Whether you are considering the purchase of a company in whole or in part, or are part of a management buyout, it is likely that you will be looking for financial support from lenders to finalize the transaction.
Both traditional and non-traditional lenders have loan facilities that can help with the purchase after your equity contribution. The most common financing solution utilized to affect the purchase is a term loan. Traditional lenders may provide a term loan, usually amortized over 5 to 7 years, for the balance of the purchase price. Since they are relying primarily on cash flow to pay back the loan, there will be heavy reliance placed on historical financial results to calculate and support the required Debt Service levels. Security over the assets and various financial covenants, often including personal guarantees, will be required.
In contrast, a non-traditional lender is generally not as “covenant heavy” but will also look to ensure that the underlying assets can provide security. The non-traditional lender will likely be willing to provide an interest-only loan (albeit at higher interest rates) if the purchase is perceived to be too risky for a traditional lender (for example, the earnings have not been consistently positive or growing).
Additional forms of financing that can be used include subordinated debt financing and, in certain circumstances, the purchaser may be able to leverage the working capital assets of accounts receivable and inventory.
There are a few key considerations for all lenders as the debt structure is created:
Purchaser Equity – All lenders want to see that the purchaser has “some skin in the game”. This means that the purchaser should be prepared to put at least 20% of the purchase price into the deal. These funds should be coming into the transaction in the form of pure equity or a fully subordinated shareholder loan that is not expected to be repaid in the short term.
Debt Service – Since the loan(s) are going to be paid back using the company’s cash flows, its ability to service the debt is critical. Traditional lenders will want to see that the company has annual operating earnings of at least 1.2 times the cash needed to pay all interest and principal payments that result from all company debt.
Valuation – Lenders will perform their own assessment of the value of the business, which will be used in their determination of size of loan with which they are comfortable. If the lender’s valuation is less than the purchase price and the security does not support the required financing, they may look to the purchaser to increase the equity injection or they may look to the Vendor to share in the risk of the change of ownership i.e., a Vendor Take Back loan (as discussed in the next point).
Vendor Take Back (VTB) Loan – A VTB must be subordinated to the lender and generally will need to be invested for longer than a year; although, depending on the company’s cash flows, repayments may be allowed after the first year.
The purchase of a business usually comes with a full or partial change of management (the current owner is exiting immediately or over time). Lenders are very cognizant of the inherent risk that this change implies and therefore look to ensure that the financing structure spreads the risk between all parties involved (the purchaser, the lenders, and sometimes the vendor) using equity and various loans.
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Barbara Cowper is a Senior Consultant with the Business Financing group at Farber. Her practice focuses on arranging innovative financing solutions for small and medium-sized enterprises (SMEs) and early stage companies. Barbara can be reached at 416.496.3760 and firstname.lastname@example.org.