Options For Borrowing Money: Debt, Equity, And Hybrid

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MBA 17 | Borrowing Money

 

Are you thinking of borrowing money and are confused about what kind you wish to borrow? This episode helps lay out your options and let you make the smartest investment decisions. Join Solomon Ali as he tackles the different options for borrowing money – debt, equity, and hybrid. Breaking down each of these, he shares scenarios and mechanisms of how you can successfully transact with them. He also highlights the difference between a creditor and an equity owner, as well as the importance of having legal representation during the borrowing process.

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Options For Borrowing Money: Debt, Equity, And Hybrid

We’re going to talk about, how do you borrow money? We’re going to try to keep it simple and easy. There are three different categories I believe in borrowing money. First, you have to identify what it is and what type of money you wish to borrow. Do you want investment money? Do you want debt money? Do you want some type of hybrid? A hybrid would be a combination of debt and equity. Debt money is a straight loan. That’s when your company, or you on behalf of your company as a guarantor, is going to borrow the money on behalf of the corporation. You and the corporation are going to be signing for it. The first thing that has to take place is if you have a corporation.

You’re going to have to do your minutes and your resolutions. The resolution is giving you the authority to borrow the money as the officer of the company, which also is giving you the binding power. It will state also within that resolution, approximately how much you’re looking to borrow and what are the general purposes of that money is why it’s being borrowed. Next, the board of directors would vote on you being able to borrow your money and then resolutions and minutes will be created. You take the resolution to you with the bank along with your certificate of incorporations and your articles. Some will have a certificate of incorporation and some will have articles of incorporation with that resolution.

Debt

I would always take a summary of how much it is that you’re looking to borrow and what is the use of proceeds are going to be? That’s for borrowing the money. Let’s go a little bit more in detail. When I go to the bank, I’m bringing all that information and I’m having a good old chat with them and I may be looking to borrow money to expand the company. I already know and have identified what the collateral is. We’re going to talk about something called cross-collateralization. I don’t do cross-collateralization and I don’t recommend that you do that neither. I got this particular asset that I’m willing to put up. I will like a carve out later in the future on this particular asset as I bring that debt ratio down as far as what I owe you.

A lot of lenders will be accommodating to that, but you’ve got to keep in mind the lender’s objective is to protect the bank the best that they possibly can with as much collateral as they possibly can. What are we talking about? I’m going to use a number of $1 million. If you’re looking to borrow $1 million and you only have $1 million of collateral, you’re not going to get a $1 million loan. If you’re looking to borrow $1 million and you have $1 million of collateral and you have cashflow that doesn’t show that you can support paying back 1.25%, plus your historical numbers do not show or justify that, you’re not getting a loan.

Here’s what it looks like. I want to borrow money. I have $1 million in assets that I can place as collateral. The bank is probably going to say, “We’ll give you $250,000.” I get $250,000. However, the bank is going to still be looking for me to be able to debt service 1.25% of that $250,000. They are also going to be looking at the last thing. They are ensuring that my collateral is good, my cashflow is good and the capacity to be able to assure servicing that debt. That’s what they’re going to be looking for. They’re going to look for the credit, making sure that you have good credit, both you and your business.

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Your business should have what’s called a DUNS number, a Dun & Bradstreet number. You should have a Paydex above 82. Some people say 81, but it should be above 82, 83 Paydex. You should have a personal credit score as signing off on the officer to a company of approximately 771 or above if you want the best possible interest rates and things of that nature. If you have a lower credit score, it doesn’t mean that you can’t get it done. It means that you’re going to possibly pay a lot higher in interest rate. That’s on straight out borrowing debt. That’s how the mechanics of that would look.

