DEBT SECURITIES: THE PRAGMATIC FUNDING ALTERNATIVE
Special Notice: This page is directed specifically to those companies that operate under conventional Australian financial and accounting standards. This page therefore is of no interest (no pun intended!) to shari’ah-based companies that are prohibited from paying interest either directly or indirectly through pseudo-interest charges.
Warning: There is a considerable amount of information here concerning the use of debt securities, a pragmatic alternative to equity raising. I understand how important this information is to you when making up your mind as to who can best help you with the expansion of your business. Consequently, as the guide covers a lot of ground, expect a long read.
Need venture funding? Don’t overlook the flexibility of debt securities
Hello and welcome. I have something quite different for you in this webpage. This webpage deals with … [shudder! shudder!] … debt funds. Now I know many of you are here only for the equity raising deal, but keep an open mind on this. You might be surprised here because when I talk about debt funds, I am not talking about bank loans, finance company loans, collateral leasing, credit cards and all the other cute systems that the debt finance industry can devise to get your hard earned out of your pockets and into theirs.
No, I’m actually talking about something completely different here. I’m talking about access to funds where you can personally negotiate on a one-to-one basis with an investor the terms and conditions of the investor’s commitment to provide your venture with loan funds to your company.
Debt securities. Companies, particularly those structured as public (unlisted) companies (and you will have one of these if you walk down the equity raising path with me) have access to the full armoury of capital raising instruments. These capital raising instruments include securities classed as instruments of debt such as debentures, convertible redeemable preference shares and promissory notes. You may not have ever seriously looked at these types of securities before, but in certain circumstances, they can be very useful. Let me show you how.
Give Debentures a miss. Debentures are the odd man out here. They are not as useful to small and mid-size enterprises as are convertible redeemable preference shares and promissory notes. The reason is that they are generally used by publicly listed companies (i.e. stock exchange listed companies) to raise much larger amounts of capital than that usually sought by small and mid-size companies. They also have a relatively longer life as an active security.
Debentures are a high maintenance security. In comparative terms therefore to other forms of debt securities, debentures require a much higher degree of management control and administrative oversight, because debentures are secured by a trust deed, usually over all the assets of the company that are not otherwise mortgaged. This makes them somewhat unattractive and perhaps unacceptable to many small and mid-size companies.
ASIC’s debenture concerns. As if to endorse my comments on cue, PS News (http://www.psnews.com.au) has reported on 19 February 2013 that the Australian Securities and Investment Commission (ASIC) has put forward proposals to strengthen the regulation of the debenture sector. Among the proposals is a move to introduce minimum capital and liquidity requirements. ASIC Commissioner John Price said the move followed a number of high-profile company collapses in the debenture sector. Commissioner Price said ASIC would also consult on proposals to strengthen disclosure to investors about debenture issuers and clarify the powers and duties of debenture trustees and the role of auditors. He said ASIC had made it clear the existing conduct and disclosure regime had been pushed to its limit.
ASIC has released a consultation paper Debentures: Reform to Strengthen Regulation, saying it was the first step in implementing the Australian Government’s roadmap for strengthening the regulation of finance companies that issue debentures to retail investors. A copy of the consultation paper can be downloaded from the ASIC website (http://www.asic.gov.au).
May I repeat my comment made earlier. Give Debentures a miss. Debentures are not as useful to small and mid-size enterprises as are convertible redeemable preference shares and promissory notes.
Promissory Notes & Convertible Redeemable Preference Shares. From the small and mid-size company point of view, the simplest method of raising smaller amounts is through the issue of promissory notes. For amounts of capital a little bit larger, convertible redeemable preference shares may be the go. What are the levels of funding we talking about, I hear you ask? Good question. I will answer in a moment, but first, I must point out that the figures I will give you are quite arbitrary and you can in fact raise whatever you like under whichever type of security suits the circumstances. This is a green fields exercise in which you can exercise great flexibility.
Debt securities provide great flexibility. You don’t actually have any constraints on your ability to act. In general however, promissory notes would be used for amounts of, say, up to $200,000; while convertible redeemable shares would be used for larger amounts, say up to $500,000. I will explain how these types of securities are used.
A promissory note debt security functions much like a private business loan. In formal terms, a promissory note is a written promise, legally enforceable, to pay on demand, or on one or more specified dates, a specified sum. This sounds complicated, but in fact, the promissory note simply sets out the terms and conditions of a private business loan arrangement between an investor and you as the entrepreneur or business owner seeking business development loan funds. In this arrangement, you become the ‘maker’; viz., the ‘maker’ of the promise to repay the loan.
