Jeff Standridge:
Hey guys, welcome to another episode of the Innovation Junkies Podcast. I’m Jeff Standridge.
Jeff Amerine:
Hey, this is Jeff Amerine. Glad to be here. What are we going to cover today, Jeff?
Jeff Standridge:
Yeah. Well, what I thought we would do today, Jeff, is talk about, financing your business for growth, and maybe have a little bit of a technical discussion, if you will, around the different ways that we see organizations, financing the growth of their businesses. How’s that? Super. so why don’t you kick us off and, and we’ll just kind of go back and forth here a little bit.
Jeff Amerine:
Sounds like a plan.
Jeff Amerine:
For sure, for sure. Well, one of the things in terms of the options, classically, there’s either debt or equity. You can go to a bank, you can get a variety of different possibilities with the bank in terms of short-term lending, which you typically will use, you have a line of credit in place to finance the difference between your accounts receivable and accounts payable, and that’s all great, or long-term loans, some of which can be signature loans, some of which can be tied to the assets that you have available in the business or personally, most of which would require personal guarantees, or you can even get stuff that would be underwritten by organizations like the Small Business Administration, et cetera, still through your banking relationship, but it allows you to stretch out the terms and do some interesting things. That’s kind of the whole category of traditional debt. And there’s a variety of other short-term things.
Jeff Standridge:
Yeah. Yeah. Let’s, let’s dig into that a little bit. Right. So, you know you brought up the concept of it might require personal guarantees, which you and I both know that means that not only is the business going to guarantee that money, but that’s that Jeff Standridge and Jeff Amerine:morine and any other equity partners you have in that business are going to sign personal guarantees, usually at the hundred percent level. Now, sometimes you can negotiate down to the proportional equity level so if you own 20%, you guarantee 20 % if somebody else owns 80, they guarantee 80, but usually the banks are going to have overlapping guarantees. Right.
Jeff Amerine:
Yeah. There’s that nasty clause of jointly and several, which, which you definitely want to understand what that means, because even if you’re only a five or 10% owner, if the terms of the loan and got that included, that means if there’s a default or whatever they call the loan, then you could personally be responsible for the whole thing.
Jeff Standridge:
That’s right, that’s right. And then, you know, you mentioned the concept of it could also be guaranteed by certain governmental institutions, sort of like the U .S. Small Business Administration. What a lot of people don’t understand is that the SBA does not traditionally loan money. What they do is they guarantee the blue sky, so to speak, or they provide additional guarantee on the loan so that the community banker or the local banker or the local banking relationship you might have might feel a little safer, a little more confident in loaning this particular loan to you for this particular purpose.
Jeff Amerine:
Yeah, that’s exactly right. It’s important nuance aside from during the pandemic, they don’t want directly a lot in, but what it amounts to is it’s an 80 % guarantee to the lender that if you default as the borrower, they’re covered. And what that means is the lender can then maybe stretch out the term longer than they normally would, or can give some other special consideration they might not otherwise do.
Jeff Standridge:
And not all banking relationships or not all banks are, are certified as SBA lenders. So you need to make sure you understand that. And I think we ought to probably spend a little bit of time talking about the importance of your banking relationship, because I see a lot of businesses that kind of hop around and they’ll go from one business, one bank to the next bank, to the next bank, to the next bank. And they may have, you know, several different banking relationships in a very short period of time. My experience is if you’re in one business, having an ongoing banking relationship and someone that you can trust in that bank and being willing to consolidate some of your operating accounts coupled with your loan accounts, your revolving line of credit accounts, my experience has been in a given business, having one banking relationship is ideal. If you can do that, if you’ve got multiple businesses, then having multiple banking relationships is not a bad idea either. But if, if you’re, if your livelihood is one particular business, having a strategic banking relationship with them is more beneficial than really trying to spread the love. My experience, I don’t know about your perspective on that.
