Denver, Colorado Sources of Financing for Companies Law Firm

Sources of Financing for Companies

September 2013

By: John A. Leonard

Below is a short guide to sources of financing for companies. Twenty-one sources of financing are listed, along with typical sources of financing, whether the financing is typically available to start-up companies and a typical range of interest rates applicable to the financing. While reviewing the sources, I think it is helpful to keep the following points in mind:

1. Successful companies consider all financing choices. When angel/ venture capital markets are flourishing, many companies pursue these sources of financing. In other times, companies raised money themselves using private placement memorandum, or sold common stock subject to puts and calls that could be exercised in two or three years. Times change and sources of funding change as well. You need to be nimble. The check list below will help guide you through different types of financing that can be used.

2. Successful companies combine various sources of financing. You do not just pick one source – the goal is to match appropriate sources with particular needs. You do not incur long-term debt to purchase an asset with a short life. You combine debt and equity to maximize your rate of return to investors.

3. Successful companies focus on management. Anybody you approach for debt or equity is more interested in the company’s management than the goods or services the company sells.

4. Successful companies establish important relationships early. Successful companies maintain a good relationship with a banker, lawyer, accountant, investment banker, insurance broker, and various consultants. Talk to them regularly so that they can be your eyes and ears. Talk to them about your business from time to time. Have a relationship with your important outside team members.

5. Successful companies learn to segregate its collateral. Pledging all of a company’s assets for a loan restricts a company’s ability to grow. Successful companies work with their lawyer, accountant, and CFO to negotiate with lenders certain carve-outs or limit security interests in collateral to certain assets.

Types and Uses of Financing

1. Boot strapping: Most start-up companies use boot strapping techniques in order to form an entity, protect their intellectual property (patents, copyrights, trademarks and trade secrets), explore market potential and identify potential customers.

Source of Financing: Boot strapping techniques range from supplier and vendor financing to loans from friends and family, deferred employee compensation, customer prepayments and accounts receivable discounting.
Available to start-ups? Yes.
Range of interest rates: Not applicable.
Legal services provided: Negotiation and documentation of the boot strapping relationship.

2. Consortium Financing: Generally used in software, but can be applied to other situations. Similarly situated large companies may have a need for application software but do not wish to engage in the development themselves. Thus, larger companies, a group, can contribute a certain amount of money as prepayment against a perpetual license for software that benefits each individual company. Smaller companies benefit by obtaining financing that is neither debt nor equity. Larger companies benefit by ensuring that there is a company that will maintain software and that the software was developed to address the large company’s needs.

Source of Financing: Customers.
Available to start-ups? Yes.
Range of interest rates: No interest.
Legal services provided: Similar to any custom work performed by an independent contractor agreement, but in the case of software, license and maintenance agreements are required.

3. Factoring: Generally used for working capital by start-up companies or companies with a weak balance sheet. A factoring company purchases the company’s accounts receivable at a discount. Because of the discount, the company must have a significant gross margin or low overhead costs. In a factoring situation, it is the credit-worthiness of the paying customer, rather than the company that is of most importance to the factoring company.

Source of Financing: Specialized factoring companies.
Available to start-ups? Yes.
Range of interest rates: There are actually four fees. A discount fee charged on each invoice up to 3%, an interest rate charged on the face value of an invoice ranging from 2% to 4%, a factoring fee commission, and a monthly fee.
Legal services provided: Negotiation of the factoring fees, whether the relationship is recourse or non-recourse, and the advance rate (typically only 75% to 90% of a particular invoice.)

4. Accounts Receivable Financing: Generally used for working capital and not used to purchase real property, plant, or equipment. Typically, a “borrowing base” is established based upon the then-current value of a company’s accounts receivables. The lender usually takes a security interest lien in the accounts receivables to insure repayment of the loan advance. Receivables financing is usually combined with inventory financing.

