CandidCapital

Aim of the Chapter

To describe the principal forms of external funding available to businesses and the objectives to which a lender or investor will work in considering financing a project. The details of how a lending or equity finance package could be structured are described in Chapter 10 - Negotiating and completing the deal.

Key Concepts described in this chapter

Loan finance
Equity finance

Introduction

Businesses can finance their growth by using the retained earnings of the business or by raising external finance. Retained earnings, by themselves are unlikely to provide the major tranches of funding which quantum changes in the business; perhaps the acquisition of new plant, the development of new product or the acquisition of another business; are likely to need. They are much better suited to funding the business's working capital need (investing in debtors, stocks and work in progress) as it grows. A company which is intending to grow rapidly by investing in innovative products, acquiring other businesses or expanding its productive capacity will usually need to raise external finance.

Moreover, if a successful management team is attempting to buy its own or another business, then it is likely to have to find a significant proportion of the payment to those selling the business (the vendors) from sources of external finance.

External finance can be raised by two principal means:

• by borrowing money to be repaid over time in return for interest (loan finance)
• by selling a stake in the ownership of the business (equity).

Although there are many variations on these two basic ways of raising money, all sources of financing can be distilled down to being loans or equity; although the frontier between the two categories is not always clear. Nonetheless, it is worth being clear about the basic characteristics of both lending and equity, not least because the approach and decision making of investors or lenders will be influenced by the type of finance being sought.

Loan Finance

Characteristics

The main characteristic which distinguishes loan finance from equity is that there is a contractual obligation on the borrower to pay interest and to repay the principal (that is the sum borrowed) on a given date or by a given date. The lender to an unquoted company will almost certainly have specific rights above those of a normal creditor to enable him to recover his interest or principal in the event of default (that is failure by the borrower to pay the full amount due on a given date). The lenders who have such rights in the case of a quoted company are described as holders of senior debt. Conversely, lenders who hold the appropriately named "junk bonds" (usually in smaller, more risky, public companies) have few rights to recover the money owing to them in case of default.

Types of lending Standard forms of lending include: term loans, which have a fixed life and repayment schedule; mortgage loans, which are loans secured against property; overdrafts, which are a flexible form of finance where the borrower can draw down and repay funds at will within agreed limits; leasing, where an asset is borrowed and interest paid against its capital value less tax allowances; and factoring, where the debts owed to a business are assigned to a finance house which lends against the value of those debts. More esoteric loans include loan stock and company (including 'junk') bonds and other products which may have unusual repayment rights or rights to interest and which may have special rights, such as conversion into shares, and which may not be secured against the assets of the business.

Security Usually, however, the lender will have some specific rights to recover the outstanding debt. These rights, in the form of a charge, may be against a particular asset or assets, when it will be called a fixed charge. Generally, these charges give the lender priority in the recovery of his debt, to the extent of the value of the assets charged, over the unsecured creditors. Additionally, the Company can grant a charge against its assets in general, called a floating charge which, while it gives priority to the lender over most unsecured creditors, ranks after the preferred creditors (Inland Revenue for PAYE and Customs & Excise for VAT, but see the definition in the glossary). The lender must register these charges; with Companies House in the case of charges on business assets and additionally with the Land Registry in the case of charges on property (ie buildings and land); enabling later lenders or other creditors to establish whether there are uncharged assets in the business available for them to seek fixed or floating charges over, or to take a general view of the quality and solvency of the business.

Appointment of a Receiver In the case of a default; particularly when it becomes clear that the borrower can no longer service the debt; the lender who has a charge on the borrower's assets will usually have the ultimate right to appoint a receiver to recover the outstanding debt from the sale of those assets.

Repayment Loans can be repaid in several ways. The principal can be repaid in a single tranche at the end of the life of the loan: called a "bullet" repayment which is, for example, the method used in an endowment mortgage home loan. It can be repaid over the life of the loan in equal tranches of principal with separate interest payments (usual for commercial term loans) or in equal payments over the life of the loan of both principal and interest combined, each payment comprised mainly of interest at the outset of the loan period but increasingly of principal as the end of the period is reached.

