My grandson asked me whether he should “give” some money for six months to some other 8th graders who had started a shoe painting business. No, I didn’t make that up.  It reminded me of conversations we have every day with investors about loans to private companies.  Without drawing too close a parallel, you’d probably help him think through the same questions that a wary investor approaches with private debt.

My first questions were how many pairs of shoes (sales) have they painted and did they know what their costs have been?  In other words, are they profitable, and do they keep careful track of revenues, expenses and profits?  Do they think that they’ll be able to sell their services one-time to customers, or will customers come back repeatedly (with more shoes, or an “upgrade” to the art)?  Recurring, profitable sales are always more valuable than one-off transactions, unless you have an unlimited sales budget.

Then I asked what he would get for giving money to “management.”  In this case, that hadn’t been defined.  The conversation followed well-trodden themes: how confident is he that he will get his money back?  If things aren’t going well, will he be able to sell unopened cans of spray paint in inventory?  Or any other materials used in producing the product?  Legally I was talking about liens on assets to help him get his money back – a secured loan, much safer than one without collateral.  For that matter, had he worked out how much money they would pay him for having borrowed money for 6 months – effectively, a coupon?

If I thought he were interested, I would have directed him to Carofin’s Debt Investment Overview and Private Lending to Operating Companies for more background.  I recommend them to you when considering the structure of a note or loan with the management of a company looking for financing.

The form of a loan or other debt investment you make must reflect, at least, the following considerations:

• Other debt the Issuer has already undertaken
• The Issuer’s historical levels and consistency of profitability and cash flow generation
• Company assets that can be used as collateral for the loan
• Whether personal guarantees from the owner of the borrower are available

At the time you are structuring the debt, you should always put into place the most senior security possible.  This may include collateral to secure your loan.  If so, the collateral must be sufficiently valuable to repay your loan’s principal and the interest due to you if you must sell it in an independent sale.  The collateral must be identified specifically in the credit agreements supporting the debt and, separately, liens must be filed which identify your claim to this collateral under the Uniform Commercial Code of the state in which the borrower is located.  If there is no collateral or third-party guarantees are not available, your debt investment is unsecured, and you must, therefore, have confidence that the Company’s cash flow alone is sufficient to repay your loan.

There are many aspects to structuring debt, and we suggest you review Carofin’s Debt Investment Overview and Private Lending to Operating Companies for more background.

We also strongly recommend that you engage a lawyer specializing in corporate finance to help evaluate the Issuer’s corporate structure and existing indebtedness (including contingent liabilities) and, then, structure your debt investment in a way that reflects the Issuer’s circumstances.  There are many, many legal nuances that will become critical to the recovery of your investment if they are not identified and reflected in the loan structure you invest through … in anticipation of a potential Issuer default.