Beyond Banks
by Pamela H. Roderick

From Entrepreneur Magazine, June 1990

Padgett Printing Corp. was in trouble. A family business specializing in advertising and direct mail printing, the Dallas-based company had revenues of about $10 million, 75 employees, relied on a local bank for its financial needs, and had never needed a business plan, much less an investment banker-until the day its credit line dried up in 1988.

Texas banks were having serious problems at the time, and Winfield Padgett, Chairman, said his business had been through a couple of bad years, too. When he went to see about refinancing his one-year note and line of credit, the bank responded with an unattractive offer. "It made sense at that point to shop for more institutions and look at other sources," Padgett says. One of the other sources he talked to was Charles V. Lemmon III, President of C.V. Lemmon & Co. Inc., a Dallas investment banking and financial consulting firm. Lemmon recommended tapping the financial markets by doing a private placement.

A private placement is debt or equity sold privately to one or a few investors, usually large institutions such as pension funds or insurance companies. It is not advertised or sold to the general public. It may be as simple as a bank loan look-alike or as complicated as Wall Street wizards can make it. Each deal is tailored for a specific company and situation.

What Padgett Printing wanted was long-term capital under $3 million and short-term capital under $1 million. And that's what it got: a six-year, fixed-rate loan pegged at 2 1/2 percent above the prime rate, and a floating rate line of credit, at prime plus 1 percent, from a second lender.

"We'd never gone through a formal planning process, in terms of organizing a package to put before an institution or a group to provide financing, so [Lemmon] provided some guidance and organization in that process," Padgett says. "But what's more important, he identified sources that would be interested in our deal."

Lemmon points out that with many out-of-state lenders, local borrowers have no way of knowing whom to approach, how to make a loan request or how to negotiate terms. That is precisely what the private placement market is for: financing a business when bank loans are not the answer.

Roger Baumberger, National Director of Corporate Finance for the accounting and consulting firm BDO Seidman, based in New York City, believes many entrepreneurs miss opportunities to expand because they are not aware that there are people out there ready to write them checks. "Too many companies don't know that a lot of institutions are just sitting there with budgets and allocated funds that they have to put out in the private placement market to satisfy their internal investing requirements."

"I think there are an awful lot of entrepreneurs who have good, solid businesses, who are doing well, and who could expand more rapidly than they are, but probably the only person they talk to is their commercial bank's loan officer," says Baumberger. "And having been one myself for many years, I know that loan officers tend to be a little insular in their perspective. A loan officer wants to make loans, but really wants to make ultra-safe loans, so his bias is naturally going to be toward an under-leveraged situation."

DEBT VS. EQUITY

Debt financings are the most common type of private placement, and they come in almost as many shapes and sizes as there are borrowers. At one end of the scale are fairly simple deals put together by small firms such as C.V. Lemmon in Dallas, which finds itself handling many debt financings - some as small as $500,000 - that Texas banks once handled for local companies. Lemmon says one of his most common transactions is global restructuring. "We'll restructure all of a company's debt so that it is refinanced long-term," he explains. "Then the company's line of credit is available to use. For instance, you can refinance the firm's real estate on a long-term basis, and provide a new line of credit. Restructuring all the debt makes it a fix rather than a patch."

At the other end of the scale is Shea, Paschall & Powell Inc. in New York City, where the smallest transaction is $10 million and president Neil Powell prefers complex deals using what he calls "finance engineering techniques" and sophisticated tools like interest rate swaps to lower costs.

A more typical transaction for small and medium-sized businesses is mezzanine financing, so called because it is part debt and part equity. A typical mezzanine deal combines subordinated debt plus some sort of equity, which may be warrants to buy stock at a certain price some time in the future, or debt that is convertible to equity at some future date.

Such combinations are popular with large investors because subordinated debt pays high interest, and the equity component offers the prospect of capital appreciation, according to William M. Clark, senior vice president for Fleet Associates in Providence, Rhode Island, a subsidiary of Fleet/Norstar Financial Group. "You get more risk, you're farther down in the capital structure, you have a subordinated claim on a company, and in exchange for that, you get a higher return," Clark explains.

Despite investor demand for high returns, going into debt is still less expensive than selling equity and sharing profits. The advantages of equity are that there is no interest and the principal does not have to be paid back.

The features that make a common stock offering attractive to companies make it unattractive to investors looking for high returns, so mezzanine financings with some equity involved are likely to include preferred rather than common stock.

E. David Coolidge, III, partner in charge of corporate finance at William Blair & Co. in Chicago, says preferred stock often pays a small dividend or requires a sinking fund, which means that at some point the company must begin paying back the investor. "Prior to going public, most venture capital investors insist on getting a preferred position - preferred in liquidation, preferred in dividends, and a requirement to buy back the stock at some future date," Coolidge says.

PUTTING THE PIECES TOGETHER

One of the most important things an investment banker or private placement adviser does for a client is help make the decision about debt vs. equity. This is a crucial part of structuring any deal and is not something a company is expected to figure out.

What a company does have to do for itself is prepare a business plan. This is the first thing an adviser wants to see. "You need to see the business's financial history and the financial forecast, and then you want to understand what business they're in," says Coolidge. "Once you have that, you can make an assessment as to what the prospects are of raising different kinds of money in private markets."

