Equity Line of Credit – Structured Financing For Companies

Equity Line of Credit (ELOC): Structured Financing For Companies

An Equity Line of Credit (ELOC) is a widely used financing option for listed small and midcap companies. It provides quick and inexpensive capital without the burdensome and costly process of a public offering. Here, we’ll explore the basics and weigh the pros and cons.

General Characteristics of Equity Lines of Credit

Equity lines are financing agreements where an issuer and an investor agree that the investor will purchase securities from the issuer in the future, based on an agreed-upon pricing formula, if certain conditions are met. After establishing the equity line through definitive agreements, the issuer files a resale registration statement for the securities involved. Once this statement is declared effective, the issuer can “draw” on the equity line by selling the securities to the investor as per their agreement.

Alternatively, issuers eligible for primary offerings on Form S-3, with a universal shelf registration statement already filed with the SEC, can immediately file a prospectus supplement to register the securities and bypass waiting for SEC approval. This setup allows issuers to access capital on an as-needed basis over months or years.

Equity lines are financing agreements wherein an issuer and an investor agree that the investor will purchase securities from the issuer in the future, contingent upon specific conditions and based on an agreed-upon pricing formula. These agreements are structured to provide issuers with flexible access to capital over time.

Establishing the Equity Line

After finalizing the definitive agreements to set up the equity line, the issuer files a resale registration statement with the SEC. This registration statement covers the resale of the securities subject to the equity line by the investor. Once the SEC declares the registration statement effective, the issuer can begin “drawing” on the equity line by selling the specified securities to the investor per the terms of their agreement.

Immediate Filing Option

Issuers eligible to make primary offerings on Form S-3 and who have a universal shelf registration statement on file with the SEC can expedite this process. These issuers can immediately file a prospectus supplement to register the securities under the equity line without waiting for the SEC to declare a registration statement effective. This allows issuers to quickly access capital when needed.

Flexible Capital Access

These arrangements enable issuers to draw against their equity on an as-needed basis over an extended period, typically spanning several months to years. This flexibility can be crucial for companies needing to manage cash flow and capital requirements dynamically.

Advantages of ELOCs – Equity Lines of Credit

Equity lines, similar to ATMs (described below), provide issuers with periodic access to cash, enabling them to capitalize on favorable market conditions quickly. Although the overall cost of capital is often higher for equity lines compared to ATMs, equity lines offer “firm commitments” from investors, unlike typical ATM programs, which operate on a commercially reasonable efforts basis. Investors might prefer equity lines because they allow for purchasing securities in tranches at a predetermined discount to market prices (based on forward or backward pricing formulas). The equity line shares, registered for issuance under a shelf registration statement or for resale, can be resold by the finance provider for profit quickly and freely.

Equity lines allow companies with smaller market capitalizations to raise substantial capital. Issuers not eligible to use Form S-3 for a primary offering can register securities under an ELOC using Form S-1, a flexibility not offered by ATM, Registered Direct, or CMPO structures. Additionally, issuers can circumvent the 20 percent rule if the average price of all securities issued under the ELOC is above the minimum price set at the ELOC’s initial signing.

Equity lines offer several advantages that make them an attractive financing option for many issuers:

Access to Cash

Similar to At-the-Market (ATM) offerings, equity lines provide issuers with access to cash from time to time. This ability allows issuers to take advantage of periods of favorable market sentiment quickly.

Firm Commitments

Unlike ATMs, which are conducted on a commercially reasonable efforts basis, equity lines offer “firm commitments” from the investor. This means the investor agrees to purchase securities as specified, providing more certainty and stability for the issuer.

Investor Preferences

Investors may prefer equity lines over other forms of investment due to the structured nature of the purchases. Securities are bought in tranches at a pre-determined discount to market prices, which may be based on forward or backward pricing formulas. This structured approach can be attractive for managing investment risk and potential returns.

Quick and Free Resale

Since the equity line shares are registered for issuance under a shelf registration statement or for resale, the finance provider can quickly and freely resell the shares for profit. This liquidity feature can make equity lines more appealing to investors.

Capital for Small Market Capitalization Companies

Equity lines allow companies with smaller market capitalizations to raise significant amounts of capital. Issuers not eligible for a Form S-3 for a primary offering can use a Form S-1 to register the securities under an ELOC. This flexibility is not available with ATM, Registered Direct, or CMPO structures.

Circumventing the 20 Percent Rule

Issuers can avoid the limitations imposed by the 20 percent rule if the average price of all securities issued under the ELOC is above the minimum price established at the initial signing. This can provide additional flexibility in capital raising strategies.

Additional Considerations for ELOCs

Since equity lines allow issuers to draw funds as needed, they may not be ideal for issuers requiring an immediate, one-time cash infusion. The shares sold to the investor under an equity line must be registered on an effective resale registration statement filed with the SEC, which can involve additional costs and timing issues if the issuer lacks or is ineligible for a Form S-3 Registration Statement.

Similar to ATM programs, equity line finance providers typically conduct most of their due diligence upfront, enabling companies to access financing quickly on an as-needed basis. The SEC mandates that the finance provider be named as an “underwriter” in the prospectus for reselling the shares sold under the equity line. Consequently, many equity line finance providers, like ATM finance providers, may require negative assurance letters and, in some cases, comfort letters, which are usually not necessary in PIPE or registered direct offerings.

