Roads to riches: alternative financing structures & the implications
The article was first published in Private Capital magazine, 2016 Conference Edition.
While private equity and venture capital firms are always focused on identifying ways to de-risk their investment in a company, alternative financing structures can help a company minimize dilution and still ensure they receive the growth capital they need to execute on their business plan.
Traditional investment structures have tended to focus on equity positions, through common shares, preference shares, convertible notes and warrants. These structures generally provide significant equity ownership in the company, especially for early-stage companies, which means the founders have to consider carefully their loss of control and upside in their equity position.
However, different business models are continuing to emerge with start-up and growth companies that will increasingly allow companies to access different funding alternatives, predominantly based on a business model that de-risks the investment opportunity for a third-party financier. Many of these options rely on the visibility of the company’s future cash flows, and seek security in these streams of cash as their trade-off for equity in a company and the position upside this could bring.
Some of the most common alternative financing structures deployed by private equity firms — which are increasingly being offered by niche alternative financing firms as standard and standalone products — include:
Royalty financing: Where there is a future predictability, a percentage of the revenue can be financed through a royalty structure. For example, a royalty may be five per cent of the revenue paid to the financier for an upfront capital investment, which therefore moves up and down with the revenue growth or decline of the company.
This can be a very effective financing method where a cap and collar is introduced to the royalty for a high-growth company, as the downside is protected for the financier. If the company outperforms, the effective royalty rate reduces accordingly as the cap-imposed limits the upside for the financier.
As the royalty is often placed at the revenue level, the most important consideration is the impact at the profit margin of the company, and hence the applicability for low-margin businesses is limited.
Asset based lending (ABL): When a company has a receivables and/or inventory balance that has value, this can be financed at a lower cost of capital. While traditional lenders have been large financiers in the ABL space for some time, increasingly private equity investors are adding an ABL facility in conjunction with a common or preference share equity position. This increases the capital available to the company while minimizing equity dilution, and also provides the private equity firm with the control position as a secured lender without bringing in another third party financier.
Contract/purchase order financing: Similar to royalty financing, where there is a long-term contract or purchase order that provides a private equity investor with comfort on future cash flow. Some or all of the investment could be structured in a way that aligns the capital need to the contract. Particularly relevant for software-as-a-service (SaaS) companies, where monthly recurring revenue is secured on contracts over multiple years, such financing availability generally increases as the monthly recurring revenue increases. Most often structured without an amortization of the facility, it provides more flexibility than traditional debt structures.
Debt: An often overlooked position, debt is becoming increasingly important for certain private equity investors in the traditional secured side of the capital structure. Where investment mandates allow for the flexibility, some private equity firms are looking at providing a complete capital solution to a company, without requiring a third-party financier. In addition to ABL structures, some firms are providing senior secured debt facilities, and venture debt for earlier-stage companies, which gives them access to a return based on the security profile of the company with some equity upside based on attaching warrants and/or equity position.
Pros and Cons
While these structures will generally be at a lower cost of capital (where a rule of thumb of a target return of 8-25 per cent could be used depending on the security offered) than traditional common share equity investing (where a rule of thumb of a target return of 30-40 per cent is standard), they do come at the cost of additional controls. Where delays in the business model lead to reduced cash flow, step-in provisions give the financiers the ability to protect their investment through rights such as board and management changes, reductions in capital investment and other spending, etc.
To find and implement the right financing option, it is important to have a thorough understanding of the terms of the financing and the resulting implications from a cash flow and capital structure perspective. While less dilution may be the goal, it is imperative to understand the potential impact of non-dilutive capital on cash flow, especially in scenarios where the downside or upside case prevails. This will ensure the right financing and capital structure is in place, through a comprehensive review of the options available, to align the private equity financing with the company’s business strategy.