The Lazy CEO Podcast

Raising Capital

by Sep 13, 2022The Lazy CEO Podcast

In this episode of The Lazy CEO Podcast, we are talking about raising capital. When you are trying to get your business going, how do you raise the money you need? Jim Schleckser discusses the different types of capital you might bring into your business and why you would choose each type.
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Episode Transcript

Intro  0:03  

Welcome to The Lazy CEO Podcast where Jim Schleckser, author of Great CEOs Are Lazy, and founder of The CEO Project features compelling experts and topics for CEOs of mid to large sized companies. Now, let’s get started with the show.

Jim Schleckser  0:20  

This podcast is brought to you by The CEO Project. At The CEO Project, we work with CEOs to help them grow their business, and our members represent billions of dollars of revenue, and profit. And frankly, amongst all of us, we’ve probably made every mistake in the book, including some you haven’t made yet. So if you want to learn from the experience of a bunch of really seasoned CEOs, we’re a great place to hang out. In this podcast, what you’re going to hear are some of those ideas, concepts, and things that are just going to help you on your journey. If you want to find out more, reach out to us at theCEOproject.com. Or you can contact me personally at [email protected] happy listening. Everyone.

Welcome to The Lazy CEO Podcast. I’m Jim Schleckser, your host. Today, we’re going to be talking about a topic that everybody is interested in, which is raising capital. So if you’re getting your business going, the question is, how do you raise the money you need? Today, we’re gonna talk about money. And you know, the various flavors of which you could potentially bring money into your company. We’re not talking about selling here, all we’re really talking about is growth capital have a variety of flavors. And we’re going to talk about the the different flavors that you could possibly contemplate and why you might want to have each of these kinds of financing coming to your company. And having said that, that this to Julie’s point, this might be the one on one or 201 version, there is a 301 and 401 version, and I’m not doing that today. So the financing is only limited by by the creativity of the financier, so you’re gonna see all variants, but I have to say that most of the variants are elements of what I want to talk about today combined in slightly different ways. So if you get these, you’ve got the Lego blocks that they use to build the larger structures that you might see.

So let’s talk about the three elements of sort of cash coming into your business you’ll one is debt, and I’m talking about a variety of flavors of debt. And that’s certainly one option as you grow your business. It’s got pluses and minuses that we’re going to talk about, and that sits on the balance sheet as a liability, because it’s an IOU basically, in cash offsetting it, equity is where somebody buys a position in your company. So they own a percentage of your company. It’s all cash goes in, there’s no liability against it. And there are a lot of reasons to like equity. And things get ugly. And I’ll talk about that a little bit. And then there are hybrid models, which I’ll also talk about that are Kike kind of debt kind of equity. And they have elements of both, and we’ll talk about that. So let’s start with straight down the middle of vanilla debt. And this would be bank debt. And this is where you go to the bank and you gotta look, my business has grown, I need capital to continue the growth. That will you loaned me money.

Now, let’s roll back for a second, there are really two reasons to need capital. One reason is capital to fund growth. And that could be capital that is used for things that move over time and things that don’t move over time. So things that move over time would be things like accounts receivable, as you grow, your accounts receivable grow, therefore, you need cash to finance your customers. Basically, you’re lending money to customers in the form of accounts receivable. So you gotta get the money from somewhere. If you’re growing fast, you got this incredible cash need, and you go away, Jim, I’ve got if I’ve got, you know, people that owe me money, then I owe people money. And that offsets? Well, yeah, but you know, normally, there’s not enough of a spread, the spread is too far for one to pay for the other, you’ll always need incremental capital to fund growth. So that’s one accounts receivable being big one another one would be inventory. If you have inventory in your business, as you grow your business, you might in fact need capital to fund your inventory that is fundamentally something that moves hopefully. And then the last one would be maybe equipment and capital capital, meaning capital equipment, machines, buildings, stuff that doesn’t move it’s long limit, and you’re going to need it to continue growing your business. But it’s not something that flexes up and down based on how the business is doing so. And then the third reason why you will not wait month growth is to increase your leverage.

