The Coronavirus Pandemic has wreaked havoc on small and mid-sized businesses (“SMBs”) throughout Texas and the rest of our country. Many SMBs have had to close their doors due to mandatory stay-at-home orders and other social distancing orders and requirements. The CARES Act and other recent legislation passed by Congress and signed into law by President Trump contain several programs designed to assist these businesses in their efforts to make it through the hardships of the next several months. But what about the longer-term capital needs for SMBs as the pandemic subsides and these businesses emerge from the mandatory stay-at-home and other orders and begin to move forward again?
This article briefly describes four structured capital raising techniques that may be available to meet those needs: (1) convertible debt instruments; (2) convertible or non-convertible preferred equity instruments; (3) preferred limited partnership interests; and (4) debt instruments issued with “equity kickers”. Investors in these structured debt and equity financings likely will include commercial credit companies making asset-backed loans, private equity, distressed asset investment funds, family offices and other private investors interested in assisting in the survival and success of SMBs.
Effects of Organization under State Law
The manner in which each SMB is organized controls how these financing techniques are implemented. Today many SMBs are organized as limited liability companies (“LLCs”) under applicable state law. The equity for these LLCs is known as “membership interests” but may be referred to in the LLC operating agreement as “units”. Many LLC operating agreements provide for the issuance of additional membership interests or units, but may not provide for the issuance of a different class of membership interests or units. Each SMB organized as an LLC will need to consider what amendments, if any, to its certificate of formation and operating agreement may be required to issue the debt and equity instruments described in this article.
Other SMBs are organized as corporations under state law. The existing equity for corporations is represented by shares of stock, and the issuance of additional shares of stock typically is addressed in the certificate of formation, by-laws, articles of incorporation or other organizational documents. Most SMBs have only a single class of stock known as “common” stock, but some also may have a second class known as “preferred” stock. Dividends on preferred stock are paid at the preferred stock’s stated dividend rate before any dividend can be paid on the common stock, and, should the corporation be liquidated, shareholders of preferred stock are entitled to be repaid prior to shareholders of common stock. SMBs organized as corporations will need to consider what amendments, if any, to their organizational documents may be required to issue the debt and equity instruments described in this article.
Finally, there are SMBs organized as limited partnerships under state law. The general partner typically is the partner providing the business and management for the limited partnership, while limited partners typically are the partners providing a significant portion of the equity capital required for the business. SMBs organized as limited partnerships will need to consider what amendments, if any, to their certificates of formation and limited partnership agreements may be required to issue the debt and equity instruments described in this article.
Convertible Debt Instruments
SMBs with outstanding debt may have covenants in existing loan or other agreements that would restrict or prevent the issuance of additional debt that could be converted into equity in the SMB. This restrictive covenant is a common provision, so each SMB should review its loan documents to determine whether the covenant must be dealt with before proceeding further with this alternative.
Convertible debt instruments are often preferred by investors because the SMB can provide a first lien in its existing assets as security for repayment of the loan. These debt instruments typically are issued as promissory notes to the note purchasers, with a security agreement, mortgage (if real estate is involved), and a Uniform Commercial Code filing (if personal property is taken as collateral). Deposit Account Control Agreements are used to perfect a security interest in bank deposit accounts. The terms of the note purchase agreement will control whether additional debt, whether secured or unsecured, can be issued by the company while the convertible debt instrument is outstanding.
The issuance of one or more promissory notes typically will be made pursuant to a note purchase agreement, which will set the terms and conditions of the sale of the promissory notes and include investor representations required to participate in the issuance under the US securities laws. The promissory notes typically include an interest rate, with alternatives for repayment of principal and interest and optional conversion into common equity of the SMB at a stated point in time. For example, an optional convertible promissory note might provide for a 6 percent coupon rate during the term of the loan. Interest during the term would be accrued and added to the principal amount of the note if not paid in cash when due.
