Wealth Systems: Direct Lending, Part II
The Oldest Wealth Engine
In Part I we covered the history, terminology and operating mechanics of a Direct Lending business.
The first rule of this business model is simple:
do everything you can to protect your principal
You are extending cash and other resources in exchange for repayment including interest in the future.
You can be creative in the ways you mitigate risk — using covenants and legal mechanisms. You can carve out upside for yourself in tax efficient ways… but make no mistake - loss of principal is a constant risk, and one big loan that fails to return can cause havoc to your P&L.
Designing a business model for a direct lending company that focuses on deploying capital to entrepreneurs, generating current income, and incorporating multiple layers of risk mitigation is quite an intricate task.
These are the elements you need to think though when designing your own direct lending strategy:
1. Target Market Identification
Focus: Entrepreneurs in need of capital, preferably in sectors with high growth potential and relatively lower risk.
Market Research: Understand the specific needs, challenges, and financial health of your target market(s)
2. System Design
Flexible Structures: Tailored to different entrepreneurial needs – short-term loans, bridge financing, asset-backed loans, etc.
Interest Rates and Fees: Competitive yet profitable, factoring in risk levels and market standards.
3. Risk Mitigation Strategy
Tiered Risk Assessment: Use a multi-tier system for assessing borrower risk (credit history, business plan viability, collateral).
Diversification: Spread investments across various industries and business stages to mitigate sector-specific risks.
4. Technology Integration
Efficient Communication: Use technology to set-up due diligence rooms, a chatroom / Slack channel where you can engage with the borrower’s operating team
Data Analytics: Leverage data for better decision-making and identifying market trends.
5. Regulatory Compliance
Legal Framework: Ensure compliance with all relevant financial regulations and lending laws.
Transparency: Maintain transparency with borrowers about terms, costs and processes.
6. Revenue Model
Interest Income: Main source from the interest on loans.
Fee-based Income: Origination fees, late payment fees, etc.
Advisory Services: Offer financial advice or business consulting for an additional fee.
7. Performance Monitoring and Feedback Loop
Regular Assessments: Monitor loan performance, borrower feedback, and market changes.
Adaptation: Be prepared to adjust strategies, products, or risk assessments based on performance data and market shifts.
The Bottom Line:
Balance Between Risk and Return: High returns often come with high risk. Your strategy should balance returns with a prudent risk approach.
Long-term Relationships: Fostering long-term relationships with entrepreneurs and investors can lead to repeat business and referrals.
Continuous Learning: The financial market is dynamic. Stay updated with trends and continuously refine your approach.
Remember, a successful direct lending business isn't just about lending money; it's about creating value for both entrepreneurs and yourself.
Keeping a keen eye on market dynamics, regulatory changes, and technological advancements will be key to staying competitive and profitable — if you decide to make direct lending one of the engines in your wealth system.
Increasing Direct Lending Yield / Financial Performance
Enhancing the current income profile of a direct lending business involves exploring additional revenue streams and optimizing existing ones.
Shorter term loans generally have greater interest rates… you can specialize in bridge loans and use AI + automation to process applications and conduct due diligence faster in order to win deal flow in that crowded market.
Or you can layer other service offerings atop the capital to increase your ROI too.
Here are some strategies to consider as you are building your battle plan:
1. Interest Rate Optimization
Dynamic Interest Rate: Implement a dynamic interest rate model that adjusts rates based on market conditions, borrower's risk profile, and demand.
Example: I will give more collateral value to assets I have bullish sentiment of, Bitcoin is a prime example
Aligning Risk Profile with Interest Rate: Offer lower interest rates if the borrower agrees to real-time business monitoring, maintaining an interest reserve and other covenants.
2. Fee-Based Services
Additional Services: Charge for value-added services like expedited loan processing, early repayment options, or flexible payment schedules.
Consulting Services: Provide financial advisory or business consulting services for a fee.
RevSystems - is a SaaS company offering revenue intelligence services that I founded, I will layer these RevOps skills atop the companies we lend to (and invest in) to improve their revenue system technology
3. Investment in Higher Yielding Assets
Bridge Financing & Factoring: Offer short-term financing solutions at premium rates.
Participation in Syndicated Loans: Participate in larger, syndicated loans that may offer higher returns.
4. Utilizing Fintech Innovations
Blockchain and Smart Contracts: Implement these for efficiency, transparency, and potentially new offerings like tokenized loans.
By exploring these strategies, your direct lending business can potentially enhance its current income profile while maintaining a balanced approach to risk and sustainability.
Remember, the key is not just to increase income but to do so in a way that aligns with your overall business strategy and risk appetite.
Liquidation Preference
When making these loans we often explore hybrid structures, combing debt and equity. Sometimes called dequity this structure offers downside protection and enhanced upside exposure.
When structuring a debt deal with the potential for equity, you need to understand and utilize liquidation preference.
Liquidation preference is a critical term in venture capital and private equity investments, determining how funds are distributed among shareholders in the event of a sale, liquidation, or dissolution of the company. The terms can vary in restrictiveness, affecting the return received by investors.
Here's a progression from less to more restrictive liquidation preference terms:
Non-Participating Preferred: This is the least restrictive form. Here, preferred shareholders receive either their initial investment back or the amount they would receive if their preferred shares were converted to common shares — whichever is higher. Once preferred shareholders are paid, the remaining assets are distributed to common shareholders. This is investor-friendly but not overly aggressive.
Participating Preferred Without Cap: A step up in restrictiveness, this allows preferred shareholders to first receive their initial investment back and then participate in the remaining assets as if they had converted to common shares. This means they get paid twice: once as preferred shareholders and again as common shareholders. It's more beneficial to investors, especially in scenarios of high exit values.
Participating Preferred With Cap: This is similar to the above, but with a limit (cap) on the total returns. The cap is typically a multiple of the initial investment. Once this cap is reached, the preferred shareholders can no longer participate in additional distributions. This cap adds a layer of balance, making it a bit less aggressive than the uncapped version.
Full Ratchet Anti-Dilution Protection: This isn't a liquidation preference per se, but it's a related term that can significantly impact payouts. It protects investors from dilution by adjusting the price at which preferred shares convert into common shares, based on the price of any future equity sales. If new shares are issued at a lower price than what the investor paid, their conversion price is reduced to this new, lower price. This can be extremely restrictive and potentially punitive to founders and other shareholders.
Multiple Liquidation Preferences: The most restrictive form, where preferred shareholders are entitled to receive multiples of their original investment (like 2x or 3x) before any distribution to common shareholders. This can severely diminish the returns for common shareholders, especially in modest exit scenarios.
Negotiating these terms requires careful consideration of the company's valuation, growth prospects, and the investment climate.
Remember the first rule:
do everything you can to protect your principal
If executed correctly, you are outlaying capital and receiving current return with your principal returned at the end of the loan’s duration.
We have explored creative mechanisms to mitigate risk while also shining a light on tools and strategies to create more upside.
Look Ahead to Part III
In our final chapter we will look at sample Loan Agreements and drill down on the fine-tuned details of due diligence, structuring a deal and monitoring your portfolio of loans after they have been made.
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