Sources of Funds for Entrepreneurs and the Motivations Behind Investment

After exiting my first company, I was asked to join a merchant bank. Over several years, I participated and/or managed several acquisitions where we deployed over $40 million of capital, and realized almost $180 million in gains. Every year I learned more about sources of funds and what the point-of-view was from the other side of the desk. The Chairman and CEO of the merchant bank came to appreciate the duality of my experiences. We became partners in several ventures over the following decade. I once asked why he trusted me with his money, his answer was that of all the employees of the merchant bank, only I had made a payroll, invested my own money, and signed a personal guarantee.

Entrepreneurs and privately held business need to understand, and appreciate, that what is most important to them is not necessarily what motivates the one writing the check. The funding landscape has changed over the past decade and is more precarious than ever. For simplicity sake, let’s break the funding landscape into three sources of funds: Friends and Family, Lenders, and Private Equity. Let’s look at the pros, cons and motivation of each:

Friends and Family

Pros: By far the least dilutive equity capital to obtain. The mission and vision of the entrepreneur or privately owned business is more easily understood. The audience is more sympathetic and typically less knowledgeable about the business metrics;

Cons: The majority of start-up businesses fail within the first 2 years from inception. Relationships between friends and family investors, and the entrepreneur become frayed and emotional if the company fails. Remember, you can choose your friends, but not your family. The risk of loss plays across a broader human spectrum that can last for years or generations.

Prime Motivation: The entrepreneur and his family, with a profit motive secondary. It’s not that friends and family members do not want to profit, but the risk/reward calculation is less important than the emotional desire to help.

Institutional Lenders

Pros: Usually the least dilutive capital to access. Banks and other specialty lenders provide working capital debt facilities based on a formula, typically a loan-to-value of 75%-85% of accounts receivable less than 120 days outstanding, and up to 50% of the value of eligible inventory. Institutional debt interest rates are priced at the Prime Rate or LIBOR, plus 1.5%-5%. Institutional borrowing is a pretty straight forward 90 to 120 day process: expect to provide historical financials, forward budgets and/or business plans and strong management attention to detail are expected as part of the decision tree;

Cons: Institutions tend to be monolithic. Personal guarantees are expected and the Company should expected regular onsite audits of the assets, payroll and tax obligations and legal matters. The accounts receivable, inventory and fixed assets are the lender’s front line of security. The formula is rarely negotiable by more than a few percentage points. Working capital facilities have 1-3 year terms, with clauses that allow the bank to call in the loan or not renew. Some specialty lenders demand warrants for conversion into equity, in order to increase their IRR. If the Company performs and manages it assets responsibly, your banker can be one the Company’s greatest friends and assets. Poor management of the balance sheet can put the Company into the bank workout department and possibly trigger the personal guarantees.

Prime Motivation: Banks and specialty lenders have one overriding purpose: to rent money. They want to be secure about receiving that rental back in one piece. A lender’s assets include business loans. The more money they rent, the larger they become. For generations, the benchmark banking metric driving stock analysts has been exceeding a 1% Return on Assets (“ROA”). Working Capital credit lines that carry interest rates of Prime + 3.5% are targeted at small to middle market businesses. Larger corporate borrowers, both private and public, often sell commercial paper or borrow from institutional lenders at rates below the prime rate. Therefore lending institutions make lending decisions on (2) primary factors: quality of assets, and the management team. When the Great Recession hit in 2008-2009, lenders didn’t raise interest rates, they stopped lending to start-ups and less mature companies with greater risk profiles. Lack of liquidity from the lending sector helped to deepen the recession and increase unemployment because access to growth capital was in short supply.

Private Equity

Pros: Private Equity Groups (“PEG”) tend to be very smart and to understand the entrepreneur’s industry in great depth. Many PEG’s specialize by industry and segment. A PEG thinks medium term (3-5 years) about the exit strategy and bases the equity ownership on multiples of cash flow or EBITDA, as opposed to a loan-to-value formula of assets. For that reason, private equity investment is usually larger than what can be financed through a working capital loan. The higher the perceived risk of the balance sheet, the greater the dilution to ownership. PEG’s will demand Board representation, but also provide access to professional analytics and market research that can lead to increasing market share, improving operating margins or acquiring other companies.

Cons: Do not mistake the equity in Private Equity, for common stock or membership (if an LLC). Private Equity in most cases is invested as Preferred Stock, priced with cashless warrants attached in order to achieve Internal Rates of Return between 20% to 35% or more. The current coupon (interest) rate is typically 10% or more. The Preferred is treated as a secured instrument, senior to all other debt holders with the exception of institutional working capital debt. When a liquidity event occurs, the liquidation preferences will require payment of the preferred investment, and then the PEG equity as the cashless warrant will be converted into a percentage of the company common equity. As part of the purchase and sale documents will be affirmative and negative covenants that are tied to corporate governance, performance and use of funds. Breaches of a covenant can trigger expensive default provisions that increase the coupon rate and/or the warrant coverage.

Prime Motivation: Profit, just like the business owner. The PEG wants to buy equity as cheaply as possible and maximize their return on investment. As an entrepreneur, your evaluation of risk/reward is much different than your private equity partner’s calculation. The PEG will enforce negative covenants; what you view as a well thought risk can trip a debt-to-equity coverage ratio, or EBITDA target. Be careful to monitor the cure provisions in your transaction documents or your cost of doing business will increase dramatically (due to legal expenses and default fees and interest), and corporate governance can become an issue. Warrant coverage that increases the IRR for the private equity group, come at the expense of the ownership. All of that said, the relationship between ownership and private equity is all about trust. In the absence of trust by either side, the relationship is untenable and carries greater consequences for the business ownership.

I have accessed capital from each of the (3) types of sources. My family was involved in my first transaction in 1985. It took almost a decade to heal the wounds from that debacle. I was confident in my knowledge of banking transactions, until I realized I hardly knew my banker. I have fought with, and benefitted from private equity. My last two ventures would not have had the successes that occurred without access to our PEG’s capital and financial expertise.

About the Author

Steven Schneider

Steven Schneider is the founder, in July 2009, of Alana HealthCare, LLC (www.alanahealthcare.com), headquartered in Nashville, Tennessee. He served as Chairman and CEO from inception through March 2014 and remains a Board member, along with senior management and representatives of the private equity group that has led two (2) rounds of funding since 2011. Mr. Schneider built and led various successful ventures in healthcare, technology and finance. In 2002 he co-founded FactorHealth Management, LLC and served as the company’s Chief Financial Officer. Prior to 2002 he served as the Chief Operating Officer at a NASDAQ-traded technology company. He was responsible for financial and strategic planning, merger and acquisition evaluation, and enterprise-wide corporate development.