What IS Sub-Debt?

Friends and family are always asking me What exactly do you DO?" I spend a lot of my time trying to explain just that, and have used a variety of catch-all phrases hoping to briefly and succinctly capture the essence of my profession. So far, I have yet to come up with anything that works well. Commercial Lending. Commercial Financing. Commercial Account Manager. Business Financing. Term Lending. And now Investment Manager. None of these has worked - each phrase is inevitably followed by "What's THAT?" And of course, sub-debt, mezzanine financing, cash-flow financing, or unsecured lending, shed no more light than any of the other terms. In the end, there is no such thing as a brief description and therefore what follows is the long version.

Sub-debt financing, short for subordinated-debt, is used as an alternative to equity financing and behaves like a traditional term loan. Therefore, to describe sub-debt, I will also describe a term loan and equity financing.

Successful businesses which experience rapid growth often lack the capital to fuel that growth. As a result, business owners must seek additional financing to support growth, above and beyond the traditional commercial loans which are available to successful companies.

In general, an operating loan, or line of credit, is utilized to finance accounts receivable, and perhaps to a limited extent, some inventory as well. If all else checks out, e.g. the industry, business, management, track record, financial institutions will provide an operating loan to a maximum of 75% of the value of a companies accounts receivable, net of any accounts which are over 90 days past due. Sometimes, depending upon the nature of the inventory, a company can also negotiate some leverage against its inventory. Financiers are reluctant to provide financing using inventory as collateral because when a business fails, it is very difficult to recover the value of that inventory. As a rule of thumb, it is not uncommon to think that inventory may fetch only "20 cents on the dollar" in a "forced sale".

In addition to an operating facility, a company can also obtain financing for its fixed assets (e.g. manufacturing equipment, construction equipment, vehicles) by way of a term loan. This is a traditional debt instrument which typically requires monthly payments (comprised of both principal and interest), are amortized over periods of less than 10 years, and are secured by underlying assets which offer the lender a "forced sale value" in excess of the loan amount.

When a successful business is growing rapidly, additional financing may be required beyond that which can be provided by the company's primary lender. The options facing a business owner are then twofold: curb the growth to that which can be supported by the company's working capital, or put more money into the business. Let's assume that turning down orders is something the business owner prefers not to do, and that personal financial resources are exhausted, including all funds that can be begged, borrowed, or stolen from friends and family. Then, only option is to sell a share of the business in exchange for cash (working capital) either to a working or silent partner. This may require giving up different levels of control, and will obviously necessitate sharing the company's financial success with the new shareholders.

But wait. Is this really necessary? Maybe not...

Let's assume that the company is successful, which means the business is lucrative and making money. There are hundreds of businesses which have enough cash flow (profitability) from operations to support additional debt, but lack the fixed assets required to support more term financing.

Can this cash flow somehow be leveraged?
Yes!
How?
With subordinated-debt!

How does this work and what does it mean? Well, subordinated-debt will replace (or supplement) equity financing while behaving like a term loan. The money is provided to the company in one lump sum (all at once, vs. the fluctuating nature of an operating loan) and repayment is made from cash flow generated by operations. Repayment is typically monthly and can sometimes follow an initial "principal holiday" which can range from 3 to 12 months. Because the company has no tangible assets to provide as collateral, the loan is unsecured, but since the lender is being repaid on a regular basis (monthly) and the company has a track record of profitability, the lender is willing to accept a lower return than that of a venture capitalist or an equity financier.

Which brings me back to what I do for a living. I meet with business owners or their representatives (such as senior management staff, external auditors, financial consultants) to determine their suitability for financing with VanCity Capital Corporation's subordinated-debt fund. This is a $25 million fund which commenced operations in January 1999. Our mandate is to finance BC-based businesses which require working capital to support growth. In analyzing financing requests, I tour business operations, meet with senior management, review financial statements and business plans, assess market situations, and speak with customers, competitors, and suppliers.

It is a fantastic career for anyone who loves to meet new people, and loves to learn.

If you have any questions, please contact me at: diane_friedman@vancity.com or call my direct line: (604) 877-6581.