Structured Finance: Equity Line of Credit

Equity Line of Credit (ELOC) is one of the most common types of financing structures for listed small and midcap companies. The reason being its ability to ensure very fast and cheap capital to companies without the often burdensome and costly process of a public offering. Due to some ELOC’s having “toxic structures” (especially in the 90’s) it is also a type of financing which has had negative reputation. ELOCs are structured in many different ways with multiple types of terms and conditions, so here we will run through the basic pros and cons.

The basics

ELOCs in essence enables the company to multiple times to request the ELOC investor to purchase the company’s stocks within a predetermined period of usually 3 years. The price of the stocks purchased is based upon the share price at the time of purchase request less a predetermined and fixed discount. The possible amount of each purchase request is typically calculated upon the daily liquidity (value of the shares traded) of the company’s shares. Hence the ELOC is a funding facility that enables the company to receive capital when it wants it without having to build a book or make a public offering.

The ELOC investor is not a long-term investor but will typically offload the acquired stocks in the stock market, hence acting like a kind of underwriter.

An Example

Biotech Company A will need EUR 20 million to finance its operations through the next clinical trials estimated to have a duration of 2-3 years. The company cannot start the clinical rials without having assurance of being able to fund the operations. The stock market is either too risk adverse to support an offering and/or the investors require a very steep discount to the share price. The average daily volume of Company A’s shares is EUR 0.5 million. Company A enters a 3-year EUR 20 million ELOC with each stock purchase request being 10x the average daily volume. With the ELOC in place the Company can request the ELOC-investor to purchase EUR 5 million (10x the average daily volume) of shares four times during the 3-year term of the ELOC. This enables the company to receive capital when it needs it and thus to able to initiate the clinical trials and fund them until readouts.

Benefits to companies

There are several benefits to companies and thus their shareholders of entering into and using an ELOC. Which ones that are the most beneficial depends upon several factors, among others the company’s financial situation, its shareholder base, the stock market, and the size of funding required. It is our experience that the main benefits are the following.

Flexible funding

Just as a bank credit line gives the borrow great flexibility as to when and how much to draw down, the equity line gives almost the same kind of flexibility. Instead of a request to a lender to borrow money, the company with the ELOC requests an investor to purchase its shares – when, how often and how much at the company’s discretion.

This is significantly more flexible than a public offering as the public offering requires involvement of investment bankers, lawyers, auditors, the stock exchange, etc. A public offering is thus not only costly and time consuming, but also involves a significant risk that investors are not interested in purchasing the offered shares. Hence, a public offering requires good (the right) timing, and the number of open windows may be limited. Further the offering may be delayed at any time due to unfavorable conditions. The lengthy and costly process of a public offering has the effect that they are best for large and long term financing.

The ELOC is also more flexible than a private placement/a book building process, as this funding also requires engagement of an investment bank and good market timing, in order to secure the funding. While the private placement process being shorter and the cost lower than a public offering, the funds requested are still usually higher than the short term financial needs of the company.

Avoidance of large and/or immediate dilution

Issuing a large amount of new shares often has a negative impact on the share price as the incentive given to investors typically is a price lower than the prevailing market price. The larger the issuance the larger the discount is. As the costs of a public offering like a rights issue creates a desire for a larger issue, the discount tends to increase – especially for small and midcap companies. If the company is in financial trouble or is on a downward path, risks and thus discounts tend to increase tremendously reaching up to 80%. The investors that do not participate in the offering, will thus face a substantial dilution.

With the ELOC the price discount is fixed and usually in the region of 8-12%, depending on the risk taken by the ELOC investor. Further, with the company only issuing new shares to the ELOC investor on a need to basis, the offering is usually significantly smaller than the standard public offering. Hence, the ELOC significantly limits the dilution, both per transaction and in total, to the other investors.

Surviving market drought & Backup

If the company has gotten into significant financial trouble and/or the stock market has frozen, the interest of acquiring shares in the company’s offering may be non-existent, no matter the discount given. However, with an ELOC in place, the company still has the opportunity to request the ELOC investor to purchase its shares.

