Debt Isn’t the Only Game in Town
Debt is the most common form of external financing for small business. But, it’s not the only option. In this lesson, I’ll provide a brief overview of equity and other forms:
- Common and preferred equity
- Mezzanine debt
- Crowdfunded pre-sales and donations
The Attractive Flexibility of Equity
Debt is rigid and uncompromising. So, it’s not really a great fit for young companies that must experiment and grow. Equity is much more accommodating. It absorbs rather than magnifies bumps in the road. Notwithstanding issues of control, the flexibility of equity makes it an attractive option. However, absent a clear “exit” strategy that will provide liquidity to investors, equity is a tough sell.
Equity investors, as a group, are at the back of the queue when it comes to taking a bite out of your company’s cash apple. Lenders’ claims are subdivided into senior and subordinated priority. Similarly, equity holders’ claims are subdivided into preferred and common stock. Founders, friends and family, and employees typically own common stock. Angels and professional investors favor preferred stock.
The Liquidity Trap
Investors motivated primarily by financial returns need to be confident that an equity investment made today has a reasonable chance to yield a significantly larger cash return in the not-too-distant future. Furthermore, their investment horizon might be limited by their source of funding.
Venture capital and private equity firms are commonly organized as limited partnerships. In order for the general partners of such funds to offer limited liability to their investors, the life of the partnership must be constrained to ten years or so. That means investors have to deploy, manage, and harvest their investments within a relatively short period of time.
So, even when the growth prospects of a company are promising, the sticking point tends to be a concern about liquidity. That is, how do investors get cash out of the business? How do they exit?
There are really only a couple of ways. They can either receive a stream of dividends and distributions, or equity holders can sell their shares. Even if a company has strong free cash flow, it’s likely that existing (or future) loan agreements will restrict payments to shareholders. In most cases, then, to exit a business means to sell one’s shares.
The Barriers to Selling Shares in a Private Company
There are several ways to effect the sale of shares:
- Repurchase with cash on hand
- Leveraged recapitalization
- Private sale
- Public offering
- Sale of business
All face material constraints. Loan agreements limit stock repurchases. Leveraged recapitalizations (i.e. using debt to buy back shares) are only feasible for certain mature businesses having strong, consistent free cash flow. Private sales are an option, but it’s tough to get full value for an illiquid, minority stake. Public stock offerings (IPOs) are extremely rare these days. Selling the business can feel like “throwing the baby out with the bathwater.”
Equity financing fits many young businesses. Nevertheless, practical constraints usually limit equity financing to investments from founders and their friends and family. A vanishingly small proportion of early stage businesses have the characteristics that allow them to access equity financing from serious angel investors and venture capital firms.
A Middle Path?
The mezzanine is between floors of a building. Likewise, mezzanine financing sits between debt and equity.
Mezzanine financing is usually structured as subordinated debt. Senior lenders commonly restrict payments to mezzanine investors. Even so, there is a built-in path to (at least partial) liquidity.
Mezzanine debt carries an interest rate of 10% to 20%. Mezzanine investors, though, seek a total return on investment of 25% to 35%. So, mezzanine lenders will receive a “sweetener” in the form of an equity “kicker” such as warrants. A warrant gives the holder an option to purchase equity at an attractive price. That way, the mezzanine lender will share in the upside if the company is sold or goes public.
Mezzanine debt is clever and customizable. It is also difficult to negotiate and runs up an expensive legal bill. Consequently, mezzanine financing is uncommon. It’s usually restricted to multi-million dollar transactions.
Crowdfunded Pre-sales and Donations
Online crowdfunding platforms have opened the door to new types of financing. These include the pre-sales of product and, sometimes, donations.
Kickstarter and Indiegogo are the leading rewards-based crowdfunding platforms. Rewards-based crowdfunding is when backers are promised a tangible or digital good in exchange for their financing support. Creative projects (e.g. films, music, and photography) account for a large number of rewards-based crowdfunding campaigns. However, consumer products companies use these platforms to, in effect, pre-sell product.
These pre-sales campaigns can generate gross funding ranging from the thousands to millions of dollars. They are an interesting way to gauge demand before making a major investment in inventory. That said, backers expect high quality photography, videography, and marketing support. Crowdfunding is neither cheap nor easy.
Platforms such as GoFundMe facilitate donations-based crowdfunding, including donations to start or expand a business. The fundraising potential is lower – more like thousands or tens of thousands of dollars. Success requires a human interest story that transcends business.
Donation and rewards-based crowdfunding totaled over $5 billion in 2015 and is growing. That’s significant. Let’s keep it in perspective, though. In comparison, the commercial loan portfolios of banks in the U.S. in February 2017 totaled more than $2 trillion.
Crowdfunding is a very useful stepping stone, particularly in the early phases of a business. But, it complements rather than replaces more traditional forms of financing.