Equity

Let’s go to equity. Equity is going to work this way. We’re going to have a board of directors meeting. We’re going to vote that we’re going to exchange some of our stock in exchange for equity. We’re going to determine that dollar amount. Once we vote, we will create both the minutes and the resolutions determining that, then we will create what’s called a Prospectus or an Offering Document. I’m going to use the word, prospectus, and that’s going to outline a summary of your business. It’s about 72 to 105 pages, but it’s going to outline the summary of your business, the marketing plan of your business, the business strategic strategy, the collateral, the use of proceeds, the management team, a forecast showing how far and how much money you’re going to make over what period of time. It’s going to show the return on investment, your KPIs, everything of that nature, your return on capital and your net present value. It’s going to show the potential investor who’s looking at that prospectus all that particular information.

In addition to that, it’s going to tell them about the business itself. Let’s say if you’re going to be selling widgets, it’s going to give a narrative of why these widgets are great and how these compare to others that are in the industry. It’s also going to look at comparisons of your competition. What is your competition doing out there in the marketplace? When you have that prospectus and all that great information in that prospectus, then what you’re going to do is go ahead and take it to different people and tempt to raise money. In some states, when you begin to raise money and after you get your first dollar in, you have anywhere from 3 to 15 days depending on which state it is to go register with that state the money to register your offering within that state. Normally, after you receive the first dollar, it’s anywhere between 3 and 15 days to get that document registered. You want to make sure that you do that.

From that point, you’re able to continue to raise as much money as you possibly can depending on the offering. Some people will do a 501. Some will do a 506. Some will do a 504 or 505. These are called Reg D Offerings and allow you to raise a certain amount of money. Don’t ask me about the crowdfunding because I’m not professional on it. I’m not able to tell you a lot about that. I’m only able to tell you about the things that I know about and the things that I’ve been doing. As investors bring in the money and you receive the money, normally it’s a good policy and it’s not required however to put that monies into an escrow account before you start using the monies. When you do that, it allows you to stay a little bit more disciplined for the use of proceeds to ensure that those monies are going where it’s supposed to be going. That’s how you’re going to raise your equity money. Some people are going to say, “Where do I go?” You’re going to start off with your family and friends.

People who know you, like you, believe in your business, then you’re going to probably branch out to your potential customers, your vendors, your suppliers. Those types of people who know your business, understand your business and who may want to invest in it and think that it’s a good idea. Most of you won’t be ready to go to Wall Street and raise capital there. At Wall Street, we want to see companies that are doing at least $10 million with at least a 20% net. You’re doing $10 million, your net is roughly about $2 million EBITDA. Most of you are not going to be there.

MBA 17 | Borrowing Money

Borrowing Money: Raising your capital means paying banking fees, underwriting fees, and the like on the front or back end.

 

If you are, then it’s possible that you can hire a brokerage company to do the offering and the raise for you, which will make your life a lot easier. When you go to a brokerage house to raise your capital, you’re going to pay what we call the banking fees, underwriting fees. Sometimes it’s on the backend. Sometimes it’s a portion of that on the frontend. My first offering was back in 1986, 1987. We had to pay almost about $600,000 upfront to sit back. We were told that it was a bad time. They wouldn’t be able to raise the money. We didn’t get that money back.

Hybrid

You can imagine if money is tight, you want to think about that 2 or 3 times before you go that route. You had to have a lot of confidence and some discretionary cash if you’re going to hire a company like a brokerage house to do the offering and go ahead, take you on the roadshow and to raise the money. A combination, a hybrid, I call it a pie. It depends on what you want to call it. We’re looking at debt. We’re looking at warrants, which are preferred positions within company stock. I prefer possession or preferred stock, meaning that you are a creditor. If someone says, “Do you want to purchase some preferred shares?” at the end of the day, that’s pretty much you’re going to be a creditor. The preferred shares could have an option or a warrant to where you’re able to convert those preferred shares directly into equity. That’s a sweet thing if you’re able to convert to equity which would be to the common stock.

