What's it worth?

Entrepreneur, May, 1998 by David R. Evanson, Art Beroff

Despite all the hoopla banks are making about the small-business market, in the final analysis, it's often a poor fit for them. There are many reasons for this: Banks are built to make large loans, not small ones. Because they are lending depositors' money, banks can only make loans where there is very little risk; there has to be plenty of cash flow and hard assets to back up a loan. And finally, banks almost always require monthly or quarterly payments on the loans.

All this is fine for the banks - it's just diametrically at odds with the experience of most small or early-stage businesses. Keeping the above in mind, consider that small businesses possess large amounts of risk and little cash flow, and they attract new business at a slow, if not random, pace.

There is another alternative, however - one most entrepreneurs probably haven't considered. "The needs of entrepreneurs and banks can be bridged by angel investors who are willing to provide loan guarantees," says Arthur Lipper III, chairman of Del Mar, California-based British Far East Holdings Ltd., a company that provides and arranges financing and offers advisory services.

"It's not cheap, and sometimes it's not easy," Lipper says, regarding the use of third-party guarantees, which he arranges for deals between $400,000 and $3 million. "But for companies with explosive growth opportunities, it can be the best way to go."

LET'S MAKE A DEAL

To get such a deal done, an entrepreneur needs three ingredients: two banks and one guarantor. Lipper says providing loan guarantees to high-growth companies is a very subjective undertaking for investors, and there are several ways a deal might be structured. However, he says a typical one-year loan for $1 million might be put together as follows:

First, the investor purchases a letter of credit from his or her bank. This letter of credit stipulates that the investor's bank will pay to the entrepreneur's bank $1 million one year from the date of the agreement.

For the bank to issue such a letter, it will charge 1 percent to 2 percent of the amount of funds being guaranteed - in this case $10,000 to $20,000 - as a fee. But also, because it's a bank (and banks tend not to take risks), it will also require the investor to deposit $1 million in government securities or $2 million of marginable securities into the bank. (So-called "marginable" securities are those that can be borrowed against, a determination made by the Federal Reserve.) These assets collateralize the letter of credit the bank issues.

With a rock-solid letter of credit for $1 million protecting it, the entrepreneur's bank will then lend the entrepreneur the $1 million he or she needs to grow the business.

POCKETBOOK BLUES

Loan guarantees don't come cheaply. In fact, when you add it all up, it can be darned expensive financing. Here, Lipper details some of the costs the entrepreneur would be expected to pay in such a transaction:

* Guarantee fee. Remember, in addition to depositing funds into the bank, the investor had to pay his or her bank a fee to get it to issue the letter of credit. "The way the investor would tend to think," says Lipper, "is 'It's the entrepreneur's loan that is getting guaranteed, not mine,' therefore he or she should pay the fees."

* Investor fee. Next, Lipper says he typically collects a fee of 5 percent of the guaranteed amount for putting the deal together. For our hypothetical $1 million deal, that's another $50,000.

* Bank interest. For deals such as this, banks typically charge the prime rate plus 1 percent (known as a premium), says Lipper. "It's outrageous for them to charge a premium," he says, "since there is absolutely no risk to the bank whatsoever." Moreover, he says, to avoid any possibility of default, the bank issuing the letter of credit will probably stipulate that the interest on the loan be taken out of the proceeds upfront.

It's important to note that the effect of all these fees coming off the top of the loan ratchets up the interest rate the company pays for the loan. In our example, the guarantee fee is, say, $20,000, Lipper's 5 percent fee is another $50,000, and the bank's interest upfront of perhaps 8 percent is another $80,000, for a whopping total of $150,000.

Looked at differently, the entrepreneur is really paying $150,000 for the use of $850,000 ($1 million loan proceeds minus $150,000 fees and interest). The true rate of interest is then 17.6 percent.

But it doesn't stop there. The piece de resistance comes in the form of a "carried interest" in the company paid to the investor. Lipper says the carried interest is either a percentage of the company's revenues going forward or a hunk of the company's equity, perhaps 3 percent to 5 percent.

This equity, by the way, can often be structured as warrants, which are options to purchase equity at a specified price for a specified period of time. "For the company, the advantage of warrants," says Lipper, "is that it doesn't surrender any equity immediately, and when the warrants are exercised, the company gets an additional infusion of capital."