RESOURCES

Basics

Many companies reach a point in their growth where they need outside financing to expand to meet their potential. Growth or expansion financing is the subject of this article. For the following discussion, we assume that the current owners of the business are not seeking to liquidate some or all of their stake in the business, but rather are looking for financing to augment the cash flows of the company during a period of anticipated rapid growth. This growth can result from an expansion of the company's physical plant or through sales growth that requires additional working capital. Growth can also come in the form of strategic acquisitions, which are discussed elsewhere on American Capital. See Acquisition Financing

This article discusses scenarios prompting a company to seek outside capital--for physical expansion, additional working capital or refinancing to replace restrictive financial partners--and analyzes the various forms of financing available to fund growth.

Seeking growth financing assumes that the company is unable to fund its immediate or near-term needs through its operating cash flows or existing credit facilities or that the owners of the business are unable to finance the full capital needs of the business out of their personal resources.

Physical Expansion

Physical expansion can be the easiest form of growth for a company to finance through outside sources. The company is increasing its asset base and therefore its borrowing capacity. As discussed below, asset-backed senior debt is typically the lowest in cost and the easiest to obtain third-party financing.

Expansion scenarios can be located on a spectrum. At one end of the spectrum is the project in which all of the costs are associated with the purchase of fixed assets. The most obvious example is the purchase of a new vehicle used in the core business of the company. These projects are good candidates for low-cost financing--asset-backed senior debt being but one possibility. The rise of lease financing as a tool for businesses provides another low-cost, off-balance-sheet source of capital that in certain situations (again, the vehicle) may enable the entrepreneur to finance 100% of the cost of the asset. Even if lease financing is not available, the enterprise may be able to use some of its own excess borrowing capacity to collateralize that portion of the debt in excess of the amount a lender is willing to advance against the assets to be purchased.

At the other end of this spectrum are projects in which a substantial portion of the use of proceeds will be spent on soft costs, generating little in the way of fixed assets to collateralize the loan. If the company has little or no debt on its books, it may be able to use its borrowing base to fund the soft costs. If the company has borrowed against those assets for its own purposes and they are unavailable, the entrepreneurs must turn to junior capital--equity or subordinated debt or both--to fill the gap.

Somewhere in the middle lie those situations in which the collateral values are too low to secure asset-backed financing for the entire transaction but in which the historic cash flows of the business are sufficient, or the likelihood that the expansion effort will succeed are so great, that a senior lender will make what is termed a cash flow loan. This loan, often structured with accelerated amortization and a cash flow sweep provision, is also referred to as an "air ball." The lender holds his or her breath for the period of time this loan is outstanding, hoping that those cash flows hold up and the loan is repaid. Cash flow loans are always more expensive than asset-backed, or secured, loans and are generally available from larger, more sophisticated banks and financial institutions. See Senior Term Debt

The introduction of junior capital into the capital structure of a growing company poses complicated issues for the entrepreneur and the senior lender. These issues are worth struggling through if the entrepreneur is committed to growth, but they cannot be minimized. Issues include agreements between the senior lender and the subordinated lender sharing rights and power in the event the company's performance declines and its ability to service its debts comes into question, as well as the thorny questions involving the sharing of equity and control between the entrepreneur(s) and outside investors.

The balance of this section discusses examples of companies with little debt vs. those with substantial debt and considers the constraints on each in raising outside capital for growth.

Clean Balance Sheet

If the subject company considering the expansion has little or no debt, it can borrow as much as 80% of the value of machinery, equipment, land and buildings secured by a collateral interest (a first lien) in the fixed assets being purchased. The borrowing base of the subject company (its initial asset base) can be used to collateralize the additional financing needed to fund the balance of the cost of the expansion, including the 20% or more of the cost of the fixed assets plus any soft costs associated with the project. In this scenario, the entire project can be funded with senior debt. See Figure 1 for an illustration of the clean balance sheet approach to expansion financing.

