Financing the Entrepreneur: Determining the Best Method for Your Client

Although the financing sources available to small business clients do not fit a logical pattern, some guidelines may be developed to assist the attorney to help his client seek and evaluate financing sources.

The optimum source and type of financing will vary with the nature of the client, the client’s present and future needs, the client’s stage of development and possible legal problems. An understanding of such variations may allow the attorney to protect the client from a harmful transaction, and will at least avoid wasting time and effort on inappropriate types and sources of financing.

I. The Needs of the Client and the Financing Source: Debt v. Equity

Debt financing creates for the issuer an obligation to repay the principal amount and to pay interest (sometimes called “servicing” the debt.) Equity, on the other hand, gives the buyer an ownership share or interest in the company, and usually voting rights. It creates an obligation for payment only of the appropriate share upon the liquidation of the issuer, and then only after (and if) all debt has been repaid. Some instruments combine debt and equity features.

Each has its advantages and disadvantages, practical and legal, some of which are discussed below.

The below discusses various types of equity and debt financing and some financing (such as leasing) which is neither debt nor equity. This discussion to some extent (perhaps misleadingly) assumes certain sources of financing use only one or the other form, when in fact some sources use both. For example, venture capital transactions are frequently a combination of debt, such as promissory notes, and equity, such as attached common stock or warrants-rights to acquire stock, or notes convertible into stock, etc.)

A. Private Sources

Bank loans and even venture capital are generally unavailable to start-up companies. Start-ups must usually be financed by the owners of the business and their friends and families, and, less frequently, angel investors. These investments, when available, frequently avoid demands by the investor for participation in decision-making.

1. Equity Financing

The discussion below conceptually separates venture capital companies from “angels” and other similar investors. Venture capitalists are assumed to be entities generally consisting of more than one partner or principal who are engaged in the business of investing in businesses which are relatively new at relatively high risk caused by that newness. “Angels” are assumed to be persons, more frequently wealthy individuals than organized entities, who invest on a more sporadic and informal basis.

Angel investing is a relatively new phenomenon in the St. Louis region. “Angels” generally do not publicize their status as such, but seek out contact with entrepreneurs in various ways, such as attending meetings of the Missouri Venture Forum, a regional association established to foster entrepreneurism and related capital formation, in which they can become familiar with the business to be financed without disclosing their status.

Venture capital has historically been more limited in the St. Louis area than in most other regions, although the situation is improving. Venture capitalists seek primarily equity investment, i.e., common stock, with an ownership share proportional to the risk involved (typically 40% or less). But the structure may also include some debt characteristics, such as notes proportional in amount to the equity investment, possibly convertible to equity, and preferred stock with debt characteristics. Frequently, it will also include warrants to purchase additional common stock if the business is successful. Most venture capitalists seek capital gain in the long term, although some, such as bank-owned small business investment companies (federal government assisted venture capital firms) seek immediate income. Of course, venture capitalists will, in that long-term, require a greater return on investment than with relatively risk-free investments. Commonly, such desired return, for a 5 year investment, ranges from 10 times the investment for start-up companies to as low as three times the investment for more mature companies.

Although not every characteristic is required, venture capitalists generally prefer to invest in businesses:

1. the management of which have a proven track record, such as prior successful entrepreneurial activity or management of a significant profit center of a large corporation;
2. with a proven growth potential and the need for $500,000 or more within the next 12 months to meet that potential;
3. with the potential for an exit strategy of an initial public offering or some other profitable sale of the venture capitalist’s interest (e.g., to management or to a strategic buyer) within three to five years; and
4. with a potential value of $20,000,000 within three to five years.

Private offerings to investors other than venture capitalists generally increase the number of investors, thus increasing the impact of federal and state securities laws (discussed below), the cost of the financing and the financial risk of litigation in the event of investor dissatisfaction. The investors must be found and the securities sold, a task which is difficult and fraught with the threat of liability. However, such investors may be less demanding and meddlesome (and less helpful) than some venture capitalists and other institutional investors. Under Regulation D and accompanying state regulation, compliance of such offerings with the securities laws has been simplified.

Public offerings, on the other hand, must comply with time-consuming and expensive securities law requirements for registration and are generally practically available only to relatively mature companies. The principals of the business may thereafter be subject to restrictions on “inside” transactions with the company, and disclosure of sensitive information to the public must be made pursuant to the concomitant reporting requirements of the Securities and Exchange Commission (the “SEC”).