The ELOC is thus extremely suitable as a back up funding scheme. Companies relying on receiving new funds from the stock market, like companies within biotech and mineral exploration, but also fast growing companies with a high cash burn, need assurance that the funds will keep flowing. When times are good, that is usually not a problem, but when markets are negative and/or the company does not reach projections, things can turn quickly. With a duration of usually up to three years the ELOC can be used as a long-term financial backup.

Capitalize on market opportunities

Timing is everything! That is even more true in the stock market and for the companies issuing new shares. However, with the lengthy process involved with a public offering it is difficult to time the launch optimally.

With the company having the (put) option of when to ask the ELOC investor to purchase shares, the company can easily time the call to when the share price is high – either due to general positive market conditions or company actions/announcements. Hence, issuing the ELOC capital call after positive news have been published can be timed relatively easily with the ELOC – something that especially biotech and mineral exploration companies have benefited from.

Saving costs

Investment bankers, lawyers, auditors, public relations, etc. are all adding to the costs of issuing new shares/public offering. Add to that potential underwriting fees and marketing expenses and the total costs can be substantial. With the ELOC the fees are more in line with the size of bank fees and often paid out of the proceeds from the share sale to the ELOC investor. The fees thus have no or a limited impact on the on the company’s finances. The fees are sometimes paid partly or fully in warrants issued to the ELOC investor. In those cases the fee will not have any negative impact on the company’s cash flow.

Regulatory and Legal Requirements

The regulatory and legal requirements differ from county to country, stock exchange to stock exchange and company to company. However, the primary requirement in order to engage/execute an ELOC is that the Board of Directors have the sufficient mandate to issue the shares to the ELOC investor. If the BoD does not have the authority (in the bylaws) that authority must be given by the general assembly. Hence, many companies ask the general assembly for authorization after and as a prerequisite for entering into an ELOC.

Things to look out for

Being a type of structured finance, the ELOC can not only take various forms, each type contains very different types of risks and pitfalls for the issuing company. The typical issues are:

Liquidity

ELOC-investors are hedge investors, meaning investors that through the ELOC structure will hedge their market risk. The key hedging factor is the liquidity of the company’s shares. High liquidity (high daily turnover) means that the investor can offload shares faster in the market without negatively impacting the share price, while low liquidity means that offloading shares in the market will take longer or will have a negative effect on the share price. Hence, the amount of shares the investor is willing to purchase is typically linked to the liquidity of the shares.

From a company perspective it is thus of paramount importance to have enough daily liquidity to be able to use the ELOC when the capital is needed.

Size

Size matters and with ELOCs it is important to make sure that the total amount possible to call from the ELOC investor is appropriate. We often see that the total amount of the ELOC is too high given the company’s market cap and liquidity, meaning that the ELOC is so large that the company in reality will never be able to use it in full. With the fees of the ELOC tied to the total amount of the ELOC the investor is liable to invest in the company, too large an ELOC means that the company pays unnecessary fees.

Market’s reactions

The ELOC needs to be disclosed to the stock market and as with all other disclosures how that is communicated is paramount. Often the communication does not sufficiently describe the benefits to the company and the investors, like e.g., the significant low(er) dilution to the shareholders and costs to the company. Giving the stock market insights to the structure is also important, as lack of details, including who the ELOC investor is, may well cause the market to become negative about the funding structure.

Share price pressure

The ELOC investor is usually not a long-term holder of the company’s shares. The agreement’s regulation of how the ELOC investor can offload its shares in the company is thus very important. There are several ways to ensure that the share price pressure is limited, but in essence it is important that the ELOC investors – as all the other shareholders – has an interest in the stock price going up.

Getting the best ELOC

The best way to get the most optimal financial solution is always to attain professional advice. With advanced financial structures and equity line of credits, that is – if possible – even more necessary. Kapital Partner acts both as an intermediary sourcing – among others – structured funding and as a financial consultant to companies in relation to securing them the best funding solution, including the optimal ELOC terms and conditions.

See more insight etc. at Kapital Partner.