Interest The return for a lender is interest payable periodically (usually monthly, quarterly, bi annually or annually) at a rate or a margin fixed at the outset of the loan agreement. If the interest is at a fixed rate then this expressed as a percentage of the capital borrowed (ie 12% is £12 interest payable annually per £100 borrowed). If the interest is variable then it is usually expressed as a percentage margin over one of the standard base rates, such as finance house base rate (for leasing or lease purchase), three month LIBOR (for lending by city institutions) or bank base rate (for loans from the clearing banks).

Lenders' objectives

A lender is usually advancing considerably more finance, as principal, to the borrower than the yield he will receive over the life of a normal loan. This means that the loss of the principal would far outweigh his gain from the interest he will receive, of which he will only keep the margin (the difference between the interest rate he pays depositors or other institutions and that which he receives from the borrower) of 2 or 3%. In consequence, his primary concern is to ensure that there is the minimum risk feasible in the lending he is doing. First, he will want to ensure that he can recover the principal, even if the worst comes to the worst and his customer fails. Secondly, he will want to satisfy himself that the business can generate the cash to pay the interest which will be due over the life of the lending.

Security The lender's requirement for security has straightforward implications: he will assess the assets being offered as security and tie the maximum of his lending to what he could reasonably expect to recover in extremis (ie when assets have to be sold quickly, perhaps by auction). This means that stock, plant and equipment have a relatively low security value, although cars have a more predictable security value because there is an active market in them. The principal assets which a lender will use for security are real property (ie freehold land or buildings and leases which have a marketable value), debtors and personal guarantees. These have their problems: property is difficult to sell in a property downturn, debts are difficult to recover and personal guarantees difficult to enforce without attracting adverse publicity. For this reason, lenders will usually advance 66 80% of the value of freehold property, 50% of debtors and as little as 10% of other tangible assets (if at all). Personal guarantees are a banker's "black art" driven by a view of the guarantor's personal assets and earning capacity; moreover, they are often used to ensure managerial commitment rather than to add to available security. Providers of asset based finance (such as leasing and factoring) will have their own specific security arrangements for advancing funds against the assets in question and against the company's general asset base.

Cashflow The lender's second requirement is to ensure that the business has the cashflow, now and over the life of the loan, to pay interest and repay the principal. Here is where two crucial factors will be uppermost in his mind: the reasonableness of the forecasts prepared by the management and the track record of that management. A lender will be most easily satisfied about the latter if the management are known to him and they have previously presented forecasts which they have subsequently achieved. The most credible forecasts will be based on the format of a business plan (see discussion of lending proposals in Chapter 8 The Business Plan).

Interest Finally, the lender will be keen to ensure that he is getting the best possible return from the loan consistent with the quality of the proposal and the company which is putting it forward. He will not be in the business of substituting margin for security because, as discussed above, the margin cannot compensate for the loss of principal even if it is a draconian margin of 4 or 5%

Bankers do lend money against less tangible assets, such as the covenant (general undertaking to honour a debt) of large quoted companies, governments and other public bodies. They are assisted in this by the use of the international credit rating agencies, such as Standard & Poor's, which assess the quality of companies' covenants on a widely understood scale. In the United States Michael Milkin, among others, successfully raised covenant borrowing for less "blue chip" companies by use of the infamous "Junk Bond". This lending carried a high coupon (or entitlement to interest) to reflect the increased risk. High yielding unsecured lending, so called "mezzanine debt", was also used by the corporate finance houses putting together large leveraged buy outs (see discussion below "Equity investors' objectives").

However, the 1990s has seen a wholesale return to the basic principles of lending against assets and predictable interest cover. Bankers found it impossible to use increased, but still fixed, margins to compensate for wildly unpredictable general business risk. The only adequate compensation for unlimited business risk is, after all, unlimited participation in profit and that is the principal characteristic of equity.

Equity

Characteristics

The alternative to loan finance is equity finance; that is money or assets provided by an investor in return for a share in all the profits of the business. The investor accepts the risk of losing his investment in return for participating, without limit, in all the profits that the business realises.

