Debt Solutions

In finance, debt solutions are ones in which money is borrowed in exchange for interest.  In practice, large companies sell bonds.  With small business, this typically comes in the form of borrowing from a bank or other financial lending institution. 
It should be noted that Businesses that are Limited Liability Corporations, S-Corporations, or C-Corporations offer financial liability protection.  This is unlike a sole-proprietorship or non-llc partnership.  This means business owners are not personally liable for the debts or liabilities of the company.  However, if the business does not have enough credit, then a co-signer may be required.  This is typically the business owner.  The issue here is that even if the business defaults, the business owner may be still liable for paying back the loan regardless of if the business is in operation.  Be aware that each loan’s terms and financial liabilities are different.  Contact an attorney and/or a CPA for understanding the particular details of a specific loan.

Barriers to entry 
A business having credit is one of the most difficult parts of borrowing money.  Typically, the solution is to back the debt with your own personal assets and earnings. This means, regardless of if the business is in operation, the loan is payable by the person who backed the loan.  SBA loans can help reduce this barrier to entry.

Loan Options

Categories of Loans
  • Unsecured
    Unsecured loans are those that are backed by credit and not by tangible assets.  These typically have higher interest rates than that of secured loans.
 
  • Collateralized Loan/ Secured Debt
    Collateralized loans, also known as secured debt, are those that are backed by tangible assets that can be resold.  These loans typically have a lower interest rate, as defaults can be recouped by the sale of the assets backing the loan.
 
  • Term Loan
    The typical loan in which a specified sum of money is borrowed for a specified number of years.
 
  • Line of Credit
    A line of credit is a fluctuating amount of money that can be borrowed, similar to that of a credit card.  For example, even if a business can borrow at most $100,000 but only needs to borrow $10,000 then the interest rate is on the $10,000 and not the $100,000.

  • Convertible Loan
    Loan contract written as a convertible loan.  This is a debt contract that starts as a loan but has the option of being converted into equity instead of the amount being paid back.  Each convertible loan issuance is different because both issuer and lender must like the terms of the loan before signing.


Loan Duration
The longer the duration of the loan, the lower the annual interest rate. 


Lenders
Institutional Lenders This includes:
  • Local Financial Institutions
    • National Banks and National Lending Institutions
    • Primary Loan Types
      • Term Loans of different types and durations
      • Lines of Credit of different types and durations
      • Interest rates are typically tied to the Federal Reserve Open Market Committee (FOMC)


Government Loans

Small Business Administration Loans
SBA Loans are typically administered through a Banking Institution.  A business can use the banking institution of its choice, even the primary business account is not held there.  According to the SBA “The SBA reduces risk for lenders and makes it easier for them to access capital. That makes it easier for small businesses to get loans. “(sba.gov/funding-programs/loans)

  • *The Payroll Protection Program loan is a subsection of the 7(a) loan.   Given the ever changing status of the PPP loan due to funding, we would recommend working with a local banker to help you through the process.

  • SBA CDC/504 Loans
  • SBA Disaster Loans
    • SBA Disaster Loans are assistance for businesses, renters, and homeowners located in regions affected by declared disasters.  These loans are often administered directly through the SBA instead of through a financial institution.
    • As it Applies to COVID-19: Small business owners in all U.S. states and territories are currently eligible to apply for a low-interest loan due to Coronavirus (COVID-19).  An advance of $10,000 will not need to be repaired. 


Office of Hawaiian Affairs:
https://loans.oha.org/business/

  • OHA: (808) 594-1888
  • Eligibility: 
  • All Principals must be U.S. Citizens
  • All Principals must be Hawaii Residents
  • Principals must be Native Hawaiian: verified by current OHA Hawaiian Registry car

Alternative lenders
Alternative Lenders can be more flexible than commercial banks, as they have less regulation on the types of loans they can make.
  • Direct lenders.
    Direct lenders are finance companies that fund your loan with capital other than a bank and without a middleman such as a broker, investment bank or private equity firm. Some direct lenders offer SBA loans. Typically, small to midsize businesses borrow from direct lenders. 

