Business owners who seek to sell their company usually want to achieve two things: to maximise the value they get for their company and to close the transaction quickly.
Debt funding is often thought of as purely a consideration for a buyer, but understanding the debt capacity of a company or arranging a finance package prior to a business sale can help a seller maximise value from a transaction and to close the transaction quickly.
Understanding the debt capacity
A business’ debt capacity is simply the amount of debt a business can incur and repay without jeopardising its financial viability.
Many variables affect the debt capacity of a business, including: industry, sector, management team, historical trading, macro-economic conditions but the two most important are:
1) Cash flow: What cash flow does the business generate to allow it to service (pay) interest and amortisation costs on borrowed money? Usually lenders will want companies to generate cash flow that is at least 1.2 times the amount of cash needed to pay interest and amortisation costs.
2) Security: This will normally be in the form of assets: fixed assets (land, buildings, machinery etc.), invoices (the debtor book can be used as collateral for a receivables financing or invoice discounting facility), or other assets (stock etc.). Businesses with limited assets (often called asset light businesses) can still borrow money as long as they generate a healthy cash flow.
When a lender is assessing how much it is prepared to lend to a business they will consider both the cash flow and the security available. While it is possible to borrow money with little or no assets in the business as securtiy, a business must normally always generate cash flow to be able to take out debt financing.
Often debt capacity will be quoted or talked about as ‘leverage’ which is simply the ratio of debt to EBITDA (earnings before interest, tax, depreciation, and amortisation). For example a business with debt leverage of 2x has debt equal to twice its EBITDA.
Debt capacity when selling a business
If the debt capacity of a business is high, a potential buyer can borrow more cash against the business, and ultimately might be able to pay a higher price for it. If the seller understands the debt capacity, i.e. the level of debt that the borrower could raise, then they are in a much stronger position when sitting down at the negotiation table.
Further, in our view debt capacity should almost serve as a valuation floor. By this I mean the minimum amount that you would sell the business for, as if you are selling a business for less than the debt it could raise, you would want to have a very good reason for doing so.
Taking it one step further: Staple Financing
Taking this one step further, a seller of a business can obtain a pre-arranged financing package for the transaction, and offer it to potential bidders. This is called staple financing as in effect the finance package ‘staples’ to the business being sold.
A stapled financing package will have been approved by the institution providing it subject to 1) the institution get comfortable with the profile of the buyer and 2) the buyer being comfortable with the terms of the financing package.
Staple financing can be arranged in parallel with the marketing of the business, such that when a buyer is found the financing is arranged and the transaction can happen much faster. Additionally arranging staple financing reduces the risk that a deal falls over because the buyer could not obtain financing.
An area where staple finance is increasingly being used is where a specialist lender or a more innovate capital provider is required and the seller is concerned that they buyer might not know or have access to such a lender.
Closing the deal: Vendor Finance
Even with a staple financing package or a financial package arranged by the buyer, there still may be a gap between the buyer’s and seller’s views on valuation. In such a situation, increasingly vendor finance is used to bridge the valuation gap.
Vendor finance is a form of lending in which the seller defers part of the proceeds from the sale of a business and is either repaid over time (deferred vendor consideration) or repaid upon certain performance criteria being achieved (contingent vendor consideration). It is not uncommon to see both of deferred and contingent vendor consideration in a transaction.
From a seller’s perspective vendor finance is less attractive as you don’t get access to all the cash directly at completion of the transaction, and there is a risk that you will never be fully repaid if events do not play out as anticipated.
Despite these risks vendor finance is still used to enable a transaction to happen and to maximise the price achieved. Sellers should make sure that any vendor finance is appropriately and robustly structured to minimise risks.
Debt funding should be a key consideration when selling a business. Understanding the debt capacity (the amount of debt a business can incur and repay without jeopardising its financial viability) puts you in a strong position when negotiating with a potential buyer as you have a good view on the level of debt any buyer could raise against the business.
Additionally an increasingly popular option used to maximise both the probability of success and speed of a transaction is staple financing, where the seller pre arranges a financing package which ‘staples’ to the business being sold. This is particularly interesting where the most appropriate financing solution might come from a more innovative capital provider who the buyer might not know or have access to.
This article has introduced some of the benefits to sellers of considering debt financing when selling a business. If you would like to know more or would like to discuss a particular situation please contact CreditSquare