Tapping into private debt: what entrepreneurs should know


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It’s tough to find capital to execute on ambitious plans to grow, acquire or turn things around in Canada, particularly if you’re looking for $1 million to $20 million in financing.

Entrepreneurs in this country have experienced this predicament for years, and while the situation has improved recently as capital availability reaches new records, financing sources remain largely few and lacking flexibility.

Bridging the financing gap…

In our conversations and deal-making experience, entrepreneurs tend to direct their capital-related frustrations at venture capital (VC) firms and traditional banks not stepping up to fill the financing gap.

There is, however, a lesser known category of capital, private debt (also known as alternative debt), that has grown to address these shortcomings.

Private debt lenders are different from VCs and traditional banks in that they typically do not require the asset coverage demanded by traditional bank debt, or the potential for a 10x return that attracts VC.

These specialized lenders seek a return in between bank debt and venture capital, investing significant time understanding a company’s business model in order to provide a more meaningful amount of financing and more flexible structures relative to banks.

There is no requirement for “home-run” potential to access private debt; companies that have promising prospects – but are not necessarily the next Google or AirBnB – make strong candidates.

Trevor Simpson, director, private capital, FirePower Capital. Photo courtesy of the firm.

Recently, a specific form of private debt, venture debt for tech companies, has stolen the spotlight. That is a positive development, but it can make non-tech borrowers believe this kind of financing isn’t available to them.

In reality, private debt can be useful in addressing a range of different issues across industries.

1. Accelerate growth

There is a segment of growing companies that are not achieving the 100 percent year-over-year growth that attracts strong VC interest. Further, this segment typically doesn’t have the Ebitda to access bank financing beyond small lines of credit.

Private debt may provide a solution.

Often this debt facility will grow with the borrower; as the company realizes various milestones, more capital becomes available. Typically, this positions the company to better execute on its growth strategy (relative to not raising capital), ultimately reaching a positive cash flow position where it can access lower-cost bank financing.

2. Finance an acquisition

Growing through acquisitions also poses a financing challenge for entrepreneurs, as bank financing may be unavailable on a timeline that works for the acquisition process, or falls short of the dollar size that’s needed or expected (especially if the deal is not ‘vanilla’).

Private debt can be used as a bridge to complete an acquisition when timing is tight, and after closing, to provide the runway needed for the combined entities to become financeable by banks.

Much like banks do for more established companies, some private lenders will provide acquisition lines to companies executing on an acquisition strategy.

The lender underwrites the acquirer and its strategy and provides indicative terms for future acquisitions. This arrangement allows an acquirer to move quickly once they’ve found an acquisition target – an advantage in the current competitive M&A environment.

3. Reduce the high cost of equity

While it’s true that an early-stage, hyper-growth company is likely to find an equity investor to provide capital, that potential investment raises the issue of valuation.

VCs make bets that can yield a minimum 10x return on their investment; all else being equal, it’s easier to get those returns if valuation is low.

Further, as valuation negotiations transpire over the VCs’ lengthy evaluation and due diligence process, and with borrowers often burning capital, some investors prolong the deal until the company’s cash on hand reaches a point where the entrepreneur urgently needs the equity. Often, that leads to a lower valuation.

Private debt lenders typically move faster than VCs, and can delay the need for an equity raise, while allowing the company to keep its “foot on the gas” and build enterprise value.

Alternatively, private debt can also pair with an equity investment to reduce overall dilution for business owners. The example below illustrates the significant cost of an early-stage equity investment to a high-growth company relative to the cost of private debt.

What’s the cost? Private debt versus equity

Suppose a company is worth $10 million today, and it seeks to raise $2.5 million. Further suppose it can either raise equity or private debt.

Equity

Today: 20 percent stake sold to a VC for $2.5 million, with a 1x liquidation preference.

After five years: On the $40 million sale, the VC gets a total of $10 million back, comprised of its $2.5 million (the 1x liquidation preference), and 20 percent of the remainder (20 percent x $37.5 million = $7.5 million). The net cash return to the VC is $7.5 million, which is the cash cost of the equity.

Private debt

Today: sample loan terms: 13 percent interest, 3 percent warrants, no principal amortization.

After five years: during the term, the lender is paid $0.975 million in interest. On the $40 million sale, the lender is paid $1.05 million for the warrants. This adds up to $2 million, the cash cost of the debt.

In this example, with its reasonably representative terms, the difference in cost between the two funding options is staggering: $5.5 million.

As can be seen, private debt is extremely valuable to shareholders of fast-growing companies. Because of their immense enterprise value growth, the cost of selling off equity is particularly high.

The private debt takeaways

While private debt is more costly than traditional bank debt, it’s typically available on a much shorter timeline, in a more meaningful size, and with far more flexibility on terms and structure.

It can provide a bridge to lower cost financing by supporting the growth necessary to get there, and can significantly lower the cost of more expensive, dilutive equity financing.

The bottom line? Private debt should be part of an entrepreneur’s arsenal of financing options when seeking out growth (or other) capital. It could be the option that makes the most sense.

To view the original article, including explanatory notes, please click here.

Trevor Simpson is a director, private capital, at FirePower Capital, a Toronto-based mid-market investment bank and venture debt lender. He leads the private capital division’s client engagement efforts and credit underwriting activities.