Where’s the Money?, Winter, 1999

RESUME: LOAN GUARANTEES FROM INDIVIDUAL INVESTORS
Definition or Explanation: A guarantee of payment which stands behind an early stage company and enables it to take out a loan from a bank. Conceptually, private guarantees play the same role as a Small Business Administration loan guarantee.

Appropriate For: Early stage companies which within a year will turn the corner toward profitability, or commence product sales. The limited time frame stems from the fact that loan guarantees typically only last for a year, and at the end of that period, the company must be able to raise equity capital to pay off the original loan, or be able to successfully apply for and get a loan based upon its own fundamentals.

Supply: Though this technique is uncommon, the supply is theoretically abundant. Specifically, any wealthy individual, i.e. angel investor willing to consider an equity investment, should also be willing to consider a loan guarantee as well.

Best Use: For companies which can put the borrowed funds to use and show an immediate result either in profitable product sales, or the commercialization of a product or service concept. Loan guarantees work particularly well for very young companies, who would otherwise end up selling a majority equity stake in the business if forced to use equity capital.

Cost: The fees and interest on a loan guarantee can be very expensive compared to a traditional loan. However, loan guarantees make it possible for an entrepreneur to raise capital without surrendering any control, which makes it cheap compared to most forms of equity financing.

Ease of Acquisition: Loan guarantees are somewhat easier to negotiate than pure equity investments because the investor guaranteeing the loan never turns over any of his or her own funds, unless of course the company does not perform as projected.

Range of Funds Typically Available: No upper or lower limit.

WHY LOAN GUARANTEES WORK
Whether youzzre are raising debt or equity capital, you have run into the same behavior: lenders and equity investors are reluctant to let go of their money. While the attitude is the same, the motivations are quite different.

The bank would simply love to lend you the money. After all, the only way it makes an above average return is to lend out what depositors put into the bank. But, because a bank is lending other peoplezzs money, it operates in what is known as an “abundance of caution” mode. That is banks, because of the way they are built, are only allowed to make loans in situations of absolute safety. When working with emerging growth companies there are few instances of absolute safety, hence the challenge of loan financing.

Equity investors would generally like to finance your company as well. But they too have problems. Mostly itzzs the fact that emerging growth companies are not just risky, but illiquid. Once they swallow the risk, most equity investors are still reluctant to cut a check because they know that even if the company succeeds, it will be tough to get their money back. To do so, the company will generally have to go public or get bought out. And if the company only succeeds on a marginal basis, then their investment can remain trapped inside the company.

Itzzs because of these emotions and constraints that loan guarantees can work so well. Specifically, when an angel investor stands behind a loan and guarantees it on behalf of a company, he or she doesnzzt have to shell out of their own capital, at least not initially. And with a guarantee in the picture, the loan is absolutely, positively, 100% safe, meaning that almost any bank in the continental United States can make the loan.

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Donzzt Forget: The concept of a loan guarantee isnzzt anything new. In fact, loan guarantees provide the underpinning of the Small Business Administrationzzs 7(a) loan guarantee program. However, when loan guarantees are practiced in the private sector they can be more flexible and deliver significant benefits to lenders, investors, and most importantly, entrepreneurs.

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According to Arthur Lipper III chairman of British Far East Holdings, Del Mar California, which provides and arranges financing as well as advisory services, “To get such a deal done, an entrepreneurs will need three ingredients. These are: two banks and one guarantor.” Lipper says that providing loan guarantees to high octane growth companies is a very subjective undertaking, and that there are lots of 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 will stipulate that the investorzzs bank will pay to the entrepreneurzzs bank $1 million on a certain date one year in the future.

Lipper says that for the investor to get his or her bank to issue such a letter, it will charge 1% to 2% of the amount of funds being guaranteed — in this case $10,000 to $20,000 — as a fee. But also, because itzzs 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 marginal securities into the bank. (So-called zzmarginablezz securities are those which can be borrowed against, a determination which is made by the Federal Reserve.) These assets collateralize the letter of credit which the bank will issue.

Now, with a rock solid letter of credit for $1 million protecting them, says Lipper, the entrepreneurzzs bank will then lend the entrepreneur the $1 million he or she needs to grow the business.

Loan Guarantee Flow Chart for $1 Million Loan

None of this comes cheaply. In fact, when you add it all up, itzzs darn expensive financing. Here are some of the costs the entrepreneur would be expected to pay in such a transaction, according to Lipper.

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A Good Deal: If you get a loan from your bank which is guaranteed by a third party, negotiate for prime interest rate, since by virtue of the guarantee, your bank is not incurring any risk.

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First, therezzs the guarantee fee. Remember, the investor had to pay his or her bank a fee to get them to issue the letter of credit in addition [italicize in addition] to depositing funds into the bank. “The way the investor would tend to think,” says Lipper, “is that zzitzzs the entrepreneurzzs [italicize entrepreneurzzs] loan which is getting guaranteed, not minezz, therefore they should pay the fees.”

