Legal Watch: How to Leverage Debt

Every business needs money to prosper. Cash is vital to growing your electronic security business simply given the need to invest in the ongoing creation of recurring revenue. (Remember, the more recurring revenue, the bigger the paycheck on exit!) When raising cash in an industry debt transaction, smart operators leverage it to maximize returns. Remember these key points in the process.

Partner with your lender.

Borrowing money is a unique transaction. The lender is giving you a boatload of cash, which means they need to be adequately protected.

A successful loan transaction begins with the lender and borrower getting comfortable with each other. This process takes time. Start before you need financing so your lender understands your business. The most successful borrowers treat their lenders as a partner. Lenders know the industry and can be an invaluable source of insight and guidance. They’re in position to see what other industry players are doing and what constitutes good (and bad) operating metrics. Soak up every ounce of wisdom you can from lenders.

Be knowledgeable about your business and share information with your lender.

Begin the debt process by analyzing your business as if you were buying it. Undertake a thorough due diligence. Compare the results of your investigation to generally accepted industry best practices and expectations of lenders. (An effective comparison may require you to retain independent outside professionals, diligence experts or even a knowledgeable industry broker who works with lenders and can help you prepare your company for debt transactions.)

Understand lenders’ concerns and be prepared to deal with them.

Industry lenders have specific concerns they’ve developed over the years while doing hundreds of debt financings (and sometimes finding out the hard way where problems are hidden). Know what they are prior to the process and know how to deal with them ahead of time. Typical concerns include:

Subscriber contracts. Your subscriber contracts are the lender’s primary collateral. Use a form from a recognized industry lawyer. Otherwise, you may have to re-contract your base before borrowing.

Regulatory compliance. Make sure your company is licensed or registered.   If you’re not licensed as required, the lender may close on the loan but they’re likely to require you to become licensed after the closing.

Clear business strategy. Be able to explain how you’ve built your business and prepare to provide a roadmap of where you intend to take your company and how you expect to get there.

Attrition rate. Attrition is like high blood pressure – it’s the “silent killer.” Evaluate attrition monthly. Understand how to calculate attrition, the difference between gross and net attrition and what metrics are important to lenders, including the generally-accepted formulas to track it.

Creation cost metrics. Know and understand your fully-loaded cost to create a dollar of recurring revenue.   Reduce the cost to a multiple of recurring revenue. Creation cost multiples are a key financial metric and lenders often require borrowers to create recurring revenue at or below a stipulated multiple.  

Financial readiness of borrower. Lenders prefer audited financial statements and require them when the loan exceeds a specific amount. Lenders rely on a borrower’s accounting firm and may require you to switch to one they approve. They also prefer borrowers who use common industry financials and other systems because lenders need reliable information reporting. Be prepared for a comprehensive set of financial covenants in the Loan Agreement that will track the key metrics of the business.

Retain experienced legal counsel. Don’t let a lawyer spend his time (and your money) learning your business. Borrowers pay their legal bills plus the bills of lender’s counsel. This is no time for an expensive third-party professional to learn on the job. Make sure you hire someone who understands the process and can guide your through it.

 

Eric Pritchard co-chairs the electronic security group of Kleinbard Bell & Brecker LLP. Pritchard focuses his practice on the electronic security industry with an emphasis on acquisitions. This column does not constitute legal advice; contact an attorney with specific questions.

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