by Owen D. Kurtin
In our April article, we argued for the satellite industry to pursue higher-grade investment in the resurgent economy and to turn from its historic reliance on high-yield debt. Here are some thoughts on how to do it.
High-yield debt is an investment deemed to be at substantial risk and which therefore offers the investor a high rate of return known as the "risk premium," compared to other debt. It is available at an early stage of corporate or project development, is very flexible in its attributes and is relatively illiquid. It shares those characteristics with early-stage strategic or financial investors' equity. Unlike equity, the cost to the issuer of high-yield debt, payable in the form of interest, is tax deductible. Because of the availability of high-yield debt and early-stage equity when investment grade capital is not available, many emerging companies have recourse to them. Because they are so relatively expensive, it is critical for satellite sector issuers to: (1) limit the amount of money raised through early-stage equity and high-yield debt to those amounts (a) absolutely necessary to build out the business plan and (b) not obtainable from higher grade investment sources at that stage; and (2) "retire" such debt and equity by paying it off with higher grade investment as soon as possible to reduce the cost of capital.
Retirement of early-stage equity and debt should be staged as project milestones are achieved and corporate performance matures. Securities can be structured to activate conversion features at such project milestones, be they preferred stock convertible into common or debt instruments convertible into equity, at moments when the risk premium of the project has lessened or the equity cushion improved because of the passing of those milestones and the risk premium originally justified is no longer valid. Because private equity and high-yield debt financing sources are often more sophisticated at the structuring of complex securities than are the satellite sector issuers, it is important for issuers not to accept "plain vanilla" provisions and assurances that they are "industry standard" and not subject to negotiation. It is also important to remember, from the issuer's point of view, that not all investors have the same objectives, risk tolerances or exit strategies.
Preferred convertible stock and convertible debt are usefully thought of as hybrids of equity and debt instruments. While preferred stock's usual voting rights, rights to elect directors and officers and conversion into common stock are equity attributes of the security, the usual liquidation preference is a debt attribute. Similarly, convertible debt instruments allow the lender the security and deductibility of interest payments, a debt instrument attribute, and the ability to be converted into equity when the post-conversion equity position appears more valuable than owning the debt. Although financiers often assert in negotiations that such conversion features should be at their option or upon the occurrence of a known "exit" event, such as an initial public offering or sale of the issuer, that is only a negotiating posture that issuers should contest with a milestone-tied approach.
Later-stage equity and debt should also be layered according to considerations of what the invested money is intended to achieve in the issuer's business plan. Issuance of bonds (collateralized long-term debt) or debentures (uncollateralized long- term debt, secured only by faith in the issuer) will be relatively lower yield, reflecting a lower risk premium and may also have conversion features. Mezzanine debt will typically be used as a bridge between early-stage equity and senior-bank debt, expecting principal return on investment in the form of interest payments but frequently with so-called "equity kickers" in the form of warrants (options to buy equity securities) appended. Senior debt, usually provided by commercial banks, is low risk, highly-secured (subordinating other lenders), and consequently relatively low interest-bearing debt that is typically reserved for working capital needs of businesses with realized business models and recurring revenue streams. Effective corporate finance requires not only use of all of these instruments over time, but recognition that the proper mix of the various securities available is constantly changing as the issuer matures and its risk premium changes.
Finally, satellite issuers have special concerns that affect their securities offering choices. For example, since foreign ownership of radio broadcast licenses is still restricted under U.S. and many other countries' laws, the use of generally exempt convertible debt can attract non-U.S. investors. The use of "blocking entities," or special purpose vehicles, can also isolate foreign ownership, while providing effective control for majority investors below the regulatory radar screen through voting provisions in shareholders or other governance agreements. Entities such as limited partnerships and limited liability companies, which can provide pass-through tax status, allow the issuance of securities without stranding profits or losses in a corporate entity and can also be used to comply with foreign ownership restrictions.
Michael Flynn co-wrote this article. Kurtin and Flynn are partners in the New York office of law firm Sonnenschein Nath and Rosenthal LLP. They may be reached at 212/768-6700 or by e-mail at okurtin@sonnenschein.com and mflynn@sonnenschein.com, respectively.
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