The Promissory Note agreement. Your negotiations for the promissory note will initially settle a rate of interest; generally referred to as the ‘coupon rate’. By agreement, this interest payment will be paid monthly, quarterly or annually with a maturity date that sets out the date when the principal amount of the loan is returned in full to the investor. The investor has the right to sell the promissory note at any time to a purchaser for a negotiated price.
Flexibility in Note offers. To attract investors, makers (that’s you, the borrower) often issue promissory notes in fractional amounts to provide flexibility in sales; thus, a typical debt offering to investors of $200,000 would be through the offer of 20 Notes at $10,000 per Note. In practical terms therefore, a promissory note functions much like a private business loan between two parties, but without the complex legal and administrative framework that surrounds traditional business loans from commercial lending organisations.
Actual Note price subject to bargaining. It is important to understand that you, as the maker, cannot set the sale price of the promissory notes alone. The commercial reality here is that the price paid for the promissory notes will be the subject of bargaining negotiations between the investor and you as the maker. Factors that may influence the saleability or otherwise of a promissory note to an investor will include, but not be limited to, the attractiveness of the interest rate, the conditions of the promissory note agreement and the quality of the underlying business.
Advantages to you as the entrepreneur/business owner
- Promissory notes permit you to raise development funds without diluting shareholder equity by issuing new shares.
- Promissory notes are effective in dealing with the situation where, due to a lack of sufficient collateral security, you are unable to obtain the funds required from traditional lending organisations. In many cases, this will have nothing to do with your credit worthiness but will everything to do with the fact that traditional lending organisations will not acknowledge any value in your business as collateral.
- Note payments establish a credit history. Payment of the regular payments scheduled under the promissory note terms over a period of time (usually between 12 and 36 months) will establish a credit history of regular interest payments and a business management history. This is important because at the point where the promissory notes’ maturity date is reached and the investor is required to be repaid in full, you will then be in a good position (if you don’t have sufficient cash on hand to pay back the principal) to cash out the promissory notes by obtaining a standard business loan from a traditional lending organisation at a much lower rate of interest than the coupon rate.
- This method of obtaining business development funds permits you to tap into a broader market
than presently exists in the private equities market.
- The use of promissory notes has the added advantage of great flexibility.
Advantage to the Investor
Built-in exit strategy. The advantage of this system to the investor is that there is a built-in exit strategy. That is, a process exists through Chiron! the business doctor.™ for the Investor to sell the promissory notes through the Australian Small & Mid-size Companies’ Equity Capital Board™ should the investor’s business or personal circumstances require him or her to divest the promissory notes for any reason.
Note saleability. Factors that will dictate the saleability or otherwise of promissory notes to investors will include, but not necessarily be limited to, the attractiveness of the interest rate, the conditions of the promissory note agreement, the length of the period until the promissory notes’ mature and must be repaid, and the quality of the underlying commercial business.
This non-bank private business lending system is emerging as a popular funding alternative to bank and finance companies.
Using promissory notes
Usefulness. Promissory notes are useful in situations where you simply may not want to deal with traditional lending organisations or traditional lending organisations refuse for some reason to lend you the funds required. That situation of course may not necessarily be a personal problem of yours based on your credit worthiness; it may simply be that traditional lending organisations will not accept your business as collateral. Traditional lending organisations are notorious for requiring substantial ‘bricks & mortar’ collateral, and this limits the ability of entrepreneurs and small and mid-size enterprise business owners to tap into this source of funds.
Uses. While there are a many situations where promissory notes can usefully be used as a vehicle to raise operating capital, I set out two examples for you to think about: The first example is where you wish to raise funds on a short-term basis for a specific small-scale project. One to three years is the typical time-frame. Such purposes could include, for example, the purchase of new machinery or equipment or undertaking some market research expected to result in an increase in product sales.
Importance of the underlying business. Whatever the reason however, the investor will expect you to be able to demonstrate that the underlying business is healthy, that the periodic interest payments can be met and that you will be able to cash out the loan by repaying the full amount at the due date. If you can see how your business could benefit from the use of promissory notes, then call me confidentially on 61 (0) 405 702 644.
Use in the sale of a business. The second is in the situation where you may want to sell your business, but the business purchaser, due to a lack of sufficient personal collateral security, is unable to obtain the total amount of funds required to settle the transaction from traditional business funding or mortgage originator organisations. As indicated earlier, this may not be a consequence of the business purchaser’s credit worthiness – it may just be that the traditional lending organisations will not accept your business as sufficient collateral for a traditional loan to purchase the business.
Be prudent. In such situations, you may consider the option of taking a promissory note from the business purchaser as part of the purchase price. You would of course need to be prudent in these circumstances. However, the process appears to be particularly useful where a business purchaser can pay a substantial deposit towards the purchase price but is unable to obtain traditional finance for the balance.
