Definition or Explanation: A guarantee of payment that stands behind an early-stage company and enables it to take out a loan from a bank. Conceptually, private guarantees play the same role as an SBA loan guarantee.
Appropriate For: Early stage companies that within a year will turn the corner toward profitability, or commence product sales. The limited time frame stems from the fact that loan guarantees typically only last a year, and at the end of that period, the company must be able to raise equity capital to pay off the original loan, or be able to apply for and get a loan based on its own fundamentals.
Supply: Though this technique is uncommon, the supply is theoretically abundant. Specifically, any wealthy individual--i.e., angel investor--willing to consider an equity investment should also be willing to consider a loan guarantee.
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Best Use: For companies that can put the borrowed funds to use and show an immediate result either in profitable product sales or the commercialization of a product or service concept. Loan guarantees work particularly well for very young companies that would end up selling a majority equity stake in the business if forced to use equity capital.
Cost: The fees and interest on a loan guarantee can be expensive compared with a traditional loan. However, loan guarantees make it possible for an entrepreneur to raise capital without surrendering control, which makes it cheap compared with most forms of equity financing.
Ease of Acquisition: Loan guarantees are somewhat easier to negotiate than pure equity investments because the investor guaranteeing the loan never turns over any of his or her own funds, unless, of course, the company does not perform as projected.
Range of Funds Typically Available: No upper or lower limit.
First Steps
Whether you are raising debt or equity capital, you will run into the same behavior: Lenders and equity investors will be reluctant to let go of their money. While the attitude is the same, the motivations are different.
The bank would simply love to lend you the money. After all, the only way it makes an above-average return is by lending what customers deposit. But because a bank is lending other people's money, it operates in what is known as an "abundance of caution" mode. That is, banks by design are only allowed to make loans in situations of absolute safety. Working with emerging growth companies means few instances of absolute safety, hence the challenge of loan financing.
Equity investors would generally like to finance your company as well. But they too have problems. But they too have problems. Emerging growth companies are not just risky; they're also illiquid. Once they swallow the risk, most equity investors are still reluctant to cut a check because they know that even if the company succeeds, it will be tough to recoup their money. To do so, the company generally must go public or be bought out. And if the company succeeds only on a marginal basis, their investment can remain trapped inside the company.
It's because of these emotions and constraints that loan guarantees can work so well. Specifically, when an angel investor stands behind a loan and guarantees it on behalf of a company, he doesn't have to shell out his own capital, at least not initially. And with a guarantee in the picture, the loan is 100 percent safe, meaning that almost any bank in the continental United States can make it.
According to Arthur Lipper III, chair of British Far East Holdings in Del Mar, California, which provides and arranges financing as well as advisory services, "To get such a deal done, entrepreneurs need three ingredients: two banks and one guarantor." Providing loan guarantees to high-octane growth companies is a subjective undertaking, Lipper says, and there are many ways a deal might be structured. However, a typical one-year loan for $1 million might be put together as follows:
First, the investor purchases a letter of credit from his or her bank. It stipulates that the investor's bank will pay to the entrepreneur's bank $1 million on a certain date one year in the future.
Lipper says that to issue such a letter, a bank charges 1 percent to 2 percent of the amount of funds being guaranteed-in this case $10,000 to $20,000-as a fee. Because it's a bank, and banks tend to avoid risks, it will also require the investor to deposit $1 million in government securities or $2 million in marginal securities. (So-called marginable securities are those that can be borrowed against, a determination that is made by the Federal Reserve.) These assets collateralize the letter of credit the bank issues.
Now, with a rock-solid letter of credit for $1 million protecting it, Lipper says, the entrepreneur's bank will then lend him or her the $1 million needed to grow the business.
Following are some of the costs the entrepreneur is expected to pay in such a transaction:
First, there's the guarantee fee. Remember, the investor had to pay his bank a fee to get it to issue the letter of credit, in addition to depositing funds into the bank. "The way the investor tends to think," Lipper says, "is that it's the entrepreneur's loan that is being guaranteed, not mine; therefore, the entrepreneur should pay the fees."
Next, Lipper says, he typically collects 5 percent of the loan as a fee for putting the deal together. For our hypothetical $1 million deal, that's another $50,000.
Then there's the interest to the bank. For deals such as this, banks typically charge the prime rate, plus 1 percent, says Lipper. "It's absolutely outrageous for them to charge a premium like that," he maintains, "since there is no risk to the bank whatsoever." Moreover, to avoid any possibility of default, the bank issuing the letter of credit will probably stipulate that the interest on the loan be taken out of the proceeds upfront, as shown in the above example.
The only positive thing you can say about all these fees is that they generally don't come out of your pocket. In most deals, they come out of the loan fees, so you as the borrower end up paying them in the form of a higher effective interest rate.