BDC Perspective: Subordinate financing - a lesser known financing alternative

You may have heard it called "mezzanine financing", "junior debt", "structured equity" or "quasi-equity financing" but as Anthony Esposti, Manager of Subordinate Financing at BDC explains, the myriad of names all share a common principal - subordinate financing is basically a hybrid of debt and equity financing.

"It shares some of the characteristics of debt financing because the borrower has the obligation to repay," emphasizes Esposti. On the other hand, subordinate financing also mimics equity financing because repayment is based on cash flow rather than depreciating company assets. "What's important to remember is that the word "subordinate" basically refers to the fact that the security of BDC, for example, ranks behind or is secondary to senior lenders." Ultimately, the risk is shared.
So what's the key advantage of this type of financing for a small or medium-sized business? "Subordinate financing provides the capital necessary for a business to fuel its growth or secure its continuity. Repayment is not based on diminishing asset value but more on cash flow potential." emphasizes Esposti.

Expected cost
Entrepreneurs can expect part of the cost to be in the form of fixed interest, which is a deductible expense. The remaining cost comes in the form of a variable component such as a royalty, bonus payments or options to purchase shares in the company at a discount. "It's a higher risk so naturally a investor is looking for a higher return," he says.

Right now, if you're considering subordinate financing as an option, Esposti believes that talking to organizations such as BDC is important. "The industry is typically focused on larger transactions at $5 million and over. The Business Development Bank is a dominant player in the market for smaller transactions under $3,000,000," he says. "As Canada's small business bank, we truly understand the needs of SMEs."

Who's eligible?
Essentially, BDC would consider a small or medium sized business eligible if they have a sound management team, a record of profitability and an established line of credit. This means that start-ups are not considered for subordinate financing "We're looking for companies that have a proven track record and want to move to the next level."

However, he emphasizes that subordinate financing is not a formula-driven solution and can be customized to specific needs, depending on factors such as business seasonality, working capital requirements and the repayment structure. "The first step is to sit down with your lender, bring in your transaction and explain exactly what you're looking for. After that, a customized deal can be worked out," he says.

Typical investment scenarios
So what are the most typical scenarios when lenders consider subordinate financing as an option?

Management buy-outs/buy-ins
With an aging population, many 50+ business owners are looking for ways to exit their companies. Subordinate financing can provide the necessary funds for an existing management team to invest in the company. "Basically, we're helping entrepreneurs fill the financing gap in a transaction ," says Esposti.

CASE
Company X is an insurance adjuster in business since 1986, one of the fourth largest in Canada, showing $22 million in sales and very profitable. 14 senior managers in the company want to buyout owners who are 60+ and are looking to retire. The lender structured a deal that involved an equity injection by the new owners, a loan provided by the exiting owner and subordinate financing to round out the financing.

Mergers & Acquisitions
Mergers & Acquisitions naturally involve both fixed assets and more difficult-to-finance and intangible assets such as "goodwill." Subordinate financing can help companies purchase the goodwill while preserving their cash flow during a period where some uncertainty may exist.

CASE
An online research company has been in business since 1973 but has postponed its IPO due to market conditions. The company has expanded into the US and acquired businesses that will drive 25% growth over the next two years. The company has proven profitability, a strong management team and is a market leader with consistently retained earnings. The deal involves subordinate financing with payment at maturity, allowing the business to preserve cash flow.

Working capital for growth
Subordinate financing is often used to finance working capital for growth, which enables companies to increase revenues and profits. Entrepreneurs looking to invest money in market penetration, improve product R &D or finance additional headcount can take advantage of subordinate financing without compromising their regular cash flow used for daily operations.

CASE
A hardware company in business since 1981 has recently completed development of a proprietary technology. Financing was needed to help the company market this technology to existing clients and a broader market. This business needed to react to the market on a timely basis and to pre-build a one-month inventory of its products. The subordinate financing deal enabled this company to do just that.

Business owners: How to get money for your business!

There are many different ways that you can finance your business. The number of options can be overwhelming sometimes, as can the criteria of lenders and investors. Financing is not always readily available, but you can increase your chances of accessing financing by preparing. Browse through this information to determine what type of financing is best for your business and study the documents on how to make a pitch to a lender or investor. Government financing Government financing Government departments and agencies provide financing such as grants and contributions, subsidies and loan guarantees. Private sector financing Private sector financing Your business may be eligible for a wide variety of different types of private sector financing, including debt and equity. Personal assets Personal assets Most new entrepreneurs will use some of their own assets to get the business off the ground. Financing for specific demographic groups Financing for specific demographic groups Find out what financing is available for specific demographic groups, including Aboriginal peoples, immigrants, persons with disabilities, women and youth. Financing from not-for-profit and community-based organizations Financing from not-for-profit and community-based organizations Look beyond traditional funding sources. There may be not-for-profit or community-based organizations that can offer you financing or direct you towards financing. Steps to Growth Capital Steps to Growth Capital Learn how to develop the plan, the materials and the confidence to go after the equity financing for your business opportunity. for more info, consult http://www.canadabusiness.ca/eng/82/150/

Factors to consider when requesting financing for a start-up

QUESTION:

What are the most important factors to consider when asking a financial institution for financing to start a business?

ANSWER:

Most bankers look at four factors:

Your professional profile

Bankers try to evaluate your ability to manage the project. You must show that you have the experience, skills, determination and self-confidence necessary to successfully carry out your project.

Your project's viability

You should have a business plan that is clear, structured and short, but also covers all the elements of your business idea. You need to present at least two years of financial projections as well as an analysis of market size, market potential and positioning.

Your financial strength

You will have to reveal your personal and business net worth (assets minus liabilities) so a banker can judge your ability to meet your financial obligations. A banker will also look at your past credit history to gauge the future.

Your collateral

Bankers often also look for assets to secure a loan. They invariably ask for some investment on your part as proof of commitment. This investment might have been raised by you privately.

Of all these factors, perhaps the most important is that you have planned out your idea beyond the idea stage. Before approaching a bank for financing, you should be able to predict, and answer in detail, all possible questions about your business, such as how you are going to do it and what its potential is.

You should also have a clear concept of where you want to be in five years, and have a list of steps required to get you there. If you can convince a banker of this, many of the other factors can be negotiated.

Sources of Financing for Entrepreneurs

For your information, the Governement of Canada have an interesting website that you should visit. Sources of financing can help you locate traditional or alternative sources of financing for your small business. You will find an extensive directory of Canadian financial providers, information on different types of financing, and tips to help you secure financing. I found this site quite helpful to understand the financing process and to also locate sources of financing.

Please click here to visit the website.