Originally published in Middle Market Executive
One of our favorite aspects of middle market financing is the impact that imaginative approaches to financing can have on companies’ business plans. But understanding all the options available, how each can fit a particular situation, and what the wisest choice is takes energy and expertise.
Middle market companies have many options for financing, which provides the latitude to structure it to each company’s unique circumstances. While having many options can enable a business to efficiently leverage all of its resources, it can also lead to misunderstandings. To make the most of them—and stay out of trouble, business owners must be able to put their debt options into context.
There are fundamentally six ways for a middle market company to finance itself. We’ve listed them below in order of risk to the investor (sometimes, lender), from low to high. The low-to-high-risk continuum also tracks the type of relationship between the investor and a company; from a relatively low-maintenance contract to more of a partnership, in which the investor is making decisions along with the business owner.
There is no better source of capital than the operating cash flow retained in the business. But, a business can grow faster with access to more capital than its sales provide. That’s when outside lenders and investors come in.
Sell an asset
Factoring. The business owner sells accounts receivable to generate cash in a shorter time period than when the receivable would have been collected.
Securitization. Sellers pool assets into a trust to create a more secure and standard investment to collateralize a loan. This is typically available for certain well-understood cash-generating assets like mortgage loans, movie rights or insurance policies.
Sell an asset and lease it back
· Leaseback. A transaction in which the borrower sells his property to a lender with an agreement to lease it back, changing a capital investment to an ongoing expense.
Borrow with the loan secured by an asset
Your business’s assets can be source of cash when presented as collateral for a loan. (Conceptually, company debt backed by a personal guarantee falls in this category. The asset is the owner’s personal savings.) Two common examples are:
· Mortgages. Real estate loans secured by property.
· Asset-backed loan. Short-term debt secured by an asset.
Borrow unsecured or subordinated debt
· Unsecured debt. The borrower borrows money against the business’s track record of generating profits. There is no specific asset that backs the debt.
· Subordinated debt. In the event of default, the lenders in these arrangements are paid back after senior debt claims are paid in full. In return, the lenders get higher interest and often a modest say in how the company is run.
· Preferred stock. Selling company ownership for cash. Preferred stock holders are repaid before common stock holders in the case of liquidation, and after secured stockholders. In return, preferred stock investors get a share of the profits of the business and some say in how the company is run.
· Common stock. Selling company ownership for cash. Common stock holders are the bottom tier in terms of secured repayment in the case of default, but have the ultimate say in company decisions.
No financing option is intrinsically better than the next. It all depends on what is right for you and your business when you need financing. The financial market changes and so does your business — and both variables affect your financing options.