Ordinary shares The investor will usually buy shares in the business in return for cash. Although shares can carry a wide range of different rights, and have names to match, the standard share is called an ordinary share. Even the ordinary share may have special rights, but usually has the following basic rights and characteristics: the holder can vote at general meetings of the company (usually on the basis of one vote per share held); the holder has the right to receive any dividend that the directors declare payable (expressed as x pence per share); and the holder will receive his share of the proceeds of the assets of the company on sale or liquidation. The extent of a shareholder's participation in a Company's payment of dividend or distribution of capital is determined by the proportion of the total ordinary shareholding which he holds:

For example: A shareholder owns 250 £1 ordinary shares in a company with a total issued share capital of 1,000 £1 ordinary shares. He owns 25% of the company's equity. This means that when a dividend is declared he will receive 25% of the total dividends which the company pays out. Similarly, if and when the company is sold or liquidated, he will receive 25% of the shareholders' proceeds. If the company's total assets are less than its total liabilities to creditors when it is liquidated, then he, along with the other shareholders, will sacrifice their investment in the company to the extent of that investment. He may have paid more for his shares than their face, or 'par', value of £1 each. If so, then the amount he has paid over the par value is entered into a share premium account which is part of the company's permanent capital and which is part of a shareholder's potential liability.

A shareholder does, of course, have the right to sell his shares or to buy further shares (subject to the company's articles of association and his ability to find a buyer or seller).

Normal shareholders' rights The ordinary shareholders appoint the directors and auditors (or, more usually, approve their appointment) and must approve any amendment to the memorandum and articles of the company, its legal status or changes to its capital structure. Finally, they must approve any resolution to wind up the company. The resolutions effecting these changes require differing majorities of the shareholders entitled to vote dependant on the proposed change.

Special shareholders' rights A venture capitalist may insist on some special rights for his equity, which give it preference over that of ordinary shareholders, but all equity ranks after all lenders, all creditors and all preference shareholders. This means that not only will he seek rights to preference over the ordinary shareholders, he will also take other control rights to secure the value of investment. These rights may include the requirement to seek his permission to: alter the company's share capital; acquire, dispose of, or charge assets; fix managers' salaries and other payments; determine a mandatory dividend policy; make acquisitions; and sell the company.

Equity Investors' Objectives

An equity investor will want to receive a yield (ie dividends paid periodically), or a capital gain, or a combination of both, which provides a strong return to compensate him for the risk he has taken in buying shares. Unlike the lender, the equity investor accepts the risk of losing the capital he has invested in a company's shares because he assesses that there is a reasonable expectation of a financial return which will compensate him for the risk he has taken.

The investment of equity by an investor, such as a venture capitalist, will be based on an assessment of the investee's current and future profitability. He may well want to see an ability to pay dividends year by year but, more importantly, he will be looking for the potential to develop a trading record which would make it an attractive candidate for sale or flotation (thereby enabling the present shareholders to realise a substantial capital gain on their investment). The circumstances of the investor will usually determine the extent to which he needs a realisation of his investment within a predictable timescale, rather than holding his shares for a unspecified period and taking a strong dividend yield from them. However, it is important that a management team establish from the outset what the investor's ultimate objective for the investment is and whether that objective is compatible with their own aims for the business (this is discussed further in Chapter 10 - Negotiating and completing the deal).

The equity investor will try to avoid unnecessary risk to his investment in a similar, but more painstaking, way to that which the lender uses to ensure that a borrower can service and repay a loan. He will look at the management and its track record, and the historic performance of the business but he will also try to understand the nature of the investee's business, its products or services and their potential in their marketplace. Cashflow is important, but only in that poor cash management entails the risk of financial failure through insolvency. He will use this appraisal to assess the forecasts put forward by the management and, therefore, the profitability which he believes the business will achieve, This, in turn, allows him to offer an investment which has a level of risk proportionate to the expected return.