If the business is one of the few small businesses which qualify for a public offering, however, such an offering may offer substantial stockholders the opportunity to sell (at a price possibly significantly higher than the amount which they paid) all or part of their holdings in the offering or in the public market which may develop thereafter, or to use their stock as collateral. A public offering may also provide the company greater  visibility in the financial and business community. This may in turn provide a greater opportunity for future financings, for expansion through acquisitions and mergers, and for attraction of executive and other personnel with offers of employee stock plans.

Venture capital and investor financing through private and public offerings are used to finance virtually any business need, including working capital, inventory, payment of existing debt and acquisition of machinery and real estate.

2. Debt Financing

Generally, commercial banks, savings and loan associations, and commercial finance companies provide the standard, straightforward debt financing familiar to most attorneys. Such sources tend to specialize, restricting their financing to certain types of business needs for certain terms and serviced with certain types of agreements. The nature of such restrictions Is generally a function of the length of the payback period, the collection methods dictated and the collateral made available by the fulfillment of that need.

Commercial banks will generally, for mature companies, issue unsecured short term demand notes for 90 day periods, and unsecured lines of credit for 1 year, to finance working capital needs of corresponding time periods caused by fluctuations in accounts receivable and inventory. Both are expected to be paid out of the sale of that inventory and the collection of such receivables. Such unsecured credit is generally not available to new companies. Such working capital needs for less mature companies are more likely to be financed by commercial finance companies, venture capital firms and small business investment companies.

Machinery, other capital equipment and real estate, however, are generally financed by fewer sources. Banks finance such purchases with term loans and revolving credit agreements, secured with chattel or real estate mortgages. Savings and loan companies in some cases will make loans for expansion and the purchase of machinery, in addition to real estate and construction, but will still require that the loans be related to and secured by real estate.

Commercial finance companies typically provide loans (at higher interest rates) to (1) rapidly growing companies which are short of working capital due to such growth, (2) companies rebuilding after isolated setbacks, and (3) investors (including management insiders) for leveraged buy-outs. Such financing is often called “asset-based financing” because it is secured on the “current assets” of the company (i.e., inventory and receivables). It is intended to provide working capital for companies with several years experience and is generally not available for the purchase of equipment, land or buildings, or for start-up companies for initial capitalization.

Leasing companies, obviously, may only lease and thus provide effective alternative financing for leasable (generally tangible) assets. Leasing is not, therefore, available to assist with working capital, payment of debt, etc. However, because the leasing company retains title, simplifying its collection procedures, leasing is available to companies in virtually any stage of development, from start-up to maturity (if the risk of default on the lease is not excessive). Leases in effect provide 100% financing (of the leased assets), and because they are generally for longer terms than loans, they result in lower periodic payments. Leasing, however, is usually significantly more expensive than traditional debt financing.

An “operating” lease is not capitalized and does not appear as a liability on the balance sheet, but the leased property’s depreciation may not be deducted on tax returns. A “capital” lease (or a “lease purchase”) does so appear as a liability, so the property may be depreciated; the property generally becomes the property of the lessee at the end of the lease.

B. Government and Community Support Sources

A number of federal, state and local programs have been created to assist small businesses with financing, including the United States Small Business Administration (SBA), local governments and local development companies.

The SBA is authorized, subject to numerous restrictions, to guarantee loans by private lenders. Under its “7A” program, the SBA guarantees up to 85% of bank loans of less than $150,000, and up to 75% of larger loans. Such guarantees limit a bank’s risk, thus encouraging the bank to make loans it would otherwise not make, and possibly to lower the interest rate. Interest rates, which are generally favorable, are a function of the prime rate and a statutory rate and the cost of funds to the government.

The SBA’s 504 Loan Program is administered locally by certified development companies (“CDCs”). In the St. Louis area that is the Business Finance Corporation of St. Louis County, telephone 314-615-7663. Such loans are intended to provide growing businesses with long-term fixed rate financing for fixed assets, such as land and buildings.

Other SBA programs are also available to borrowers with specific characteristics. All such programs are described on the SBA’s web-site.

