In this podcast, Davis Vaitkunas, Director at Bond Capital, talks about:
- Instances when mezzanine financing is used;
- Cost of different sources of capital;
- Advice on how to structure business acquisitions; and
- Common elements of business owners that are successful in growing through acquisition.
About the Guest
Davis Vaitkunas is a director at Bond Capital and has completed more than 130 financial transactions with growth entrepreneurs in Western Canada and the Western USA. Each of these transactions has centered on banking, investment banking, mezzanine debt and private equity.
Bond Capital provides direct investments ranging from $2 million to $20 million structured as debt and/or equity. Bond Capital will participate when a gap exists between the entrepreneur and the Bank.
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Noah Rosenfarb: Hello and welcome! It’s Noah Rosenfarb, the author of Exit Healthy, Wealthy and Wise, and a partner of Freedom Business Advisors where we help business owners protect and transfer their business in conjunction with their financial and stay plan.
Today, we’ve got Davis Vaitkunas from Bond Capital. He has done over 130 transactions and got a lot of experience in investment banking, mezzanine debt, and private equity. But our focus for today is really on capital structure and I wanted Davis to share with us some stories around different ways that owners have utilized capital structure to enhance the growth of their business and eventually their exits.
So, Davis, thanks so much for coming on the show.
Davis Vaitkunas: Thank you for having me, Noah.
Noah Rosenfarb: As I was alluding to prior to the call, you and I were talking about how owners in this lower middle market often are confused about what available sources of capital exist. They know they could go borrow from a bank and they know they could sell their company or equity in their company, but obviously there are some other alternatives and maybe you could share with the audience what they are and how people could access them. Let’s tell some stories about ownership forthwith and how it has helped them grow their business.
Davis Vaitkunas: Really it breaks into five specific pieces. At the very top of the stack, there is something we call senior debt or asset back or stretch lending. Second to that, typically something called senior subordinated debt. Next down would be convertible subordinated debt. Next down would be redeemable preferred stock and last would be your equity. The middle three pieces, the senior subordinated, convertible subordinated and redeemable preferred are just other ways that you can bring in people on a temporary basis to help you make a step change which is typically because you want to buy out an existing shareholder or you want to buy another company or you want to make a substantial investment in your existing assets of your business.
Those pieces, they often when the risk is somewhat behind you, you’re not looking to sell equity. The bank always has its limit. It might be somewhere between two and three times capital. Unfortunately, if you’re a smaller business, often that number is towards two not three. An example, if you’re trying to buy a business, and if the owner wants between five and six times for his business, how are you going to finance that missing two, three, or four in terms of cash flow. This, I guess, is the lose spot on that.
Noah Rosenfarb: Suggest to me, maybe tell a story about an owner that has approached Bond Capital. What were the circumstances and how did you evaluate their current capital structure and propose some suggestions to help out?
Davis Vaitkunas: A good example is small buying big. We had an owner, father and son team, who were running a small business that was quite successful, and they wanted to expand from distribution into manufacturing and they had come to understand that the manufacturer of their product was actually looking to retire and get out of the business. Their business was quite small and so they certainly took that equity value as part of a transaction. They borrowed some senior debt that we arranged for them and then there was a piece that was missing.
Obviously, you can’t buy something if you don’t have 100 cents on the dollar. So between the value of their business and the bank’s debt, they had about 70% of what they needed and we basically did a further 20% from Bond Capital mezzanine ebt – that was a private debt structure. Then, we found a creative equipment lender that was willing to give them 10% of the financing just because he believed in the asset value of the manufacturing plant. There was equity in that that he was able to leverage.
That’s when obviously those guys on the one hand, they used our advice. On the other hand, they also used their money to make that transaction complete.
Noah Rosenfarb: If you can, you don’t have to use specific numbers, you could use ranges, what were the cost of the various sources of capital?
Davis Vaitkunas: That senior debt, I think you’re doing a bad job if you’re not getting it under 5% today. There is this next range which is I call it alternative debt. That will be guys that are leasing maybe a lease or an ABL. That product comes in between sort of 5% and 9%. Then, there is what I would call subordinated debt and that is typically because your asset is secured. You’re looking at sort of 9% to 12%, but in each of these cases, leverage let’s just assume turns by one. So two times cash flow is your senior debt piece at sub five. From two to three, you’re just getting other creative equipment lenders to take it a three times leverage and then above three times leverage, you’re looking for someone that is willing to look deeper into the balance sheet and perhaps they see other goodwill that they would consider as security or they just believed in the character of the business owner. That might take you to four times leverage. Then my advice would be for above four times leverage, you probably want to have an equity partner or have the equity yourself to fund out that further amount.
