Business Buyers Will Always Check For This… It Could Be Costly
Blog Series 3 of 6
Author: Mark Mroczkowski
Valuing and financing a company is more complex than using a discounted cash flow model or market comparable EBITDA multiples. Debt compliance plays a significant role in valuing a company. Fixed-charge coverage ratios, leverage ratios, weekly or monthly borrowing base calculations, and capital expenditure caps all play a part in determining how much debt can be borrowed and how much equity is needed to close a transaction.
As a buyer, modeling a transaction’s capital structure goes beyond calculating the projected IRR of an investment. Instead, a buyer needs to understand the monthly working capital requirements of a business, its after-tax cash generation capabilities, and its liquidity. Businesses that are seasonal, cyclical, and have high working capital requirements, tend to be valued less because excess free cash flow is less, if not zero. A buyer must know if available revolving credit lines can support growth, seasonality, or illiquidity. Buyers must also know if a business can make its interest, principal, and capital expenditure payments in an expanding or contracting market.
Buyers typically use a combination of revolving/asset-based debt, senior debt, and subordinated debt to fund transactions. Each type of debt has specific terms, costs, and covenants that must be met to avoid a credit default or a liquidity crisis.
Revolving or asset-based credit financing uses a company’s accounts receivable and inventory as collateral for the loan amount. It establishes a borrowing limit based on the assets’ quality, age, location, salability, and liquidation value. These items affect a company’s borrowing capacity because “advance rates” on “eligible” accounts receivable and inventory determine how much a company can borrow. For example, the company may have a revolving/asset-based credit facility of $10 million. Based on the accounts receivable characteristics and inventory characteristics, the company may only be allowed to borrow half of that amount or less. Revolving/asset-based credit is not permanent capital and is subject to limitations and quality restrictions. Having a credit line does not mean you have unrestricted access to it, nor can you use it to finance an acquisition.
Both senior debt and subordinated debt are considered long-term debt supported by all the company’s assets, whether tangible or intangible, as well as a pledge of the company’s stock. Typically, senior debt lenders provide the revolving/asset-based credit and have a first lien on all the company’s assets. In contrast, subordinated lenders are typically uncollateralized and considered to have a second lien on all the assets and stock. Commonly, the amounts loaned are more than what the lenders could recover in an orderly liquidation. The lenders monitor the business’s liquidity and cash flow generation capabilities with various financial ratios and restrictions, such as fixed charge coverage ratio being greater than 1.15, senior debt ratio not exceeding 2.50, total leverage ratio not exceeding 4.00, and many others. These ratios are based on the company’s negotiated adjusted and projected EBITDA for the business (please see April’s perspective Adjusting and Normalizing EBITDA for more details). For future years, the financial ratios become more stringent (increases or decreases based on the ratio), thereby holding a buyer accountable for the representations and projections that the business can generate the cash needed to meet all operational, tax, and debt obligations.
In summary, a buyer’s diligence of a company’s historical profits, quality of assets, and projected earnings provided by a seller affect the amount of debt a buyer can borrow, the amount of equity to be invested, and the potential equity return (IRR) on invested capital.