Due diligence check required. Whatever the reason for the circumstances, if you are willing after a ‘due diligence’ check on the business purchaser, you may seek to advance the balance of the purchase price as a private business loan negotiated through Chiron! the business doctor.™ in the form of promissory notes. The business purchaser can in turn use the promissory note for the agreed period of time to establish a credit history of regular interest payments and a business management history.
Advantage to the purchaser. This would eventually provide the business purchaser with the capability, if necessary, of cashing out the promissory notes at the agreed settlement date with a traditional business loan at a lower interest rate. Here again, if you can see how your business could benefit from the use of promissory notes, then call me confidentially on (+61) 0404 631 230.
Divestment of promissory notes
The promissory note: an illiquid asset. In the past, there has been a reluctance to use promissory notes as a vehicle to raise short term development funds, because promissory note holders could not easily liquidate the promissory notes by on-selling them to a third party willing to purchase them. In practice, promissory notes were perceived as an illiquid asset because there was no public market place where the details of promissory notes could be advertised to prospective purchasers of promissory notes.
The promissory note: no longer an illiquid asset. Chiron! the business doctor.™ has the ability to facilitate the sale and purchase of promissory notes by providing a convenient, continuously available, secondary sale platform: the Australian Small & Mid-size Companies’ Equity Capital Board™. Promissory notes therefore no longer need denigrating as an illiquid asset, but can rightfully take their place as a useful weapon in the armoury of capital raising instruments.
Convertible Redeemable Preference Shares
In technical terms, Convertible Redeemable Preference Shares are defined as preference shares that (in accordance with their agreed terms of issue):
- attract a negotiated rate of interest, again referred to as the ‘coupon rate’, and
- can be converted on one or more specified dates into Ordinary Shares on the basis of some defined ratio and financial consideration, or
- can be redeemed in cash by the issuing company on one or more specified dates, and
- have no voting rights.
Use Convertible Redeemable Preference Shares for larger amounts. Convertible Redeemable Preference Shares are used for amounts that are larger than is generally the case with the use of promissory notes. The amount to be paid by the investor(s), the dates for conversion or redemption, the interest rate to be paid, and the conversion ratio, must all be negotiated between the parties.
Share sales & purchase. Chiron! the business doctor.™, through the Australian Small & Mid-size Companies’ Equity Capital Board™, provides a public market place where the details of Convertible Redeemable Preference Shares being offered for sale can be advertised and prospective investors (purchasers) can examine the terms of sale.
Chiron! the business doctor.™ therefore has the ability to facilitate the initial sale and purchase of Convertible Redeemable Preference Shares being issued by a company seeking capital, as well as providing a convenient, continuously available, secondary sale platform where investors, the purchasers of Convertible Redeemable Preference Shares can divest the shares as and when required.
When should debt securities be used?
Use debt securities when the funds required are small. The main purpose for your use of these debt securities is to raise smaller amounts of capital. What I mean by that is that you would not go into an equity-raising program to raise only $300,000. Apart from the disproportionate volume of administrative work that would be involved for such a small amount, it would be unlikely that a professional investor would commit such a small amount to a formal long-term investment based on Ordinary Shares.
Many advantages for investors. The investor may however come into a deal for promissory notes or convertible redeemable preference shares because he or she will get regular interest payments on the funds lent, the interest rate will be much higher than the prevailing community rate and the fixed maturity date means that the investor will know when the principal will be returned.
Debt securities increase your options for funding. In practical terms, I simply bring these debt securities to your attention for two reasons. In the first place, they constitute another weapon in your armoury to be used when you have a need for an injection of capital, but the amount is only small in relative terms. I am sure you have experienced situations over the last few years when you could have used promissory notes or convertible redeemable preference shares to raise some funds to fix a problem or difficulty that was then emerging.
Flexibility. In the second place, the use of these debt securities constitutes another situation where I can help your company. If you are presently dealing with a situation in your company that could be more easily resolved through the use of debt securities rather than through an equity raising program, please call me now on 61 (0) 405 702 644 without obligation. As I have said on my other webpages, I don’t mind what time of the day or night you call me, if you need to talk through a pressing problem that is worrying you. And don’t forget, unlike your solicitors and accountants, I never charge for telephone calls that are made because you need some urgent practical advice.
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© Graham Segal, Author. March 2013. All Rights Reserved
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This website and the associated webpages content are produced by Graham Segal trading as Chiron! the business doctor.™. They are licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License based on Graham's work at https://chironthebusinessdoctor.com.
Date this webpage was last reviewed/updated: 5 May 2013