We Have No Debt. I hear this from some business owners, early in our first meeting.
It seems “Debt” has a bad reputation. As a family-owned business, “no debt” may sound like a stronger company. But, things are quite different when you consider a growth opportunity, or a transaction for the business. The fact is, debt should not be feared – it is fundamental in financial engineering – because it greatly increases the rate of return on the equity investments. Here’s what you should know about debt.
Different Types of Capital– a business should layer different types of investment in the capital stack, some layers are debt and some are equity. Why? Because each type has a different level of risk vs. return. So, to be most efficient, the company can be structured with the cheapest capital first, then the more expensive capital is used later. Of course, the company can only handle so much debt, and that is easily analyzed in the cash flow models. Here are the basic layers:
- Senior debt, or “bank debt” is typically the cheapest, today around 5%. It is secured against assets and may involve a personal guarantee. It amortizes monthly, that is, you pay against the principal and interest monthly.
- Sub-debt, or Mezzanine debt, is more flexible, but more expensive, today around 10-12% interest. Some Mezz debt may include warrants on stock as a sweetener. This type of debt is subordinate to any senior debt and is generally not secured by assets. The good news is that it is not paid monthly, and often, the interest is just rolled into the note – that means there is little or no strain on the monthly cash flow. This type of debt behaves very much like an equity investment in that it is paid when the business has the cash, typically when the business is bigger, in a future sale. The Mezz investor’s return is capped at the interest rate, and may be less than the equity return. But, the Mezz investor will get paid before any equity gets paid.
- Preferred stock may be used and it behaves very much like Mezz debt. Typically there is an interest payment, which may be rolled into the stock, and it may have a feature to convert to common stock. Even though it has “stock” in its name, it behaves like debt.
- Equity – last in the capital stack is equity, which is cash invested by the buyer. Today, most buyers expect 15-20% return on their equity investment, which is down significantly from prior years, because of the competitive nature of the M&A market. As you would expect, the equity does not have any returns, unless the company has paid off the debt and can declare a dividend, or in the case of a sale of the business. Equity can have an unlimited return – if the company sells for greater value, the equity holders reap the benefits. However, the equity investment is not secured and could be entirely at risk.
As you can see from the list above, only the senior debt is a burden to the company’s monthly cash flow. The rest can be viewed as different forms of “partner-investors” in the business. They win, to different degrees, as the business does well. And they can lose, to different degrees, if the business does poorly. Industry reports show that the average level of debt for transactions during 2018, on companies of $20M to $50M in valuation, was 3.9 times EBITDA. Most valuations are 6-8 times EBITDA, so you can see that some form of debt generally accounts for more than half of the capital stack.
The return for the different layers of capital can be illustrated this way. Think about a company that is valued at $30M, and is capitalized in 3 equal parts, $10M each of senior debt at 5%, Mezz debt at 10% and the rest in equity. Five years in the future, the business has paid the senior debt and sells for $36M, a modest 20% increase in value.
But how is that 20% return divided between each layer, per year? It would be: Senior 5%, Mezz 10%, and Equity about 40%. Which would you prefer?
Seller’s Options – in a business transaction, the seller also can participate in the new capital stack. In many deals, if the seller is not quite sure what he’ll do with all the proceeds, then he may consider the option to partially finance the transaction with a seller note, very similar to being a provider of Mezz debt. This may provide better returns than other investment options he is considering, post transaction.
Perhaps more importantly, the seller may choose to “rollover” some equity into the new capital stack. The rollover investment is done at the leveraged cost of equity, meaning after the debt is applied. In this case, the new debt is your friend, because you buy equity in the company at a discounted rate. For example, if the value of the company is $50M, that is what you would receive. If the buyers use $30M leverage, in a combination of senior and Mezz debt, then the new equity value is $20M. Then, you may choose to buy back in 30% of the equity, which would cost $6M at the leveraged rate, so your net proceeds would be $44M. Without any debt in the transaction, then 30% would cost $15M, and your net proceeds would be $35M, a difference of $9M to you.
In summary – don’t fear the name “debt”. Not all debt instruments are the same, and most don’t affect the monthly cash flow. How do you avoid any risk? By understanding the different types of debt and using them wisely, especially with a conservative cash flow model. Any good investment banker can work through the details with you.