Now I’ve talked before about private equity companies, and how they put debt on businesses to increase their cash on cash returns. The same thing is true for you. In fact, there is an optimal capital structure for your business that includes debt. Zero debt is the low lever model, which means the lowest rate of return that you can have a little bit of debt will increase your cash on cash or Cash on return on assets. But there’s a limit, you don’t want to have too much. So it’s that sort of Goldilocks position, some debt to get me leverage and improve my return, but not so much debt that I’m getting trouble if things go bad, and I’m gonna talk about that a little bit. So the first option is go to the bank and get a vanilla loan. Now, the easy one, if your position is an SBA loan, this is desirable, because it’s got better terms than a normal bank debt. Why? Because the government is basically backstopping the bank, they go hey, we then the government is say, we think it’s really important for you to loan money to small businesses, and grow them and medium sized businesses. And so we will take some of the risk off your table if they don’t pay you back. Consequently, the bank doesn’t need his higher rate of interest, and they don’t need as much security. But those kinds of loans because they got the government backstopping you, seven, A is probably the plan you’re going to look at, it’ll go up to $5 million. And it can use the US for all the things I just talked about working capital inventory equipment, there’s another one that’s a little more focused exclusively on capital assets, like buildings and real estate. And that’s called the 504. Again, $5 million limit, but you get about $5 million on an SBA loan. And generally, they don’t require a personal guarantee. But let’s just talk for a second about personal guarantees. And it for those were on last year with AMI, he is sort of a fixer, he can help you find an SBA loan. So if you want to hit the easy button and get an SBA loan, called AMI, we can hook you up with him and share it if you could pull up the name of this company and maybe put it in the link on EcoStar Ka, SS AR, he can help find it for you for like 1% of value. So you don’t have to go find it. Like I’ll give you example, I tried to go talk about to my bank, my primary bank about an SBA loan. And they said, Yeah, we’re not doing them right now. So I gotta go find another bank that I don’t have a relationship with, I probably just hit the easy button and use me. So you go help me find somebody will do an SBA loan for lots of banks do them, lots of banks specialize in them, my particular bank doesn’t so.

So let’s talk about personal guarantees. This is one of the big deltas between an SBA loan and a non SBA loan, when you go for a relatively unsecured loan, and generally they’ll do it on multiples of cash flow. Now, they’d love to have security, like, if you don’t pay us, we take your building, if you don’t pay us, we take your inventory, which they don’t like much. But let’s say they just do it on cash flow, they say look, you’re making a million dollars a year, we’ll loan you $2 million against that, that’s a pretty typical loan, generally, a bank will require you to do business with them. If you’re going to get a loan from them, then we want to see all your cash moving in and out of the account. They will also require covenants, which I’ll talk about in a minute, but the big thing they’re going to require typically at the size of most of these people on the call is a personal guarantee, which is to say, if you don’t pay it, yet, we loaned it on your cash flow. We like the business. But if you don’t pay us, we’re coming after you personally, we’re going to take your house, we’re going to take your bicycles, we’re going to take your kids, we’re going to take your cars, we take everything which has a way of clarifying an entrepreneur to make sure the bank gets paid back, right when you’re on a PG like that.

I’ll tell you that the reality of how many times I’ve seen a bank go after somebody on a personal guarantee zero, never ever have gone after anybody on a personal guarantee, they really don’t want to be the guys and gals that take people’s houses, they have the right they use it to clarify your thinking. They will rarely rarely ever execute on that now one of you will go get a deal alone, give a PG the loan will fail. And they’ll take your house and you’ll say, Hey, Jim, I thought you told me that wasn’t gonna happen. I’m like, I’m not promising you. I’m just saying I’ve never seen it. Okay, so just to be clear, it’s not a guarantee here. But personal guarantees are really a struggle. And what’s crazy about this is, you know, we’ve got one CEO we work with that has a $5 million personal guarantee on some of the loans that he’s got from a bank. And I don’t think the guy has a million dollars of personal net worth, like, how does that work that you guarantees $5 million. And he only has a million dollars he could ever, ever give you if he gave you every nickel he had. So it’s a little weird. And again, it isn’t about recovery for them. It’s about the multi funding Perfect, thank you. It’s about keeping you focused.

So let’s go to covenants for a minute because that’s gonna be a really important point and an important point in negotiation. When you start talking to the bank, they’re gonna if you do it on a cash flow basis, so they’re willing to loan you an amount based on the multiple cash flow, no guarantee no security. In other words, they’re gonna say, yeah, that’s all good, but we need to make sure you stay healthy so you can pay us back and what they’ll implement are what called are called covenants. These covenants require that your financial performance is above a certain level generally represent As a percentage of what they loaned you, or as a percentage of how much you owe them every year, so one model might be cash flow. So my example I did a to write the it was a two times multiple, we loaned you $2 million on a million dollars of earnings of cash flow. And so they would do something like you need to keep your ratio of debt to cash flow below two, but doing that the right direction got to get ya debt to cash flow below two, meaning you got more cash flow than you need to pay us back, right.

Another one they might say is a coverage ratio, which is the interest only on the payment on the note that we have to you, you can cover that by a factor of let’s say, three or four. And if you get into trouble your business cycles, right, and you go, you violate you break those covenants, they have the right to reprice your loan, and sometimes charge you penalty as well. And you allow what kind of sets is that make Jim that I’m in trouble, and they want more interest, and they hit me with penalties on top of it, welcome to bankers, all they care about is getting their money back. And so you become more risky. And when you think about risk and return, they go, Hey, that deal just got riskier, because they violated the covenants, therefore we need a greater rate of return to loan to that person. Right. So that’s how they think about it. They are not your friend when things go down. And so when I think about bank debt, I would think about structural debt that won’t change over time. If I have a non cyclical business, you can have plenty of that. If you have a cyclical business, I’d have a layer of this like a layer cake. That was not very big. In other words, my minimum projected performance with all the cyclicality in my business seasonal and whatever else. I won’t break into the covenants on the amount of debt I take down. And by the way, covenants are negotiable. They’ll go oh, this is easy. You borrow two times, we’ll put the covenant at 1.5. And you might go no, no, no, no, no, we’re gonna put the covenant at three times make it favorable to yourself, they’re going to try to snuggle it up against what they loaned you, you can negotiate this to be more advantageous to give you some buffer. So covenants are negotiable. 100%, make sure that if you ever go get bank debt, you negotiate your covenants, because they will be the thing that come back and bite you in the tush.