Leveraged Balance Sheet

If the subject company already has pledged its assets as collateral to its existing lenders, whether or not the company has borrowed to the full extent of its borrowing base, it is more limited in its ability to use its core assets as collateral to raise additional senior debt. While the fixed assets purchased as part of the expansion can serve as collateral for the new financing, most senior lenders are unlikely to finance the full cost of the fixed assets, much less the soft costs associated with the expansion (e.g., the costs of installation or of wages and salaries during the build-out of the project). Having depleted its senior debt borrowing base, the company is forced to seek subordinated debt or equity to finance at least some of the expansion costs. (See Figure 2.)

Many companies that find themselves in a period of rapid growth that requires outside capital may find their current financial partners unprepared to accept the level of outside financing needed to facilitate that growth. Thus, using the example set forth in Figure 2, the subject company may need to finance not only the $1.1 million gap between the collateral value of the project assets but also the prepayment of the existing $3 million loan to the company. This situation is fairly common in smaller companies that have a long-term banking relationship with a smaller, local bank. The local bank has little or no experience with "structured finance" (layers of debt and equity above and beyond the asset-backed borrowing capacity of the company) and no interest in gaining this experience. Just as the company has outstripped its physical facilities, it has also outgrown this banking relationship.

Subordinated Debt Financing

The asset-backed lender has a relatively easy question to answer in assessing the credit-worthiness of a growth-financing proposal. The question: "What are the assets to be purchased really worth?" The answer to this question is slightly more complicated than the obvious "whatever the entrepreneur is about to pay for them." What the lender is really trying to get at is what he or she can sell the assets for if that becomes the only way to get repaid. Whatever this number is, the lender multiplies that by 50% to 80%, depending on the character of the asset and the lender's appetite for risk or desire to win the opportunity to finance the company. The result is what the lender will advance. (See below for further discussion of advance rates and other devices the asset-backed lender uses to be certain he or she never lends more than the assets are really worth.)

The subordinated lender, as the name suggests, is also lending money to the company with the sincere and earnest hope of being repaid. However, the subordinated lender is rarely in the position to conduct the simple analysis the asset-backed lender undertakes. Instead, the subordinated lender is put in the position of making educated guesses about the profitability of the core business and the likelihood the expansion will enhance rather than diminish that overall profitability. These guesses are backstopped, but never completely, by a second lien on the assets of the company subordinated to the senior lenders.

As the senior debt is repaid, assuming the value of the collateral does not decline more quickly than the principal balance on the senior debt, the subordinated loan becomes increasingly secure. (See Figure 3.) As is apparent from the illustration, if the collateral is of the sort that quickly declines in value (e.g., the vehicle discussed earlier as compared to a tract of land or a building), the subordinated debt may never have any collateral coverage as the senior loan may amortize at the same pace as the collateral declines in value.

During the first several years of the financing, the subordinated debt is highly dependent on the accuracy of the cash flow forecast. Unlike an investment in a company with a historic level of cash flows that the investor is being asked to underwrite simply on the basis that those cash flows will continue at historic levels, the growth financing requires the subdebt investor to buy into a change in the business brought on by the growth. Issues of particular importance in evaluating the proposed change in business include:

• Potential execution risks inherent in the expansion project.
• Management's ability to manage the larger business.
• The company's ability to expand profitably by taking market share or capitalizing on overall market growth.
• Challenges inherent in geographic or other market diversification.

In addition to risks associated specifically with the expansion project, the investor must weigh the risks of the basic business, including the effect of the business cycle on the company's profitability. This last point is particularly acute for a subordinated lender making a loan of as long as 10 years; the economy is sure to trough at least once during that period, and the lender must be satisfied that when that happens, the company can still service the subordinated debt.

These modes of analysis, involving an assessment of the likelihood of the cash flows of the enterprise rising to and holding at a certain level for a period of time, are common to subordinated lending whether or not the growth being funded involves fixed-asset purchases. The fact that there are fixed assets on which the subordinated lender can obtain a second lien may help reduce the cost of the money to the company, but unless the lender is fully collateralized, the cash flows of the company provide the lender with the primary way out of the loan.