Which Way To Go

If you’re able to convert to common stock, that means you’re able to share within the marketplace, especially it’s great if the company is public. If you’re a private company, which most of you are, it won’t be as sweet because most companies are going to take anywhere from 5 to 7 years to build it up to the point to where they’re even ready to go public and meeting the requirements are stringent. It’s a very taxing thing. There are approximately 4,000 companies that are publicly traded in the United States. There are roughly thirteen black-owned managed companies in the United States. I, Solomon RC Ali, was an Officer and a Director of three of them. One was Universal Bioenergy, stock symbol was UBRG. One was the Revolutionary Concept, stock symbol REVO. The other one was JMI Telecommunication, stock symbol JMIM. Those companies are no longer trading but that tells you that I sat in a unique position. I have an idea and I’m an authority on what I’m talking about in that sense. If nowhere else, at least within my own mind.

That being said, we can look at which way you want to go. If I was raising money for a brand-new company, I’m going to try to go the route of debt. That means I’m going to give up the least amount of ownership. I’m giving up no ownership of my company. I’m borrowing money with a promise to pay it back over time. I’m going to try to get that in the most favorable terms and everything that I possibly can. That’s what I’m going to try to do. If I’m excited about the idea and then what I’m going to look at is, “What do I want to borrow against? Am I borrowing against my accounts receivables? Do I want to borrow against my inventory? Do I want to borrow against my contracts?” Some will try to say contracts and accounts receivables are one and the same. Yes and no. Contracts are generated long-term. Accounts receivables are typically, you’re showing that work has been done and a company will buy that work that has been done and sign off on it. That is short-term, normally 30 days.

Contracts that have 2, 3, 4-year contract, you’re able to sell that off. Many times, the banks will buy that or loan you money against that. I don’t like it when the banks want to buy my contracts. I like to borrow against my contracts. In most businesses, here’s what we’re trying to do, I am trying to make the spread between the line of credit that I have for my company and the profits that I’m making. That’s what you’re trying to do in business. You’re trying to get the largest amount of credit lines that you possibly can get and you’re trying to make the spread. If I get a $300,000 credit line, I want to go out and make $500,000 in gross profits with a 20% net. At 20% net will give me $100,000. I offer that $300,000 I was successful in making a gross of $500,000 in sales, but we net it $100,000. That means that I did good. I was able to pay the $300,000 back and at the end of the day I made $100,000 profit. One would do the math there and say I manage that line of credit extremely well and did well with it. That’s how you want to look at it.

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When the creditors are looking at it, that’s how they’re looking at it. They’re looking at, “Can you manage the money? Do you know how to manage money?” The other thing is let’s think of it from the creditor’s standpoint. If I’m loaning you $250,000, why would I make that loan to you? It’s simple. You put up $1 million of collateral for me and even if you fail, I can have a fire sale and sell your asset off at $500,000. I can still get my money back. I can still pay my attorneys, accountants and the people who had to collect the asset. I can go out, sell the asset and make a little profit. That’s why they do it and you need to understand that. When they sell the asset to an end-user that they purchased for a $500,000, they’re able to sell that asset for let’s say $750,000 to an end-user. The end-user is feeling good because he still has 25% equity as a margin in there. He bought it for $750,000, so he’s feeling great. That’s how it works in the real world.

You’re not going to get 100% dollar for dollar. It doesn’t work that way. My numbers might be a little bit extreme for some of you. You might feel that way. Let me tell you, those numbers are pretty right on. If they have to take that asset and sell it, they have to be able to sell it quickly in a fire sale. When we say fire sale, we’re trying to get rid of that asset in less than 30 days. That’s a fire sale. What else do you need to know? I’m going to need three years of historical numbers on my business. I’m going to need three years of financials. I need three years of tax returns. My financials will need to show an upward trend. In other words, we’re making more money year-after-year and our profits are going up and that we can debt service the amount of money we are looking to borrow. I’m also going to need three years of my personal financials and three years of my personal tax returns.

