“Non-Public Income Deposit Securities (A New Financing Option for Private Companies)”		«BACK
	by Dennis L. Monroe
	from January 2005 Restaurant Monitor

Recently, there has been a great deal of discussion concerning a new type of security known as Income Deposit Securities (IDS) or Enhanced Income Securities (EIS).  An IDS is a publicly-traded (AMEX) combination equity and debt security designed to enable companies to distribute a substantial amount of their free cash flow to investors.
IDS’ have been in use in Canada for some time but only recently debuted in the United States capital markets.

To date, IDS’ have been offered for sale by only a few restaurant industry companies, including Davco, the large Wendy’s franchisee, Carrolls Corp., the large Burger King franchisee and concept owner, and Buffets, Inc.  As with any registered securities offering, the process of listing IDS’ on a national exchange has made it difficult for these and other companies to successfully navigate the Securities and Exchange Commission’s (SEC) complex registration process, and thus only a few of the offerings filed with the SEC have made it to the public market. In the case of Davco, Carolls Corp. and Buffets, Inc., additional investment-related issues eventually prevented IDS’ from being sold to the public.

Even though it appears that public capital markets are not as receptive to IDS’ as was once originally thought, use of a private IDS, or what I call a “Private Income Deposit Securities” or “PIDS,” could be a very attractive alternative to traditional methods of capital raising in the private sector. The following discussion describes the PIDS and the characteristics of a successful PIDS offering.

Like an IDS, a PIDS has two components, a common equity component and a subordinated note component, which are bundled together to create the PIDS.  PIDS holders receive dividends on the common equity portion as well as a fixed interest payment on the debt component. When the dividends and interest payments are combined, they provide an overall blended return or yield to the investor. 
Raising capital through a PIDS offering is attractive for several reasons. On the investor side, the cash distribution model of the PIDS itself can decrease the amount of time it takes for an investor to receive a return on its investment, a significant issue for many long-term investors in privately held companies. 

On the company side, the sale of PIDS would generally not require registration of the PIDS with the SEC, which in and of itself drastically reduces the financial and human cost of capital raising and gives the issuing company more flexibility with respect to the sale. In addition, if properly structured, the issuing company will be able to take a tax deduction for the interest payments on the debt portion of the PIDS. 

The issuing company’s ability to deduct for tax purposes the interest payments on the debt component of the PIDS is a critical aspect of the PIDS structure; if for some reason the PIDS’ subordinate notes are not characterized as debt, then the interest payments on the notes would not be tax-deductible by the company and would result in some degree of double taxation.  A key factor to ensuring that PIDS interest payments are tax deductible is to structure the PIDS such that the debt component of the PIDS can be separated from the equity component.

Let’s look at how this great idea may be used by a mature, large, multi-unit franchisee or other multi-unit retail and restaurant concepts. 
The type of companies that are good candidates for PIDS:

• Companies with a good track record of predictable and sustainable cash flow;
• Companies with moderate or limited needs for capital expenditures;
• Companies that would use the funds to either de-leverage the company or create liquidity for existing owners; or
• Companies with strong, proven management. 

Description of a PIDS Offering:
Let us look at an example of how a company might structure a PIDS. 
Company XYZ is a 100-unit franchisee of King Cleaners (“KingClee”).   The opening balance sheet for KingClee is:

The income statement for KingClee is:

KingClee issues $50,000,000 of PIDS units in a private offering ($10,000,000 of common equity and $40,000,000 of subordinate debt).  The debt carries an interest factor of 10% and matures in ten years.  The company uses the $50,000,000 to pay down debt of $20,000,000, and buy out some existing shareholders of $30,000,000 for a total of $50,000,000. 

The balance sheet after the issuance of the PIDS is:

Key factors for a successful PIDS offering:

• The debt interest payments are a legal obligation of the vote; and need to be paid according to the terms, presumably quarterly.
• The cash flow payments to the equity component of the PIDS have to be a priority.  The issuing company must adopt a policy of distributing out most available cash flow after payment of the subordinate debt interest, reasonable reserve and moderate capital expenditures. 
• The issuing company must be able to deduct for tax purposes the interest on the subordinate notes portion of the PIDS (using the KingClee example, take a tax deduction of $4,000,000 of interest expense on the subordinate notes (10% x $40,000,000).  
• The subordinate notes should come due in eight to ten years and require the issuing company to pay off the notes at their face value. 
• The equity portion of all PIDS offered for sale would probably have a common ownership interest of about 20% with voting rights. 
• The equity portion of the PIDS could provide the company a right to call the equity portion of the PIDS (the right to buy it back) after the debt portion of the PIDS has been paid off (presumably eight years).  This call right would provide for a premium in the neighborhood of 40% over the original issue price. 

As you can see, this type of investment provides a wonderful opportunity to get cash into the company.  In most cases it will not inhibit the company from doing other moderate borrowings.  PIDS keeps control of the company in the hands of the original owners and takes advantage of the present desire of many investors to have predictable cash flow.  PIDS is a significant investment option to the restaurant industry.  For those companies who meet its requirements, a PIDS is something that should be considered.