Debt is not Equity part 2

If you are looking to raise capital for your business, you have two basic choices. Debt or equity. We’re in the debt biz, but we have great ringside seat on the equity world as well.

Here is the high level debt primer I promised yesterday (folks at Thomson please take note):

1. Debt is not venture capital, inasmuch as the capital markets treat the phrase “venture capital” as a synonym for equity capital (usually pref shares, mind you); General Atlantic makes no bones about their approach, for example. Venture capital = equity.
2. You have to pay debt back. Once someone provides your company with equity, it is yours, subject to whatever liquidity rights (ie., sale or IPO of the business after 5 years) might be negotiated at closing.
3. Debt sits on your balance sheet as a liability; equity doesn’t. If you issue pref shares with retraction rights (you can retract – require repayment of – the prefs after 5 years, let’s say), then your auditors will categorize them as debt.
4. Debt providers often take security over the assets of a company; equity players never do.

Debt comes in many forms:

– operating lines
– term debt (also called senior debt; loan is due on a certain date)
– amortizing debt (can be either senior or junior; regularly scheduled payments)
– venture debt (speaks to the nature of the borrower; often technology and life science sectors; can be senior or junior debt; usually requires equity participation)
– subordinated debt (ranks junior to senior debt; term can be 6 months to 7 years, for example; may require equity participation for some “upside”)
– mezzanine debt (ranks junior to denior debt; usually 5 year term or longer; may require equity participation)
– convertible debt (this usually ranks junior to bank debt but has all of the upside of equity and much of the downside protection of a secured lender)

Debt can be provided by many different types of institutions and firms, which can be either regulated or unregulated:
– Banks, Life Insurance companies, BDCs (Business Development Corps.) and Savings & Loans would make up the largest part of the regulated market (ie., a government body would oversee such things as capital ratios, for example).
– In the unregulated marketplace (ie., no statutory regulator for their lending business; but would have a Securities Regulator if they were a public company) you would find such firms as Wellington Financial, HTGC, CapitalSource (they’ve structured themselves as a REIT), Quest Capital, Montcap (factoring), Laurus (won an award in 2006 for stock arbitrage and convertibles), Fortress (a fabulous hedge fund), Integrated, Penfund, CIT, etc.

The message is simple. Finding the right debt provider might seem like a tall order, but the industry has had a few thousand years to structure itself to serve the corporate customer base. For every dollar of equity issued in North America last year, eleven new dollars of debt was issued.

JP Morgan arranged over US$2.5 billion last year for one mature software firm alone. The lending world is getting more comfortable with lending against I.P. and maintenance streams. Debt is a natural component of growing any successful business enterprise.

But equity it isn’t.

MRM