DEBT FUNDING
In addition to selling equity to investors, a company may also have the option of borrowing money, either from an angel investor or an institutional investor specializing in debt financing.
PROMISSORY NOTES
As will be discussed in the Equity Issues chapter, angel investors oftentimes fund a startup with a promissory note (i.e. loan) rather than with stock. The angel may not wish to protract the funding negotiations with discussions of how much money your company is worth; not enough science, people, and money have passed to allow one to determine a proper value.
One form of a note is a simple cash note. The repayment term is either "payable upon demand", on a schedule, or at a specific date, preferably beyond the time when additional financing is expected. If the note is due beyond 12 months, then a rate must be provided; otherwise one will be implied by the IRS or be re-characterized as dividend income. A cash note has several disadvantages to the prospective investor. Upon its repayment, the investor would realize a simple 1x return. Future investors may be discouraged by the knowledge that a portion of their investment will be used solely to pay back the loan and accrued interest owed to a previous investor.
Usually the note will have some form of an equity kicker. In one method, the note is convertible to the next round of equity at the next round price discounted by a factor of 10-30% from the financing round's price. A second method attaches a warrant that allows the note holder to purchase stock in the company at a future date, with limitations, at a pre-determined price. The amount of the warrant will usually be expressed as a percentage of the loan amount. For example, if the principal amount of the convertible note is $100,000 and it has 10% warrant coverage with an exercise price of $0.50, then this would allow the note holder to purchase 20,000 shares of stock ($100,000 x 10% / $0.50) at a future date.
BRIDGE LOANS
Sometimes the best-laid plans for equity funding do not materialize at their designated time. When cash starts to run low, certain current investors, banks, or other hybrid institutions may agree to advance the company funds until the latter of the closing of the next equity round or a fixed date in the future. Lenders will perform due diligence to ensure that the advancement of funds is indeed a "bridge" to the next round of financing, not a permanent issuance.
As with a promissory note, the bridge loan will carry an interest charge, a conversion rate based upon the share price of the next round of funding, a fixed repayment date if the equity event has not yet occurred, and an attached warrant. The amount of the warrant will be expressed as a percentage of the loan amount. In these cases, the warrant coverage may be as high as 50% of the loan amount. Some loans will have a tranche effect on the level of warrants. For example, the warrant conversion rate might increase if a particular milestone were not achieved, such as raising the next round by a certain date or the successful completion of a clinical trial.
The loan may be advanced in increments rather than as a lump sum. Entrepreneurs should seek terms that include multiple advances. Should the entire amount of the note not be advanced (e.g. in the event that the company closes a round of financing sooner than expected), there would be proportionately less dilution in the next round.
You should discuss these transactions with your tax advisor before their execution. Further, while these types of notes avoid the valuation discussion, negotiations are still necessary to determine the amount, conversion rate, maturity date, whether the note automatically converts upon financing or if conversion is at the note holder's option, the equity kicker, and the consequences of no liquidity event.
SECURED EQUIPMENT FINANCING
One might ask: if I have raised enough equity to carry the company beyond a key milestone, why would I want to also receive debt financing. The answer is twofold: debt financing is cheaper than equity financing and it is most always better to have more cash today than to count on receiving more tomorrow. To determine the cost of equity financing, one needs to examine the "cost of capital". Investors, VCs in particular, are seeking a 3050% annual rate of return on their investment in your company. On the other hand, banks, leasing companies, and others who offer debt financing are seeking a 10-20% annual return, including all payments and fees.
Some of the terms in a debt deal would include the following:
A. Loan Terms
- Loan/Lease Amount -- usually expressed as a commitment amount that would be drawn over a fixed period of time
- Soft Costs Allowance % - soft costs include leasehold improvements, software, installation, sales tax, and shipping. Soft costs generally are regarded as being more risky and, therefore, carry a more expensive debt cost
- Takedown period -- the period over which the commitment amount is available for advance to fund the assets
- Documentation requirements for takedowns -- invoice copies, purchase orders, cancelled checks (try to avoid this one; it extends the time which the company would be required to fund the asset)
- Depreciation schedule for older items to be financed -- with equipment financing, items with an invoice date of as young as 31 days old may not be funded in its entirety
- Items not fundable -- sometimes certain soft costs, used equipment, items purchased with a credit card or on an employee expense report item are not funded
- Loan Term/Maturity -- the period of time over which the borrowed funds must be repaid. There may be an initial period where there are only interest payments followed by a fixed term for payment of principal and interest or a separate loan amortization may be defined at each month or quarter in which advances were made.
