It can be challenging for a privately held SME to fund its existing and future business activities. COVID-19 has made matters far more uncertain and difficult, particularly in those sectors hardest hit by the pandemic.
This Client Alert explores some of the financing options that may be available to an SME.
Bank Lending Facilities
The customary sources of external finance for an SME, bank lending facilities, have in the light of COVID-19 become severely restricted due to credit constraints in the market.
Furthermore, banks’ credit approval processes have been lengthened and become more intrusive; and even where credit would be available, onerous collateral and security requirements are often imposed. Cash or liquid securities are likely to be the only accepted type of collateral; any other asset offered as security may be rejected or subject to a significant haircut. The security requirements may also be extended to include personal guarantees given by the shareholders and the directors.
In many cases, the company may find the increased pricing and credit requirements imposed by banks unacceptable. Alternatively, the company may conclude that the economic value of taking out any facilities does not exist in the first place.
Aside from bank finance, the board of an SME can turn to its existing shareholders. Shareholder finance can come in two forms: the issuance of new equity (or the creation of a new class of equity) or the grant of shareholder loans. In either instance, the shareholders are likely to require a premium as compensation for the increased risk.
Under a shareholder loan, this premium would be reflected in a higher than market rate of interest. In addition, the shareholders may require security over all or some of the assets of the company.
As for new equity, the SME could consider issuing a new class of share – preference shares with special rights attached. The holders of preference shares would ordinarily be entitled to a fixed dividend ranking ahead of ordinary shares, but without the benefit of any security. The company may however and depending on the urgency of its financing needs and its relationship with the shareholders, be compelled to grant additional rights to the holders (e.g. as to certain reserved matters.)
Shareholder finance, in the form of preference shares, does allow the SME to generate liquidity without raising debt finance. The lack of voting rights attached to preference shares allows the ordinary shareholders to retain control. The company may be able to insist on the preference shares having callable features, which would give the company right to repurchase the shares (it would do so where interest rates fall or where its financial condition has materially improved).
Investor Finance – Convertibles
The SME may be able to attract third party investors by agreeing to issue convertible loan notes (“Convertibles”).
Under Convertibles, the holders receive interest payments and have the right to convert the loan notes into discounted-priced shares where certain events in the future occur (e.g. on maturity; at a new equity finance round). Convertibles are therefore a hybrid of debt and equity.
For an SME, Convertibles have various advantages over customary debt or equity financing. Interest payments tend to be lower and are deductible by the company against tax. The loan notes are unsecured. Dilution of the ordinary share capital is deferred (at least in the short term) which allows the existing ordinary shareholders to retain control. The related documentation requirements are simpler. Convertibles are often used as a form of bridge finance prior to the next equity finance round.
Mercatis Law can assist with the drafting of the Convertibles, shareholder loan agreements and related documentation. This includes reviewing existing arrangements which SMEs have in place, articles of association and assisting with negotiations with investors.
About the Author
Justin Boyd has over 28 years’ legal and regulatory experience in commodities trading, origination and financing, wholesale banking, bank regulation, energy project development, financial derivatives and corporate transactions.
He has held senior in-house legal and regulatory risk positions, and has been a partner of an international law firm. Most recently, he was the Global Co-Head (Legal) of Financial Markets, and the Head of Global Regulatory Reform, both at Standard Chartered Bank.