Structuring the deal includes deciding how much of the money should be debt, how much should be equity, what type and on what terms. "Once the structure is established, we work out a 'term sheet,' " Baumberger says. "This specifies what the terms should be for the interest rate, the payback period, final maturity, equity, warrants if appropriate, and so forth." Using the information in the term sheet and the business plan, supplemented by "due diligence" personally investigating and verifying of the company's data the adviser draws up a formal private placement memorandum to present to selected financial institutions or investment funds to see who is interested. "That institution then does its own due diligence, confirming the information in the memorandum, visiting the company's physical facilities and getting a feeling for the management people," says Baumberger. If all goes well, the adviser gets a formal commitment from the financial institution, the deal goes to the lawyers and then to closing, and finally the company gets a check.

Each step in this process may take a month or more, starting with preparing a business plan. Jeffery Pollock, partner in charge of investment banking for Mabon, Nugent & Co. in New York City, considers timing one of the biggest potential problems in putting together a private placement. He considers six months realistic, if the company already has prepared a business plan and has a fairly good balance sheet. It took Padgett Printing 18 months to complete its deal, although all concerned agree that was an unusually long time.

HOW MUCH CAN YOU GET?

Cash flow is the most important consideration in determining how much debt a company can carry. Neil Powell says, "Obviously, if the cash flow available for debt service is less than what the debt service requires that's not a good sign. Then you've got to liquidate the company to pay off debt, and that is not something you want to do. You want that ratio to be greater than one to one. It sounds like a silly statement, but a lot of people lose sight of these basic and important things."

Jeff Pollock at Mabon Nugent cautions that a private placement is not a remedy for businesses with bad financials. It can be an alternative to a bank loan, or a supplement to bank loans, but not a replacement for loans no bank will make.

With a small company, Bill Clark at Fleet Associates says investors get worried if cash flow falls below two times or gets close to one-and-a-half times the firm's fixed interest payments. The type of business and the stability of its revenues are also important in determining how much debt to carry.

"Senior lenders, paticularly, look at asset coverage," Clark says. "They'll probably lend 70 to 90 percent of receivables, and 40 to 70 percent of inventories, depending on the type of inventory." A lender might not be interested in a shoe company's inventory, but would be comfortable with a commodity chemical business whose products could easily be sold to a major chemical corporation if the company had to be liquidated. Real estate is also an important asset to consider, especially plant property and equipment.

Once assets are pledged as collateral, cash flow becomes even more important. David Coolidge at William Blair & Co. wants a company to have a few mi1lion dollars in net worth and close to $1million in pretax income. He estimates a $5 million debt will generate interest costs of $500,000 to $600,000, and if there is less than $1 million of earning power, most lenders will not be interested. Profitability is what generates the most enthusiasm among potential investors. "If you're trying to borrow money, there are only two ways to pay it back," Coolidge says. "One is to liquidate assets: the other is to generate cash flow from operations. If you don't have either, you're not going to be much of a candidate for debt financing."

WHAT IT COSTS

When it comes to a private placement, everything is negotiable, but the placement is also subject to what the market will bear. Debt is priced off treasuries of like maturity, just like commercial bank loans. Interest rates on straight debt are based on the risk involved.

Christine Evans-Kelly, a partner at William, Blair & Co. who works in debt financing, says a small, straight, debt deal for a good, solid company could be just 175 to 200 basis points (1.75 to 2 percent) over treasuries. "That's a company that has been around for awhile, has good historical numbers, a good management team, and is in an established industry," Kelly explains. "To the extent that you move away from those things if you're a new company, with varied returns, or in a high-tech industry, then you're going to move significantly above 2 percent."

Mezzanine financings, with their subordinated debt, are more expensive. Bill Clark estimates a typical mezzanine deal will include an interest rate of 13 to 14 percent plus some kind of equity, such as warrants, for a total return of about 20 to 25 percent, compared with 10 to 11 percent for a simple bank loan. "The thing is, though, you've got to pay back a bank a lot more quickly than you've got to pay back a mezzanine lender, and a mezzanine lender doesn't have a senior claim on your assets," Clark says.

Venture capital may be even more expensive. Clark estimates venture capitalists want to see returns of 30 to 40 percent, and they want it in equity. The cost reflects the uncertainty of the return and the investor's position far down in the company's capital structure. "If a company goes belly up, then that equity or mezzanine may be worth nothing," Clark says. "At least a bank may get 50 cents on the dollar."

The fees investment bankers charge for their services vary widely depending on the deal, but are almost always a percentage of the money raised. Since fees are the most negotiable item of all, bankers are reluctant to quote specific amounts.

One banker says his firm wants to get a minimum of a few hundred thousand dollars for its work, particularly when negotiating mezzanine deals. For pure equity or high-risk venture capital, the fee is likely to exceed 5 percent of the money raised, and could conceivably go as high as 10 percent. Generally, the smaller and riskier a deal is, the higher the fee.

Winfield Padgett was satisfied. He got the financing he wanted for a fee he thought was fair, and says he never could have done it himself. "I don't consider myself a dummy, but I'm certainly no expert on finance," Padgett says. "For somebody in the trenches, running a small business day in and day out without a staff, finances aren't something to which you're able to devote time."

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