Source of Financing: Financial institutions, typically a commercial bank or commercial finance company.
Available to start-ups? Typically, no.
Range of interest rates: Typically, a base rate (the prime rate or LIBOR) plus an amount of interest. For example, prime + 4 is the prime rate plus 4% on any outstanding balance.
Legal services provided: Negotiation of the borrowing base, sub-limits, the total amount of line, the term, and collateral.

5. Inventory Financing: Generally used for working capital and not used to purchase real property, plant, or equipment. Typically, a “borrowing base” is established based upon the then-current value of a company’s inventory. The lender usually takes a security interest lien in the inventory to insure repayment of the loan advance. Inventory financing is usually combined with receivables financing.

Source of Financing: Financial institutions, typically a commercial bank or commercial finance company.
Available to start-ups? Typically, no.
Range of interest rates: Typically, a base rate (the prime rate or LIBOR) plus an amount of interest. For example, prime + 4 is the prime rate plus 4% on any outstanding balance.
Legal services provided: Negotiation of the borrowing base, sub-limits, the total amount of line, the term, and collateral.

6. Sale-Leaseback: Generally used to provide working capital. Many established companies have real estate, plant and equipment that can be sold to specialized companies and leased back in order to create a source of capital. There are also venture leasing firms that can provide sale and leaseback arrangements with early stage companies that own appropriate assets. This can be used in lieu of bridge financing between rounds or in lieu of venture backed equity investments.

Source of Financing: Specialized finance company.
Available to start-ups? Depends if company owns equipment or real estate it can sell and leaseback.
Range of interest rates: Highly dependent on size of company and nature of equipment.
Legal services provided: For established companies, identifying and clearing liens on real estate and equipment, negotiating leases and specific terms including the sale, proceeds received, lease payments, and allocation of tax benefits / implications. For early stage companies, all the foregoing apply plus the negotiation of any warrants or royalty payments on future income.

7. Equipment Leasing: Companies of all sizes may choose to lease equipment to preserve capital for other sources. Many manufacturers have programs or relationships to provide leased equipment.

Source of Financing: Sources could be specialized financing companies (e.g. GE Capital), specialized bank divisions, specialized manufacturer divisions.
Available to start-ups? Some very specialized venture capital companies or companies that lease to venture-backed companies are active in this market. For start-ups, warrants or preferred stock are also part of the transaction.
Range of interest rates: Usually expressed as a “cap rate,” these rates are very dependent on the size of company and nature of equipment.
Legal services provided: Negotiation of lease as a “true lease” or “financing lease”, division of the tax benefits, negotiation of collateral, remedies, and notice provisions. Negotiations of “cap rate”.

8. Purchase Order Financing: Used to finance specific goods that have already been sold. Proceeds are used to pay third party suppliers for goods, raw materials, direct labor. Frequently used by importers and exporters of finished goods; out-sourced manufacturing; assemblers, and distributors.

Source of Financing: Specialized financing companies.
Available to start-ups? Only those with production.
Range of interest rates: Typically negotiable.
Legal services provided: Negotiation and documentation including amount, term, and arrangements with other prior creditors such as inter-creditor agreements, subordination agreements and purchase money.

9. Line of Credit: Generally used for working capital. May be secured or unsecured by either company assets or personal assets. The specific payment schedule collateral used for security (if any) differ from case to case. Generally not used to purchase real property, plant, or equipment.

Source of Financing: Generally commercial banks.
Available to start-ups? Typically, no.
Range of interest rates: Typically, a base rate (the prime rate or LIBOR) plus an amount of interest. For example, prime + 4 is the prime rate plus 4% on any outstanding balance.
Legal services provided: Negotiation of the borrowing base, sub-limits, the total amount of line, the term, and collateral.

10. Revolving Loan / Revolver: Generally used for working capital, a maximum loan amount is established based upon a percentage of assets (cash, accounts receivable, inventory, etc.) owned by a company. Generally not used to purchase real property, plant, or equipment.