  • Peer-to-peer lenders.
    Peer-to-peer lending directly connects businesses with investors.  This includes  borrowing from friends and family.  Because financing through a P2P marketplace poses a larger risk to lenders, the interest rates are often higher. Interest rates vary, but alternative loan products can have annual rates from 15% for a 36-month P2P loan and up to 45% for a four-month institutionally backed loan, according to the U.S. SBA. This is compared with an interest rate of less than 5% for industrial and commercial bank loans.  It is recommended that a private loan contract vetted by an attorney is in place if this debt strategy is used.

Equity Solutions

Financing a business through equity involves selling a percentage of the business in exchange for capital, typically in the form of cash.  How the portion of the business that is sold and the mechanisms in which it can be sold depend on the legal structure of the business.  In a C-Corp or S-Corp, shares of the business are sold. In a large C-Corp, this is known as selling stock.  In an LLC, it would be selling a percentage of the business.  It should be noted each different legal structure has its own limitations on the sale of equity, and there are also company specific limitations based upon the By-Laws or Operating Agreement of the individual business.

​Additional Perspective on an Equity Sale for Cash
For a good perspective from the restaurant industry as to who to bring-on as a partner, read Life, on the Line: A Chef's Story of Chasing Greatness, Facing Death, and Redefining the Way We Eat by Grant Achatz and Nick Kokonas of Alinea.  Kokonas has a background in finance and is a former Derivatives Trader at the Chicago Board of Options. What Kokonas boils his advice down to is: Find partners that can give your business more support than just money.  Find someone who also has skills to contribute like an accountant, a financial advisor, or an attorney.   This is because, as a co-owner, they ultimately benefit from helping the business succeed.

Valuation of the Business
When the decision to sell equity is made, the first question to ask is: “How much much is the company worth?”  This will help determine if a $50,000 investment is worth 5% of the company  or 20% of the company.  

Valuation of a company is as much of an art as it is a science. The reality is, a company's value is only what both parties agree for it to be worth.  The best way to settle upon a mutually agreed upon valuation is to have a numbers based discussion.

There are main approaches to Valuation:
  • Income Based Valuation (Intrinsic Value)
    • Using Discounted Cash Flows calculations are the most common way to determine the value of a business. In this valuation method, future cash flows that are “discounted” to the present. Discounting happens because an asset that pays $1 a year from now is worth less than $1 today because of the opportunity cost of capital.  This is commonly known as “interest”, and the interest rate is based upon the risk adjusted rate of return that could have been earned in another type of investment like stocks.  The discount rate is one of the main points of discussion in this method of valuation.  The other main point of discussion is the modeling of future cash flows.

  • Market Based Valuation/ Relative Valuation
    • In the Market Based Valuations approach, comparable companies which were sold are looked at.  A company's value is then derived from how it compares to the companies that were sold.  This is similar to the valuation of a home, which is dictated by the selling price of similar homes.  This method is where a multiple of revenue is used to calculate a company's value, with the multiple being derived from the sale of a similar company.

  • Asset Based Valuation
    • Asset based valuation calculates the value of the tangible assets of the company minus the liabilities of the company.  This will yield the lowest valuation of any of the methods.

There are entire professions based upon figuring out the value of a business, including investment analysts, underwriters and investment bankers.  For small businesses, looking for valuation help: 
  • The American Society of Appraisers has a “Certified in Entity and Intangible Valuations™” (CEIV™) Credential
  • The American Institute of CPAs has an “Accredited in Business Valuation (ABV)” Credential.

Contracting

To execute an equity sale, a business will need to create a contract with all the terms of the equity sale.  An attorney specializing in corporate law would best be able to help steer a business through this process and define the terms of the agreement as they apply to a particular entity.

Catherine Taschner, a Partner at of McCorriston, Miller, Mukai, MacKinnon LLP provided the following perspective:

Finding an Attorney
If you are planning for an equity sale, make sure you ask for a corporate attorney, because they will have the specialized knowledge to guide you through the process.

The best way to find an attorney is by word of mouth. Reach out to your friends and family, and see if they have any recommendations for attorneys that they’ve worked with. 