In my personal tax returns, what they’re looking for is to make sure that I was taking the money out from my salary and not creaming the company. It’s is being shown where I’m paying my taxes. They are also looking on my personal financials as well, what other assets you may have that’s shown on your balance sheet or other streams of income that you may have that may be able to support paying that debt back. That’s what you’re going to need to show a banker to be able to borrow and get some debt money. The last thing within your package and your summary, you’re going to show them a summary, what the use of proceeds are and what the collateral is. That will be it for your debt. If we’re doing equity, you’re going to have to show a great prospectus, a great business plan to mention all the things that I mentioned before. You’re going to have to be excited about what’s going on, what’s the use of these proceeds are, so that people will want to buy your stock.

Here’s what I like to do. I like to sandbag. What do I mean by that? Sandbag is I might know that I have twenty contracts that’s pending, but I might only talk about 15, 16 or 17 of the 20 contracts. In other words, I might not talk about the ones that are iffy. I may leave them out. I may feel like I can get them done. There are going to be twenty, but let’s not talk about those because if they don’t happen, then you look bad. If they do happen, that’s what I’m calling sandbagging. You look good. You look like you got it going on. That’s what I like to do. If I got twenty contracts that I know I’m going to close and three of them are iffy, I’m not going to talk about those three. I’m only going to talk about the seventeen contracts that I know for sure that we pretty much already have signed and it makes sense. The other thing, I’m not going to talk about, no pie in the sky. I’m not going to talk about, “I hope and I dream to close this deal or to do this.”

I’m going to talk about it and keep it to the facts. That’s what you want to do. Let’s keep it to the facts. We live in a time, in an age where people can google anything. Don’t stretch the truth. Keep it to the facts. Keep it personal. Keep what your beliefs are and why your beliefs are that way. What you want to do is inspire other people to see the same things that you see. When I’m raising money, I’m going to go in hand with my prospectus. If I’m looking at and I have contracts, I’m going to be showing my contracts. I’m going to have a nondisclosure agreement so that the potential investor cannot talk about it, share that information or anything. I’m going to start off with probably my accountant, CPAs and attorneys to see if and who they know and along with my family members to begin to raise my money.

MBA 17 | Borrowing Money

Borrowing Money: The more you tell and disclose, the safer you will be.

 

I am going to have my stock priced at a certain price. Let’s say it’s going to be $5 a share. If they do this right now, I may be offering them shares at $4 or $4.50, whatever the case may be. In other words, I’m offering them the stock at a slight discount to what my actual offering is going to be. You also have to disclose that. Within your document as well, remember when you’re a company that’s raising public money, disclosure. You want to tell the good, the bad, the ugly. Tell it all. The more you tell and the more you share, the safer you will be. You don’t want someone to come back and say that they didn’t know that. Let’s say you’re taking a salary of $500,000, you want them to know that. Let’s say if you’re hiring your wife, you want them to know that. If you’re hiring a child or a sibling, you want them to know that.

If you’re getting a contract from a family member or a close friend, you want them to know, “I am getting a contract from a family member,” or it could be the other way around. “I’m giving a contract to a family member.” Please always share that. The second thing I’m going to say is this, don’t make a move without an attorney and make sure that he opines on the things that you’re looking to do and that he says, “It’s okay.” In other words, it’s his butt on the line or should be his butt on the line. You’re still ultimately responsible, but you want to make sure that your attorney signs off and opines and tells you that, “Yes, you can do it this way and this is how it’s done.” Don’t go out there and trying to be all creative and stuff because you’re working with limited capital or resources. That’s not going to work. All that will do is get you in trouble. Don’t do that.

The other thing we’re going to go is once you get your money, place it in the escrow. Have those monies going to escrow. Don’t begin to start spending that money and don’t go say, “I’m spending it on eating out.” You can, but no. Let’s be clear. You told the people if you didn’t discuss it and share in that prospectus as part of your use of proceeds, don’t go using that money in that way. Only use that money for how you said you were going to use it within those use of proceeds. Be clear and be thoughtful of what you’re planning to do. If you plan to buy a dog to watch your premises, make sure it’s in the use of proceeds and then you can buy the dog. If you go buy a dog and it wasn’t in your use of proceeds, shareholders are going to feel some way. Be mindful, disclosure. Tell people the truth right upfront. It’s better to tell them right upfront than to have to backpedal and try to tell them later or explain it later when they may not be sympathetic to what you’re doing at that time.