Jeff Amerine:
Yeah, I know I couldn’t agree more. And a lot of times when we advise clients, it’s, we might recommend four or five they talk to and we treat it like an interview process and go find out where you think you can establish the relationship. It’s not just necessarily about the financial terms of the products, but that banking relationship is such that something goes wrong or you have some kind of short-term issue. Or as an example, let’s just say you’re reliant on government contracts and the government decides to lose their mind and shut down like they do, I don’t know, a couple of times every other year, you might have a shortfall, in which case you’ve got to call that banker up and say, hey, can we increase our line of credit? I’ve got to be able to cover payroll. So having that really strong banking relationship typically with a community or regional bank where they still have commercial lending officers and commercial account managers that can take a direct interest will be better than if you go to one of the large national banks where they’re really good at their mobile banking transactions and systems, but they’re not great at sort of that local white glove touch, so to speak.
Jeff Standridge:
And my experience as well is that the better your banker knows you and the way they get to know you is number one, they know the volume of your operating accounts. Number two, they know the volume or the size of your cash reserve. Number three, they know your payment history on the loans that you have outstanding with them. The better they know you, the more comfortable they are with you, the more of a strategic banking relationship they have with you the more likely they are to grant you proportional guarantees versus joint and several guarantees, the more likely they are to provide you with a line of credit to get you through these difficult times in cashflow and what have you. I’ve just had a great experience in a banker or two within a particular bank and working with them.
Jeff Amerine:
Yeah, I would agree with that. And they can help you scale as well. I mean, they’ll be there. If you, you know, if you, if you present good results and you have good returns and good historical information, they can help you scale the business for sure. But what, excuse me, what about the other side, the private equity and the venture capital side? If you want to go that route, what are, what are some thoughts about that?
Jeff Standridge:
Yeah. So, so clearly, there’s there, the two rounds that I think of, that virtually every business owner goes through at some point is the bootstrapping round where I just, fund my business out of my personal savings, out of my, access to funds, whatever I have, the funding out of the business through customers and selling and, and, what have you. Then there’s the, the friends, family and fools round, right? Where I go to the people early stage that I know that maybe I have personal relationships with, family relationships with. Then we start getting into the angel rounds, right? As I get a little further down the path, I may go to some angel investors that I may or may not have a relationship with. Most large cities and even moderate size states have angel groups, I know we have the Arc Angel Alliance here in in Arkansas that’s statewide, but then we have some groups up in Northwest Arkansas as well that are kind of geared toward toward Northwest Arkansas and maybe Eastern Oklahoma. So you got angel groups and then you’ve got your your your VC your venture funds and then your more advanced venture capital firms, I would say. Right.
Jeff Amerine:
Yeah, that’s right. I mean, there’s a myriad of things and depending upon where you are in the stage of business would depend which of those things are more appropriate or less appropriate. And I think that there is significant differences based on the stage of interest of a venture capital or even an angel group and the size of the check they want to write and the sectors they cover. So it’s incumbent upon business owner to research that. They don’t want to waste anyone’s time. They don’t want to solicit people or send out a bunch of, you know, LinkedIn sales navigator stuff, hoping that they’ll get a lead on something that doesn’t cover businesses like theirs has made no investment. So key to really do your research to find out which one of those categories of equity investors would be best.
Jeff Standridge:
Yeah, of course we run a venture fund slash firm called Cadron Capital Partners. And I don’t know about your Cadron Capital email account, but mine is full of solicitations. And only occasionally do I get one that really matches our investment thesis. I get a lot of solicitations of things that are just nowhere in our wheelhouse, industry wise, check wise, geography wise or what have you.
Jeff Amerine:
Yeah, and you’re exactly right. Probably one out of a thousand of those will capture the interest. And, you know, it’s better if you’re trying to raise money to take kind of a rifle shot rather than a shotgun blast. You’ll find the people that have invested in companies similar to yours at your stage and target them. And even the better part is reach out to some of their portfolio companies, talk to them first before you contact the fund and say, how are they to work with? Are they the kind of people you really wanna be married to? Because that’s what it is once you get in bed with a venture capital firm or private equity firm.