Source of Financing: Financial institutions, typically a commercial bank or commercial finance company.
Available to start-ups? Typically, no.
Range of interest rates: Typically, a base rate (the prime rate or LIBOR) plus an amount of interest. For example, prime + 4 is the prime rate plus 4% on any outstanding balance.

11. Royalty Financing: Mining companies, drug companies, companies that license their intellectual property with established track records can assign all or a portion of royalties due in order to finance working capital or, depending on the amount of royalties, retire debt and repurchase equity.

Source of Financing: Specialized finance companies with knowledge of specific industries.
Available to start-ups? Typically, no.
Range of interest rates: Negotiable on the size of company, type of customer base, and estimated sales.
Legal services provided: Legal protection of the underlying asset (copyright, patent, trade secret, trademark), licensing agreement(s) with customers, royalty agreement with financing company including term, advance rates, guarantees.

12. Term Loan: Generally used to purchase “hard assets” such as real estate, computers, machinery, equipment and leasehold improvements and real estate. Equipment loans tend to be for shorter terms (2 to 5 years), heavy fixed equipment, real estate and significant lease improvements can have terms from 5 to 40 years. Term loans are generally not used for working capital or for equipment with a short lifespan. In any event, the term of a term loan generally should not last longer than the lifespan of the asset purchased. Term loans are an important method to segregate collateral for a specific purpose, (e.g. long-term financing). Some assets should be used for working capital collateral. Other assets, with longer lifespans, should be used as other types of collateral.

Source of Financing: Financial institutions, typically a commercial bank or commercial finance company.
Available to start-ups? Typically, no.
Range of interest rates: Typically, a base rate (the prime rate or LIBOR) plus an amount of interest. For example, prime + 4 is the prime rate plus 4% on any outstanding balance.

13. Senior Debt: Senior Debt refers to the place in line that a secured lien holder has on a company’s assets. Companies that grow without outside equity investment from Angels, V.C.s and private equity firms rely on Revolvers, Term Loans, Receivables and Inventory Financing. These lenders take a Senior, or first priority security interest in that collateral to insure repayment of the loan.

Source of Financing: Financial institutions, typically a commercial bank or commercial finance company.
Available to start-ups? Typically, no.
Range of interest rates: Typically, a base rate (the prime rate or LIBOR) plus an amount of interest. For example, prime + 4 is the prime rate plus 4% on any outstanding balance.

14. Junior Debt: Junior Debt is a broad term that refers to either secured debt where the lender has taken a lien subordinate to a first lien holder or it refers to debt that may be unsecured. Because of the risk, it earns a higher interest rate and can be used as working capital for a start-up or growing company. It can also be used to finance business exits. For example, middle management could purchase the stock of a founder using Senior Debt (including a term loan guaranteed by the SBA), Junior Debt, and a Promissory Note held by the founder.

Source of Financing: Specialized finance companies, private equity firms, venture capital and mezzanine lenders.
Available to start-ups? Yes.
Range of interest rates: Highly negotiable and may include preferred stock and warrants for options. May also include royalty on future income.
Legal services provided: Negotiation and documentation of documents.

15. SBA Guaranteed Loan: Generally a term loan that is guaranteed by the Small Business Administration. Start-ups and other small companies can use an SBA guaranteed term loan to start operations, grow and facilitate an exit strategy.

Source of Financing: Financial institutions, typically a commercial bank or commercial finance company.
Available to start-ups? Typically, no.
Range of interest rates: Typically, a base rate (the prime rate or LIBOR) plus an amount of interest. For example, prime + 4 is the prime rate plus 4% on any outstanding balance.

16. Bridge Loan: A short term loan used by a company in anticipation of receiving additional financing or other liquidity event. For example, a company raising $2,000,000 in a private placement of Series B Preferred Stock may obtain a 3-month Bridge Loan while the preferred stock is being sold. The Bridge Loan is repaid out of the proceeds of the preferred stock sale.

Source of Financing: Specialized finance companies, private equity firms, venture capital and mezzanine lenders.
Available to start-ups? Yes.
Range of interest rates: Highly negotiable and may include preferred stock and warrants for options. May also include royalty on future income.
Legal services provided: Negotiation and documentation of documents.