The other thing is hybrids. I call them hybrids because it’s easy to say. I know everybody who’s got a lot of people to work around me who have an MBA. They like to sit back and say, “You make it sound so simple. I didn’t learn it that way in school.” We all get to the end result. I was helping a young lady years ago and she was in the MBA program and she was doing poorly. By me helping her, she ended up pulling out a little bit above B, under A. She would always say, “We were working on net present value.” If you don’t know what net present value is, go look it up. I could almost look at the numbers and tell what it would be, whether or not if it’s a zero. What do you do if it’s a one? What are you going to do if it’s a three or above or if it’s a negative number? I could almost look at it every single time and tell her what it was. She would say, “You do it the black way.” I said, “I don’t know what the black way is. I know how to do it.” She will laugh. She would take about fifteen minutes to write out the complete formula. By the time she’s two minutes in the formula, I already knew what the answer was.

It’s like this. If it’s a one, I’m doing the deal. If it’s a zero, I got to seriously think about that deal. If it’s a negative number, I’m not doing that deal. I’m going to run like hell. That is some of the things that people in business school learn. They learn, “What makes a deal? How much capital is going to take? When are the returns on this capital I’m going to take place? What are the cycles?” That’s critical stuff to know. When you’ve been in business as long as I’ve been in business, if you don’t have a gut feeling for this stuff, then you better rely on the professionals around you. One of the other episodes I talked about, you better not be the smartest person in the room. That’s trouble. You want people far smarter than you in the room, and you want that collaboration to take place to create that other mind. You want people who can dot those i’s and cross those t’s.

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Picking A Board Of Directors

Let me go back a little bit. Picking a board of directors is extremely important. Do not go out and pick your mother, brother, next-door neighbor, a good friend because you trust them. They have no expertise. Pick people who have expertise, who understand what it is to run a company in the direction that the company needs to go in and the things that need to be done, even if they come from different industries than what your industry is. You know that they all vote the way you want them to vote. That’s a fast way to run a company right into the ground is to have a bunch of people following each other like a dog chasing his tail. You don’t want to do that. Find people, seek them out, who have run a business, who understands the business, duties, obligations and the responsibility of sitting on the board. When you take on shareholders as the owner and founder, that is no longer your company. It is the company of these shareholders. You may be one of those shareholders. You may even be the largest shareholder.

What I do for one, I have to do for all. I can’t share certain information with one shareholder and not the other shareholders. The board of directors have a fiduciary responsibility to govern the company, to protect the shareholders and the creditors from you making dumb decisions or running it like your personal pocketbook. Make sure you have a good solid board of directors who understand that, who understand the business, accounting, legal, financing and operations or marketing or other different things that you may need. That is extremely important. Don’t hire an attorney just because he’s the cheapest one you can find. You may have to pay a lot more for an attorney. You might not be able to afford it. Save your money and get the right legal representation. It’s very critical. It’s the same with accounting. Don’t pick the person that you can afford or work with. Get the right accounting representation to make sure that your books and everything are going to be correct and stellar because that is your credibility and reputation. You want to make sure these things are done correctly.

Raising And Using The Money

Last, get a strategic consultant who understands how to grow a business, how to finance a business and that can let you know what the various challenges are going to be and help you to work with your legal professionals and your accounting professionals. He at least has that understanding and that knowledge that you don’t have to ask the questions that you won’t even know to ask to help keep you out of trouble. Make sure you get that strategic guy that will work with you and help you with working with your legal counsel, asking the right questions. Making sure what you’re looking to do, it’s been shared with the council correctly and properly and the same with accounting personnel. All that being said, you’re off and you’re ready to go raise the money. Make sure you use the money under the use of proceeds the way you said. Remember, disclosure.

