Equity Line Funding by Alvin Donovan

Aug 14, 2010 in Stock Trading

Equity Line Funding – is a funding structure that has been used by hedge funds for the past ten years or so to provide funding to small and large companies looking to raise capital.

It can be used by small or large companies and can be used in the United States, Asia, Europe and Australia. Its use has been widespread and seems to be growing.

The way the Equity Line Funding works in the United States, is that the company registers shares of its common stock with the U.S. Securities & Exchange Commission (SEC). Once the shares are registered pursuant to an S-1 or S-3 registration statement, the company can then “draw down” by sending a funding notice to the investor.

The amount of funding for each request is based on a specified formula that the company and investor agree upon in advance and which is disclosed to the public in the registration statement.

The formula is based on the share price and trading volume of the company’s common stock during the draw down period, which is usually five trading days. The company decides when and how much to request for each draw down period.

In Australia, equity lines are also being used by companies to raising working capital, to make acquisitions or to pay down debt. The funding structure is also based on a formula similar to those used in the United States.

The funding terms are based on a discount to the Volume Weighted Average Price (VWAP) as reported by Bloomberg and the pricing period is generally 15 trading days. Make sure that your management team has the information it needs regarding equity line funding and the mechanics of how this financing structure works.

One of the main benefits is that the company has control over the timing of draw downs, which is one of the benefits of using an equity line. A number of terms and conditions are used to give the company additional control over the draws down.

They include the following: – agreed upon discounts based on closing bid prices of the company’s common stock; – cancellation notices if a certain minimum price is not maintained; – the company controls the amount requested in each draw down; and – the company controls when the draw down notices are given (which can only be given by the company).

Some companies use an equity line funding to have it in place when they need capital, even if they don’t necessarily need capital at the time they file the registration statement.

Raising capital through a equity line funding is sometimes preferred by companies over a convertible debenture for two main reasons.

Firstly, pursuant to the terms of an equity line funding the company is the one that controls when to request capital and sell shares of its common stock.

In a convertible debenture financing, although capital is provided to a company up front, if there is no floor on the conversion price it becomes a toxic convertible and can be highly dilutive since the debenture holder can keep converting into the company’s common stock and selling into the market.

This downward pressure can hurt a company’s stock price and the company may have very little if any control over the situation since it must honor the conversions.

Secondly, most equity line funding agreements contain a provision that allows the company to cancel in the middle of a funding draw down if the price of the common stock falls below an agreed upon “minimum acceptable price”. This gives the company significant control over the funding process.

It effectively allows the company to stop the funding temporarily, indefinitely or even permanently.

The “minimum acceptable price” can be any price or formula that the company and investor agree upon. It can be a fixed price or a moving price which is more common.

For instance, the “Minimum acceptable price” can be defined as 70% of the volume weighted average price(VWAP) of the company’s common stock for the fifteen (15) trading days prior to each draw down date.

This way if the company’s stock price starts dropping rapidly after the draw down is given, the company can cancel in the middle of the draw down period. This way, the company would only be responsible for issuing shares to the investor up to the cancellation date and the investor would be required to fund that amount through the cancellation date.

One of the best uses a company can make of an equity line funding is to make an acquisition. Whether it is an asset purchase or a corporate acquisition of a competitor, if it provides cash flow and increases net income it is usually a good move for the company. Of course, price terms must be favorable to the company so that it is not over paying for the acquisition.

Some private companies in the United States and Australia are even using equity line funding to get a pre-listing commitment in advance of a reverse merger or direct listing.

Simply using an equity line to pay down debt or for working capital is generally not a good idea unless it will have the effect of increasing the company’s net income. Otherwise, it will simply dilute the company and the percentage of ownership interests of all its existing shareholders.

Also, if the capital that is raised is not used effectively by the company, then it will have the effect of putting downward pressure on the stock price causing it to trade lower.

Although the company must first register the shares of common stock that will be used to draw down funding under the equity line, it can be a useful funding tool for a company because once registered, if the equity line was structured properly, the company can use it to draw down capital over a period of two or even three years in some cases.

Depending on certain factors, a company might be able to register up to 30% of the number of shares of common stock it has issued and outstanding at the time it files the registration statement. Factors to be considered include, whether an S-1 or S-3 registration is being used, how many shares are actually in the public float not counting affiliate shares, the relationship between the company and the investor, is the investor simply acting as a conduit for the company and if the offering is viewed as a primary or secondary offering.

Hedge Funds have become good sources for companies looking for capital through an Equity Line Funding. Some companies have raised substantial sums through these funding vehicles.

Below are examples of some terms found in a typical Equity Line Funding Term Sheet:

Investment Period: The “Investment Period” begins on the effective date of the Registration Statement and continues for a period of twenty-four (24) consecutive months. During the Investment Period, the Company may exercise Puts of up to the maximum Put Amount with an aggregate total not to exceed the Commitment Amount. Prior to the exercise of a Put the Company must have an effective registration statement on file with the SEC registering the resale of the Common Stock.

Put Notice: During the Investment Period, the Company, in its sole discretion, may issue “Put Notices”, subject to the terms of the Standby Equity Purchase Agreement. The Company shall deliver the Put Notices to Investor via facsimile transmission. The Put Notice shall specify (i) the amount of the Put the Company wishes to exercise; and (ii) the beginning and ending dates of the Pricing Period.

Price Per Share: The price per share paid by Investor (the “Purchase Price”) on any particular day shall be equal to ____% of the “Market Price”. The Market Price shall be equal to the lowest daily volume weighted average price (“VWAP”) of the Common Stock on the Principal Market during the Pricing Period.

Pricing Period and Settlement:

(i) The pricing period (“Pricing Period”) will consist of the five (5) consecutive Trading Days immediately following the Trading Day the Put Notice is received by the investor.

(ii) There will be a minimum of three (3) Trading Days between Put Notices.

(iii) The number of shares of Common Stock being purchased and the aggregate Purchase Price shall be calculated at the end of the fifth (5th) Trading Day of each Pricing Period (each a “Settlement Date”).

(iv) Only one Put shall be allowed in each Pricing Period. At no time shall Investor be required to purchase more than the requested Put Amount for a given Pricing Period.

Aggregate Purchase Price: For each Pricing Period, Investor shall be required to pay not less than the “Aggregate Purchase Price”, which amount shall equal the lesser of:

(i) That amount equal to 15% of the aggregate daily U.S. trading volume (excluding block trades of 50,000 or more) during the Pricing Period times the Purchase Price; or

(ii) The amount stated in the Put Notice.

About The Author

Alvin Donovan, Institutional investor partner substantial funds, bestselling author, hedge fund industry pioneer, completed several billion dollars transactions, consultant to fortune 500 companies, faculty member most of the world’s largest management institutes, raised over USD$1.5 billion for funds.

http://www.alvindonovan.com