Next, Lipper says that he typically collects perhaps 5% of the loan as a fee for putting the deal together. For our hypothetical $1 million deal, thatzzs another $50,000.

Then therezzs the interest to the bank. For deals such as this, banks typically charge the prime rate, plus 1% according to Lipper. “Thatzzs absolutely outrageous for them to charge a premium like that,” 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, [italicize upfront] as shown in the above example.

The only good thing you can say about all these fees, is that they generally donzzt come out of your pocket per se. In most deals they come out of the loan fees, so you as the borrower end up paying them in the form of a higher effective interest rate.

INFO BOX:

Donzzt Forget: Private loan guarantees offer a short term solution only. Generally, youzzll need to replace the guaranteed loan at the end of the year with another loan or quity financing.

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Itzzs important to note the effect of all these fees coming off the top of the loan proceeds ratchets up the interest rate which the company pays for its funds. In our example, the guarantee fee is, say $20,000, the consulting fee is another 5% fee or $50,000, and the bankzzs interest up front of perhaps 8% is another $80,000 for a total of $150,000.

Looked at differently, the entrepreneur is really paying $150,000 for the use of $850,000 ($1 million loan proceeds – $150,000 fees and interest). The true rate of interest then is 17.6% ($150,000/$850,000).

But it doesnzzt stop there. At least not for Lipper, as well as many other investors who typically structure such deals. The piece dé resistance comes in the form of a “carried interest” in the company. Lipper says the carried interest is either a percentage of the companyzzs revenues — three to five percent — or a hunk of the companyzzs equity, the percentage of which is subject to negotiation. If youzzre a purist and donzzt want any outside owners of your company, give up some of the revenue and keep the equity.

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,” according to Lipper, “is that the company does not 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 such financing, therezzs a compelling benefit that makes it hard to dismiss out of hand, especially for very early stage companies. Specifically: by using guarantees to get a loan from a bank, a company can avoid surrendering any ownership in the company which goes part and parcel with raising equity capital.

This is particularly important for very young companies in the early stages of their growth. 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 are taking. The net effect is that an entrepreneur can be left with little more than a grub stake before they even get out of the starting gate. By contrast, a loan, even a very expensive loan, leaves the founder with 100% of the company, a feat which presumably will motivate them to work even harder to make the venture a success.

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Shop Talk: When the guarantor starts talking about a fee structure with a zzcarried interestzz, it means they want a piece of the action beyond consulting fees such as a percentage of sales, options, or even equity. It would be unimaginable that a guarantor would not request a carried interest. After all they may be, as in the above example, putting $1 million at risk, and certainly want more upside than a $50,000 fee.

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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 of their money at risk, a guarantee only requires them to deposit securities into the bank issuing the letter of credit. The earning power of the common stock or bonds the investor uses to collateralize the guarantee are not impaired in anyway, and continue to work for the investor, hopefully growing in value. In essence the investor is simply leveraging [italicize leveraging] his or her own assets.

Lipper says itzzs a mistake for any investor to guarantee a loan which they are not prepared to write a check for if things go south. “Most investors are the same however,” he says. “They believe they can pick the deals that will work, and avoid those which will not.” For better or for worse however, itzzs this mindset which makes pitching a loan guarantee much easier than pitching the concept of direct investment.

END GAME
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, and unneeded profits is a mighty, if near impossible feat for most companies.

The object of the initial loan guarantee is not to pay off the loan per se. More accurately, and far more likely in a successful scenario the company would, at the end of the loan period, be in a position to pay off the loan with another [italicize another] loan that it was able to negotiate without a guarantee, or with an equity investment from another investor. Presumably, with the growth the company demonstrated, and the potential it holds, one of the two alternatives becomes viable.

Looked at this way, a loan guarantee is for companies that can make a go of it with interim [italicize interim] financing as opposed to permanent [italicize permanent] financing.

It is also for companies which have high profit margins. For instance, if a companyzzs operating margin (sales less cost of goods sold less selling, general and administrative expenses) is 10%, and the investorzzs share of the revenues is 5%, then therezzs not much left over. In fact, the remaining interest expense might convert a slim profit into a loss [italicize loss]. “This kind of financing tend to work best for technology companies where there is some form of intellectual property which gives them a protected profit margin,” according to Lipper.

In addition, a loan guarantee financing will tend to work best in situations where the price of the companyzzs 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 gas station could not do this, while a database management company probably could.

Finally, a loan guarantee should be contemplated by entrepreneurs whose companies can generate predictable sales and [italicize and] earnings. “The nightmare for the company is that they make the revenue projection, but do not hit the earnings projection. Then they are left with very high financing costs and very likely little or no profit.”

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Taking Action: If youzzve talked to angel investors about an equity investment, and they have turned you down, contact them again, and ask them to consider a loan guarantee instead. Remind them, that if the deal goes as planned, all of their liquid assets remain intact and working for them.

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