The other element that you can get from a bank is what they call an ADL is an asset based line. Now, asset baselines are secured, so the interest rate is lower. And because if things go south, they can go claim the asset that secures the loan, its asset base, and normally, they’ll only lend a percentage of the value of the asset. So for example, you get an acid baseline on your inventory, they might only be willing to pay 60 cents, they don’t only loan you 60 cents on the dollar on your inventory, you got a million dollars of inventory to loan us $600,000 on it, if they think it’s marketable. Like if everything went to hell, and they had to just go take the inventory and sell it firesale on the market, they’d be able to get their 60 cents out. So that’s how they think about it. How much could I get if things went horribly, horribly bad, and I just dumped it, because they’re not going to do an organized sale, we’re just going to dump it.

The other thing that lend against is receivables. So if you have quality clients that take a little bit of time to pay you government, let’s say the government’s your client, that’s pretty good client, but they take their sweet time paying you for any of you that do business with the government. 60 days is not a typical 90 Sometimes. And you could go to the bank and say, look, I’ve got a million dollar invoice to Social Security, there are known good payer, I want you to loan me 70 cents on the dollar on this invoice. And they will happily do that. In fact, they won’t do 100% But they’ll do a healthy percentage on a known good if it’s a little more dodgy client, they’re gonna go lower percentages, right? Because they’re not sure that you’ll collect the money. They also will not count any international business. So anybody who does business outside of the US and Canada is counted as outside the US unfortunately, as as Mexico as as Caribbean as they don’t count that they will not count that in your accounts receivable. So we’ve had some clients that had, you know, 30 40% of the Business International and they went to get an ABL and asset baseline and the bank goes great that 40% That’s going to you know, Mitsui in Japan, which is a multi multi multi billion dollar company, we don’t count that doesn’t count. It’s Japanese, we don’t understand it, but that 60% of business in the US will give you 60% on that. So they end up only loaning you 36% On your total receivables which is kind of a kick in the pants, but it is very hard to get factoring or ADLs on your receivables outside the US very, very, almost impossible. I’ve never been able to do it. Supposedly the ExIm Bank will do it but they’re like the only one.

So structural debt asset baseline. So those are the two and I think you really have to look hard at your seasonality and cyclical Do you have the business? When you think about what’s the right debt structure for you, if you are in oil and gas, or in technology or in anything, let’s say you’re in things to get the direct to consumer, where can q4 Is the Christmas season is always the biggest season, highly, highly seasonal, you want to keep that debt level at your q1 q2 numbers, not your q4 numbers, right. And you let the ABL float up right during the busy period and then float back down when you get out of the busy periods. So that’s a perfect use of structural debt and an ABL sitting on top of it to deal with your cyclicality. So Bruce, you probably have a big q4, you would want to use an asset baseline for q4 sort of cycle. Now, I think your credit card, so you don’t worry about this. But suppose you extended credit, you’d be thinking like this. And there are third parties that will do factoring there are factoring companies that tend to be at higher interest rates than banks. But if you can’t get a bank that you can go to a factoring company, and that the math can work on that as well. There are reputable factoring companies out there, there’s another tier of debt that’s available, that’s structural, if you really want to lever up your company. And sometimes you have to do this, let’s say you did a big acquisition and you really stretched into it. So you put some bank debt in to cover the acquisition, and you don’t and you put your capital in, and you don’t quite have enough to bridge the whole gap.

There is a category called mezzanine debt that you can think about there. And these are not provided by traditional banks. These are provided by private lenders. And there are funds that are mezzanine debt funds, that’s what they do. And the idea of mezzanine is when you think about the debt stack, first are the secured creditors that might come the bank debt, and then might come the unsecured creditors. So they’re kind of risky, right? If things really go bad, there’s like third in line to the whole bunch of other people, including the employees are actually first you know, bankruptcy employees, then then secured and unsecured and these guys might be third, right, so they have no security so their interest rates going to be high. So traditional bank debt we’re seeing right now because interest rates are just stupid low 567 percent depending on how risky you are. mez debt will go 12 to 20. So you gotta be sure you need mezzanine debt before you go get it right, because it’s gonna be doubled the cost of your bank debt, or even your ABL, which it might be a little bit higher, might be eight or nine. So available again, it will have covenants on it. And these are the really risky ones. Because if you’re pushing your debt levels, highlight that any little miss and your numbers, you’re going to violate covenants and anybody who’s been in covenant violation, and I have been you can I’ll tell you it is a very, very unhappy place to be.

