When you work with small business owners, you typically find that they’re not holding a diversified mix of assets. “It is not uncommon for many entrepreneurial businesses to have all their wealth locked up in their company,” says Gordon Tunstall, of Tunstall Consulting in Tampa, FL. “And even if the company is prosperous and growing, the bank’s credit requirements are such that they require a certain debt-to-net-worth ratio. So the business owner keeps leaving the profits in the business, because the banks require it. It exposes the entrepreneur to a lot of business and personal risk, if a disruptive competitor comes along, if there’s a lawsuit or the market dries up.”
Advisors are also asked to help a business owner fund new sources of financing when he or she encounters an opportunity that could dramatically increase the size of the business.
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Inside Information
Banking by the hour
The traditional solutions – a venture capitalist or a bank – come with drawbacks. The venture capitalist is going to want equity and control in return for financing, and is typically looking for a 50% annualized rate of return on the money. The bank, meanwhile, wants to see collateral greater than the amount of the loan, which won’t be there for the expansion opportunity and may not be available if the line of credit is already fully-tapped.
Is there a third option? Tunstall has been described as a “banker by the hour;” his job is to provide customized searches for financing on a fee basis rather than working for a commission. This is very different from the traditional loan brokers, who take 10% of the deal if they raise equity or a 2% commission on the loans they bring in – creating conflicts of interest that favor the funding organization.
“We’re paid by the hour,” Tunstall says. “It doesn’t matter what the size of the transaction is; we would sit down with the client, see what kind of financial statements and information he has, and put together a package to send to the lenders.”
This is where the situation gets interesting. Tunstall says that in the past five years, two new sources of capital have emerged to provide funding for business owners. “Ever since 2008, when the banks started to clam up on extending credit, all the smart guys on Wall Street developed two types of funds,” says Tunstall. “The first kind, which we call a non-regulated bank or nonbank bank, loans to the company and takes a first lien on assets. These companies don’t fall under a bank’s regulatory supervision because they get their money from pension funds, insurance companies, hedge funds, endowments and/or family offices.”
Tunstall has 75 of these non-regulated banks in his database. He views them as an alternative to traditional bank financing.
Another type of lender that has grown even faster since the credit market meltdown. “There are now about 400 of what we call mezzanine financing firms that have grown up in the last five years,” says Tunstall. Often these are called business development corporations, which Tunstall compares to a REIT, except that it is an operating business instead of a real estate investment organization. “They raise money in the public market – there are some on the NYSE, some of them on the Nasdaq – and then they invest that money in mezzanine transactions,” he explains. “And then 95% of their cash flow is distributed to the shareholders, just like a REIT. So it is only taxed at the shareholder level, not at the corporate level.”
One example, which is somewhat unique since it allows you to view its whole portfolio online, is Main Street Capital out of Houston, TX. A number of brokerage firms have their own versions; business development corporations have been created by JP Morgan, Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Morgan Stanley and PNC Bank. “Altogether, there is a tremendous amount of capital looking for transactions,” says Tunstall.
Mezzanine financing at work
The loans provided through mezzanine financing are somewhat different from traditional lending, in three ways. First, these loans are subordinated to any bank debt the company may hold, which means the bank loan is paid back first if the borrower is having trouble making its payments. Second, the loan provided by the mezzanine finance company doesn’t require a personal guarantee by the business owner. And third: the mezzanine financing doesn’t require fixed repayments on a schedule.
So how, exactly, does this work? Let’s say your small business client has built up some wealth in the company, and she’s nervous, because almost none of her net worth exists outside of the business. She’s 50 years old, plans to run her company for another 10 years and then sell it. “But right now,” says Tunstall, “she would like to diversify her wealth, create an investment portfolio, and between now and retirement, she’s willing to pay the interest to do this.”