Jeff Standridge:
Yeah. And for the most part, early-stage venture capital, angel investing, certainly friends, fools, and family, certainly early stage venture venture capital. They’re writing a check for a small portion of the equity in that business. The founder, the owner of that business is usually retaining or the owners are usually retaining a fairly significant portion, certainly controlling interest in a fairly significant portion of the equity in that company. And then we begin to move on to growth equity, private equity, what have you, which more times than not, and maybe I’m speaking a little out of turn here, but oftentimes they’re recapitalizing that company and maybe actually acquiring it. And, the founder-owner is retaining a portion of equity and may actually have that equity tied to an earn-out period or a portion of the consideration of that investment tied to an earn-out period over three or four or five years or, or, or what have you. So later stage, larger really looking to recapitalize the company. Talk a little bit about that.
Jeff Amerine:
Yeah, that’s true. That’s true. And for context, in those early rounds with an angel round or VC round with each round, whether it’s a pre-C, a C, series A, series B, you’re talking 10 to 20% of the company you’re giving up in terms of dilution with each one of those. The theory being you’re going to own less at each go, but the pie is getting increasingly large. The value of the company is increasing, you hope, because you’re adding value to go. With the later stage stuff, a lot of times the private equity folks are coming in because they want to have a controlling interest. And sometimes that’s viewed as a recapitalization, like you said, and that’s an opportunity for the management team, the ownership team to take a little bit of money off the table. Now, typically there is some kind of earn-out and that’s over a period of years, three years, five years, whatever is appropriate, because if they’re going to keep you in the business, that is the private equity firm that’s doing the investment. They want you to stay motivated to continue to perform as the business goes. And so therefore you’re not getting all the money on the front end. And that’s kind of typical.
Jeff Standridge:
Yeah. And, and then you have, the different strategies that these private equity firms will bring to the table. One might be a, financial engineering strategy where they really figure out, and many times there’ll be a rollup of multiple companies there where they feel like that, yeah, they might get some marginal growth, but they really feel like that they can engineer the way the money flows through the organization and create significant, significantly greater margin than any of them have as individual operating companies. And then, and then, more of a growth strategy where we feel like if we, if we come in and put some investment behind this company, we can help them, 5X, 10X, 12X, 30X, the actual growth of that company. It’s more of a growth play.
Jeff Amerine:
You see both really, you see an acquisitive growth or roll-up strategy where they say, well, there’s all these pieces that can be bolt-ons and typically if they’re doing a roll-up, there’ll be a company that will be the hub, kind of the centerpiece. And then the other pieces are kind of bolted on around it. From an operator standpoint, it’s always a lot better to be the hub rather than one of the bolt-ons because you tend to command a higher value. You’ll also see private equity where it’s all about.
We think we can help this company improve margins and do organic growth. So go from a 20 or $30 million to $100 million, maybe no acquisitions are required. They’re just going to inject some discipline, some better process, maybe some people that aren’t currently in the leadership and the ownership team.
Jeff Standridge:
For sure. And then we start thinking about the actual investment instruments. So at the very base level, straight equity, right? And many of our listeners probably see that on Shark Tank a lot. For this amount of investment, I’m going to give up X amount of my company, right? So straight equity where I’m selling off a piece of my company in exchange for investment.
Jeff Amerine:
Yep. And it’s typically preferred rather than rather than common stock, which is the same basis that the founders have. They’re at a preferred level, which means they get their money out first. And it means there can be also also a whole bunch of additional productive provisions associated with how that preferred is defined.
Jeff Standridge:
Yeah. So if, if something happened, the business were to be liquidated or were to receive some type of recapitalize yet again, recapitalization, and there’s not enough money to go around proportionally, then those preferred elements of the, of the structure enabled them to, to be at the front of the line, so to speak.
