Over the last few months, I’ve had interesting conversations with David Pritchard and Jonathan Cunningham of Aequitas Advisors about how companies raise capital. They were both previously investment bankers and now spend their time advising companies on the risks and benefits of different deals. Recently I decided to interview David to get his perspective on how companies should think about using debt and equity to grow their business.
The interview covered how to think about financing your business at different stages of growth, how to treat debt and equity, and how to run a process in order to get the right financing for your business. Here’s the full interview:
Cody Boyte: If I want to raise additional capital to grow my business, how should I be thinking about it? What should I take into consideration?
David Pritchard: I think about the spectrum of investors and spectrum of products, where does the company want to fit on cost of capital vs financial flexibility? That’s what I’m weighing all the time. Companies really need to consider the true ‘all-in’ cost of capital. The idea being that when you’re looking at the spectrum of capital options there are a range of costs.
Equity has the highest cost of capital, but there’s no fixed cost. There’s no debt service or redemption date. Debt financing, on the other hand, can be your cheapest cost of capital. The more restrictive it is, secured debt for example, the cheaper it will be. But it tends to come packaged with debt service requirements, covenants and restrictions and reduces the financial flexibility of the business.
If I’m looking at the spectrum with debt on one end and equity on the other, all the options in between have some mix between the two. Either debt with some equity components or equity with some debt components. I’m always thinking, as a company seeking capital, I want to start looking on one end of the spectrum and work my way towards the other end.
I’m weighing the fixed cost of capital against financial flexibility. I can minimize my cost of capital, but likely only in the context of something that’s going to reduce my financial flexibility.
CB: From reading the press, it seems like many companies just sell equity to finance their business growth. But you’re calling it the most expensive type of capital.
DP: Every time you sell equity, you hope it will prove to be a lousy sale. You may not recognize it, but if you sell equity in your business today you’re at a point where in you’re balancing your need and ability to take on leverage to fund your business versus your want to take on permanent capital that can’t bankrupt you, can’t create refinancing risk, etc.
Making the choice for equity is saying that you’re hoping the permanent capital will let you execute on your business plan in a way that, three years from now, you wish you hadn’t sold the stock. You can never back out at that point, but if you hadn’t sold the stock you wouldn’t be where you are.
Every business is growing on some balance of debt and equity all the way up the food chain. High-yield debt theory says that if you can make a 25% return on invested capital, you should be willing to take on debt at rates up to 24.9%. But that doesn’t give you much room for error. It puts an enormous amount of pressure on the company. Every time you sell stock, you hope you’re looking back saying you’d never done it.
CB: Let’s say I’m a lower middle market manufacturing business who has decided to raise capital. How do I run the process and protect my interests?
DP: If I’m a lower middle market manufacturing business, I’m going to parallel process a path with both a potential strategic investor and a private placement. And, to the extent possible, I’m going to let the other party know that I’m pursuing the other avenue at some point in my dialog. Anything I can do to create a view of there being multiple avenues or competitive dynamics can only work to my favor.
I can’t be pressing this angle if there’s no substance to it, but where I can I want to create competition. A very significant number of companies who go public are also parallel processing a path with strategic investors and are trying to ascertain where they’ve got the best bid.
You’re trying to find that spot where the company’s needs and objectives, the company’s desire to preserve or forego financial flexibility, the company’s desire to pay a fixed price and the company’s risk profile meet the needs and objectives of whatever investor segment you’re positioned to be approaching for the most optimized cost of capital at this point in your growth cycle. You’re always balancing that around the dilution and control issues for some of these companies.
There’s a sweet spot where a deal happens.
CB: What about an alternative to straight debt or straight equity like a 5 year mezzanine loan where the whole loan comes due at the end of the term – how should I be weighing the risks? Do I have other options in the middle of debt and equity?
DP: When you go down a path of mezzanine debt, you can predict – with greater certainty than almost anything else that will happen to your business – that in five years you will have some sort of refinancing event. What you’re hoping is that five years from now your stock is going to be up so much that you’re going to fund half the refinancing by selling common equity 30x higher than it is today and then the other half you will be borrowing at half the interest rate this slug came with. If that happens you’ll be delighted.
But that’s an example of refinancing risk. It’s a huge point of exposure based on how your company is doing. You have no choice but to refinance at the end of the term, but you don’t know where that’s going to put you.
With a convertible bond one of the interesting things, for a transaction that is structured with true convertibility, is that if my stock appreciates the debt instrument can convert into common equity. The liability can be completely equitized off your balance sheet. It’s dilutive at that point, but it’s dilutive above where you are at day one. It’s an enormously deleveraging event. But who knows, at that point you may be saying “Darn, I wish this wasn’t convertible because I don’t think we’re going to 10, I think we’re headed to 50.”
CB: What else should I watch out for during a capital raise? What would you tell CEOs or CFOs who are in the process?
DP: Companies need to diligently analyze the “all-in” cost of capital to understand what it is they’re signing on for. You’re looking for embedded optionality. There are often embedded options or warrants that could represent significant value if the events or conditions that could give rise to them are triggered. The triggers could include reset provisions or accelerations of maturities. The companies have to read the fine print – that’s the biggest thing. It’s incumbent upon management to engage in the capital raising process with their eyes wide open.
If that involves the use of expert advisors in some contexts, then that makes sense. I’m of the view that the finance people at these businesses should not be expected to have this expertise. I want to say, “you are doing a stellar job being the CFO of your company right now, running the company itself. Do you think it’s appropriate for you, your CEO or the board to expect you to be completely current on all the ways of raising capital today?”
Companies will hire advisors and consultants in the context of a thousand things they do. What is the level of due diligence that someone considers sufficient if they’re making an acquisition of a given size? Why will that same company do a dilutive financing or incur indebtedness of that same size with a fraction of the diligence they apply for an acquisition?