A look at 4 alternative financing structures & their benefits
There’s no doubt that PE and VC firms are well aware of the various risk factors that come to light when making an investment in a company. Company founders and owners are constantly on the lookout for ways they can limit their risk in an investment while ensuring they receive proper growth capital needed to execute their business plan effectively.
In traditional investment structures, the focus is often set on equity positions, through common shares, preference shares, convertible notes, and warrants. Because these structures generally provide significant equity ownership in the company, founders must carefully consider their loss of control and upside in their equity position.
Alternative financing structures, on the other hand, can help companies minimize dilution and de-risk their investment. According to Ben Gibbons, Partner, Corporate Finance at Collins Barrow Toronto LLP, these models allow companies to access different funding alternatives – predominantly with start-up and growth companies – creating new opportunities for a third-party financier.
The promising visibility of the company’s future cash flow is seen as trade-off for equity in a company, and the position upside it could harvest. According to Gibbons, 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: In cases where future predictability is guaranteed, a percentage of revenue can be financed through a royalty structure. This can be an 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 a company outperforms, the effective royalty rate reduces accordingly as the cap-imposed limits the upside of the financier.
Key Consideration: 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 receivable and/or inventory balance that has value, financing can be done 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 including ABL facility in conjunction with a common or preference share equity position.
Key Consideration: 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 predictability and future cash flow, some or all of the investment could be structured in a way that aligns the capital need to the contract. Monthly recurring revenue is secured on contracts over multiple years, such financing availability generally increases as the monthly recurring revenue increases.
Key Consideration: 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, mainly in the traditional
secured side of the capital structure.
Key Consideration: This structure appeals to private equity firms who are looking at providing a complete capital solution to a company without including a third-party financier.
While these structures are generally at lower cost of capital than traditional common share equity investing, 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.
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.
*Click here for the full version of the above article, originally published in the May 2016 edition of Private Capital Magazine and written by Ben Gibbons, Partner, Corporate Finance at Collins Barrow Toronto LLP.