Capital. Every business needs it to grow, especially small businesses and medium sized businesses (SMB). You need it to develop and build out infrastructure to launch new services including the marketing of those services (growth working capital), expand through mergers and acquisitions (M&A), general bridge financing, and sometimes to fund the front end of a rather large project.
At Cogent, we are strong believers in investing your own business cash flow and currently available funding, such as a line of credit (LOC), where possible. Especially when there can be a good return on that investment in short order. Sometimes that just isn’t enough and company executives need to seek other avenues of funding. Generally speaking, that’s not an easy or guaranteed task to achieve even if the company is doing very well. Small and lower mid-market businesses are often challenged with finding a traditional source that will lend the money, and quickly, for growth purposes when there are not enough physical assets to hedge their risk. Add to that the fact that larger loans for larger companies are favored in any market climate, but even more so in a tighter market with more stringent loan criteria.
All the above means greater tough times for any service business including cloud (CSP), managed services providers (MSP), VARs and project or consulting oriented IT service firms as they don’t have the physical assets and collateral to back up a loan nor are they typically especially large businesses. Enter the use of a non-traditional lender, such as private equity firms, and creative non-traditional lending vehicles, as opposed to bank loans or lines, into the equation.
What do non-traditional lending vehicles look like? They typically, but not necessarily, come in the form of:
Senior Notes- holding first position only secondary to bank loans and LOCs if they exist, high fixed interest paid in cash, typically 7-10 year terms, balloon (known as a “bullet”) principal payments, no prepayment, usually not secured by collateral, covenants based on “incurrence” (meaning being prohibited to do specific actions like taking on additional debt, selling assets, etc. versus “maintenance covenants” like maintain certain ratios such as Debt/EBITDA)
Subordinated Notes- Subordinate to all Senior Notes and bank loans/LOCs if and when they exist, even higher fixed interest paid in cash, typically 8-10 year terms, balloon/bullet principal payments, no prepayment, usually not secured by collateral, covenants based on “incurrence” (See Senior Notes)
Mezzanine Debt- Very diverse in what parameters get conjured here including possibly looking a lot like Senior Secured and Senior Subordinated Notes with twists and turns. Because they typically involve very high interest plus equity parameters, they are generally granted faster and easier. Sometimes senior sometimes subordinate, typically very high fixed interest paid in cash and/or “paid in kind” (also known as PIK meaning this type of interest gets added to the principal to be paid later also making the cash interest amount paid increase), typically 8-12 year terms although it can be very short term such as 1-3 years like a bridge loan, balloon/“bullet” principal payments sometimes with an option to amortize, typically no prepayment or prepayment with a penalty kicker attached, usually not secured by collateral, covenants based on “incurrence” (See Senior Notes), and the big difference is it likely includes, or a combination of, preferred stock, Convertible Debt (into stock), Stock Warrants.
Each of these vehicles has its own rules of default as well as what happens upon a default based on the parameters of the agreement. Be that selling of secured collateral, exercising warrants, etc. to collect on the outstanding debt and interest.
What does a good candidate for a non-traditional lender look like? As you can imagine, every funding source has different criteria. Have no doubt that these funding sources are looking to make money from their deployed capital. That means the ability to easily pay any cash based interest along with amortized principal if part of the agreement. They want to lend to a solid organization to use the money well and wisely to achieve their end goal and then some, especially with balloon payments involved, which could also mean a company game plan to pay off the loan through a traditional lender or sale of the company down the road. Some loan only to certain types of companies, while some are agnostic. All of them will have a minimum deal size, which for most will be in the $1MM to $3MM range, and they will all have a varying maximum amount depending on the source and the vehicle used.
If you are any flavor of IT Service provider (MSP, MSSP, CSP, VAR, Data Center Operator, Consulting, Staffing, etc) running a solid company with a good management team and are in need of capital, contact a partner at Cogent Growth Partners to discuss if we and our trusted non-traditional lending sources can help you out.
About the Author: George Sierchio, EVP & Sr. Partner at Cogent, is well versed in many areas of M&A including growth strategy, acquisition targeting/evaluation, valuation, due diligence, deal structure, agreement development/negotiation, and corporate governance, leading over 25 transactions in the IT Services space.