Has anybody ever read the book, man and fool by Thomas Wolfe, we read it. It’s a book is the guy who wrote electric Kool Aid acid test and famous author anyway, that Bonfire of the Vanities. He wrote a book about real estate developer in Atlanta, and the man and he’s a man and fall right. And he’s beautiful wife, big house, beautiful kids big car, Lent doing big projects, he goes up to 38th floor of this gorgeous bank building, they got mahogany and leather and crystal glasses for the drinks. And as they’re loaning the money, then things go sideways, and he starts breaking covenant can’t make his payments. While the next meeting they call him into the bank and he goes meet Jana 36. A flirt note in the basement. He goes in in the basement. It’s it’s plastic tables, once one one leg is shorter than the other. So he’s rocketing the chair, you know, cinderblock walls, there’s no windows, because hey, where’s my relationship guy going up? He’s not around anymore. You’re dealing with me now. And these are the workout guys. And they are there for one purpose to extract the maximum dollars, they can have the dollars they lend to you. And they don’t care. They don’t care. They don’t care, they don’t care. So it’s all you know, I laugh when people say I’ve got a great relationship with my bank to lend me all the money I want, I go, sure they will break one covenant and see you who’s in front of you the next time it won’t be Mr. Friendly bankers gonna be somebody else.

So you don’t want to break the covenants. It’s a bad thing to do. But sometimes you have to lever up and hopefully you got to plan to lever down through earnings as quickly as you can. All right, there are another class and I won’t recommend doing business with these people. But there’s another class of sort of rapid advanced type players where they will lend you money in a day or two. And what they generally are looking at like they would be willing to lend Bruce money for example, they look at your credit card flow, and they’re focused on on bankable companies, mostly which most of you don’t fall in that category. And they go, here’s the deal, we’re gonna lend you $40,000 You got to pay us back $80,000 And what we’re going to do is going to put a new credit card system in and every credit card swipe you take we’re going to take 10% of it to pay down your loan. And we projected that over you know 12 answer. So you’ll pay down the $80,000. You owe us right now some of you might be going, Hey, wait a minute, they loaned me 40. And they’re getting back at and it’s one year to pay it back. Holy moly, that’s a gigantic interest rate. Yes, it is. But the way they structure it to avoid the usury laws, because there are laws about how much you can charge for interest. It’s not structured as a loan, the way it is, is you just owe us a number. There’s no interest rate, there’s no nothing, we gave you money, you give us money back. And the timeframe is fungible. If it takes 12 months, great. If it takes 18 months, fine. That’s all there really, they go, that’s my risk. And I go, well, even if it took me two years to pay back, it’s still a stupid good return. What are you talking about?

So there are people that use these organizations? They exist, you’ll see ads for them, I would avoid them unless it is it is a last resort option for anybody. By the way, on the leverage thing, just a quick example, on leverage, like why would you put debt on a business to lever it up, I talked about return, but there’s a tax advantage to here. So let’s say I had a business where I loaded enough debt that it consumed all the earnings, which you can’t really do. But let’s say you could do it, and I drive all of that money into growth. So no earnings, no taxes, right, because the interest is deductible. So I have no earnings, no taxes, and then later, I’d have driven all the money into growth to increase the size of the company. So later, when I sell it, I get capital gains, which at the moment you pay at 20%. So I took all the taxes, income, depending on what your number is 40 plus down to 20, by using debt, and I’d be able to grow faster.

So that’s that is one of the reasons beyond the leverage reason why people use debt to reduce their taxes and move it over to capital gains. So people don’t think about that. But that’s true one, all right. If you have a bank, you’re going to have to report quarterly, you’re gonna have to have nice tidy financials, you have to sit down with them every so often and tell them how your business is doing. The good news is they’re not on your board, they won’t be on your board, because that would conflict them, but you will have to answer to them. So you have a partner in the business, even though it’s alright, just for let me give you one last element, there is an option to go to friends and family. So you say look, I need 100 or 200 $300,000, I got a rich uncle, I can borrow the money from my rich uncle. All good. And you will be able to offer your rich uncle, an interest rate is very attractive to you. But there are lower limits on how much you can track charge for interest. And they’re called the applicable fund rates AFR, you can look it up. And at the moment, the applicable fund rate for a short term loan is point 2% interest, you could charge as low as point 2% interest for an in and out loan, middle term 1% long term 2%. So you can borrow from friends and family super cheap if you can get it. It’s not violate the law. Okay, so that is an option. All right, anything that’s sort of my stopping point on debt. Questions, comments, thoughts? Anybody trying to raise some money or borrow some money find this relevant?

Guest Speaker  23:02  

Yeah, Jim, we we’ve been kind of having an interesting process. Going after SBA seven A, we turned down three times. The reason is they can’t see the need for the funding, which is fascinating to me.