- Balloon/Backend payments -- this is a payment that may be required as the final payment of a loan, typically expressed as a percentage of the amounts advanced
- Interest Rate -- may be expressed as a fixed rate, as a percentage over the lender's prime rate, or as a hybrid of the two (e.g., the rate would be Prime + 1% but no lower than 6%)
B. Advance payments or deposits required -- upon acceptance of the lender's term sheet, the borrower is required to make a good faith deposit. The lender will deduct from this deposit any out-of-pocket processing and legal fees and will then return the remaining balance to the borrower once the loan has been approved.
C. Commitment Fees and/or Loan/Lease Fees -- any number of other fees could be assessed; caveat emptor.
D. Collateral and Lien(s) required as security -- the lender has the right to take and hold or sell the specified collateral property of a borrower as security or payment for a debt. The specified property may range from just the assets being funded (e.g. equipment) to all the assets of the company, including intangible assets such as intellectual property. Guard your IP with your life; at a minimum, obtain a negative pledge on IP with exceptions permitting licensing, partnerships, or joint ventures entered into in the ordinary course of business. An all asset lien may hinder your ability to seek future debt financing with other institutions or even vendors offering attractive lease terms. The workout is to have your lending institution provide a subrogation agreement, which may be difficult to obtain. A compromise position would be to negotiate a specific dollar value carve-out for use in securing future debt.
E. Prepayment Penalties or Similar Payments required -- should you decide to repay the loan early, for example, because of a merger, the lending institution will typically ask for all future amounts to be repaid, principal and interest, less a discount factor.
F. Financial or Operating Covenants -- may be as simple as a requirement to submit monthly financial statements and a copy of the annual budget, putting adequate insurance in place, or agreeing to deposit substantially all funds with the lending institution and maintaining stringent financial ratio requirements. In the latter case, you should determine what the lender's return on invested funds has been and how that compares to other deposit sources.
G. Restrictions on or Allowances for additional debt being taken on by the Company -- the inclusion of this term generally depends on the financial condition of your company.
H. Legal Work and Fees -- addresses whether lender legal fees are to be paid by the Lender or the Borrower and if there will be a cap on such fees.
I. Warrants:
- Coverage % (as % of loan amount)
- Life of warrant
- All other terms
- Have your attorney review a draft of the warrant agreement prior to signing a final term sheet.
J. Investment rights -- the lender may request an option to invest in your next round of financing. A cap should be determined, and the lender, if it chooses to take advantage of this option, should be required to pay the same price as all other investors in that round.
K. Material Adverse Change (MAC clause) -- this is the lender's wild card. Put simply, in the lender's sole discretion, if it feels uncomfortable with the general affairs or financial direction of your company, or if you have deviated sharply from your business plan, they may cease to advance any further amounts to you and, in the most extreme circumstance, transfer the remaining unpaid principal from your bank accounts without notice. This is a difficult clause to avoid. The lender's record on this matter should be well understood.
LETTERS OF CREDIT
A letter of credit (LC), long popular in international trade, is frequently used as an alternative to cash security deposit for an office lease. An LC is an instrument issued by a bank guaranteeing the payment of a customer's obligation for a stated amount for a stated period of time. In effect, the LC substitutes the bank's credit for the buyer's. The LC would be drawn in favor of the landlord, meaning that if the company defaults on its lease, upon written notice, the bank would pay the landlord his security deposit.
Often, as equipment financing is being negotiated, the rate the lender would charge for providing an LC and the maximum amount to be provided could be included in the negotiations.
ABOUT THE AUTHOR:
JACK MALLEY, PARTNER, FIRSTJENSENGROUP
As a part-time or interim CFO for his clients, Jack provides financial, systems and operational consulting services to technology and life science companies. Jack has a valuable combination of operational, financial/computer systems and finance expertise, having spent twelve years in industry where his responsibilities with growing companies included combined finance and operational responsibilities. His biotechnology client list has included Acusphere, Critical Therapeutics, eNOS Pharmaceuticals, the Massachusetts Biotechnology Council, Scriptgen Pharmaceuticals and TolerRx. Prior to joining FirstJensenGroup in 1995, Jack held senior finance/operational positions with Fidelity Investments, Eastern Exclusives, and the Emerging Business Services Division at Coopers & Lybrand. He holds an MBA in Finance and Accounting from Northeastern University, a BA in Economics from the College of the Holy Cross and is a Certified Public Accountant. Jack can be reached at jmalley@firstjensengroup.com.
ABOUT FIRSTJENSENGROUP
FirstJensenGroup is a partnership of skilled senior managers and advisors that provide a comprehensive range of interim management, consulting and tax services to the technology and life science sectors. Clients include entrepreneurial start-ups, established private and public companies, private equity investors, banks and specialty lenders.