“I may not be able to pay a debt back, so I borrowed X amount of dollars. Would you be willing to accept X amount of my shares and forgiveness of the debt?” That’s it. “I may not be able to pay the debt back. Would you exchange my debt or what I owe you for preferred shares?” You’ll still be in a creditor’s possession. You’ll still have them in a creditor’s possession. However, it’s preferred shares. They’re still a creditor, which means they have a better chance of still getting their money back if the company ever had to file bankruptcy. Equity owners normally get wiped out or cram-down. That’s how it works. I don’t make the rules. If you’re an equity owner, you have the possibility of being crammed down and getting little to none of your money back whatsoever. If you are a creditor, you have a strong possibility of help getting most of your money back, if not all of your money. That’s the difference between being the creditor and being the equity owner. You as the CEO and your management team need to understand that when you’re going out raising money, you’re going to have to give up something.

There are no fairy tales where somebody is going to give you $1 billion for your great idea and your great dream. It’s not happening. Let’s be real. You’ve got to be prepared to give up something and you need to understand and give it a lot of thought and consideration of what it is that you would like to give up and why you want to give up that. What does it mean to you and the company at the end of the day? As I always say, 100% of 0 is 0. I rather have 20% or 30% of something than 100% of 0. Be prepared to give up something. Once you give up something and you prove that it works, you have a name and a reputation out there for being able to do the things that you said. You also have a reputation for paying people back in your venture working out. The next time you’re able to not take the 30%, you may be able to get 70%, the 80%. Don’t think you’re about to walk into anybody’s door, whether it’s a private equity, venture capital, Angel investor. You’re about to turn around and get to keep 80% of your company and give them as little as 20%. That’s not going to happen. That’s not even realistic.

MBA 17 | Borrowing Money

Borrowing Money: Pick people those who have the expertise and understand how it is to run a company in the direction that it needs to go in.

 

These people have worked hard to accumulate their money or to get other monies from other people to invest in various deals. They have to make sure they have a fiduciary responsibility to protect these people’s money and even their own money to make sure it’s going to come back with friends. That’s the bottom line. That’s the only reason people invest is because they think that your idea has enough merit that it may work and that you as a manager may be able to pull it off and execute it. That’s what everyone’s looking for. That’s how you get the money. If you don’t have those things in place, hire confident people that can help you put those things in place and go out and raise the money. There are brokers out there that can help you raise the money. They charge you anywhere from 10% to 20% depending on how they do it, whether it’s debt or equity finance. If you don’t like doing selling or pitching or you’re uncomfortable and talking in front of people, then you may want to utilize them.

I would want to utilize them because a lot of times they already have a Rolodex. They will take it to people that they have a good idea that they can raise the money rather than me go around trying to pitch it myself without a Rolodex and only family and friends that are limited. It’s going to take longer. A lot of people say this, “Do minorities have a disadvantage in raising capital?” Absolutely. The average discretion income from minorities, discretion cash I should say, is roughly $5,000. I go to ten people, that’s only $50,000. The average discretion cash for whites is $75,000. If I go to ten people that are white, my ten white friends, that’s $750,000. It’s a lot easier to take your business a lot farther depending on who your friends and your network are. If I had ten friends that are black, I’m probably going to raise $50,000. That’s not going to take my company too far. If I have ten friends that are white, I’m going to raise $750,000.

Do you understand why it’s a little more difficult for blacks to raise capital? Not only that, but there are also other reasons outside of race. When we go to private equity, we normally don’t know anyone there. It’s harder for them to relate to us and see us. That’s where representation may come into play and having somebody go that have a name that can represent you. You’ve got to keep these things in mind. Whites have a lot easier time. It’s not that it’s fair or anything like that raising capital, but you can balance out the plain field by hiring the right people to go do those jobs. I want to thank you for tuning in to the show. Thank you so much.