At maturity, the note purchaser could decide to (1) accept payment in full of the accrued interest and principal, or (2) convert the amount of the accrued interest and principal into a specified number of shares of common stock or common LLC units, thereby diluting the equity ownership of the original investors. Should the note purchaser decide to accept cash as payment in full, and the SMB is unable to deliver such payment, the note purchaser could proceed to exercise its remedies under the security agreement and related documents in order to liquidate the assets subject to the security agreement and be repaid ahead of general unsecured creditors and any equity.
Preferred Stock and Preferred LLC Units (Convertible or Not)
An SMB considering the issuance of preferred stock or preferred LLC units should first verify that the issuance of such equity is authorized under its organizational documents and, if necessary, execute appropriate documents authorizing such issuance.
The issuance of preferred equity will typically involve a preferred equity purchase agreement (also known as a “subscription agreement”), which among other things will set the terms and conditions of the preferred equity issuance and include investor representations required to participate in the issuance under the US securities laws.
Investors are attracted to preferred equity because, in the event the SMB fails and is liquidated, those investors by agreement are repaid after payment of all secured and unsecured creditors and administrative expenses, but before any payments to holders of the common equity of the company.
Preferred equity in these cases usually includes the right to vote for directors of a corporation or managers of an LLC. In many cases, the investors in preferred equity will require representation on the board of directors for an SMB organized as a corporation or the board of managers for an SMB organized as an LLC. Representation, along with supermajority approvals required to issue any additional debt (whether convertible or not and whether secured or not) help the investor in preferred equity manage the risk of achieving full redemption of its preferred equity and the stated return on such equity. For example, the terms of the preferred equity purchase agreement may control whether additional debt, whether secured or unsecured, can be issued by the SMB while the preferred equity is outstanding, and if so, at what required percentage vote of approval.
Preferred equity typically provides for a stated percentage return on the amount of the equity investment and that return typically must be paid in full prior to any distribution of dividends or profit to the investors in common equity. It is possible that the return can be paid in kind and added to the amount of the investment, with payment of all accrued return and the amount of the investment on redemption of the preferred equity by the SMB issuer. But generally investors prefer that the preferred return be paid currently or as soon as profits are available.
Preferred equity may be issued with terms allowing the purchaser thereof to elect to convert the preferred equity into shares of voting common equity. In such cases, the preferred equity purchase agreement would provide the conversion date and the conversion rate (for example, conversion into common equity equal to two times the amount of the preferred equity purchased, including any accrued but unpaid return on the preferred equity).
Finally, the preferred equity usually is issued with either a mandatory redemption date or a date on which the holders of the preferred equity can elect to require the SMB to redeem the preferred equity. This date typically is coordinated with the conversion date mentioned above if the preferred equity is issued with a conversion feature.
Preferred Limited Partnership Interests
The issuance of preferred limited partnership interests for SMBs organized as limited partnerships involves many of the same issues involved with the issuance of preferred equity for a corporation or an LLC. A key difference is that under many states’ limited partnership statutes, a limited partner’s participation in management is severely restricted, if not prohibited all together, as a condition of the liability of the limited partner for limited partnership debts being limited to the limited partner’s equity contribution. This means that the existing limited partnership agreement may prohibit the issuance of additional debt and equity interests and, if so, will have to be amended to allow for the issuance of preferred limited partnership interests. Alternatively, some limited partnerships may consider converting to an LLC to provide managerial rights to prospective investors who require such rights in order to invest.
Once the limited partnership has positioned itself to issue preferred limited partnership interests, the issuance will typically involve a preferred limited partnership interest purchase agreement (also known as a “subscription agreement”), which among other things will set the terms and conditions of the preferred limited partnership equity issuance and include investor representations required to participate in the issuance under the US securities laws. This agreement also may specify what debt or equity may or may not be issued by the limited partnership while this preferred equity is outstanding.
