27 Dec OTC Musings: 001 – Debt Financing & Best Practices
I wanted to write this blog to shed some light on a topic that I think most investors and shareholders within the OTC may not be too familiar with, the issue of debt-type-financing. More specifically, I want to focus on the mechanism or tool that is referred to as a Convertible Debt Note (hereinafter, “CDN”). Before I go into that, please allow me to disclaim the following information. I have long been a fan of training, teaching and mentoring—it’s how I’m wired. Therefore, I offer the following blog as a tool and/or nuggets of wisdom that I hope other CEOs of publicly traded companies on the OTC could find useful. It is neither legal nor financial advice, nor is it meant to take the place of anything that your own counsel and/or advisors may offer you. And, of course, the following is my personal opinion, it is not a comment or commentary on Zenergy or any other company that I may be affiliated with.
In my experience, it seems that most companies on the OTC, at one time or another, have used this widely popular tool. Unfortunately, many have also misused and/or abused this tool. In many of these cases, they often become referred to as “toxic debt deals,” which, for pre-revenue companies, run the risk of becoming disastrous; and for companies that exist in theory only, they definitely become disastrous and/or ripe ground for “pump and dump” schemes. However, for early-stage companies, these types of deals are definitely sources of expensive capital, though may not necessarily be more expensive than early stage angel or venture capital in a private company setting; therefore, in my humble opinion, can become a viable option.
For early stage and emerging growth companies, the CDN can become a great mechanism to bridge the company to its next level of growth and/or newer and friendlier sources of capital; without the pigeon-hold mechanics often put in place by some of the aforementioned private investors. To elaborate, let me be very clear in stating that I think they can be a useful tool, when used as an appropriate “bridge”; that is to say a bridge to more favorable forms of financing while the company is simultaneously maturing its business plan model and/or even sales and marketing efforts.
While there is certainly no shortage of financiers who are readily available to fund your next offering (some of whom with questionable motives), it is imperative that CEOs thoroughly weigh out the decision to take in this type of capital mechanism. In my humble opinion, there are at least two primary drivers that must be in effect and/or about to go into effect in terms of trying to assess the proper timing and whether or not this will become a useful tool for your company.
The first evaluation metric pertains to actual growth in the way of value and revenue creation. Early stage companies should, at some point in time, turn the page from concept to execution or from platform-build to customer acquisition. Many investors in emerging growth and early-stage companies first buy into the management team and into the vision while they wait for the model and revenue to come to fruition. However, as your company goes from vision to execution (“heart and soul to shoulders”), it’s only a matter of time before the fundamentals of your business will speak for themselves. It is during these times of transition when it may make sense to use the CDN as a mechanism for your business.
The second driver or evaluation metric pertains to the concept of the strategic or intrinsic value of the company. However, I should stress that the company itself must be on the precipice of demonstrable, upward positive change. It should be fully prepared to enter into its next stage of growth or development. Both the immediate and long-term impact of this change must be clear and plain to the marketplace because it must be both strong and valuable enough to outweigh the potential negative impact that such dilution or even worse, potentially bad actors, may cause to your share price. This is clearly much easier said than executed because there is always the issue of timing and information; and, of course, access to, and understanding of that information, which many shareholders and investors are simply not privy to immediately or in real time, for a myriad of reasons. Obviously, it is here where trust and faith in the management team must be strong, and the business model and prospective value must be effectively communicated. Many of these CDN financiers are purely short-term thinkers and most of them just don’t care about your business or what goods, services or value it provides to the marketplace. Unfortunately, any downward pressure that they may create on your stock doesn’t affect them or their thinking in any way. This type of downward pressure can have a negative emotional impact on your longer-term shareholders who have actually taken the time to understand your business model. Clearly, this creates a challenge and could exacerbate an already negative dynamic; hence, my reason to stress the timing of the evolution of the business/company.
Again, in my personal opinion, these two elements above are very important, almost mission-critical. However, not just to absorb any short-term negative hiccups associated with these short-term sources of capital but, more importantly, to attract new and friendlier sources of capital. The idea is to move your business along the growth line, allow it to mature, and as it matures it attracts better sources of capital and hopefully also attract smarter long-term investors. As a CEO, you want to the type of capital and debt sources that believe in and understand your business. They aren’t going to require horrendous amounts of coverage, thereby giving you the currency your company needs to maneuver more effectively.
This concept of coverage is foreign to most OTC shareholders and it is in these details wherein the devils lie. You see, the downward pressure associated with reckless converting is only one aspect of the CDN. There is another aspect that is largely unseen, which can actually be far more harmful than the converting itself. Within the CDN terms and conditions is the concept of “coverage” and “reserve”; this means that the company must hold in reserve anywhere between four (4) and up to eight (8) times multiple of shares to cover the respective note. This multiple will vary based on negotiation, but it is indeed very real, incredibly dynamic and the impact to the company can also be very real. For example, any downward movement in stock actually increases the required reserve amount that the CDN note holders are respectively entitled to. This then runs the risk of forcing the company to authorize more shares, however, not for the pure sake of dilution but because of the reserve amounts that may required. So, essentially, these shares are just frozen in time providing in some cases absurd amounts of coverage for the CDN note holder. Of course, this can make it very difficult for the early stage company because (a) their shares are a form of currency and (b) they have to deal with the optics of issuing more shares, which is clearly not an easy topic for CEOs to address.
In closing, let me summarize a few important points to serve as takeaways:
1) Find the Right CDN Partner – Not all CDN financiers are bad actors; there are very great people to work with and I hope that you as a CEO of an OTC company would find the right partner for your company. Personally, I’ve had a mixture of experiences but the upside is that now I know. I suggest interviewing them properly and thoroughly and calling CEOs of other companies with whom they’ve done business for references. Side Note: Perhaps there should be some sort of report card or best practices report that CEOs can vote and/or report on in terms of their experiences with these financiers.
2) Timing, Timing and Timing – Take an honest self-assessment of what stage your company is in. Then, from this perspective, create a realistic use-of-funds schedule and measure what value each line item will add to the company. Keep in mind that in order for you to absorb dilution, conversions and/or to be able to refinance the CDN, your business will have to be much farther along over the six months following the date you executed the CDN. Therefore, I could have easily titled this sub-section “Execution, Execution and Execution”.
3) Effective Communication – I cannot stress enough the importance of properly communicating your business model, strategy and the value that it is creating and what it may create in the future. It goes without saying that you should always observe best practices and all regulatory guidelines, especially when dealing with materially sensitive and/or non-public information. Herein, I am referencing the basic vision, mission and value that your business creates, fulfills and/or provides services for. It should be simple, powerful and repetitive. I realize that this can be difficult for early-stage companies because it is not uncommon for CEOs to tweak and course correct the vision, model, and strategy in real-time—nevertheless, this should remain a mission-critical constant.
I hope you find this information useful and I wish you all the very best, onward and upward.