Generally, these and a number of other programs are administered by, and information concerning them may be obtained from, local government business assistance offices, including the City of St. Louis, telephone: 314-622-3400; the St. Louis County Economic Council, telephone 314-615-7663; the Missouri Department of Economic Development, telephone: 314-340-6823. The SBA may be contacted at 314-436-2202.

Industrial revenue bonds, the income from which is exempt from federal and state income tax, are available for financing of fixed assets. Such programs are also administered by local government business assistance offices, including the City of St. Louis and the St. Louis County Economic Council.

II. The Client’s Stage of Development

The type of financing available to a business varies with the risk to the source of such financing of loss of part or all of the investment. It is generally believed that such risk drops as the business ages and develops from start-up through operations and initial profitability to maturity.

Some businesspeople in a start-up posture are inclined to seek out financing from numerous small investors, in the (often erroneous) belief that such small investors thus have an opportunity to “get in on the ground floor” of a soon-to-be-booming business, and the (generally correct)  elief that other sources, such as venture capitalists and finance companies, will demand more control of the business, higher interest payments, etc. And, in fact, there are sufficient prospective small investors who would otherwise seek to avail themselves of such “opportunities,” without the  inancial expertise and ability to understand and bear the risk, that federal and state legislatures have adopted the securities laws regulating the offer and sale of such investments. As a general rule, offerings to numerous small investors, other than close friends and relatives, are not available to the start-up business without undue legal risk.

Similarly, commercial bank financing is generally not available to start-up businesses. Such banks generally require unsecured financing to be paid within a year and will make longer term loans only if secured on accounts receivable or personal or real property. Banks also generally require that the borrower’s financial statements show an ability to make principal and interest payments from the revenues of the business, (i.e., to “cash flow” the debt service.) These and other bank requirements can generally not be met by start-up businesses, for which revenues sufficient to pay such debt or provide such collateral are not anticipated in the near future.

III. The Client’s Ability to Pay a Return: Ratio Analysis

Your client should try to determine that form or structure of financing-debt, equity, or a combination of both-which is best for its present needs, and also for its anticipated future financial needs and structure. That is, the present financing should be chosen so as to optimize the opportunities to obtain financing and other business necessities now and in the future.

The ratios between various financial characteristics of a business are generally believed to be indicia of the various strengths and weaknesses of the business. Present and future sources of financing (and other persons important to the client) will examine at least those of the client’s ratios which indicate probability of repayment. Therefore, you and your client should determine and analyze the present “ratios” and attempt to optimize the client’s future ratios.

The ratios most important to potential lenders and other present and future sources of financing are the leverage, liquidity and coverage ratios.

The leverage ratio compares the amount of debt of a business with the amount of its equity investment and net worth. A highly leveraged firm is more vulnerable to business downturns, particularly if the interest rates it is required to pay are high. The debt-to-worth ratio is the ratio of total liabilities (both long and short term) to total tangible net worth. It is one indicia of the degree of protection provided the creditors by the equity owners. A high ratio indicates a greater risk being assumed by creditors. However, during a period of high income (calculated before debt service) such a ratio would benefit equity investors by allowing proportionately greater retention of earnings, payment of dividends, or both.

Liquidity ratios measure the adequacy of current assets to meet current obligations as they come due. The current ratio is the ratio of current assets (cash and assets which may be converted to cash within one year) to current liabilities (debts which must be paid within one year). The quick ratio is the ratio of the sum of cash, cash equivalents (e.g., marketable securities) and accounts and notes receivable to current liabilities. It expresses the degree to which a company’s current liabilities are covered by the most liquid current assets. Generally, any value of less than one-to-one indicates the necessity to liquidate inventory or other current assets to pay short term debt.

Coverage ratios measure a company’s ability to make its payments of interest and principal from revenues. A high ratio of earnings (profit) before interest and taxes (EBIT) to annual interest indicates a borrower has little difficulty meeting such payments, and also serves as one of the better indicators of the firm’s ability to immediately meet new interest payments on additional debt. The ratio of cash flow (the sum of net profit, depreciation, depletion and amortization expenses) to current maturities (i.e., within one year) of long term debt, is an even more direct indicator of such ability, because cash flow is the primary source of debt payment.