Of course the equity investor will look to minimise the level of risk is by trying to get other providers of finance to take risk on themselves. This process, commonly called leveraging, was the basis of the large buy outs of the 1980s (see Chapter 4 Buy out). Equity investors and their advisers put together deals in which lending, which was not fully secured against assets, was a critical part of the deal structures. The lending banks were prepared to take the implicit risk on the basis that the businesses had strong historic cashflow, the post buy out plan showed strong growth in net assets and they were offered a large margin on the borrowing (3 to 5% above prevailing base rates). This type of lending is not equity, on the one hand, nor secured (or senior) debt, on the other. Falling between the two it is often described as mezzanine debt.

Non equity share capital

There are, however, several other categories of shares. These carry different, or additional, rights to ordinary shares and may, or may not, be equity. It is important to focus on this latter point: when is a share equity? As we discussed at the beginning of the chapter, it is sometimes difficult to draw the line between lending and equity, particularly when some shares are, effectively, lending. Section 744 of the Companies Act 1985 provides a useful definition of what is equity:

"Equity share capital means, in relation to a company, its issued share capital excluding any part of that capital which, neither as respects dividends nor as respects capital, carries any rights to participate beyond a specified amount in a distribution."

With this definition in mind it is possible to look at other classes of share and decide if they do count as equity.

The second most common class of share, after the ordinary share, is the preference share. Normally, shares of this class have dividend rights (usually expressed as a percentage of their par value see glossary) which do not participate in any distribution beyond a specified amount. Applying the criteria of Section 744, preference shares do not, therefore, normally count as equity.

Furthermore, preference shareholders will enjoy 'preference' over ordinary shareholders. First, they are entitled to their dividend, so long as the company has distributable reserves (see glossary); which dividend will be paid before any dividend to the ordinary shareholders. An experienced investor will normally insist on share rights which will ensure that the preference share dividend is payable irrespective of any dividend policy the directors may wish to decide upon. Secondly, they are entitled to the return of their capital in full before any capital distribution is made to the ordinary shareholders. The combination of these rights and the limit on their participation in the company's profitability, point to the preference share as form of lending. This is important when it comes to looking at the rationale behind investment decisions.

There are forms of equity that are deceptive. Some special classes of ordinary share, often designed by venture capitalists, may have the words preferred or preference in their title, yet these shares are equity. The guiding principle must be: do the shares in question meet the criteria of Section 744? Therefore an A Ordinary Share or, to use its full title, the Cumulative Convertible Participating Preferred Ordinary Share (CCPPO), commonly used by 3i, is equity despite the "preferred" in its title. The clue lies in the "participating" which points to the right of the share to "participate beyond a specified amount in a distribution", therefore meeting the equity criteria of Section 744.

Preference shares are most often used in unquoted company finance as a mechanism to allow some ordinary shareholders to pay more for their stake than others. This is the so called "envy ratio" where a venture capitalist will normally put up more cash for his percentage of the equity that the management shareholders will. This size of this ratio will vary from deal to deal.

For example: In a buy out funded by a clearing bank subsidiary the total purchase price may be £1m for net assets of the same amount. It may be possible to borrow £600,000 against the tangible assets of the business (property, debtors etc) leaving the management and venture capitalist to find £400,000. The management team might raise £100,000 between them and expect to hold 60% of the equity: an effective price of £1,600 per 1%. This would mean that the venture capital investor would be subscribing £300,000 for 40%: an effective price of £7,500 per 1%. In this deal it might be sensible to structure the new company with a share capital of 166,666 £1 shares, meaning that the venture capital investor would pay £66,666 for his 66,666 £1 shares. He could then invest the remainder of his funds as £233,334 £1 preference shares or a mixture of preference shares and loan.

The venture capital investor in the buy out described in the last paragraph could use an unsecured loan, or loan stock, as an alternative to preference shares. He might do this to give himself a better chance of a running yield (the company will have to pay interest on a loan no matter its profitability, where the fixed dividend on preference shares is payable only when it has distributable reserves see glossary) or, by taking a debenture (see glossary) with a floating charge, to give himself increasing security as the company's asset base grows.

There are other classes of share, notably deferred shares, which are used in particular circumstances. Deferred shares were more commonly used for some forms of equity restructuring before the 1981 and 1985 Companies Acts created a mechanism by which companies can buy in their own non redeemable shares.

Summary

Glossary