There are certain words or phrases that when heard create an indelible recognition to a listener as being distinctly American. It may be mom and apple pie, or Old Glory and Uncle Sam that rings the bell and instantly brings to mind a recollection of a time and place where life in the good ol’ USA was peaceful, easy and pure. These words and the subsequent images are the essence of American life and idealism. For capitalists, and particularly for entrepreneurs, the phrase “Other Peoples Money (OPM)” rings just as true as mom and apple pie, because OPM has been the source for bring to fruition the dreams of countless men and women.
As a participant in the exciting and dynamic world of capitalism, you will no doubt find that at one time or another you will require OPM to achieve your dreams. After all, you have to have money to make money and OPM is the ticket that provides money for those who don’t.
What follows is a primer on this capital chase that defines American capitalism.
OPM Overview
- OPM comes from a variety of sources:
– Friends, family and fool
– Angel investors
– Banks and other financial institutions
– Government institutions
– Venture capitalists and other private equity providers
- OPM is never free; it always has a cost which makes it the ultimate deal with the devil.
- OPM comes in two forms – debt or equity; lenders provide debt and investors provide equity.
The form OPM takes and who it comes from is largely determined by the following factors:
- Business Stage
– Start up, early stage, established company
- Business Potential
– Scaleable
– Proprietary/Revolutionary
– Exit
- Capital Requirements
– Need a little; look to a lender
– Need a lot; an investor is the likely provider
- Business Risk
– Lenders don’t like risk
– Investors like risk; it costs
- Your Expectations & Desires
What does the typical lender profile look like? Here are some things to keep in mind when pursuing a lender for your OPM needs:
The Lender’s Persepctive
- Lenders look for security; they prefer fixed assets like equipment and real estate that can be collateralized.
- Lenders are risk adverse; they like the last big thing and businesses and industries that have long track records.
- Lenders like to see the borrower taking risk; if the borrower is not willing to put money into the deal, why should they?
- Lenders like the borrower to be collateralized; it comes back to protecting themselves. They are not risk takers; they want to ensure the debt is satisfied if there is a failure.
- Lenders are not a life vest and support mechanism for bad times – they get paid first.
Typically, lenders (debt providers) fall into one these three buckets:
- Lenders are not a life vest and support mechanism for bad times – they get paid first.
– Fools include individuals, vendors/customers
– Good source for start up money
– Be prepared for the consequences of success & failure
– Make sure it’s a formal arms length transaction
- The U.S. Government
– Guarantee programs administered by the SBA
- Financial Institutions
– Commercial banks
– Community-based lenders
– Asset based lenders (factoring)
– Vendor capital groups
The two most common government guarantee programs are
the SBA 504 and the 7a:
- SBA 504 Loans
– Long-term loans for fixed asset projects
– Utilized for purchasing land/buildings, new construction, leasehold improvements, machinery & equipment
– Loans for $500K +
– Low down payment – 10% equity in most cases; fixed rates and terms: 20 years on real estate; 10 years on equipment/machinery
- SBA 7a
– Used for free standing commercial and industrial buildings
and other business opportunities (acquisitions, franchises,
medical practices)
– Loan size $100K - $2,000,000; 90% loan to value
– 25 year terms
The Investor’s Perspective
What does the typical investor profile look like? The first thing to remember is that investors are far from typical as each one is unique in their requirements and tastes. Here are some things to keep in mind when pursuing an investor for your OPM needs:
- Investors will gamble on hoping to hit the next big thing; they don’t like what was popular yesterday.
- Investors like to take chances; the ultimate believers in the philosophy of no risk no reward.
- That being said, they are not fools - the higher the risk the greater the desired reward.