17. Common Stock: The proceeds are used for and in lieu of all or some of the foregoing debt. Debt is expensive. Debt must be repaid. Common stock is equity ownership in the company and is exchanged for cash by founders and other investors. It is not secured by any assets and may never be repaid. Every company has at least one class of common stock. Many companies only have one class of common stock and no preferred stock.

Source of Financing: Founders and other company owners.
Available to start-ups? Yes.
Range of interest rates: No interest.
Legal services provided: Company formation, drafting of by-laws, issuance of stock, preparation of shareholder buy/sell agreements, documenting securities registration exemption (e.g. Regulation D), drafting private placement memorandum.

See JOBS Act notes at the end of the article.

18. Preferred Stock – Usually associated with Angel / V.C. Financing: Preferred stock is the primary vehicle used by angel investors, V.C. investors and many private equity firms. Preferred stock usually has rights and privileges superior to a company’s common stock. Preferred stock is convertible to common stock either voluntarily or upon the occurrence (or non-occurrence) of certain funding events. Prior to conversion, a preferred stockholder may be entitled to certain rights such as board representation, the right to vote as if a common stock holder and other rights. Proceeds from preferred stock are typically used for start-up and growing companies to fund pre-revenue and early revenue operations. Preferred stock is generally used by early stage companies that do not desire to grow organically and do not have the financial strength to borrow from banks and other institutions.

Source of Financing: Angel investors, venture capital investors, private equity investors, and mezzanine lenders.
Available to start-ups? Yes.
Range of interest rates: Highly negotiable, typically 10% or less.
Legal services provided: Drafting preferred stock term sheet, filing amended articles and certificates of rights documents with the state, negotiating and documenting investor rights agreements, issuing preferred stock, documenting securities registration exemption (e.g. Regulation D), drafting private placement memorandum.

See JOBS Act notes at the end of the article.

19. Minority recapitalization: Used by established companies to create liquidity. Specialized private equity firms loan money to a company as mezzanine debt and / or purchase preferred stock. The proceeds are then used by the company directly, or indirectly by other shareholders to purchase a portion of the shares held by a company’s founder or significant shareholder. In this way, a founder can partially liquidate his investment as part of a planned exit and / or method to diversify his wealth.

Source of Financing: Specialized private equity firms.
Available to start-ups? Typically, no.
Range of interest rates: Highly negotiable.
Legal services provided: Restructuring agreements between existing debt and equity holders, negotiation and documentation of documents between the company and private equity firm for the infusion of capital.

20. Majority recapitalization: A majority recapitalization can either be at a sale by the holders of a substantial majority of the stock (typically 75% or more) to a private equity firm. The private equity firm then either sells off a company division by division as its exit or, grows the company so that it becomes an attractive target for a strategic investor, is merged into the strategic investor and sold at a premium within three to five years. A majority recapitalization can also be accomplished by a private equity firm using mezzanine debt and / or preferred stock to inject funds into a company, which in turn, redeems a significant amount of the founder’s stock or pays an extraordinary dividend to the founders. Companies that have strong management, are profitable and have strong growth opportunities, may find that a majority recapitalization is a way to take the company to a higher level of growth that cannot be financed organically through sales. Thus, an established company might use a majority recapitalization to redeem the stock of angels and other early investors, partially liquidate the founder’s stock and create funds for plant, equipment, R&D and other activities needed to significantly expand a company and groom it for a merger and acquisition by a strategic investor in three to five years.

Source of Financing: Specialized private equity firms.
Available to start-ups? Typically, no.
Range of interest rates: Highly negotiable.
Legal services provided: Restructuring agreements between existing debt and equity holders, negotiation and documentation of documents between the company and private equity firm for the infusion of capital.

