Debt Risk
- Use of proceeds - clear purpose with high expectation of pay-back period i.e buying a machine to increase capacity
- Asset cover - the value of the assets (individual or via a Debenture over the company) provide greater value than the facilities required
- Earnings cover - the cash generation and (or) profitability exceed the servicing costs of the facilities required
- Forward or backward looking - debt service requirement is covered by legacy/historic trading i.e the loan costs £0.5m per annum and the business has been generating £0.7m per annum beforehand
- Downside protection - the business and (or) shareholders already have cash/investment to cover trading liabilities outside of the requirement for funding
Equity Risk
- Use of proceeds - unclear purpose or supporting an unproven aspiration i.e the business wants to develop its own intellectual IP
- Asset cover - the value of the assets (individual or via a Debenture over the company) are less than the facilities required
- Earnings cover - the cash generation and (or) profitability are insufficient to support the servicing costs of the facilities required
- Forward or backward looking - repayment of the facilities required are only possible by a level of trading not yet demonstrated by the business
- Downside protection - the business and (or) shareholders have insufficient cash to cover trading liabilities outside of the requirement for funding
Once it is clear whether the funding requirement is a result of Debt or Equity Risk, the appropriateness in fit of possible providers and facilities can be considered. What is common, however, are situations where there may be overlap (i.e not fully Debt Risk but not fully Equity Risk - otherwise known as the “Equity Gap”). In these instances, we can apply a range of possible solutions (including but not limited to):
- Can the timing of the requirement be reduced, phased, re-shaped such that its debt service requirements make it more naturally Debt Risk?
- Can the financial reporting and modelling of the business be developed such that the company's ability to create debt service can be proven beyond hope/speculation?
- Can the company create cost savings and (or) increased earnings elsewhere to assist with bridging the “Equity gap” now or via the financial model?
- Can the funding requirement be serviced by combining multiple lending products and including debt providers which are directed at contributing to the Equity Gap?
- Can the company's shareholders (or new prospective investors) introduce monies to cover the Equity Gap?
- Can the funding requirement be covered by company/shareholders/investors in the short-term and in doing so have the business benefit from the reward of its use of proceeds i.e increased size/earnings, such that their monies can then be refinanced by Debt providers shortly after as the transaction is now Debt Risk?
Whilst these are concepts familiar with those in the debt, investment and advisory markets, they are often uncommon for SME business owners who just have activities/requirements they want to fund and cannot understand all the questions and requirements for information which come from lenders (sometimes all asking the same questions and sometimes asking widely different questions).
The role of a great advisor is to minimise the mgmt distraction caused by such a process, to maximise the funding capacity & terms and ensure the company has the best advice in terms of the appropriateness of circumstances, provider, product and what any decisions taken now may mean for the future of the business?