Hold On to What's Yours

John Lie-Nielsen, 28, is on the fast track. The San Francisco-area company he and a partner started in 1999, Allied Cash Advance, is growing right out of its britches. Happily, when it came time to buy bigger britches, Lie-Nielsen knew right where he could find the deep pockets he needed.

Lie-Nielsen has been luckier than most--he's nailed down three rounds of angel capital that helped him open the first retail locations for his short-term consumer-loan business. In three years, the company has grown to more than 35 stores while doubling revenues each year. But the business is consumer-driven, and Allied Cash Advance growth is fueled predominantly by opening new locations.

With its angel capital spent, the company needed to secure more long-term financing if it wanted to continue its rapid rollout. As the economy slowed in early 2002, however, angels and VCs were growing reluctant to write checks--and Lie-Nielsen was equally reluctant to sell stock at valuations that might not reflect the company's significant prospects for growth.

The answer? Subordinated debt. Sometimes called mezzanine financing, or just sub debt, a subordinated loan is unsecured (not backed by collateral), and therefore the claims of the lender in such a loan are second in line--subordinate--to claims from banks and other secured (asset-based) lenders.

Do the Math

"Of course, subordinated debt carries a higher interest rate than a bank loan or other asset-based loan," explains Barry Morganstern, a managing director at the Los Angeles-based corporate finance advisory firm Glick Morganstern Capital Group. "Typically, the rate is between 10 percent and 14 percent for a five-year note."

It may seem like subordinated lenders are asking a high price, but Lie-Nielsen, who previously worked as an investment banker, quickly points out: "Fourteen percent interest is much cheaper in the long run than the dilution or loss of control that would come from another round of pure equity investment. Our current shareholders could lose share value through dilution if we took in another investor in these turbulent market times."

To evaluate different finance options you have to be able to figure out the true cost of capital, often a tricky calculation. There is no rule of thumb that works in all situations. It's important to remember, however, that selling stock can work against you if the cost (in terms of share of the company) is greater than the growth you'll realize by investing that money.

Cash, Not Collateral

The key to subordinated debt financing is cash flow. Sub debt is not secured by collateral like the typical loan you might get from a bank. Much like a credit card company, a subordinated debt lender is willing to take on the extra risk of an unsecured loan in exchange for a higher return on its money. "Most sub debt lenders are looking for a total of 25 percent to 30 percent internal rate of return," explains Morganstern.

The difference between the 14 percent interest you pay and the 25 percent return that sub debt lenders hope to realize is made up with stock warrants. Warrants give the holder the right to purchase shares of stock in your company at a pre-determined price. Essentially, owners of company stock warrants hold some of the value of your company without actually becoming shareholders.

CapitalSouth Partners, a sub debt lender in the Southeast, regularly lends companies from $2 million to $10 million for growth and restructuring. Their typical borrower has greater than $10 million in revenue and between $1 million and $10 million in EBITDA (earnings before interest, taxes, depreciation and amortization). Joe Alala, president and CEO of CapitalSouth Partners, says the company charges between 12 and 14 percent for the loan, and receives "warrant coverage" equal to 10 to 20 percent of the company's outstanding stock. (Alala warns, however, that for companies with less than $1 million in EBITDA, warrant coverage can be much more expensive.)

In some cases, the lender will convert those warrants into marketable stock--and cash--if the company is sold or goes public. Because few companies ever go public, however, CapitalSouth and other sub debt lenders regularly sign a "put option" with the company. This put option gives the lender the right to sell the warrants back to the company at a future value. The sell-back price is based on company valuation, which can be set as a multiple of earnings or by a third-party appraisal.

One to Grow On

Subordinated debt is considered a long-term liability, and therefore should be used for long-term projects. Sub debt can be used to finance a variety of intangible growth-related expenses, including marketing, IT projects, product development, R&D or, as in the case of Allied Cash Advance, lease and build-out expenses for new store locations. Subordinated debt is not generally intended to cover short-term needs like payroll or inventory.

"Half the borrowers use the money for growth, and half are going through either an ownership change or restructuring," Alala estimates. Sub debt is often ideal for purchasing a company or for rolling two companies together. Because cash is often tight in these situations, CapitalSouth commonly structures loans with interest-only payments.

Where to Find It

Despite--or perhaps due to--the decline in venture capital investing lately, there are a growing number of financiers making subordinated loans. As with most financial instruments, you can find a lender through finance intermediaries--usually called corporate finance advisors, like Glick Morganstern--or forge the relationships yourself.

If you enlist an advisor or broker to help you work a deal, you can be pretty sure they'll give you a clear understanding of your options for both secured (traditional) and subordinated debt instruments. Advisors can also assist you in putting together a detailed presentation for your deal and shop it around directly to the decision-makers at several sub debt lenders.

On the other hand, sub debt lenders are becoming more numerous and easier to find. Many banks and credit unions have associations with sub debt lenders. As Alala of CapitalSouth Partners puts it, "Although it helps to be introduced by someone I know, anyone can call me or send me a note from our Web page." Alala estimates that he sees around 15 sub debt deals a week, only a small fraction of which come through his network of agents and acquaintances.

Putting It to Use

Back at Allied Cash Advance, John Lie-Nielsen has perfectly matched his growth plans to the funding sources. The company received a line of working capital from a traditional lender that finances accounts receivable. Then a regional sub debt lender stepped in to help with the money needed to open new storefronts.

The stockholders in Allied Cash Advance couldn't be happier: The subordinated debt lender has provided enough capital to maintain strong growth for several more years and has taken only a small piece of the equity to do it. The income from new storefronts more than pays debt service on the loan, and the existing shareholders were not penalized in the process.

David Worrell is a strategy and finance specialist in Charlotte, North Carolina.

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