LOAN TRANSACTIONS
By James Verdonik

Growth companies usually obtain most of their capital from sales of equity securities. This is true for the following reasons:

• Most growth companies need long-term financing.
• Most commercial lenders, such as banks, lack sufficient experience to evaluate the risks related to lending to young growth companies, especially experience in valuing intellectual property.
• Interest rates are usually not sufficient to reward lenders for taking the high risks associated with lending to young companies.
• Most young companies lack sufficient tangible assets, cash flow and operating history to reduce lender risk.

Where very young companies borrow money from bankers, the lender usually requires the company founders or others to personally guarantee the loan. The assets of the guarantor act as a substitute for the assets of the company.

As companies grow and start to generate revenue, they can sometimes obtain lines of credit or other short-term financing from commercial lenders such as banks without personal guarantees. Usually, however, such loans are not sufficient to finance the Company's growth and have to be combined with other debt and equity financing. Other sources of loans include:

• Venture equipment lessors
• Venture lenders
• Subordinated debt lenders
• SBIC's

Transactions with these types of lenders are described below.

Challenges of Borrowing

The challenge to you in dealing with different types of lenders is to develop an overall debt structure in which default is not triggered by financial covenants unsuitable for an early-stage company and allows you to borrow more as your company grows and can support larger debt payments.

You want to avoid having to go back to all your creditors for approval each time you want to increase your debt. The lenders will often ask for concessions from you as a price for their approval of later deals. Concessions may be in the form of additional warrants, increased interest or prepayments of principal. When negotiating each deal, look ahead and avoid restrictions that prevent you from meeting your future needs.

Venture Lessors

Many growth companies don't own the equipment they use. Instead, they lease their equipment from venture lessors. This allows companies to sell less equity and hopefully results in less dilution.

Venture lessors usually work with companies funded by venture capital investors. Venture lessors usually do less due diligence than venture capital equity investors. They rely in part on the judgment of the venture investors that your company is a good risk.

Venture lessors make money from monthly lease payments with a high interest factor built into the lease payments. Since the equipment lessor owns the equipment, the lessor also depreciates the equipment for tax purposes, which shelters its income from taxation. Lessors also often charge a commitment fee and may impose other charges. Finally, venture lessors usually also receive a long-term warrant to purchase shares of your company's stock. The warrant rewards the equipment lessor for dealing with a lessee whose credit risk is higher than usual.

Lessors protect themselves by retaining the right to repossess their equipment if you default on the monthly lease payments. They also have the right to sue you for nonpayment of the lease and for their collection expenses. They also often require a cash deposit of two month's rent. The lessee usually has an option to purchase the equipment at the end of the lease, since the lessor doesn't place a high value on getting back obsolete equipment.

Venture Lenders

Banks and other financial institutions also extend loans or lines of credit to growth companies. Generally, these lenders require the company to have revenue, but the company need not be profitable. Like venture lessors, these lenders are more likely to make loans to companies funded by venture capital equity investors and often rely on the due diligence conducted by venture investors.

Like venture lessors discussed above, venture lenders rely on a mix of interest, commitment fees and warrants to earn their return.

Venture loan deals usually differ from equipment lease deals in the following ways:

• Depreciation and Interest. The lender doesn't own the equipment. The lender can't depreciate it for tax purposes. This may result in a higher interest rate compared to venture leases.
• Use of Loan Proceeds. In some cases, the borrower may be prohibited from using the loan proceeds for any purpose other than equipment purchases, but in many cases all or part of the loan proceeds can be used for other corporate purposes.
• Collateral. The loans of venture lenders are often secured by all the assets of the borrower, including intellectual property. In most instances, venture lessors can repossess their equipment, but lessors usually are only general creditors of the borrower when they sue to collect unpaid lease payments. This means you are still free to borrow for general corporate purposes and give the lender a first lien on your assets when you lease equipment. If you borrow to buy equipment, the security interest you give the lender may prevent you from obtaining other loans.

Another factor in choosing between an equipment lessor and a lender is banks sometimes use venture loans as an introduction to sell your company other services. Banks, therefore, often have greater motivation to do a deal, which can result in better terms for you. Banks sometimes do equipment leasing (usually through a subsidiary).

Generally, both venture lessors and venture lenders face less risk than equity investors. They can repossess equipment or other assets to recover part of their investment. Also, they usually invest at a later stage than equity investors. Consequently, their ROI is usually lower.

Sub Debt Lenders

SBICs and some other lenders often will take a subordinate position to other (senior) lenders. The senior lender has the right to collect all its loans and expenses before the subordinated lender collects. It also usually means the subordinated lender can't foreclose on your assets, if you default on the subordinated debt, as long as the senior lender is willing to delay foreclosing on your assets. This allows you to obtain loans from senior lenders, because the senior lenders have the ability to waive defaults as long as they continue to have faith in your company. In return for subordinating their loans, sub debt lenders expect a higher ROI than senior lenders.

Small Business Investment Companies.

The key thing to remember about SBICs is that many SBICs borrow most of the money they invest from the government. An SBIC has to pay interest to its lender. It generally requires the companies in which it makes investments to pay interest and to have a reasonable probability of being able to repay the principal amount of the loan. In return, SBICs will usually accept a smaller percentage of the equity of your company than a venture capital fund would require.

SBICs usually invest in companies with a developed product and either have an established revenue stream or the likelihood a revenue stream will develop soon. Don't look for seed capital from SBICs or to fund long development projects.

SBICs, however, are a good source of capital to finance expanding your sales team, moving a basic existing technology into additional applications, adding depth to the management team or expanding production capacity.

If your company is able to generate revenue to pay interest and meets the risk profile of the SBIC for repayment of principal, you are likely to get a better deal from an SBIC than from most venture capital funds in a second or third round financing.

The past few years have seen the rise of SBICs who receive equity investments from the government. These SIBCs are better positioned to make equity investments than those SBICs who borrow their money.