Meaningful analysis of the ratios requires the comparison of these ratios with such ratios for other companies in your client’s industry. Such data are available from such services as the Risk Management Association (formerly Robert Morris Associates), Dun & Bradstreet and various trade association publications in your client’s particular industry. As a general rule, financing which increases the leverage ratios or lowers the liquidity and coverage ratios will make future debt financing more difficult because future lenders will interpret such ratios as indicating a reduced ability to service debt. Future equity financing would also thus be made even more difficult because dividends and liquidating amounts on such equity securities are paid only after debt service. Also, highly leveraged firms, particularly if small, will be perceived to be more vulnerable to business downturns. (Of course, debt financing provided by the client’s insiders who also have a substantial equity investment may be excluded when making such calculations to the extent such persons would not demand payment in times of financial stress.) On the other hand, high leveraging and low liquidity and coverage could provide, in times of prosperity, the ability to generate substantial earnings and growth (particularly if the interest rate on the firm’s debt is low and fixed).

IV. Securities Laws Considerations

Prior to any offer or sale of a security, such offer or sale must be registered federally under the Securities Act of 193313 (the “1933 Act”) and, in most situations relevant to new or small businesses14, under the Missouri Uniform Securities Act or other state securities statutes (often called “blue sky” laws), unless exemptions from both the federal and the applicable state registration requirements can be affirmatively established by the seller of the security. If such sale was not registered, and the seller cannot establish an exemption, the buyer may “rescind” the sale and recover the purchase price plus interest at the legal rate from either or both the seller or the “controlling persons” of the seller.

Registration, however, is not feasible for most small businesses, due to its legal, accounting, printing (sometimes) and other costs. Therefore, this discussion is generally limited to highlighting the exemptions which are most available and useful to small businesses. (However, one type of registration-”SCOR” offerings-is discussed briefly below.) Counsel are well advised to read other more complete analyses of both registration and the exemptions therefrom when actually structuring a financing.

A. Federal Exemptions

Section 4 of the 1933 Act18 exempts certain “transactions,” and Section 3 thereof exempts certain “securities” (some of which are actually “transactions”), from the registration requirements.

1. Private and Small Offerings: Regulation D

The most important exemption under Section 4 for a small business seeking to finance is probably the time-honored “private offering” exemption of Section 4(2)20 for “transactions by an issuer not involving a public offering.” The cases and administrative pronouncements have, in a somewhat confusing manner21, fashioned the concept of a private offering to be one in which (1) offers (including mere indications of interest) are made to only a small number of investors, (2) all offerees (regardless whether they purchase) possess investment sophistication (i.e., as defined in Regulation D discussed below, they possess sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment), (3) all offerees have “access” to the information which would be available in a registration statement, (4) no offer is made by general advertising or solicitation, and (5) all purchasers at the time of the purchase have an “investment” intent (rather than an intent to resell the securities).

Section 3(b) of the 1933 Act authorized the SEC to add to the list of exempt “securities” any class of securities as to which the public interest does not require registration because of the small number of purchasers or the small amount of the offering. Pursuant to this “small offering” exemption, the SEC has adopted Regulation A (discussed below) and, in conjunction with the “private offering” exemption of Section 4(2) and the “small offering” exemptions, Regulation D.

Regulation D22 combines the “small offering” and “private offering” concepts into its Rules 501 through 508, and establishes three types of offerings as set forth in Rules 504, 505 and 506. Offers and sales satisfying the requirements of Rules 504 or 506 are exempt pursuant to Section 3(b)(i.e., as “small” offerings), and those satisfying Rule 506 are exempt pursuant to Section 4(2)(i.e., as “private” offerings).

Rule 504 exempts any offering up to $1,000,000 during any 12 month period. Rule 504 requires no specific disclosure, investment sophistication or riskbearing ability and sets no limit upon the number of purchasers, and de facto defers to state regulation the decision whether to impose such limitations. (And, as discussed below, other factors may dictate use of an offering circular, and the generally applicable exemptions from the state registration requirements limit the number of purchasers.)

Rule 505 exempts sales of securities of up to $5,000,000 during any 12 month period to up to 35 investors without regard to investment sophistication, financial riskbearing ability or the number of offerees,, and to an unlimited number of accredited investors. An extensive disclosure document must be provided to investors prior to sale, under Rule 502 discussed below.