Noah Rosenfarb: And between three and four, I’m seeing rates that are 10 to 20.
Davis Vaitkunas: It just depends obviously because it’s a very inefficient market and the one thing about having an advisor on your side is that they’ve done it before and they can help you negotiate what these parties. That’s why we did an example about small business transaction. We helped those guys enjoy a weighted average cost of debt of 7%. If that’s your cost of debt, it made it very attractive to proceed with the transaction of buying the business. That deal was pretty highly levered. The piece that we were doing was between sort of three and four times leverage and the cost on that was about 17%.
Noah Rosenfarb: But even still as you mentioned, the total weighted average cost of capital was 7 which I think is great when you’ve got a group that basically has the ability to now go out and acquire and vertically integrate, and they would never be able to do that without help from someone like you.
Davis Vaitkunas: Exactly. The other thing that comes out of that, if you’ve got a number of different layers that you can slot in, it’s just like a big champagne fountain. You want to take as much in the higher cups as you possibly can because you’re going out typically at some point in your business group, you’re really advancing. You look to grow inorganically. Obviously, organic growth means you’re just getting more customers. Inorganic growth is you’re buying someone else’s customers by acquiring their company somehow or their customer list somehow.
Noah Rosenfarb: When you’re first introduced to owners, what would you say on average is their familiarity with these different sources of capital?
Davis Vaitkunas: Little or none. If you go back 30 years ago, it was very common. You could go to a bank and they had a fellow sitting in the corner office. He was called the bank branch manager and he was the fellow that gave you all these information and these tips. With the advent the of the internet and computers, that person now sits in New York sort of like the video review in the NFL and basically it’s made more difficult for smaller businesses or medium-sized businesses just to access advice. That’s why people like us exist. We’re filling that void.
Noah Rosenfarb: You had created a website called www.structuringfinance.com. Tell me about that.
Davis Vaitkunas: We sure did. We noticed that a lot of basic questions we were getting asked. It’s not that difficult to create a website. I just put all those frequently asked questions into the form of an education piece and try to, I think, encourage these businessmen that you can grow your business and you should grow your business, because ultimately if you’re not growing, you’re probably shrinking and it can get dangerous if you’re shrinking.
Noah Rosenfarb: Maybe you could tell me another story about people that have come to you looking for help and what their thought was originally and then how maybe through your advice you were able to structure something that was totally different than their initial approach to you and how it benefited them.
Davis Vaitkunas: I guess there are a couple of things. What Bond does is we go into a transaction knowing that it’s funded and the cost of that debt or debt and equity might be 18%, let’s say. The good news is you start that transaction knowing that you got all your money and then all that happens next is the deal starts to get negotiated and you might be able to do better through good negotiation with the other side or whatever it is you’re trying to accomplish, just getting a lower price or better terms. The other side of that coin is you start meeting other people such as you’re talking to the senior bank now and you’re looking at equipment to lenders and you’re using these specialty players to just reduce the amount of money that you might take, say, from a Bond Capital. That’s kind of I guess the best example.
We’ve done this in a number of cases. Essentially, it’s a bought deal. The guy is confident he can go out and he has got the allowance to make his purchase. Then we work with him to shrink the Bond piece to its smallest possible size by bringing in as much lower cost capital as we can possibly find.
Noah Rosenfarb: How does your industry for other people that do it at the same way, how do you get incentivize to basically take out your money that the owner has already committed at 18%?
Davis Vaitkunas: I don’t understand your question.
Noah Rosenfarb: If you closed the transaction, you’ve already advanced the capital to the owner and so they are essentially on the hook with you. What it’s in it for you to go out and get them a great deal on some senior debt or some alternative?
Davis Vaitkunas: Oh that’s easy. It’s statistical diversification. When we’re all in kindergarten, our mom said, ‘Don’t put all your eggs in one basket.’ Our strategy from our perspective is very, very simple. The more investments we have and the smaller they are, the greater the probability of ultimate success. It’s a bit of a contrarian view. We are very good at marketing. We attract lots of deal flow, and it has just allowed us to be favorable to these situations. The other thing too, as I used to work at a senior bank and I had really taken a focus at Bond Capital, we prefer to have customers and not prisoners. Just in that philosophy, it’s just a more harmonious end game. Notwithstanding we charge people between 13% and 18% for their money, we have a lot of really happy customers that have earned in excess of 500% return on equity.
That is ultimately the missing moment. Not a lot of people are good at calculating return on equity. And even all of these things that you do, like why would you even lever a business? Why would you even go and buy something with debt? Well, it’s because eventually you’re going to earn terminal value and that’s going to have an impact on your return on equity.