Straight Debt with an Equity Kicker
Regardless of whether the SMB is organized as a corporation, LLC or limited partnership, another alternative is to consider the issuance of an investment unit that includes (1) a non-convertible straight debt instrument and (2) an equity kicker (described below) designed to enhance the attractiveness of that debt instrument. The SMB should review its outstanding loan agreements and related documents to determine whether those documents contain a covenant that would restrict or prevent it from issuing an investment unit that would consist of a more traditional debt instrument along with an equity kicker. This restrictive covenant is a common provision, so each SMB should review its loan documents to determine whether the covenant must be dealt with before proceeding further with this alternative.
As mentioned above, debt instruments are preferred by investors because the SMB can provide a first lien security interest in its existing assets as security for repayment of the loan. In addition, the terms of the investment unit purchase agreement will control whether any additional debt, secured or unsecured, can be issued by the SMB while the debt instrument issued pursuant to the investment unit purchase agreement is outstanding.
The promissory notes issued as part of the investment unit typically include an interest rate, with alternatives for repayment of principal and interest at maturity. For example, such a promissory note might provide for a 6 percent coupon rate during the term of the loan. Unlike the convertible debt instrument described above, the straight debt instrument typically provides for periodic payments of interest in cash to the investment unit purchasers. The principal amount of the straight debt instrument may be payable over a set period with an amortization schedule or may be payable as a balloon payment at maturity. Should the investment unit purchaser not be repaid interest and principal in full, the investment unit purchaser could proceed to exercise its remedies under the security agreement and related documents in order to liquidate the assets subject to the security agreement and be repaid the amount of its investment in the straight debt instrument.
Equity kickers issued in conjunction with the straight debt instrument can include (1) common or preferred equity in the SMB, (2) warrants or options to purchase same at a pre-determined purchase price and date, or (3) a conveyance of an interest in property owned by the SMB (e.g., an oil and gas overriding royalty interest) free and clear of the security interest created to secure repayment of the debt instrument.
The financial consequences of issuing straight and convertible debt, convertible and non-convertible equity, and equity kickers is complicated and may require the assistance of bankers, accountants and lawyers to determine which technique is the most appropriate for the circumstances. In particular, assistance may be needed in modelling the expected future cash flows of the SMB so that the company can determine the optimum level of financing and the timing of the returns it can pay to investors.
The attractiveness of structured capital is the great flexibility to customize the terms of the capital, whether debt or equity, to the particular needs of the SMB so that the company and the investors have the best opportunity to achieve their respective objectives. Liskow & Lewis is well-situated to provide legal advice in the structuring of these securities to meet the financial needs of each SMB.
Federal and State Securities Laws
The issuance of straight and convertible debt, convertible and non-convertible equity, and equity kickers involves the issuance of one or more securities subject to state “Blue Sky” laws and federal securities laws, including the Securities Act of 1933 and the Securities and Exchange Act of 1934. These securities are typically sold pursuant to exemptions from registration under federal and state law. These exemptions require that the securities be “restricted” (not freely transferable) and the securities usually must be sold in a private transaction without any general solicitation or advertising (there are some recent exemptions that allows limited advertising/soliciting). In addition, the SMB will usually have to file a notice of the offering, called a “Form D”, with the SEC and the states where the securities are sold. Finally, most offerings are structured to be sold only to “accredited investors”, which lessens the regulatory burden. Liskow & Lewis is well-situated to provide legal advice that assists SMBs in understanding and complying with these laws.
Federal and State Tax Consequences
SMBs usually can issue convertible debt and equity without adverse tax consequences. But, the tax rules dealing with conversion and thereafter can be complicated. Moreover, there are special rules applicable to the issuance of straight debt with an equity kicker. Liskow & Lewis is well-situated to provide legal and tax advice that assists SMBs with the analysis and understanding of the tax consequences associated with the issuance of these securities.
Should you have any questions regarding Capital Structuring and Tax please contact John Bradford. For Securities questions, please contact John Anjier, and for Corporate Governance, please contact Nina Skinner.
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