Jim Schleckser  23:19  

Well, that’s it, but Well, it’s a good comment. I mean, what they don’t want you to do is bring $3 million into the business and immediately distributed to yourself. So they’re not willing to do debt cash out, some banks will do that, but not as an SBA loan. So what are you telling them the use of funds is, what are you telling him, Jim?

Guest Speaker  23:37  

Well, we’re telling him that we’re showing them our basically our projections, we’ve got some pretty aggressive growth, which is going to require the majority of the capital is for onboarding employees. These are revenue generating employees, and, and it’s, and it’s gonna take generally about 90 to 120 days to get that money back and then and then and then move beyond breakeven at about, you know, 120 days.

Jim Schleckser  24:05  

And so maybe forced into a vanilla a normal bank loan. Yeah. Unfortunately, that’s when you’re gonna sign a personal guarantee. Right? Yeah. So you know, you’d love to do an SBA. But try, by the way, try AMI, please. I mean, I get nothing out of I just know, he’s a good guy and does a good job. This guy knows where all the bodies are buried on the SBA program. So if you’re getting turned down, and that’s the reason he’ll help you either restructure your application or find a bank that’s a little more aggressive or it was worth it’s worth giving it a try before you go to a conventional loan, I would say,

Guest Speaker  24:42  

okay, yeah. Beautiful. Yeah. I as soon as you as soon as that was posted, I grabbed it.

Jim Schleckser  24:46  

Yeah. Good guy. Just tell him tell him we said you know, they’ll help you out. He’s a good guy. And this is all he does is help middle sized companies find money. That’s all he does. I don’t quite understand how he makes it. Any money himself with a 1% fee, but that’s his business, not mine. So whatever. Yeah, yep. Anybody else? All right. Let’s move on. And by the way, it didn’t talk about all of the sort of COVID PPP mainstream, because they’re all kind of evaporating, they’re going away. So those loans are largely not available anymore. The we’re back to sort of conventional SBA conventional bank debt. All right. Yeah. Yes, sir. Yeah, yeah, I

Guest Speaker  25:25  

got a question. We’ve gotten an ABL loan, and we’re not going to be in are we? We took it out right at the beginning of COVID. So we couldn’t find a bank? Of course, it right at the beginning and COVID Nobody, nobody was lending money. Yeah. We’re not going to make our covenants for the first half of the year. We’re that we’re gonna be okay. sales were down.

Jim Schleckser  25:48  

You don’t What are you gonna do? Yeah, yeah.

Guest Speaker  25:51  

Manufacturing Company. Sales are down our biggest customer is office furniture. Go figure,

Jim Schleckser  25:58  

you know, deal with the moment, right?

Guest Speaker  26:00  

Yeah, right. Now they’re coming back. But Glenn, I’ll

Jim Schleckser  26:03  

give you just some thoughts on when you’re in that position. Is that would that be helpful? Are you looking for a different question? I don’t mean, oh, yeah. Give

Guest Speaker  26:11  

me your thoughts. Please go.

Jim Schleckser  26:12  

So option one, because it depends on which covenant, you’re going to break. But many times, there’s like a cash on cash on the balance sheet to debt ratio, you could put capital into the business, that’s one option if you have it. So you put cash into the business and buff, it buffs up the balance sheet makes the bank more comfy. Off you go. The second element, and I would advocate this is as soon as you realize you’re going to break covenants, and you you’re sure you’re going to do it, get in front of the bank and tell them don’t want to say hey, by the way, last quarter, we busted covenants, you want to go, Hey, next quarter, I think I might bust covenants. And then here’s what I’m going to do to make it better. Sometimes they’ll play ball with you like the guy All right, we get it, we understand the field, you’re about the 197 person this week that told me they’re gonna bust governance, we’re not going to kill you, we’re going to try to work with you, as long as you got a reasonable plan to get yourself out of covenant violation. I’ve seen them being willing, sometimes they’ll go, I’m gonna have to nipa quarter point of interest, or half a point of interest you guy, right? Well, that’s what happens. But as long as I can, you’re not going to call the loan, not gonna put me out of business. And they don’t want to do that, like they don’t want to go to work out if they can avoid it. They’d rather work with you if they can,

Guest Speaker  27:28  

I’m not worried about workout, I got plenty of assets, it’s just the just we’re going to be out of covenant. So

Jim Schleckser  27:35  

get in front of them, tell them go tell him and maybe you go look, I want you to lift two options, either. If they say we understand we’re going to nip you up a quarter percent or whatever half percent on rate, you go, alright, that’s fine. Increase my covenant ratios, make them make them more liberal, if you’re gonna jack up my rate, and like, alright, we’ll do that for depending on your recovery plan, six months, we’ll keep them at the higher level, then we’ll start toggling them back down to the level we got them at. That’s generally what they’ll want to have happen. But I think get in front of it and have an adult conversation with them. And look, alright, stinks. But we got it. Let’s get it. Let’s figure out a plan. And yeah, you know, take the stress out of the whole damn thing. Makes sense? Yeah, it makes sense. Yeah. Just don’t surprise them. Right. The bankers I know. Right there conservative, risk hating people.