Noah Rosenfarb: I’m actually negotiating a deal now and try to explain that to the buyer. At the end of paying the trail of the payout to the seller, you own 100%.
Davis Vaitkunas: Even further to that, I’ll look at that issue from a slightly different perspective. If you only want to make 5% on your money, well then you don’t need a bank. If you want to make 10% on your money, well you don’t need Bond Capital. Most equity returns, and you can just sort of see this from looking at the stock market, are somewhere in 18% to kind of 28% range. The real wins, this is all the stuff that gets reported in the movies and the magazines, is when people do this substantial returns that are like I said 500% or something like that. It only happens because that person has decided that they want to make more than, let’s just say, 20%.
Once you decide that you want to make more than 20% on your money, that’s the starting point. You need to decide what you’re trying to make on your money. The rest of it is just reserve engineering, the how. Use leverage, change the types of things the way you interact with your customers and suppliers, try to reduce the amount of working capital that is in your business. Stop working at your business, like retire to become chairman and hire a president. All these things add value to your business and ultimately prepare you for an exit.
Noah Rosenfarb: I have had an instance where a father was selling his business to his son, and his daughter was going to receive essentially a portion of the payout as a way to equalize his estate planning. Unfortunately, the son went and bought a new building and business went bust with the economy. It was really terrible. I have seen in situations like that unfortunately in hindsight, but I have tried convincing owners that using other people’s money and not yours as a parent – again, it’s not all of your eggs in one basket at the time when you might need it most. Do you find owners coming to you in these succession situations and how do you get them comfortable taking outside money and burdening their children with the debt?
Davis Vaitkunas: I’ll give you an example. We had a business owner that we had invested with and he was the largest regional player and he was approached by another company that wanted to buy him, because they wanted to get into that region. Essentially, they made a pretty substantial offer. He said, ‘Well, look at this offer I got. It looks pretty good.’ So my response was, ‘Well, I don’t know. You got to recognize, if you sell your business, then you’re not going to work there anymore so the number you should really be asking yourself is how much money do I need to not care if the business disappears.’
It’s sort of an odd way to look at it, but in that guy’s case, he wanted to pay off his house mortgage. He wanted to make sure a couple of his grandchildren had endowment so they could go to a university. He kind of added up all these numbers and it added up to about $6 million. The way that he went into that transaction was to make sure that he got $6 million cash on close, and after that, he took some stock in that acquiring business that was on top of the cash pay. That allowed him to do two things. One is it fully funded his retirement and it de-risked his family’s estate. Secondly, he still had some upside opportunity in what he considered to be a good investment.
To your point, just because it looks like a good investment in 2007, after the recession of 2008 and 2009, some of those investments didn’t look so good. But if you had the $6 million still in your bank account, you hedged your bets and back to not putting all your eggs in one basket. It often works best if you just do partials. Also like on the mezzanine debt side is having a mix of equity and senior debt and mezzanine debt. This provides a person with insurance in case the weather changes which it does.
Noah Rosenfarb: One of the things in terms of our conversation is that I found people that speak the way you speak and have the types of transaction in terms of the structure that you adhere to tend to be dealing at different places in the marketplace. Tell me a little bit about how your sweet spot in that $2 to $20 million range. What do you see are the opportunities and what should owners be thinking about if they are in that neighborhood?
Davis Vaitkunas: It depends on who you’re trying to deal with. What is the transaction? Let’s assume you’re trying to buy another business, right. I think the reason why we’re in this space we’re in is because where I happen to live in Vancouver and Canada and we basically do business anywhere from Denver, North and West. So in Northwestern North America which is our trading area, it’s just simply put I don’t care to travel that much. As an investor, I want to be fairly close to where the investments are in case we have to go there and do some heavy-lifting, so that’s our strategy.
Then when I look at just the backdrop of the businesses that exists in this area, in the Pacific Northwest, there are lots of computer businesses. They seem to be more equity investment because they are early stage. A lot of those guys are, so I’m not playing in that space. There are lots of big lumbar companies, big mining companies, and big oil and gas companies. Those guys aren’t really using our product because they are in the public market on the New York stock exchange with their billion dollar plus corporations.
We found ourselves just focusing on these businesses between $5 million and sort of $250 million in revenues, noticing that at that stage you don’t really have a treasury department and you’re often looking for someone to help you both access the lowest cost of capital, as well as access the right mix of debt and equity and then going back to that LBO example. If you’re buying well, you make all your money when you buy. That’s why you want to buy a business at three times cash flow and not seven times cash flow.