Rule 506 exempts sales to up to 35 purchasers during any 12 month period without regard to the dollar amount of such sales. Under Rule 506, the issuer must reasonably believe each non-accredited investor or his “purchaser representative” possesses investment sophistication. A Rule 502 disclosure document must also be provided to investors prior to sale.

Rule 502 establishes, inter alia, the requirements for disclosure to investors in Regulation D offerings. No specified information need be provided to investors in Rule 504 offerings, or in Rule 505 and 506 sales to accredited investors. However, Rule 505 or 506 sales to nonaccredited investors must be preceded by the provision of certain specified information (usually in the form of a “private placement memorandum”.) Such information, particularly financial information, is significantly more difficult and exhaustive for offerings in excess of $2,000,000. Also, in offerings under Rules 505 and 506, the issuer must make available to all purchasers the opportunity to question company representatives concerning the offering and to verify all written information obtained.

Sections 502(c) and 502(d) prohibit the use of general means of advertising or solicitation, restrict the further transfer of the securities by purchasers (i.e., “secondary trading”) and require the issuer to use reasonable care (by inquiry of purchasers, investment letters and “legending” of certificates) to insure that no purchaser intends to resell the securities in non-exempt transactions.

However, recent amendments to Rule 504, creating Rule 504(b)(1)(i), eliminate these restrictions if the securities are registered and sold only in states requiring filing and delivery to investors of a “substantive disclosure document” prior to the sale to them. And the North American Securities Administrators Association (NASAA) has promulgated and 45 states including Missouri, have adopted, a streamlined registration process entitled Small Corporate Offering Registration-”SCOR”. The most noteworthy aspect of this registration process is its allowance of a disclosure document (on Form U-7) which is significantly less exhaustive than the disclosure documents required under federal rules. Therefore, pursuant to federal Rule 504 and the relevant state SCOR rules, an issuer may make a much less expensive public offering (but only up to $1,000,000 in any 12-month period) with no restrictions thereafter on secondary trading by the purchasers in the offering.

Rule 503 requires that for any Regulation D offering Form D (which is available from SEC regional offices, and which contains only very brief information about the issuer and the offering) be filed with the SEC within 15 days after the first sale.

2. Regulation A -”Mini-registration”

Pursuant to the SEC’s Regulation A an issuer may sell up to $5,000,000 in securities during a twelve-month period23. The issuer must file a notification with the regional office of the SEC, one exhibit to which is an offering circular similar to (but much less comprehensive than) a prospectus in a registered offering. Another important feature similar to that of a registered offering is that securities purchased in a Regulation A offering are not subject to the restrictions of federal law on “secondary” trading (i.e., resale by the original purchasers) usually applicable to unregistered securities.

Different from a registered offering, however, the disclosure requirements of Regulation A, particularly as to financial statements, are more easily compiled with, and the review by the SEC is more expeditious than with, a registered offering. (e.g., the SCOR disclosure document format discussed above, may be used.) These and other differences make the Regulation A offering significantly less expensive than a registered  ofering, although generally more expensive than a Regulation D offering.

3. The “Intra-state Offering”

Section 3(a)(11) of the 1933 Act exempts any security which is part of an issue offered and sold only to persons resident (and who have no intention to resell to persons not resident) in the state of the issuer’s residence or incorporation, place of doing business and location of most assets (all of which must be the same state). This exemption is peculiarly risky because of the difficulty in defining “doing business” and other interpretational problems and the risk of out-of-state offers or sales being integrated into the issue. To clarify the availability of the intrastate exemption, the SEC adopted Rule 14724 in 1974. Rule 147 requires that the securities be held by purchasers in the state concerned for at least nine months, and that the issuer take certain steps to avoid interstate distribution. The intrastate exemption has the advantage that the issuer is not required thereby to disclose or grant access to any specified information concerning itself or the offering, or to make any filing with the SEC.

B. Missouri Exemptions and Low Cost State Registration

Numerous statutory “securities” and “transaction” exemptions from the Missouri registration requirements are set forth in Section 409.402(a) and (b), respectively, of the Missouri Act. But only four are generally important or available to small businesses seeking financings. Also, the Missouri Securities Commissioner, under its rule-making power, has adopted two other exemptions.