Guest Speaker  28:23  

Yeah, don’t surprise the bank. Don’t surprise your customers like that. You know, my customers. They’re billion dollar businesses. So yeah. Okay, thanks.

Jim Schleckser  28:34  

No problem. Awesome. Yeah, sorry, you’re there. I’m happy to chat with an awful lot about it offline to be helpful. But I’ve been there a couple of times and sucks. Anybody else any other comments on debt, or things going on that we should worth talking about or sharing? Alright, let’s go over to equity for a little bit. This is actually simpler, except for one hybrid offering I’m gonna talk about so. Equity is people investing in your business, they then own a percentage of your company, right? Early days, that’s seed capital, friends and family, most likely, rich uncle, grandma, whoever. And you know, you, this is horrible, but you, you generally don’t have highly sophisticated investors. So you can have very light kind of constrictions on yourself when raising money from friends and family. They’ll give you the money because they like you. They believe in you. They believe in what you’re doing. They’re not going to be looking for control provisions or board seats or anything like that. They’re like, hey, just kill it do great and make a lot of money and make me something right. So friends and family is one thing you want to go to. But the next level is, is high net worth. And when you’re doing your early rounds, you can raise a million to 2 million bucks at a high net worth. And that’s about the limit you can get to unless you got somebody really affluent and generally even a 2 million it’s a club for people chipping in half a million bucks. You’ll be rare to find somebody who’s willing to stroke a $2 million check on a risky proposition early stage proposition when they are around but they’re hard to find the thing Finger remember is there is no $5 million investor.

So if you want to bring capital in your business for growth, and you want to raise $5 million, there is no $5 million investor ultra high net worth is going to tap out at 1,000,002 million, maybe three on the outside professional money funds really only get interested in round 10, there are a few, it’ll do lower, but it’s a lot of overhead and time and to do this deal, they don’t want to put a small amount of money to work, they want to put a larger amount of money. So is very, very rare to find in a fund that will do a $5 million equity investment for growth. So you’re kind of in no man’s land, if you’re looking for five, I’d either scale up your ambitions and go to 10 or scale down your editions and Bootstrap for a little while due to when you get to professional money or a high net worth, there gonna be more restrictions on the money, not covenants, that’s not relevant, because it’s not an obligation. But you know, at 10 million, they’re gonna want a board seat, you need a board, you need audited financials you need, they’re gonna be have a vote on the board, they might have some control provisions on big decisions. So things start showing up when you raise equity like that. And I’m assuming for the moment, it’s all common, everybody’s the same. The tricky one, and a lot of professional investors will say we’re happy to invest, but we’re not going to invest this common, we’re going to invest this preferred. So preferred is a different class of stock from common, and it has rights that common does not have, sometimes it’ll have voting rights. Normally not normally, it has the same voting rights as common law, there’s a whole golden share thing we can talk about later. Normally, what it’s got is voting rights, or sorry, it’ll have a board seat, it’ll get interest. In other words, I put $10 million in in common, I get a 10% interest rate on my investment before anybody else gets paid, guaranteed return on my mind, my preferred. Now sometimes they’ll say, I’ll, I’ll pick it, Damon inkind Dec P IK. And what that means is, instead of paying me every month or every quarter every year, I’ll just increase my ownership of the company every year by the amount of my dividends. That’s an insidious little guy, if you don’t sell fairly quickly, because over 8%, no big deal. 8% over three, four or five years turns into a big number. So be careful about pick, if you’re not planning on doing a transaction fairly short order.

The other thing you’ll see almost typically in preferred is a liquidation preference. And what this means is, when we sell the company, I get my cash out first. And then I participate like common. So let’s say I sold 10% of the company to my preferred investor for million dollars, I’m making that up, right. And we sold the company for $20 million, they get their million dollars off the top day one, there’s now $90 million left, and they get their 10% of the company, they get 10% of the $19 million as well. So they get 1.9 plus $1,000,002.9 million on a million dollar return. What you’ll now see a one times liquidation preference is actually a little uncommon. Most of the time, they’re going to negotiate for higher than one, a 1.5 liquidation preference two times liquidation preference. So what that means in my example is we sold a lease by putting a million I own 10%, we sold the company for 20 million, I’ve got a two times liquidation preference. So I get $2 million, million plus another million off the table, there’s 18 left for everybody else, and I get my 10% of the 18 for another 1.8. So I make $3.8 million on the exit. I’ve talked before about how private equity groups don’t add value, they make their money by structuring the deal with debt and other elements. This is one of the elements that they use to guarantee their rate of return in a transaction. So if I’ve got a two times liquidation preference, you know, I kind of almost don’t care what happens to the business, right? Let’s say let’s say I go in for 10 is a $10 million valuation I buy I put a million in, I get 10%. We sell two years later, for only $10 million. The worst scenario, no growth while I go, Well, I got a two times liquidation preference, I get my $2 million off the top right, then I get 10% of the 8 million that’s left. So I took $2.8 million on that deal with no growth. So see what they did there that guaranteed their rate of return. And I didn’t have to do a dang thing. And I didn’t even include an interest rate or a pic. Because that would make this whole conversation even worse, right?

