or she even gets out of the starting gate. By contrast, a loan, even a very expensive one, leaves the founder with 100 percent of the company, a feat which presumably will motivate him or her to work even harder to make the venture a success.

Another benefit is that it may be easier to get an investor to guarantee a loan than to buy equity. Whereas the latter requires the investor to cut a very large check and put all his or her money at risk, a guarantee only requires him or her to deposit securities into the bank issuing the letter of credit. The common stocks or bonds the investor uses to collateralize the letter of credit are not impaired in any way and continue to work for the investor, hopefully growing in value. In essence, the investor is simply leveraging his or her assets.

Game Over

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."

Contact Source

British Far East Holdings Ltd., fax: (619) 793-7199, arthur@pobox.com