21. Employee Stock Ownership Plan (ESOP): For established small to medium-sized companies, an ESOP provides a buyer for the founder’s stock. The principal benefit of ESOPs is they are very flexible and can provide a buyer of a closely-held company where a buyer might not otherwise exist. Two drawbacks of an ESOP are that: first, the company essentially purchases the stock twice. Once from the founder and then from the employees as they retire or leave the company. Second, an ESOP is subject to administrative costs that many small companies cannot justify.

Legal services provided: Negotiation and drafting of ESOP.

The Jumpstart Our Business Startups Act (JOBS Act) was signed by President Obama on April 5, 2012, significant provisions are discussed below. Although the law has passed, the SEC must provide regulations before issuers may rely on the JOBS Act.

Note One:

ELIMINATING THE PROHIBITION AGAINST GENERAL SOLICITATION AND GENERAL ADVERTISING IN REGULATION D OFFERINGS

A. WHAT IS THE CHANGE IN THE LAW?

The proposed amendment to current law would provide that the prohibition against general solicitation and general advertising contained in Regulation D would not apply to offers and sales of securities made pursuant to Rule 506 of Regulation D, provided that all purchasers of the securities are accredited investors. The proposed amendment to Rule 506 would also require that, in Rule 506 offerings that use general solicitation or general advertising, the issuer take reasonable steps to verify that purchasers of the securities are accredited investors.

B. WHAT IS GENERAL SOLICITATION?

Examples of general solicitation and general advertising, include advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars whose attendees have been invited by general solicitation or general advertising. By interpretation, the SEC has confirmed that other uses of publicly available media, such as unrestricted websites, also constitute general solicitation and general advertising.

C. WHAT ARE THE PRACTICAL EFFECTS?

The issuer must take “Reasonable Steps” to verify that the purchasers of the securities are accredited investors. “Reasonable Steps” are not defined and will depend upon the particular purchaser. Questionnaires, coupled with physical proof (W-2s, balance sheets, etc.) may be required.
All purchasers of securities must be accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes that they do, at the time of the sale of the securities.
Issuers should have all general solicitations reviewed. It is still a violation to offer or sell securities with a material misstatement of fact or material omission of fact.
Issuers should have stockholders agreements with buy/sell provisions, drag-along rights and consider mandatory repurchase provisions if a Purchaser has represented its status as an accredited investor.

D. WHEN DOES THE PROPOSED RULE BECOME FINAL?

September 23, 2013

Note Two:

Crowdfunding

JOBS Act creates an exemption from registration for “crowdfunding.”
Crowdfunding is a method where small aggregate amounts of securities of an issuer are sold through brokers or funding portals or platforms to investors in small individual amounts.
Restrictions on crowdfunding:
- Aggregate amount sold by an issuer, when added to the amount of securities previously sold by the issuer in reliance on the crowdfunding exemption, must not exceed $1mm in previous 12 months.
- Aggregate amount sold in previous 12 months to an individual investor by an issuer is limited to
  - $2,000 or 5% of the annual income/net worth of the investor, whichever is greater, assuming the annual income/net worth of the investor is less than $100,000
  - 10% of the annual income/net worth of the investor, not to exceed a maximum aggregate amount sold of $100,000, assuming the annual income/net worth of the investor is more than $100,000
- Transaction must be conducted through a broker or funding portal
- Not available to foreign issuers
Issuers and intermediaries must fulfill a number of other requirements, including SEC filing, recordkeeping, disclosure and investor education
Definitions of “Crowdfunding” Being Used in Colorado
- Kickstarter et cetera – Where it all began is still ok
- JOBS Act – is still NOT ok
  - [SEC website = “…offers purporting to rely on the crowdfunding exemption would be unlawful….”)
- “Colorado Crowdfunding NOW – Raise $1M Online” – Registered offerings in Colorado:
  - State registrations generally (e.g Form RL) [pros and cons and interactions with federal exemptions]
  - Consequences of being public at the state level

This Article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis of the specific facts involved.

Comments or inquiries may be directed to:

John A. Leonard.

Insights

Sources of Financing for Companies