So it’s all structural, when they tell you that we’re here to make money by growing you when they try to structure it so that they don’t care if you grow or not. I don’t mean they’re evil. That’s the deal. That’s the market but when you’re negotiating it, ideally no preference. If there is a preference as small as you can make that preference. You’re able to get it is what you want. All right. I mean, the good news is they’re aligned with you mostly right? You’re an equity holder. They’re an equity holder they want to sell While the company they want to grow it, hopefully they’re long term greedy, they want to create a lot of value they want to serve, a lot of clients make the business bigger, so they can exit for a greater value in the future. So that part’s all good. But you will have a partner in the business, you’ll be majority in most cases. But even when they’re minority, there is something called minority with majority like control provisions, they’ll have little things that they have to be consulted on before you can do them. So you aren’t going to have the free rein you have today. If you take professional money, it’s not a bad thing. It’s an okay thing. But just realize, if you by the way, if you do a deal with a private equity firm, bring in equity, and you don’t have any debt, just realize the first thing we’re going to ask is, how can we No no debt on this deal, let’s put it up a turner to a debt on it, and Jack the returns right? So that that conversation will happen.

And then just the last instrument I’m gonna talk about, and then I’ll open it up for dialogue is convertible preferred, I guess, sorry, convertible debt, I should actually, by the way, sometimes on an equity invest, they won’t get a pic, but they’ll get warrants, that’s another element, they’ll add to juice their deal a little bit, which is options to buy at a certain price. So that that may exist in an equity investment as well. But the other one to think about as a convertible debt structure. Now that has become a very common structure for early stage companies. And the reason why is as I’m growing, I go, I How much is your business worth? And I think it’s worth 20. And they go out and maybe it’s worth 10? We don’t know, now we’re having a contest on what’s the dang business worth, it’s really not the argument we want to have because the market determines the value of the business, not us. So I’ve got one company I’m working with, they’re doing this, they’re maybe a year away from a series a investment, which would be a larger investment from professional money, and we’ll get a valuation at that time, right might be as $25 million for that particular business 20 $25 million. And there’s an investor that wants to come in now. And we started having the conversation around, well, what’s the valuation I’m like, guys, like? Who knows? Really, right? Until we saw it? We don’t know. And we’re not looking to sell it at the moment. So why don’t we look at a convertible note. And so what that is, is they put a debt instrument into the business with an interest rate, let’s say 8%, it’s not usually a very high interest rate on these things. It’s unsecured an IOU for a million bucks, let’s say, for 8%. Sometimes we pay that sometimes it accrues, and it picks could do either. And then when we do the series, a date can convert their debt into equity, but at a discount to the Series A. So let’s say the series A goes off at $25 million, right? They go great, we’re going to convert our million dollars into equity, but not at 25 million and 20 million, right. So they’ve locked in a profit on there a 20% profit on their investment, the minute we do the financing, and then they participate in the growth going forward. So you’ll see that very commonly. And it’s a very good way in a growth company to avoid the argument over what the company is worth, when it’s very hard to define a value on the company, right?

So there’s a lot of investors, both private and professional money, they’re willing to do convertible debt notes. And I think they’re probably slightly favorable to the company and slightly unfavorable to the investor, in my estimation, because they don’t get their evaluation for a year. And they’re not if you say, I’m not doing a series a for four years, they won’t do this, right, it’s got to be a fairly short term raise to establish value. If you’re not going to do that for a long time, they won’t do this. But if you’re going to do a valuation event in a relatively short period, they’ll go in. Anyway, I think it’s slightly unfavorable. Because you know, what if the valuation today is the last round was 10 million, and we think in a year, it’s worth 20, based on growth, why, you know, they’d rather buy in at 10, than a discount to the 20. But c’est la vie, they’re done, you should know about them, you may get exposed to them, you may get asked to invest in them, but that’s how they work. They have very little rights, you generally don’t get a board seat, you generally don’t get a lot of restrictive covenants in them. But it’s pretty clean debt with a not with a convert option at the end. That’s what I had to talk about today. What do we got for questions or comments or thoughts? Or anybody contemplating one of these vehicles? Or another one I didn’t talk about that we could share with group

Guest Speaker  39:16  

Jim. Can you give us your view on VC firms and how they operate in this structure? Business?

