Much of the buzz in the energy storage sector is focused on DOE administered subsidy programs and what they will mean for investors in smaller public companies. The buzz began when Title XVII of the Energy Policy Act of 2005 (“EPACT”) authorized $2 billion in loan guarantees for innovative energy technologies. It ramped up rapidly when the Energy Independence and Security Act of 2007 authorized another $2.5 billion in loan guarantees under the Advanced Technology Vehicles Manufacturing (“ATVM”) program. It reached a crescendo when the American Recovery and Reinvestment Act of 2009 (“ARRA”) authorized $7 billion in smart grid, battery manufacturing and job training grants. Speculation about who will be first in line when Uncle Sugar arrives at the party with duffle bags full of money is running rampant.
I’ve had nothing but praise for a plan the DOE developed to administer $4.5 billion in ARRA grants for smart grid projects. My fondest hope is that a comparable plan will be implemented for the other classes of ARRA grants. EPACT and ATVM loans, on the other hand, create an entirely different and to my way of thinking dangerous dynamic. I fear that these loans could be a kiss of death for any smaller public companies that are unfortunate enough to survive the application process.
The simple and undeniable truth is that nothing destroys financial statements faster than leveraged investments in depreciable plant and equipment, which is why many tax shelters are based on building and equipment leases. By the time you account for interest accruals on debt and depreciation on hard assets the double hit to earnings is devastating. The problem is compounded by the fact that the lion’s share of any positive cash flow ends up flying out the door to cover debt service costs; leaving little or nothing in the till to grow a business and pay for research and development, marketing and corporate overhead. By the time you work your way down to the bottom of the balance sheet, the shareholders’ residual interest in total enterprise value becomes almost inconsequential. For proof you don’t need to look any further than the latest GM restructuring proposal that will leave 1% for shareholders, 10% for bondholders, 39% for the unions and 50% for the government. It’s not pretty, but debt financing never is.
For investors that want to transcend the hype and irrational expectations that frequently accompany government guaranteed loans, I’ve found that subtracting 10% of the planned debt from the expected annual cash flow works well as a simple and reliable acid test. The net positive cash balance, if any, represents the maximum contribution a leveraged project can make to other corporate activities. Since the 10% figure is based on an assumed 20-year amortization of principal and an assumed annual interest rate of 5%, a higher acid test number may be appropriate.
While debt financing can be a heavy burden for borrowers that are well financed and profitable, it gets almost unbearable when the borrower is a smaller public company. First, the borrower will be required to contribute at least 20% of the project costs from its own resources, and that can be a big stretch for a small company. Second, if the borrower has a weak balance sheet or a history of losses, a lender will usually insist that the borrower obtain enough capital to eliminate the weaknesses and provide a cushion against future losses. In risk averse markets like we have now and can expect for several years, the probability that a highly leveraged smaller public company will be able to negotiate significant unsecured debt is almost non-existent; which means that applicants who get loan approvals will be required to sell substantial equity before the transaction can close.
I have participated in several negotiations between investment bankers and smaller public company clients that needed to raise equity as a closing condition for project financing. The negotiations were always ugly and the per share value offered by the investment bankers was rarely more than a small fraction of the market price of the client’s stock. When the table pounding and cursing ended, my clients were stuck with a Hobson’s choice of either abandoning their plans or selling stock at a steep discount to the market. Either way, the existing shareholders ended up holding the short straw.
Three of the cool emerging companies I track are pursuing loans under the EPACT and ATVM programs. Beacon Power (BCON) is engaged in advanced due diligence for a $50 million EPACT loan that will be used to build a 20 MW frequency regulation facility. In January of this year Ener1 (HEV) announced that it had applied for a $480 million ATVM loan to expand their existing battery manufacturing facilities and build a new plant. Last month, Valence Technology (VLNC) announced that it had applied for a $608 million ATVM to build a new battery manufacturing plant. Of the three announced applications, Beacon’s is the only one that even comes close to having a reliable future revenue stream to pay debt service costs. The other two have business models are entirely dependent on the commercial acceptance of electric vehicles that third parties plan to introduce to the market at a later date. None of the applicants has a history of operating profits or a tangible net worth that represents more than a fraction of the requested loan amount.
My big question is “What the hell are they going to do if the DOE says yes?”
I hope that Beacon will be able to change its pending subsidy application into a request for a combination of ARRA smart grid grants and fill-in EPACT or ARRA loans. They’ve been working on their 20 MW frequency regulation project for a long time, it represents an important smart grid technology and it deserves to be installed and thoroughly tested. From what I know about the process, I believe the DOE would be likely to approve a combined grant and loan structure. I’m less optimistic about the chances that Ener1 or Valence will be able to negotiate financially sound alternative proposals. If they can’t do so, a rejection of their ATVM loan requests would probably be the best thing for their shareholders.
In almost 30 years of practice I have never seen a smaller public company borrow its way to prosperity. The debt financed projects I’ve been involved in never worked as well in the real world the way they did on paper. The existence of a large secured creditor with a first claim on major assets always complicated negotiations with junior lenders. A highly leveraged capital structure always made negotiations with new equity investors difficult if not impossible. In every case, existing shareholders who bought a debt-free capital structure and ultimately found themselves at the bottom of the food
chain felt the lion’s share of the pain. This is not a theoretical issue for me. It’s one that has cost me millions of dollars over the years. I’ve been through the drill more than once and would never go there again.
John L. Petersen, Esq. is a U.S. lawyer based in Switzerland who works as a partner in the law firm of Fefer Petersen & Cie and represents North American, European and Asian clients, principally in the energy and alternative energy sectors. His international practice is limited to corporate securities and small company finance, where he focuses on guiding small growth-oriented companies through the corporate finance process, beginning with seed stage private placements, continuing through growth stage private financing and concluding with a reverse merger or public offering. Mr. Petersen is a 1979 graduate of the Notre Dame Law School and a 1976 graduate of Arizona State University. He was admitted to the Texas Bar Association in 1980 and licensed to practice as a CPA in 1981. From January 2004 through January 2008, he was securities counsel for and a director of Axion Power International, Inc. a small public company involved in advanced lead-carbon battery research and development.
Very interesting John… the insight gained from personal experience is far more valuable than the theoretical sort.