Jeff Amerine:
Exactly. And that’s not always the case, but it’s normally the case. And the other thing that’s, I think, it’s kind of instructive about that. Most institutional investors are going to require the business to be a C-Corp, not an LLC, just because they don’t want to chase K-1s forever. And they want there to be that sort of discipline and structure associated with a formal board of directors, good governance, minutes kept, all that kind of stuff, board meetings, etc.
Jeff Standridge:
Yeah. So we’ve got straight equity, then we’ve got convertible debt, right? Talk a little bit about that.
Jeff Amerine:
Yeah, so convertible debt grew up probably 15 years ago or so, maybe a little more. And it’s the whole idea that on, for the most part, early stage and or bridge rounds where you’ve got kind of a mezzanine sort of around, you can’t always peg a valuation very well. Maybe the company’s got to prove a few things or there would be a large disconnect in valuation. So it’s a debt instrument that typically has a coupon rate, an interest rate, simple interest rate that will run for a couple of years.
You’re not actually paying that out typically, that’s accumulating along the way. And then that convertible note, which is a promissory note, will also have what’s called a discount rate and sometimes an evaluation cap. And what that means is when that next bigger round of equity is raised, the investors that are in the convertible note, their shares will be purchased at a lower rate than the investors that come next, and/or it will be capped at a valuation rate that is superior or better than what the new investors pay. And all the way along, that accumulated interest rate will also convert so that their position has a kind of a good risk premium associated with it.
Jeff Standridge:
Yeah. And, and usually, whether the discount or the cap is applied is dependent upon which set of circumstances would be more favorable to the investor. Right. Yeah. So, yeah. So, and so that’s the convertible debt. And then about 10 years ago, eight or 10 years ago, there, there came along this thing called the simple agreement for future equity. I never will forget. I saw a deal like that in August of 2015, I believe it was no May of 2015 with one of the groups that I was in and the very first time I had seen a safe agreement and this was came out of the Y Combinator and it was open source documents and the group when I looked at it in May, we looked at it and said, Hey, we don’t know. We don’t even, we’re not comfortable with this. We don’t know what it is and no, we’re not going to invest in this company. Fast forward to August, Cadran Creek capital, another group that, that I was involved in actually was leading at the time.
We saw that same company and that same instrument and we made that investment into that simple agreement for future equity. And then fast forward to January by 2015, 70, 80 % of every deal we saw was a safe. And so it was widely adopted very, very quickly. And the best way I describe it is it’s almost identical to a convertible note in the way that it operates. Yet there is no promissory note. It’s not debt, but it has the ca there’s no coupon and it has the cap and the discount just like a convertible note. So it’s a simple agreement for future equity. So you’re saying I’m going to give you this money and you’re going to give me a contract that says that, or an agreement that says that when we have our next financing round, your disagreement will be converted to equity based upon the terms of the cap or the discount, which is more favorable to the investor.
Jeff Amerine:
Yeah, the thing that gave a lot of people pause early on there was where does that sit in the capital stack? I mean, is it, you know, everybody understands where creditors and debtors and convertible notes would sit or where preferred equity sits, where common stock is and eventually, I think there was enough precedent for people to say, well, if there’s a liquidation, good or bad, it’s essentially treated as equity and it will fit in whatever category it was supposed to convert to. And so that solved a lot of it, but the whole theory there was the founders and the owners still have more to prove. They’re not ready to lock in evaluation. This is a very straightforward thing to get put in place quickly and then off you go. And it’s used frequently. We do as many deals in Katarin that are safes as convertible notes, as price rounds. They’re all kind of equity equivalents in reality. They just have different features depending upon the circumstance.
Jeff Standridge:
Exactly. So talking about some of the technical aspects of raising money and some things that you need to expect, in a future episode, we’re going to be talking about some of the considerations you need to put behind this concept of raising money. Do you need to raise money? How do you know you need to raise money? What do you need to think about when you’re looking for investors? And, and so we’ll talk about that in a future episode.
Jeff Amerine:
Looking forward to it.
Jeff Standridge:
All right, this has been another episode of the Innovation Junkies Podcast. Thank you for joining.