1. Missouri Statutory Exemptions

a. Sales to Institutions

The exemption used most often (and often without knowledge an exemption is required) is that of Section 409.402(b)(8), which exempts: any offer or sale to a bank, savings institution, trust company, insurance company, investment company. . .pension or profit sharing trust, or other financial institution or institutional buyer, or to a broker-dealer. . .

b. The “First 25″ Exemption

Section 409.402(b)(9) exempts: any transaction. . .if immediately thereafter the total number of persons who are known to the issuer to have any . . .record or beneficial interest in any of its securities. . .does not exceed twenty-five. . .(excluding certain institutions) and no commissions are paid.

c. The “Limited Offering” Exemption

Section 409.402(b)(10) exempts sales to up to fifteen persons during a twelve month period, if the issuer reasonably believes, and each buyer so represents in writing, that each buyer is purchasing for investment (i.e., with no view to resale in the foreseeable future), and no commission is paid.

d. Offerings to Existing Security Holders

Section 409.402(b)(11) exempts sales pursuant to an offer to existing security holders, including holders of convertible securities, non-transferable warrants, and certain transferable warrants, if no commission is paid or the issuer files a notice with the Commissioner specifying the terms of the offer and the Commissioner does not disallow the exemption within five business days.

2. Exemption Adopted by Missouri Securities Commission Rule

a. Limited Offering Exemption Coordinating with Regulation D: 15 CSR 30-54.210

The Missouri Securities Commissioner adopted by regulation28 the “Uniform Limited Offering Exemption (“ULOE”) promulgated by the North American Securities Administration. The ULOE coordinates with federal Regulation D. It exempts any offer or sale made in compliance with Rules 505, 506 and 501-503 of Regulation D. It is not available to sales made only under the provisions of Rule 504. The ULOE requires that the issuer file the Form D with the Commissioner on essentially the same schedule as filings thereof with the SEC and pay a fee. The ULOE further requires that the investment is, or the issuer reasonably believes, “upon the basis of the facts, if any, disclosed by the purchaser. . .” that the investment is, “suitable” for each non-accredited investor. For the purpose of this condition an investment not exceeding 20% of the investor’s net worth is presumed suitable.

b. Missouri Issuer Exemption: 15 CSR 30-54.240

This exemption is limited to only Missouri corporations meeting various requirements. The issuer thereunder may sell only $500,000 in any 12-month period, and must provide an extensive disclosure document not required by other exemptions. This exemption is used only infrequently.

3. Low-Cost Registration Format: SCOR

In response to the same widespread criticism by the small business and entrepreneurial community (that federal and state regulations were preventing its ability to raise capital) that led to the SEC’s adopting Regulation D, the North American Securities Administrators’ Association in April 1989 adopted and promulgated to its state members a less exhaustive format for registration of securities. That format includes a  significantly less exhaustive and thus less costly disclosure document-the Small Corporate Offering Registration (SCOR) form. The SCOR registration format, after development since adoption, is now used primarily to register under state law offerings which are exempt from federal registration under Rule 504 (limited to $1,000,000 in 12 months) of Regulation D, and under Rule 147 (the intra-state exemption). The main advantage to such registration is that it removes the restriction on “secondary trading”. That is, it allows the purchasers to immediately freely trade their securities and it thereby allows a secondary trading market to develop. The availability of such a market (if it develops, which is not assured) often facilitates future financing by the issuer. The details of the form and the SCOR registration process are beyond the scope of this discussion.

The Missouri Securities Commission has adopted the SCOR registration format as part of its “Missouri Issuer Registration rule. Both the NASAA Statement of Policy concerning the SCOR format and the Missouri rule place numerous restrictions on the use of the SCOR format.

Conclusion

A small business client and its attorney must make numerous considerations when seeking financing. This paper, in a rather broad brush approach, has touched on a panoply of such considerations. Many, but not all, of the subject areas discussed above will be examined during deliberations leading to any one financing. But over the course of a client’s development from start-up to maturity, all such subject areas and many others must be considered by the client. And even though some such subjects, such as ratio analysis, may not be the attorney’s primary responsibility, his familiarity with these subjects will increase his value to the small business client and his ability to deliver knowledgeable and efficient legal care. And it will cause that care to mesh easily with the professional services provided the client by his accountant, banker,  investment banker and others.