While equity lines offer flexibility and other advantages, there are several additional considerations and potential drawbacks:

Immediate Cash Needs

Equity lines may be less suitable for issuers needing an immediate, one-time cash infusion. The ability to draw funds as needed over time is advantageous for managing ongoing capital requirements but may not address urgent financial needs effectively.

Registration Statement Requirements

The shares sold to the investor under an equity line must be registered on an effective resale registration statement filed with the SEC. Issuers must consider the additional costs and timing involved if they do not already have, or are not eligible for, a Form S-3 Registration Statement.

Upfront Due Diligence

Similar to ATM programs, equity line finance providers typically conduct extensive due diligence upfront. This thorough initial process allows companies to access financing quickly on an as-needed basis going forward, ensuring the investor’s commitment and confidence.

Underwriter Designation

The SEC requires the finance provider to be named as an “underwriter” in the prospectus covering the resale of the shares sold under the equity line. This designation means the finance provider has certain responsibilities and liabilities, which can affect the terms and conditions of the equity line agreement.

Additional Documentation

Equity line finance providers may require negative assurance letters and, in some cases, comfort letters. These documents, which are not typically required in Private Investment in Public Equity (PIPE) or registered direct offerings, can add complexity and cost to the process.

Equity Line Of Credit – The Basics

ELOCs allow a company to request an ELOC investor to purchase its stocks multiple times over a predetermined period, usually three years. The purchase price is based on the share price at the time of the request, minus a fixed discount. The amount requested is typically calculated based on the daily liquidity of the company’s shares. This funding facility enables the company to receive capital as needed without building a book or making a public offering. The ELOC investor, who acts like an underwriter, usually sells the acquired stocks in the market shortly after purchase.

ELOC – Example

Biotech Company A needs EUR 20 million to finance clinical trials over 2-3 years. The company cannot start without securing this funding. Given that the stock market is too risk-averse or demands a steep discount, Company A, with an average daily volume of EUR 0.5 million, enters a three-year EUR 20 million ELOC. Each stock purchase request is 10 times the average daily volume. Over the three-year term, the company can request EUR 5 million four times, ensuring it has the necessary capital to initiate and fund the trials.

Benefits to Companies

ELOCs offer several advantages, which can vary depending on the company’s financial situation, shareholder base, market conditions, and funding needs. Key benefits include:

1. Flexible Funding: Similar to a bank credit line, ELOCs provide flexibility in timing and amount of capital received. Unlike public offerings, which require extensive preparation and favorable market conditions, ELOCs allow companies to request funds at their discretion.
2. Reduced Dilution: Issuing a large number of new shares often results in a significant price discount and dilution for existing shareholders. ELOCs typically involve a smaller, fixed discount (8-12%), limiting dilution per transaction and overall.
3. Market Drought Survival and Backup: ELOCs provide a backup funding option during financial trouble or market downturns, ensuring companies can still secure necessary capital.
4. Market Opportunities Capitalization: Companies can time their ELOC capital calls to coincide with positive market conditions or company announcements, optimizing share prices and capital received.
5. Cost Savings: ELOCs are less costly than public offerings, which involve fees for investment bankers, lawyers, auditors, and underwriters. ELOC fees are comparable to bank fees and are often covered by the proceeds from share sales.

ELOC – Regulatory and Legal Requirements

Regulatory and legal requirements vary by country, stock exchange, and company. The primary requirement is that the Board of Directors must have the mandate to issue shares to the ELOC investor. If this authority is not in the bylaws, it must be granted by the general assembly.

Considerations and Risks

ELOCs, as structured finance instruments, come with various risks and pitfalls:

1. Liquidity: High liquidity allows investors to sell shares without impacting the price negatively. Companies need sufficient daily liquidity to effectively use the ELOC.
2. Appropriate Size: The total amount of the ELOC should align with the company’s market cap and liquidity. An excessively large ELOC can lead to unnecessary fees without being fully utilized.
3. Market Reactions: Clear communication about the ELOC’s benefits is crucial to avoid negative market perceptions. Transparency about the ELOC investor and structure is essential.
4. Share Price Pressure: Regulations on how the ELOC investor can sell shares are important to prevent undue pressure on the share price.

Conclusion

Equity lines of credit offer a flexible and strategic financing option for issuers, especially those with smaller market capitalizations. While they provide several advantages, such as firm commitments from investors and the ability to raise significant capital, issuers must carefully consider the associated costs, regulatory requirements, and the suitability of ELOCs for their immediate cash needs. Professional advice and thorough planning are crucial to maximizing the benefits of equity lines and ensuring they align with the company’s overall financial strategy.

Getting the Best ELOC

Securing the best financial solution requires professional advice. We act as both an intermediary for sourcing structured funding and a financial consultant to help companies secure optimal ELOC terms and conditions.

In summary, while ELOCs offer flexibility, cost savings, and reduced dilution, companies must carefully manage liquidity, size, market communication, and investor relations to maximize their benefits.