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Financing For Troubled Times

Posted: 2009-04-01 16:39:30
Filed Under: Small Business, Small Business Finance, Small Business Funding, Starting a Business
Forbes.com

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Hybrid securities, which act as both debt and equity, can help. Here's how they work.

Wait long enough, and all the old fashions come back. The latest example: hybrid securities.

Hybrids act like both debt and equity. They come in handy when credit is tight (and it hasn't been tighter in a long time), when cash is trickling (as in the early stages of a start-up) and when typical equity investors (friends and family, angels and venture capitalists) prove too skittish.

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    Hybrids became popular back in the 1960s, after the U.S. government started the Small Business Investment Companies program, which allowed wealthy individuals to form entities (SBICs) that could borrow funds from the Small Business Administration to re-lend to start-ups. The SBICs charged interest on that debt and also took an equity stake to compensate for the risk. SBICs were the start of institutionalized venture capital in the U.S.

    As venture capitalists piled in during the last 20 years, they switched to using preferred stock and the amounts they were willing to invest in any one venture rose to $2 to $3 million--well beyond what many early stage companies were able to attract. This left a gap between the couple hundred thousand dollars that entrepreneurs might scrounge among their own personal networks and the millions that VCs preferred to pitch in. For awhile in the late '90s, equity was easy to come by in the starstruck public markets, but that party ended when the dot-com bubble burst. And in the current crisis, initial public offerings have all but dried up.

    What to do when both credit and equity are hard to raise? Offer both, in the form of a hybrid security. These offer: 1) ready access to cash; 2) less dilution than regular equity investment; and 3) no personal guarantee of the debt.

    A hybrid security is a form of subordinated debt. In a company's capital structure, that means this slug is senior to common stock, preferred stock and trade creditors, but behind bank debt, if any. Hybrid holders assume less risk than equity investors, but often there may be nothing to recover if the venture fails.

    As a with any debt instrument, hybrids have fixed repayment schedules, frequently due in five to seven years. The interest is accrued, meaning that it doesn't have to be paid on a monthly basis but comes due on or before the principal due date.

    If the company performs well, that subordinated debt can be converted into some number of shares of equity. (In exchange for the potential upside, investors do not seek a personal guarantee on the debt.) The conversion price is spelled out in the agreement, so investors know the percentage of the company they are receiving, assuming no further dilution. If the entrepreneur prepays, investors may negotiate the right to buy their ownership stake by exercising warrants.

    Why go with a hybrid versus selling common stock? First, the interest you pay on the debt is tax deductible, if you have income. Second, hybrids tend to be less dilutive than common equity--and you want to be compensated for your toil. Third, in this troubled economy, hesitant investors may be more willing to reach into their pockets knowing they are ahead in line if things go wrong (assuming, that is, there are assets worth pursuing).

    Perhaps the best reason of all: This may be the only game in town.

    Dileep Rao is the president of InterFinance Corp., which consults with governments, lenders and businesses on venture growth. Rao is also an adjunct professor of entrepreneurship and venture finance at the Carlson School of Management. He holds a Ph.D. in business administration from the University of Minnesota. Dileep can be reached at drao@infinancing.com.

    2009-04-01 16:28:38
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    kinesisjax 08:23:59 AM Jun 10 2009

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    christinegrants 11:14:00 AM May 01 2009

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    I want to open a place were the kids in our small town in Grantsville, Utah we have 2 elementry schools and 1 Jr High and 1 High school and these kids dont have any thing to do except get into trouble and we have 1 little library they 3 computers so I want to add at least 10 Computers with Key cards worth $5, $10, $15 and $20 and charge at least $2.00 and Hr to use the computers and I also wanted to have A full Soup and Salad Bar and Soda Bar and an Ice Cream Bar with all the toppings. I will also serve a few simple things like Fries With or without cheese or chili. and a few other things like a Juke Box and have Family nights. I was also thinking of putting in a game room. The Place I want to buy is 3105 sq. feet with a storage Basement of 1200 Sq. feet. The cafe size is 69 x45 and the lot size is 85x175 with a large parking lot. It has most of the resturant equipment and stoves and fryers it has 2 sections on one side I want to put the computers in with Juke box and game room iwith

    giftladysez 04:17:39 PM Apr 11 2009

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    Every little bit helps and encourages Americans to make and effort to become self-sufficient. All of this is great news even if it doesn't apply to everyone's situation. Start a business and its easy to become overwhelmed with information overload and many hats to wear, but with an assistant (virtual) you don't pay for a full time employee, and get the biggest bang for your buck. Try me. With over 20 years' experience you'll get top talent! See my ad on craigslist or go straight to The Freelancers' Union to see my skills and profile: https://be.freelancersunion.org/f/member/12791

    dcwconslt 08:09:17 PM Apr 02 2009

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    Oh PLEEZE! This method of financing has been going on standardly for-ever! It's about the only way lenders ever lend.......they take all the security they can get regardless of the company's age or profitability. Too bad most lenders don't perform decent due diligence because they, their attorneys and their fee based financial brokers make too much money in fees...taking investors for ride in the meantime. It's all about fees.

    benlorgservices2 09:21:49 AM Apr 02 2009

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    WHATTT "RECESSION"???? There is a "Famous" Quote that goes something like this, "The Major Key To Your Better "Financial" Future Is YOU!"If you are Open-Minded, a BIG Thinker and ready to get your "own" (MBA)Massive-Bank-Account, CHECK THIS OUT!!!What Do You Have To LOSE?>http://www.casshnurface.com

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