Emerging Views®

Preparing for An Initial Debt Financing

Scenario: You are the chief financial officer of Greater Growth Company, a privately-owned middle market company with several subsidiaries (taken together, “GGC”) that has been growing rapidly over the past few years. You believe that GGC needs additional capital to make the necessary investments in working capital, capital expenditures for plant and equipment, and acquisitions to get to the next stage of its development. You have studied the various options for capital raising and believe that GGC should obtain third party debt financing provided by a bank or direct lender to support its growth.

You believe, correctly, that this initial financing for GGC will establish the template for future financings so you want to make sure it is done right. Thus, you want financing on terms that are economically beneficial for the company but also recognize that the non-economic terms of the debt documents are critical as they must afford GGC sufficient flexibility to continue its growth trajectory. Finally, you are sensitive to minimizing transaction costs for a financing as well as controlling, as much as possible, the additional time and work demands that a financing and its aftermath will place on GGC’s employees.

The following briefly discusses the issues and steps GGC should consider when undertaking an initial financing transaction in order to achieve the goals set forth above.

A. Ensure All Stakeholders are On Board. It is important to ensure that all relevant stakeholders of GGC - equity owners, board members and executives - are supportive of the initial financing transaction before moving ahead. The presence of a lender and the covenants contained in the loan documents will impose procedures, disciplines and constraints on GGC and its stakeholders that did not exist prior to the financing. For equity holders and board members that are used to operating on informal and free-wheeling basis the formalities and procedures imposed by the presence of a third-party lender and extensive legal documentation can be, at least initially, time-consuming and annoying. It is important for all involved to understand this and fully support the effort.

B. Define the Financing Sought. GGC must determine the type of financing it wants and the purposes for which it wishes to use the borrowed funds. Is GGC seeking term loans to finance the acquisition of plant and equipment? revolving loans to help finance its cash needs through the ups and downs of its revenue cycle? a combination of both? In deciding on the financing, GGC will need to prepare detailed projections to demonstrate its ability to repay the loans under various amortization, interest rate, and business condition scenarios.

C. Financing Costs. The costs of any financing go well beyond the interest rate that will be charged on the loans. Lenders typically charge various fees (arrangement fee, up-front fee, agency fee), often expressed as a percentage of the loans to be provided, that must be paid at the closing of the financing. The borrower must pay the fees and expenses of lenders’ counsel as well as the fees and expenses of its own counsel. Where collateral is located in multiple states, advice from local counsel in those states may be needed again at the borrower’s expense. There are also expenses, which can be significant depending on the transaction, for diligence items such as good standing certificates, lien searches, title searches, environmental reports, appraisals, etc. GGC should consult with counsel for assistance in determining the magnitude of these costs. The magnitude of these costs may influence GGC’s decision as to whether a debt financing is cost effective.

D. Collateral. Lenders will require GGC to provide collateral to serve as security for the repayment of the Loans. GGC should identify the various assets it owns and consider their value as part of a collateral package for the lenders. GGC should consult with counsel as well because the costs of providing some types of collateral (e.g. diligence costs, documentation costs, perfection costs, title insurance, etc.) may outweigh the collateral value. Potential collateral includes the following type of assets:

• Equity interests in subsidiaries and, possibly, in GGC itself
• Owned real estate
• Leased real estate if the lease duration is significant term or the property is uniquely valuable (e.g. store location)
• Equipment
• Physical inventory – both raw materials and finished goods
• Intellectual property such as trademarks, patents, and copyrights and licenses of the foregoing
• Contracts that are material in value and/or duration
• Bank accounts

If GGC proposes to use any of the foregoing as collateral it will want to ensure that the collateral will hold up to scrutiny by the lender and its counsel. If equity interests in subsidiaries are to be pledged, GGC will want to ensure it has all the necessary original stock certificates and that the corporate documents reflect that the equity has been issued properly. For real property, whether owned or leased, it will be important to have documentation reflecting the correct description of the real property, complete copies of leases with all amendments, indications of whether the property is in a flood zone, and (possibly) surveys and appraisals. For intellectual property, GGC will want to ensure that all necessary PTO and other filings have been made, licenses (if any) are in effect and that there are no known infringements. Similar analysis will be required for other categories of collateral. In short, before embarking on a financing GGC should conduct internal diligence to ensure that the collateral it wishes to provide to a lender will in fact represent value to that lender.

E. Covenants. Loan documentation contains provisions, known as covenants, that specify what the borrower and its subsidiaries must do (affirmative covenants) or not do (negative covenants) over the life of the loan.

Affirmative covenants often impose unexpected additional costs on the borrower in terms of time and money. For example, the financial reporting covenants typically will require GGC to deliver annual audited financials, quarterly financials, and, depending on the lender, monthly financials. There may be requirements for delivery of periodic compliance certificates, budgets, and projections and delivery of notices regarding material events. Depending on how GGC’s business has been operated to date, this may result in additional costs for outside accountants and internal financial staff. Environmental compliance covenants may impose monitoring or reporting obligations on GGC which may be costly. Insurance covenants sometimes require borrowers to obtain insurance coverage that they otherwise would not. When contemplating a financing, GGC will need to consider the possibility and magnitude of these additional costs.

Other covenants impose restrictions on the borrower’s operations. Typically, covenants limit the ability of a company to borrow money, enter into capital leases, grant liens on its properties, make investments in other entities, acquire other businesses, make capital expenditures, pay dividends, or deal with affiliated persons or entities (e.g. equity owners) on other than an arm’s length basis. As it considers the terms of a financing GGC will need to consider in consultation with its counsel what exceptions to these limitations it requires in order to have the flexibility to achieve its plans for growth and how best to make a case to the lenders that these exceptions are necessary. For example, if GGC’s growth is predicated on increasing production, the capital expenditures limitations and, if expenditures are to be financed by debt or leases, the debt covenant, will need to allow it to spend the necessary funds or incur the debt necessary for it to acquire the needed plant and equipment. If growth is to be achieved through a strategy of selective acquisitions, the covenants will need to allow for such acquisitions. Finally, dividend flexibility may be needed if the equity holders of GGC will entertain growth only if some level of dividends can be maintained. In any event, it will be important for GGC to make its requests for covenant flexibility early in the financing process.

Careful consideration and negotiation of non-economic terms such as covenants is particularly important for an initial financing because the terms of the initial financing often unwittingly establish the template for future financing transactions.

F. Transaction Efficiency. As noted above, GGC, as the borrower, will be obligated to pay the costs of lender’s counsel and other specialized consultants as well as the costs of its own counsel and other advisors. To keep those costs under control it is in the borrower’s interest to anticipate lender’s requirements for information and documents, provide information and documents in an organized and prompt manner, and reduce the time it takes from the start of the transaction to the closing of the transaction. To achieve this GGC should prior to starting down the financing trail assemble and organize the following documents and information:

• Lists of subsidiaries including states of organization, tax ids and addresses
• Copies of charters, bylaws, limited liability company agreements, and partnership agreements, as applicable, for itself and each subsidiary
• Lists of directors, managers and officers for itself and each subsidiary
• Good standing certificates for each jurisdiction in which it and each subsidiary is organized
• Foreign qualification certificates for each jurisdiction in which it and any subsidiary would be viewed as doing business
• Certificates evidencing equity ownership in subsidiaries and joint ventures such as stock certificates
• Originals of promissory notes for which it or any subsidiary is the payee
• Complete copies of all material contracts, licenses and leases and all amendments
• Lists of certain assets including bank accounts, intellectual property and registrations
• Lists of all litigation with a brief description
• Lists of all locations at which it conducts business

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