Succeeding in Your Business: Giving your lenders a piece of the action

Cliff Ennico

“We started a tech company last year and are getting ready to launch our first product. To do so, we will need to borrow $200,000 from friends and family.

“We have been told to structure this as a loan, but we want to give our family members a piece of our future growth if the company is successful. What are the various ways to do that? We don’t want to set this up in such a way that it puts off venture capital investment down the road.” {mprestriction ids="1,3"}

Generally, someone who lends money to your company does not participate in the growth of the company; all the person is legally entitled to get back is the interest on the loan.

There are a number of ways, however, to give lenders a stake in the future growth of your company.

The most common of these is the convertible promissory note. You would give your lenders a note promising to repay their loans with interest, and you would give them the option of converting their notes into equity (in the form of stock if you are a corporation; in the form of membership interests if you are a limited liability company) at any time until the loan is repaid in full. The equity they’d receive would be based upon the outstanding principal balance of the loan at the time of conversion, as well as the valuation of your company at that time.

Sometimes — not always — you would also give the company the right to compel conversion of the debt into equity upon certain stated circumstances (for example, a funding round of at least $500,000). Given that this is friends and family money, you might want to include such a provision, as venture capitalists and other professional investors usually do not like being subordinated to people who aren’t participating in the day-to-day management of the business (OK, they don’t like being subordinated to anybody, but that’s a column for another day).

If a convertible promissory note is not a viable option, there are other ways to give your lenders a piece of your company’s future performance.

The Equity Kicker. A loan with an equity kicker provides for two types of interest: a fixed or variable rate of interest, plus additional interest, the amount of which depends on the future performance of the company.

Sometimes the equity kicker takes the form of warrants, which allow lenders to purchase shares of stock in the future based on today’s valuation of the company (similar to a stock option, except that it is granted to investors, not employees).

Sometimes the equity kicker is an increase in the amount of fixed or variable interest payable under the note, which is triggered by an increase in the company’s valuation. For example, a note could be structured in such a way that if the company’s valuation were to increase by at least 10 percent in a given year, the interest rate on the note would increase from 5 percent to 6 percent, or an additional 1 percent per annum for each 10 percent increase in valuation year over year. Such a note would perform in much the same way as a phantom stock plan in which participants receive cash as the company’s valuation increases year over year.

In drafting such a note, consideration needs to be paid to two important issues.

First, what happens if the company were to decrease in value? Would the increase rate be reduced to match the company’s performance, or would it stay at the higher level? It might be prudent to include a provision in such a note that any decrease in interest rate would not fall below the interest rate initially provided for in the note (i.e.,a floor).

Second, you need to keep an eye on your state’s usury laws, which normally provide for a maximum rate of interest that can be charged on business and consumer loans. While these laws are generally extremely flexible and they provide for legal interest on business loans at rates of 20 percent, 30 percent or even more, if your company were to take off like a bottle rocket, you may end up inadvertently paying your lenders more than the legal interest rate, which could get you into trouble if state or federal regulators were to discover it when auditing your books. In any promissory note, there needs to be a provision that says the interest (including any equity kicker) will not exceed the highest rate allowed by law.

The Deferred-Interest Note. Big companies often include a provision in their note that says a decline in the company’s valuation (or other measurement of performance, such as pretax earnings or net revenue) of more than X percent will trigger a decrease in the rate of interest payable under the note.

While designed to protect companies against recessions or other material-adverse changes in the economy that are often beyond management’s control, these notes are not popular with investors — especially elderly family members who may rely on the interest as retirement income.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”

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