Friday, November 5, 2010

Equity Kickers in Qualified Commercial Loans in Texas

Let's say a company is attempting to raise $10 million, and an investor is willing to loan that amount to the company, but the investor is seeking a 25% return on the investment.  Unfortunately, the highest lawful rate in Texas is generally 18% (Texas usury laws are quite complex and beyond the scope of this post, but an 18% rate is generally permissible for typical business transactions).  Does that mean the company cannot get funding from this investor?  Not if the investor is willing to accept a lower interest rate with an "equity kicker."

Section 306.101 of the Texas Finance Code provides that for a "Qualified Commercial Loan" certain loan charges will not be deemed interest for the purpose of Texas usury laws.  A Qualified Commercial Loan is defined in Section 306.001 of the Texas Finance Code as a commercial loan of at least: (a) $3 million, if the loan is secured by real property, or (b) $250,000, if the loan is not secured by real property (with certain written disclosures required for loans less than $500,000).

Among the loan charges which are deemed not to be interest with respect to a Qualified Commerecial Loan are "equity kickers" such as (a) an option to purchase capital stock or other equity securities of the borrower, or (b) an option to participate in a share of the income, revenues, production, or profits of the borrower.
   
Thus, in our hypothetical above, the company could issue an 18% note and a warrant to purchase, say, 20% of the common stock of the company at the common stock's current fair market value, in exchange for the investor's $10 million investment.  If the company's value were to grow substantially, that warrant to purchase 20% of the company's common stock could be worth a lot more (or a lot less) than the 7% interest rate (25% - 18%) that the investor gave up.

Equity kickers are often a great way to bridge the gap between investors demands for high returns and interest rate limitations set forth under Texas usury laws.

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