One of the growing trends in lending is funding tech companies. Goldberg Kohn’s Maria McGuire has some insights that may prove helpful for those who want to join them.
Lenders and Tech Companies Don’t Always Speak The Same Language
Unique lenders who have never operated in this space will benefit from learning about tech companies before expanding into the area. EBITDA valuations for many companies are not coming out for another cash flow company, especially as more software companies transition from a traditional license subscription to software-as-a-service. This creates a huge hit to EBITDA. Lenders need to look at recurring revenue as a mode to evaluate those companies because EBITDA is very low, or even negative. New entrants in the lending space are struggling with this issue.
Tech companies seeking to help a lender understand how to evaluate them can use these common questions to prepare a presentation:
- What is open source code?
- What due diligence do we need to do on this open source code?
- What do we need to know about IP?
- All the IP is held outside the U.S., so if bankruptcy is in the U.S., how do we perfect? What are the issues?
Some Interesting Observations About Tech Lending
Along with these common tech-focused issues, McGuire shared some interesting anecdotes. She said, “The year end is always busy for closing transactions. There’s a rush to get done before the December 31. But for the first time since 2003, people are saying they are going to wait until January in case something radical will change in the tax code. So they are holding off on some transactions.”
Some of McGuire’s partners had clients who wanted to finish documentation at the end of last year but close in January, so the transaction would be in 2017 and fall under the 2017 tax code.
“Who knows if anything is changing?” McGuire asked. “But people have been talking about the possibility, and a handful of deals are being held until 2017 on the chance that the tax treatment will be different due to the new administration.”
Of course, no one from the incoming presidential administration has said anything specific about possible tax code changes.
“Some of it is because capital gains for sellers may be affected, as could be carried-interest,” McGuire said. “People are reading into the uncertainty and saying they want to wait and see what happens, which is unusual.”
Nevertheless, McGuire said her law firm clients prefer to know rather than not to know, so even for bonuses, they asked to close in 2016 versus 2017.
When asked what happens in a tech sector downturn, McGuire said, “People have been watching for a bubble. I have not seen a lot of walk-outs on the tech deals. I thought maybe 1.5 years ago I had a challenging workout and maybe that will be the tip, but it wasn’t. I started to think that the software industry is not so much its own separate industry, but now a piece of all sectors of the economy. Because they are in construction, enterprise software, or healthcare, you can think of them as a software company. Therefore, it’s correlated with the overall economy.”
Tech companies are different from other businesses in a number of ways, McGuire said. “They need to continue developing their internal resources or make their products better and stay competitive,” she said. “Yahoo! is an example of a company that did not put enough capital into their core product. They lagged behind their peers. Their products are not selling, and they no longer are competitive. The investment banker will say it is not going to be advantageous to sell the company now; either acquire new IP and new products that will make you competitive or take more years and money to develop something new.”
Assets in a software company aren’t worth a lot on the market, unlike in the manufacturing sector. So lenders lending to software companies need to focus on company development, the product, and the potential acquisition of new products.
“If they are not developing internally, they need to acquire a competitive advantage,” McGuire said. “Borrowers expect lenders to understand that and be flexible in incremental facilities. In delay draw commitments, incremental facilities will be important. In the workouts I’ve had, the way forward is to take more money and a few more years. Lenders have to buckle in for a longer haul because if they sell quickly, it will be a fire sale.”
Companies owned exclusively by one private equity (PE) sponsor willing to sell to another PE sponsor can have an auction. Potential buyers will turn to lenders and ask them to submit proposals for the transaction.
Asked how investors and lenders can protect their investments while still winning deals in the tech space, McGuire said, “Lenders have to be flexible and do their IP research. Borrowers and private equity sponsors have tremendous bargaining power. You may be backing two or three more sponsors bidding to purchase one company.”
Sponsors in those cases often send a grid showcasing the various terms for the credit facility. The lender will then fill in the grid with the numbers they are willing to offer for the deal. This is typically done before the deal is bid on. So lenders need to be accommodating but focused on licenses, IP, and the company’s ability to develop and acquire new products.
“You have to understand what their growth trajectory is in order to understand the grid in a way that will be competitive,” McGuire said.
One other growing trend is private equity firms controlling the documentation. It used to be unheard of, particularly in middle market deals, but it’s happening with more frequency now.
“PE sponsors will say ‘we pick you to finance us, but we will draw the credit agreement instead of using the bank’s form’” McGuire said. “Then the bank will have to put in borrowing mechanics and such. But for rep, affirmative, and negative covenants, the PE firms are coming up with their own forms.”
That puts a lot of pressure on law firms like Goldberg Kohn’s because those documents are not brief and the law firm never knows what’s buried in them. Attorneys have to review them quickly before the deal is closed.
“PE have a lot of leverage,” McGuire said. “If it’s a good deal that many people want and you want deals with this sponsor again, many lenders will be okay with it. Fewer banks will do this, but other financial institutions who want to get their foot in the door will do it.”
Who are Goldberg Kohn?
McGuire is one of 80 attorneys in Goldberg Kohn’s 33-person commercial finance department located in Chicago. She’s been at the firm for 11 years and also practices in the Goldberg Kohn general corporate office in Pennsylvania. “Our group represents lenders, mostly senior lenders, but we do some sub-debt, or mezzanine, work along with litigation, real estate, and corporate law,” she said. “With a few exceptions, our bankruptcy practice only represents creditors. We see a significant amount of cash flow deals and a lot of asset-backed lending for bank clients and other lending institutions.”
She sees the issue at hand being the huge influx from other cash flow lenders into a historically niche space. Silicon Valley Bank, Wells Fargo Tech Finance, and Capital One are examples of banks that focus on lending to tech companies. Every industry has a software company aimed at providing services to the companies in those industries and the typical cash flow lenders are doing more work with those software companies.
McGuire’s practice is focused on cash flow deals rather than asset-based, but Goldberg Kohn does both. “A number of partners are involved with commercial finance associations,” she said.
Richard Kohn, a founder in the law firm, has worked with the UN Commission on International Trade Law to develop model-secured lending for other countries to use and to help other countries to adopt them. In many cross-border transactions, the U.S. company needs a line of credit, as in Holland and Germany. Local laws are important, so to encourage availability of capital in other areas of the world, Kohn has been involved in developing cross-border activities.
Written with Nicki Jacoby.