Jim Schleckser  39:23  

Yep. So um, you know, there are VC firms and their VC firms. Early early stage Vc, Vc firms when I got like an idea and a dog and one client and that is generally seed money that comes from high net worth grandma, uncles, you know, and once you proved the concept, and what they’re looking for is how much risk Have you taken out of the equation for how much money would I put in and how I might think about it. So if and if you look at Shark Tank, and then when he watches Shark Tank, so you look at how they value things particularly, not so much Mr. Wonderful because he’s all about the numbers but They go, all right, and watch the questions they go, do you have a product or as a prototype? Do you have a customer? Do you have repeat customers? Do you have revenue? Do you have profitability, so all of those questions are pushing you further, that you’re decreasing the risk of the investment, right? If you’ve got an idea and a prototype, they don’t like those very much. They rarely get money, right? Because you’ve not proven you can sell it, you’ve not proven you can sell it a second time, you can’t no repeat customers, like you don’t know, you can turn it into volume production at the right cost, like all these risk factors are there, they are not interested or really low valuation, if you start clearing those hurdles, they go, alright, this is a real business, we’re going to put real money to work, you just need gas in it.

So I’ll give you an example of one business, we’ve had people and we’ve had some venture type funds interested in it. But they’re saying you prove that you can sell more than one and to have repeat customers in one state prove that you can open up to other states, and you’re gonna have repeat customers that will put money to work, right. So they do want to see a level of de risk. Only in Silicon Valley, you get these crazy, you know, you got an idea and a team and a PowerPoint presentation. And we’ll give you five $10 million to go turn it into something right. And even then what they do is they go, we’ll give you a million dollars to prove the idea. Once you’ve proved the idea and dropped it to prototype, we’ll give you $5 million to bring it to market and show you can gain customers. And once you prove that we’ll give you $20 million to expand. You know, they only they when you hear the number you go, Oh, they gave us $100 million commit Well, yeah, but they didn’t stroke a check for 100 million dollars is progressive release. So and then there are VCs that invest in each of those stages to right, there are early stage VCs that’ll do the early, really early stuff. There’ll be later stage VCs ago. All right, they need gas in the tank, but basically, they got the idea proven they should predict the market. That’s a different kinds of VC.

What’s interesting about how the VCs think about valuation, this is the really different thing about them. How do you value a business? That’s $3 million, making nothing growing fast, I don’t know. 3,000,005 times revenue, 10 times revenue, I don’t know. Right? They think about it more in terms of the opportunity different than private equity groups that engineer their return, they go this business, if it does decently should be a $50 million business. And we know in the market, if it gets the $50 million growing fast, we can sell it for $400 million. I’m making that up, you know what I mean? So if we can get if we can put $10 million to work, right? And we own 25% of it 10 million turns into 25% of 4,000,010x return, let’s go right? So they think more about what is it going to be and the return that it will generate if achieves any reasonable outcome, then they’re in so they think very differently about valuation from what’s your EBITDA, how much debt can you cover, you know, how many multiples on my invest am I gonna get, that’s a private equity provider, that’s not a VC guy, they think very differently. And part of why they think like 10x, is they go, they they go, we’re going to invest in 10, companies, seven are going to do nothing, they’re gonna flame out, and we’re gonna lose all our money, right. And that’s why they do progressive release. VCs, the thing they’re really good at is they shoot their babies really early.

Not they have no emotion, right? They go, you failed to prove that you can achieve the target that we all agreed that a million dollars get you to, you’re not close, you’re still 3x away from it, we’re done, we’re out, we’re not giving the other nickel, if you could find more money, great, but we will have, we’re not giving you another nickel in this deal. They have no emotion about that, because they know seven are gonna die. And the sooner they figure out which seven are losers, the faster they can focus on the three that are the winners, right? And then two are going to do pretty good. You know, they might not go to 400 million, they might go to 100 million and you know, we’ll do okay, but not great. And then one will do really, really well. And that pays for the whole damn fund. So that’s a very different model to private equity guys that go like I need five or six of them to do pretty decent. And then I mitigate my downside on the other ones to try to blend to 25 or 30% VCs are like the riverboat gamblers of the investment space, right? So that sort of what you’re looking for. Anybody else comments, you feel comfortable when you start thinking about debt for your business, your next acquisition you little needle extra Dota cover the number or buy out a partner or open up a new geography you know how to get the money for it now right. Awesome. Alright guys. Well, thank you so much. Hey, is 10 a better time than 11? Is it’s too late in the day. Well, you guys think

Guest Speaker  44:37  

better for west coasters? Yeah,

Jim Schleckser  44:39  

well, that Yeah. Chicago is probably okay. Yeah, that’s an that’s a comment.

Guest Speaker  44:45  

Yeah, I think I I think it’s, it’s a little bit better, but I’m good to go with the flow. Whatever is good for the greater good, greater

Jim Schleckser  44:53  

group. Alright.

Guest Speaker  44:54  

I like 11 o’clock.

Jim Schleckser  44:57  

All right. Well, we’ll keep it 11 For a little bit and see how Go some awesome looking for topics. If you have any, please send them in to me or Sharon. We’d love to get any feedback on that and hopefully got something out of today a couple notes, thoughts. If you want to talk deeper, we’d love to chat with you and just help you on your journey. Thanks, everybody for coming.

Guest Speaker  45:14  

Thanks. Thanks.

Guest Speaker  45:16  

Again. Thanks.

Outro  45:21  

Thanks for listening to The Lazy CEO Podcast. We’ll see you next time. And be sure to click Subscribe

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