Many Entrepreneurs, Owners and Buyers of Technology and Internet companies have a lack of experience associated with finding funding, lending and financing for a mid-market business. It can be a highly daunting task in the hands of those that lack the experience, knowledge and network to get deals financed. Even if you are able to find a buying entity willing to acquire your company, getting the deal financed can be a difficult process.
For ValleyBiggs, Financing is something we excel at. Our proven, proprietary process of working deal packages through underwriters, venture teams and equity groups allows us to have success where others fail. And many businesses do fail to get to the finish line simply due to a lack of financing, so that failure should be mitigated at all costs by setting the groundwork at the beginning of a transaction by properly packaging the deal and working directly with 3rd party valuation teams and underwriters in order to ensure the entire process is smooth and unencumbered.
Here are a few important notes regarding Financing a Middle Market Transaction:
Size of Business
Size does matter. Businesses in the lower middle market, especially those with enterprise values below $20 Million, are sometimes considered less enticing for private equity groups (too small) and too large for individual buyers. For deals in the lower tier of the Mid-Market, generally, a competitor, high net worth individual or investor group is the most likely potential buyer. For these buyers, capital is not endless and they want to stretch their own equity investment as much as they can. They will generally use a mix of vehicles to purchase, including a large down payment, some debt (including a mix of various conventional loan opportunities), some owner financing and potentially some earn outs. Every deal is different, especially in the Technology and Internet Sectors, but at ValleyBiggs, we can provide a buyout structure that provides all parties comfort and remain well within reasonable valuation guidelines.
In the Technology & Internet Sectors, debt financing is just as real a possibility as small business lending. And banks only represent roughly 10% of the market share of Mid-Market finance deals. The other players in this space are Financing Companies, CLOs, Hedge Funds, Insurance Companies, Mutual Funds, Pension Funds and Crossover & Managed Accounts. And because of all the competition in the mid-market for debt, the result is a bevy of opportunity at some of the best rates in years.
Debt is provided generally on two principals. First, the amount of tangible assets that can be pledged as security on the loan. This debt will be senior debt. And second, the level of free cash flow available to service any amount of outstanding debt. This type of debt will be mezzanine, or subordinated (sub), debt. With respect to banks, they usually have specific covenant ratios that must be achieved. 2.5:1 and a debt servicing coverage of 1.25:1 are common. So, the first thing ValleyBiggs works on with its clients is a forecast model that takes into account assets, cash flow and a forecast of profitability. From there, it becomes a simple matter of math as to how much of a particular transaction can be underwritten via bank financing. And of course, the more bank financing a deal can achieve, the better the prospect of maximizing shareholder value at closing.
Even at the mid-market level, banks usually require selling shareholders to hold some level of paper on a transaction. By having ownership underwrite a portion of a deal, and keeping some skin in the game, they are much more likely to ensure that the deal closes smoothly and that all necessary parties are properly trained. Generally, banks like to see around 15% of a deal underwritten by the selling ownership. While every deal is different, and in some instances a bank may already have a relationship with a buying entity, 15% is a good rule of thumb.
Most Buyers prefer to use as little of their own funds as possible when buying a business in order to increase their return on equity. Sophisticated buyers are looking to generate equity returns of 25 to 35 percent on average. Very few buyers are interested in using all of their cash reserves to finance a deal.
Private equity groups tend to be some of the biggest players in the middle market. Capital markets provide a large opportunity pool of finance options for these groups, and they use these options wisely. Debt is usually collateralized by the assets or earnings of a particular company. Debt can come in the form of Senior Debt (revolving lines of credit and term debt).
LOCs are secured by the receivables and inventory of a business and based on a predetermined formula to calculate the available amount of capital that can be drawn from the line. A line of credit post-transaction is really intended to support day-to-day cash needs of a business, so if a buyer chooses to draw 100% of the available line of credit to help fund the transaction, the business could be constrained on day one. For this reason, most P/E and other investors tend to spend quite a bit of time getting an understanding of the working capital needs of a target business to ensure there is capacity under the line of credit to support the company and growth. Another main element of senior debt is term debt, which is generally secured by the fixed assets and cash flows of the company. The portion of term debt supported by the fixed assets usually has a much longer amortization period than the piece supported by cash flow (also known as a stretch piece).
Sellers of Mid-Market Tech Companies need to understand that asset light businesses may prove to be challenging acquisitions for buyers relying on significant leverage to complete a deal. Today’s asset lending environment remains competitive, while lending on cash flow is only beginning to loosen, which does tend to have an effect on valuations. Debt-to-EBITDA ratios can generally range from 3x – 6x depending on the company’s cash flow profile, asset coverage and ability to service debt. A large stretch piece of term debt may make it difficult for the business to support large principal payments because of a short amortization period. Therefore, sellers with a stake in the business post-closing should try to understand the buyer’s capital structure to gain insight into whether the business can support the leverage placed on it.
Another acquisition financing vehicle at the mid-market level is subordinated debt. This is sometimes referred to as mezzanine, sub or junior debt. Subordinated debt, as the name implies, stands behind senior debt in the order of repayment priority (but still above equity), and has secondary liens on the business. In other words, in bankruptcy, generally senior debt will collect in front of subordinated debt, which of course has an impact on valuation. This form of debt is usually tied more to a multiple of EBITDA with some maximum amount of total debt on the business. Subordinated debt is usually more flexible than senior debt, making it more expensive. Typically, there are no principal payments over the life of the loan. Subordinated debt providers are interesting partners for acquisition entities because many offer co-investment features that provide some of the equity for a transaction. This is important for sellers to know because it could mean an equity holder is joining the transaction.
Another common form of debt financing buyers utilize is to have the seller underwrite a portion of the transaction, referred to as seller notes or seller financing. In these arrangements, part of the purchase price is structured as a loan (commonly unsecured) to the sellers, which usually carries an interest rate that falls between rates for senior and subordinated debt. These instruments are very flexible and can be structured in a variety of ways. For example, they may be contingent on specific performance by the business, may carry no amortization, or can be converted to equity. Seller notes are often useful tools for bridging valuation gaps between buyers and sellers, but of course will cause less cash to be available at the closing table.
Earn Outs are another highly utilized finance vehicle for companies whose valuations outpace available debt financing. An earn out is also a highly flexible form of debt structure and almost always have an element of performance criteria. Earn Outs are oftentimes used when a company has a high growth rate and the selling shareholders want to have an opportunity to share in that growth should it continue. Earn Outs are always a touch point of negotiations and also help bridge gaps between valuation and purchase price.
As the M&A lending environment for mid-market companies expands, capital markets have developed a number of different financing vehicles to address a multitude of acquisition capital needs. One example is unitranche debt, which is a hybrid of senior and subordinated debt. Because there is one set of loan agreements, unitranche debt is often used to speed up the financing process and reduce the amount of documentation necessary. It may also be useful for transactions with businesses that have limited asset collateral, but strong cash flow by offering a lower cost of capital than pure subordinated debt. However, unitranche debt can be trickier to navigate if businesses need to restructure terms or seek more flexibility in their debt after closing. Bridge loans, although expensive, are also typically used in circumstances where buyers need very short-term financing to complete a deal.
With the wide variety of financing options available to buyers, sellers who are staying with their businesses post-sale should understand the implications of the type of debt utilized by the buyer on their financial position. To get a better understanding of the financing available on a particular middle market transaction, please contact us.