Another option is the Lawyer Referral & Information Service (LRIS), offered by the Hawaii State Bar Association (HSBA). All Attorneys licensed in the State of Hawaii are members of the HSBA. The referrals are free and clients are encouraged to contact the attorneys referred to find out whether they are able to assist with the legal issue, and the terms and costs for doing so. For more information on LRIS, contact the office at (808) 537-9140 or by email at LRIS@hsba.org. 

If you can’t afford an attorney, a good resource is the Business Law Corps (BLC). The BLC is a nonprofit organization that provides free legal advice to small businesses and entrepreneurs on corporate and other transactional matters. The BLC offers free thirty-minute consultations every Wednesday from 11:00 -1:00 pm  at either the Patsy Mink Center for Business & Leadership at the Richards YWCA or at the Entrepreneur’s Sandbox in Kakaako. The BLC also offers free assistance to businesses that qualify. For more information the BLC, please visit: http://businesslawcorps.org/.

The process of working with an attorney:
Once you find an attorney, you should schedule a time to sit down and talk with them about your company’s goals and strategic plan. 

Your attorney should be able to guide you through the type of equity you want to issue (restricted stock, stock options, etc.), and they should be able to spot some of the potential accounting and tax issues that may come up. If your company is not already in the position to issue that type of equity, your attorney can help with repositioning the company to meet your goals.

Your attorney will assist with the documentation of the issuance, which can include several agreements and securities filings at both the State and Federal level. 

Depending on the attorney, fees range from: 
Most attorneys bill by the hour, so make sure you ask your attorney for their hourly rate. Rates range from $175 for the newest associates to $600 for seasoned specialists. Many attorneys accept payment plans, so be sure to ask your attorney if this is an option at the beginning of the engagement. "

When To Close (Shut Down Point)

When to Close 
There may be circumstances when temporary or permanent closure may be a better option.  To understand when temporary closure may be the best recourse, one will need to remain vigilant of profit and loss statements to understand if fixed costs are greater than variable costs.  Essentially, if variable costs cannot pay for themselves, then a company is considered to have reached a shutdown point.

Fixed Cost vs Variable Cost
Fixed Costs are those that remain the same regardless of how much or little business you do.  Examples include, rent, internet, and phone.  Variable Costs are costs that increase in proportion to how much of them you use.  These include ingredients, and depending on your lease, electricity and water.  The biggest and most difficult variable cost is labor.  

In Practice
Typically, the largest variable cost is labor, therefore figuring out how to minimize labor is key, as well as utilizing the Payroll Protection Loan as best as possible.  To do this, the ownership group should start by providing as much labor as possible.  This is because the ownership group is essentially free labor, as they are ultimately fiscally responsible for the success of the business.  One suggestion for small business owners is to ASK YOUR FAMILY AND FRIENDS FOR HELP.  In this scenario, help equals free labor.  As repayment, you can buy them dinner or a beer (or both), and it will still be cheaper than employing someone.  Even if a family member is not trained or in the industry, they can still take a phone order, or give the proper order to a take-out customer.  These are desperate times, and they call for desperate measures and an all-hands-on-deck approach. 

Tap into your free labor sources first, then add paid employees.  The key here is to maximize your output with the addition of an employee.  Given the buffer of the payroll protection program, if that means someone can help with delivery or catch up on cleaning and maintenance, any labor that can be used is helpful.
​

Other Financial Solutions

  • Grants
    • Grants can be a great opportunity for your business.  The challenge is searching and applying for them, which can be a rather long application process.  Searching for grants can be arduous, and many are highly competitive due to the high demand.
      ​
  • Tax Relief
    • There will probably be tax relief measures implemented by the IRS.  Check IRS.gov for up to date information.
 
  • Cash + Equity
    • Sometimes, instead of paying a key employee their full market value, you can give them some cash and some equity.  The terms of the agreement would be specific to both the company and the deal worked out between the business owner and the new equity partner, and the deal execution would be similar to that as defined in the equity portion of this article.  This is a common compensation package in a Tech Start-up, but it is by no means tech-specific.  It should also be noted that when this type of compensation is put into place, vesting clauses are used. ​

Non-profit Organizations Assistance