When companies get into financial trouble, lenders often ask business owners to put in money of their own as a condition of maintaining the loan. Alternatively, lenders want collateral and/or guaranties from outside the business.
Lenders do these things for two reasons: First, because additional investment from the owner signals owner confidence in the long-term prospects of the business. Second, because by having the owner’s funds invested, those funds can be part of the lender’s recovery, should things not turn around as hoped.
Today’s newsletter is about what to consider when faced with these lender requests.
How will you get your additional investment back?
Usually, this happens when the company is sold. Sometimes it is paid in the form of dividends, or if the additional investment is structured as a loan subordinated to the lender, as principal and interest payments.
Keep in mind, though, that the business has to survive for the owner to get their investment returned. Even then, the selling price might not be enough to pay the owner back. Owners stand below all creditors – the creditors get paid first. And, as a practical matter, if the additional investment is structured as a loan, and creditors are not paid in full, creditors may go after payments to the owner. (How creditors do that is complicated and beyond the scope of this newsletter.)
In any case, step one is to determine the value of the company today. This is critical. If the business today is worth less than what the business owes lender(s) and other creditors, any additional funds put into the company by the owner are fundamentally an “option” – a bet that the company’s financial performance improves, and the business will be worth more in the future.
How much more? Enough to sell the business and pay back the requested investment in that business. There is much more to determining the value of additional investment in a company, but the key point in a distressed situation is to understand if that investment is merely an option on future success. (If the additional investment is true equity, your equity is “in the money;” consider the investment as you would any other.)
If it is an option, time to pause and take a sober and objective view of your business. Can it really be turned around? Does the business have the cash flow runway to turn it around? Can assets, even product lines, be sold to generate cash instead of additional equity investment? Is the lender that is demanding the investment willing to forbear rights and remedies, so the business will have time to turn around? Here, an outside, independent analysis really helps.
Tips and suggestions for funding the investment…
Consider an alternative lender.
The alternative lenders will likely be more expensive, but they may not require an injection of funds from the owner.
Borrow against assets outside the business.
For individuals and families, assets outside of the business are often not liquid (i.e., they can’t be quickly and cheaply turned into cash). The solution then is to borrow against those assets. Remember, though, to ask how the investment will be returned, because unless that underlying asset is sold, funds from the business are needed to repay the loan. For institutions, an additional investment often means unpleasant conversations with limited partners and/or other constraints at the end of the life of a fund.
But beware of pledging those assets outside the business as additional collateral.
Sometimes lenders will be satisfied with liens and other encumbrances on assets outside the business. This eliminates the owner’s need to sell or borrow against those assets. However, if these newly encumbered assets outside the business are detailed in the loan documents, and in the event of an ugly outcome, these assets will become known to other creditors of the business. For example, in one bankruptcy I was involved in, prior to my arrival, the owner pledged to the lender an expensive condo and a sizable antique car collection. The sale price of the business was enough to pay off the lender, but the trade and other creditors were able to grab those pledged assets, because they knew they existed.
Guaranties, personal or corporate, can have the same effect, it just takes the lender longer to collect. There are a few more legal steps to get cash from the owner than when pledging assets, but not many. Try to limit the size and duration of the guaranty.
Insist that lenders put in additional money.
If the owners do decide to invest money in the business, ask – even insist – that lenders also put more money in as an additional loan alongside your investment. Consider participating in a new loan by the lender so your investment in the company is senior to other creditors and has the same standing as the lender.
Alternatively, rather than putting money in the business, have the lender do that and deposit cash with the lender that secures the additional loan. That way, if the lender gets paid, the deposit is returned, even if there are not enough funds to pay junior creditors. Note that other creditors may try and seize these funds, but at their expense (except in bankruptcy) and with no guarantee of success.
When there is no hope of a turnaround.
Sometimes, it makes sense to invest money in the business, even when there is no hope of a turnaround. This occurs when the decision has been made to sell or liquidate the company and the cash injection will provide the time needed for a better recovery and personal or business assets outside of the company are at risk of loss, such as when collateral outside the business has been pledged to the lender or guaranties have been given. So, invest to lose less.
For example, a client of mine decided to wind down the business just as the business was headed into its slow, cash flow negative season. Two viable buyers were interested in the assets/business. The business owners already owned two buildings used by the business and those businesses had mortgages on them as collateral for loans to the business. But one of the buildings was worth much more than the mortgages. So, the owner of that building took out an additional mortgage and put the money into the business. The result was the assets of the business were sold within about 60 days at a much better price than could be had with a straight sale at auction. The recovery was 100% for the lender and overall, more assets outside of the business were retained. The second mortgage was paid by selling the building.
Lenders know how to stroke owners, including institutional owners, so they will put more money in the business. Beware. This is not necessarily a bad option for an owner, just make sure that you understand what the risks are, what you are committing to, and how you will get your investment back (and hopefully more) in the end.