This describes exactly a transaction that Tunstall closed the week before he gave this interview. “The company has bank loans, so the mezzanine fund comes in behind them, so the bank actually gets the equivalent of equity, and is in a safer position,” says Tunstall. “This particular entrepreneur did an S-corporation distribution to herself personally that is tax-free, because she has paid taxes on those retained earnings over all those years. She now gets personal wealth outside the business, there are no strings attached, no personal guarantees on the mezzanine, and the financial planner can manage those assets in a portfolio.”
The amortization structure to pay the money back can be either no amortization for 5 or 6 years, or be based on a percentage of cash flow, typically between 30% and 50%. The interest rate, in today’s market, will be somewhere between 11% and 16% – and, as Tunstall emphasizes, it is not all currently payable. “If you want to pay 8% currently, you can have the additional interest added to principal,” he says.
A real world example is a company called Hav-A-Tampa. “They make small cigars,” Tunstall explains. “The owner came to us and said, I’m broke personally even though my company is doing great. Because we’re growing rapidly, and because of the bank’s leverage covenant, I have to keep leaving money in the business, so my debt-to-net-worth requirements are met for the bank.”
The solution? “We discovered that he had $6 million of retained earnings that he had paid taxes on through his S election,” Tunstall says. “We raised $6 million subordinated to the bank, he took $6 million out tax-free, used it for his personal planning, paid it back over three years and he came back to us again. We did it again for $12 million. He paid it back. About five years later, he sold his business to Tabacalera when he had 100% of the stock. Over the course of maybe 11 years,” Tunstall adds, “he got the use of $18 million out of the company and still owned 100% when he sold it.”
There were no commissions involved, which saved the client an estimated $360,000. But these services are not cheap even on an hourly basis. Tunstall says that his typical fee ranges between $55,000 and $100,000 – whether the transaction is $10 million or $100 million.
Is it worth the cost?
Are small business clients really willing to pay these fees and above-market interest rates? “I can tell you, I do a lot of this business,” says Tunstall, “and when I tell an entrepreneur that he can take money out of his business, no strings attached, and he doesn’t have to give up any ownership or put somebody on the board to control the company, he’s all over it.”
Russ Achzet, a former planner and owner of a planning firm who now works as a marketing consultant with Tunstall, sees two applications of mezzanine financing or nonbank lending for the planning profession. One is personal. “When I was getting ready to retire, I had envisioned that my employees would buy my company, and I brought Gordon in to meet with the employees to work it out,” he says. “But after the analysis, I never became comfortable that the employee group could buy the firm, and the group was never comfortable with the numbers. We ended up seeking out a third party buyer.”
The advisor also benefits directly from providing a source of liquidity for clients. “When I was practicing, whenever I was working with the business owner, we would inevitably lose the account once a liquidity transaction occurred,” says Achzet. “The person who introduced the money to the entrepreneur had a tremendous amount of control.” And it probably doesn’t need to be said that the client becomes more valuable to the advisor when millions of retained earnings become liquid and have to be managed in an investment portfolio.”
“Knowing about this,” says Achzet, “having the knowledge of what is out there, can really help practitioners grow their business with small business owners. Who doesn’t need financing for either internal transactions or acquisitions, and to help their companies grow their operations?”
Altogether, the bank consulting relationship looks a lot like a financial planning relationship, and in Tunstall’s case, like a fee-only relationship, as opposed to the more common commission arrangement in the financing world. “We start by understanding where the company is, where they want to go, what they are attempting to accomplish,” says Tunstall. “We prepare the necessary storyline that goes along with that, and then we take it into the marketplace and we go out to 400 firms to get the best financing deal. We want the firms to bid on it. Some firms won’t respond, but others will come back either with questions or a tentative term sheet that we can negotiate around.”
The important message, Tunstall adds, is that new forms of financing are now available, and actually competing against each other to provide funding. “I make a lot of speeches nationally to entrepreneurial groups,” he says, “and I can tell you, a lot of people still think their only options are the bank or a venture capitalist. They don’t realize how many new levels of financing have been created in the last five years. This is a fantastic time for entrepreneurs,” he adds, “because now they can get comfortable financing that doesn’t dilute their ownership.”
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