Equity financing for growth is more straightforward than subordinated debt financing insofar as the investor need only be persuaded that the expansion will increase the equity value of the enterprise above the price at which the investor is purchasing equity today. The challenge is in allocating the risk that the future is not as bright as the entrepreneur believes it to be. In other words, is the price for today's equity reflective--and if so, to what degree--of the future prospects? This question runs through the pricing of subordinated debt as well, as the subordinated lender will generally seek warrants convertible to equity in the business in addition to the interest and return of principal (an equity "kicker").

The other sensitive issue for the entrepreneur whenever equity is being sold to an outsider is the extent to which that new stakeholder will be able to exert control over the business. This issue is manifest in discussions over the percentage of the company being sold, the composition of the board of directors and the rights the new investor gets, for example, in the event of a default on the subdebt or if the company fails to pay dividends on preferred stock held by the investor. Subordinated lenders are willing more often than not to take a back seat to current management as long as the company is performing to plan; pure equity investors are less willing to be passive even then. All outside investors want the ability to exert control over the direction of the business at some point, although each investor defines that point, and conceives of the exercise of control, differently.

For more detailed descriptions of subordinated debt and equity financing, see Subordinated Mezzanine Debt.

Working Capital for Growth

In some situations, a company can grow without purchasing additional assets or expanding its physical plant. Often, this growth requires additional working capital to finance inventory purchases and accounts receivable that may grow faster than payables, putting the company in a tight cash position. Provided this growth follows historic patterns and is built on business relationships with customers roughly similar (at least as to creditworthiness) as the company's current customer base, an existing revolving line of credit can generally be expanded to accommodate the new credit needs of the business.

In situations where the company is branching out into uncharted territory, or is contemplating growth that does not necessarily create a larger current asset base against which to borrow, the company may find itself in need of subordinated debt or equity. In those situations, the analysis the company will be subject to is identical to that described in the preceding discussion of subordinated debt and equity financing. The risks of the business as it is and the risks that the growth efforts will fail are weighed by a lender or investor relying on continued cash flows and equity growth to realize an appropriate return.

Refinancing to Replace Restrictive Lenders

As mentioned above, there are situations when a company is poised for growth and is held back by a reluctant financial partner--most often, but not exclusively, a conservative bank unwilling to bear the risks of growth. Banks are often in the position of curbing growth if only because they generally do not price their loans to account for the risks associated with change. Particularly where the company will require both additional senior debt from the institution in question as well as junior capital that will complicate the company's balance sheet and introduce a new party into the lending relationship, the bank may elect to exit the loan at this point.

The most important insight an entrepreneur can take into a refinancing situation is the fact that the same amount of senior debt can look very different depending on the other elements of the balance sheet, even without any changes in the company's base business. Figure 4 illustrates this concept.

Company A and Company B in this example are companies in the same business, identical in every way except for their capital structure. A bank willing to lend to Company A might very well balk at Company B because of the level of total leverage. Consider the following, which illustrates the challenge growth poses to a bank.

The 1998 column in Figure 5 describes Company A. In this scenario, we see a company expanding rapidly in the first year, fueled by the infusion of $9 million of subordinated debt. The bank in this example is not being asked to advance any additional funds--perhaps because the growth will not increase the asset base of the business. However, the bank will be relying on the company's ability to service, in addition to $3 million of senior debt, an additional $9 million in subordinated debt. Assuming an interest rate of 12% on the subordinated debt, that means the company has to generate at least $1 million of cash flow over and above that needed to service the bank's debt. If the company meets or exceeds its year-on forecast, this should not pose a problem. If the company repeats 1997, cash flow will be tight. For this reason, it is likely that the bank in place in 1998 will not be willing to tolerate the increased leverage required to fund the proposed growth.