- Investors can be a life jacket; but it costs equity or outsized returns on the investment; much more expensive than subordinated debt
- Investors like equity; debt is secondary to them and in certain situations unattractive; but -- Investors like equity on “their” terms and conditions; this means that investments may get treated like debt and converted to equity when it proves desirable
Investors come in all types; however, they are generally classified
in one of the following camps:
- Angels
– Individuals or groups; typically invest up to $500K in a deal
- Professional Money
– Private equity groups
– Government money
- Corporate Money
– Strategic investments
– Joint ventures
- Venture Capital
– Early stage
– Late stage
The most popular place for early stage investment money is
in the form of the “Angel Investor”. Angels are:
- Individuals with money
– Single individuals
– Organized groups that come together to look at deals together or to invest together. A variety of these groups are located across the United States; each group is unique in its structure and focus
- They are generally very passionate about the business/industry/people that they are investing in and may take an active role in the company
- Investments are typically in the $100,000 - $500,000 range although they may be smaller or larger (rare).
- Generally it’s an early stage investment. Their interest is usually dilutable by the next round of investors
Professional money is also unique and, unlike the angels, generally has very specific criteria that it aligns itself to. Deals are usually in later stages and may take on a variety of shapes and forms. Professional money is usually classified as the following:
- Private Investment Groups
– Equity and buyout funds
- Private Investment Government Backed
– Small Business Investment Centers (SBIC)
– Small Business Innovative Research (SBIR)
- Investment strategies and structures vary wildly
– Acquisition of a majority/minority interest
– Capital and management; hands off or active
– Debt & equity combinations
- Professional money is typically looking for larger deals, so be careful if you are trying to raise more than $500,000 and less than a $1,000,000. This is the capital chasm; often times it’s better to ask for more money than less.
Lastly, we have the darlings of the investment community, Venture Capitalists. Like the other professional money providers they are all unique, but they generally fall along this profile:
- They are highly specialized by industry, location and stage; they have a very clear understanding of what they want
- They fill the gap between innovation and traditional debt structures; they generally come in after the angels and before the banks
- What they look for in the companies they invest in:
– Strong management team
– Proprietary idea/process; revolutionary
– Scaleable – quickly
– High double & triple digit growth
– Profitable exit (return 10X)
- They provide:
– Money
– Management
– Connections
Deal Structure
In making their investment decisions, investors will utilize a variety of transaction structures. These include:
- Straight Up Equity Position
– More common with angels and the three F’s
– Professional investors like to hedge bets & will typically use combination of equity vehicles
- Debt Security with Warrants
– Provides the benefits afforded to creditors
– Provides the opportunity to participate in the upside
– Favorable stock price and terms when exercised
- Convertible Debt
– Either secured or unsecured; if unsecured, banks treat it like equity, providing flexibility to obtain traditional financing as well
– Can be converted into equity upon predetermined terms & conditions
– Provides the investor with a fixed rate of return until conversion
– Provides the company with set payment and interest deduction (tax purposes)
– Provides the benefits afforded to creditors
- Preferred Stock
– Special privileges such as dividend payments and voting rights
– Can be converted to common stock
– Liquidation preferences over common stock; anti-dilution protection
– Mandatory or optional redemption schedules
The wild card of the equity model and of the professional
money providers is the mezzanine capital groups:
- Unsecured source of funds utilized when there is a financing shortfall; junior debt behind secured creditors in the event of bankruptcy.
- Commonly used in management buyout situations or when growth is faster than debt can be utilized.
- Providers (big banks and funds) look at the ability to generate cash flow versus the asset base.
- A company can typically raise 3 – 5 times its average operating cash flow; note that the definition of cash flow varies from party to party.
- The structure of mezzanine capital is only limited by the creativity of the participants. Generally, mezzanine capital is
– More expensive than bank debt (10% - 12%);
– It has an equity kicker that brings the total cost up (18% -25%);
– Royalties, options or warrants are common kickers
If you have any questions about this white paper, contact Mike Vann at the Vann Group. The Vann Group is a business advisory firm that assists companies in transition to unlock their value. We provide practical business counsel to transitional companies through a customized approach that is founded upon our passion for business and our family′s 150+ year entrepreneurial track record. No other firm can provide the breadth and depth of services like the Vann Group, including strategic planning and business development, merger and acquisition advisory services, leadership succession planning, organizational development consulting, and crisis and turnaround management.