Another reason why we enjoy the smaller business space and sort of this $2 million to $30 million mezzanine piece that we do which can typically multiple our dollar like five, so if I’m in for two is probably a $10 million capital structure, $6 million of that is coming from the bank, $2 million is coming from bond, $2 million is coming from the owner. Now, he’s got a visa card for $10 million to go buy something. If he is buying obviously $5 million in cash flow at 2x or if he is buying $1 million cash flow at 10x, we want to back the guy that’s buying well.
We found that that smaller business space, if you decide to go buy another company, it’s just really inefficient. There are lots of opportunities to buy companies because people sell for reasons other than price.
Noah Rosenfarb: You tend to consult with the owners on how to structure the acquisition that you’re doing if they’re working with a separate team to do this.
Davis Vaitkunas: Yeah, absolutely. We will structure transactions. We will arrange financing and we will fund. We will do all three pieces or we’ll just do the one piece where the guy phones up. He’s working with someone like yourself and they know they need $2 million or $7 million in mezzanine debt and they just want us to quote on that tranche and we would do that. Some people they come to us earlier in the game and they want some assistance in structuring a letter of intent or even just strategy around, ‘Take a look at my balance sheet, Davis. Tell me how much you think I can afford if I had the right mix of debt and equity and where would I source it?’
Then, there’s this other side that too. Sometimes, you want to buy something. This is back to that transaction with that businessman that sold his company. One thing we knew about the company coming in was they needed him. They wanted him more than he wanted them, and he was able to sell his business at 9x earnings. Obviously, we’re a seller at 9x but we’re hopefully a buyer at 3. We work with people to buy well and then to have it properly funded so that you can meet your obligations going forward. We call that a cash flow to debt service. Our philosophy is 1.5 to 1. So at 1:1, you’re just servicing your needs. At 1.5 to 1, you got 50 cents leftover on every dollar to invest in your business in sustainable capex and other things that happen.
Noah Rosenfarb: If there’s an owner that’s listening that has been thinking, ‘Yeah, maybe I should go out and do my own little consolidation.’ What do you think are the makings of the right platform business in terms of the owner, the business, the capital structure? What advice would you have to those owners?
Davis Vaitkunas: I think it’s really about knowing where the money is going to come from to buy it and knowing who the targets are that you want to buy. Let’s just advance to the point where you had done a hundreds of these for some reason. By the time you get to 100, it’s pretty simple. You’re offering a guy 4.1x earnings. You’re saying, ‘You can keep your real estate. You can keep your working capital.’ Then you know that the way you’re going to pay for that is you’re going to put up 10% of the purchase price and you’re going to arrange for Bond to do say 40 of it, and you’re going to get the bank to 50 of it. That’s just what happens after you’ve done 100 transactions.
Transaction one, I think really what you’re looking for is to sit down with some people that have a proven track record, that have done it before, and are able to transfer that track record of that success to your ambitions. That’s just smart. To partner up with some sort of a mentor that can help you buy well and be properly financed, it just adds to your potential to be successful.
Noah Rosenfarb: So you’ve done 130 deals. I’m sure there are some far and away winners and unfortunately some losers. Have you seen any common elements amongst the winners or amongst the losers?
Davis Vaitkunas: I think the common trend is the winner’s passion. You really just have to love what you do and to really have that passion ultimately. It sort of seems to work itself out. I think on the loser’s side it’s when you’re just not being realistic and you’re trying to squeak through. It’s like a sports team when they’re getting down to mathematical elimination and they’re saying there’s ten games left and you’re going to have to win seven of them in order to get into the playoffs. You don’t want to be that guy. You want to be the guy that has a high probability of success. You only have to win 1:10. I think you can always look into these business things. It’s just math. It’s all about math and probabilities and as I would say a hockey analogy is, ‘You want to shoot from in front of the net. You don’t want to shoot from behind the net. It’s just way easier to score from there.’
I think in business you always want to be positioning your company and these guys that were winners, they were very good at taking calculated risk. And the losers, well they weren’t calculating the risks.
Noah Rosenfarb: The owners that you’re working with that go to do an acquisition, are you finding that they’ve explained the process of the transaction to their manager and team ahead of schedule, they’re all on board? Or is that a function that you often find that you have to do the education for them to their management team as well.
Davis Vaitkunas: Well, that’s a delicate process, right? Obviously, when there’s a big shift going on in a business or big strategic change that’s coming or just change in general, some of the human capital gets very nervous about that. They start to look inward and wonder about their job security. So you need to be very careful. The most classic example is if you were to buy a business, you typically do not need two accountants, so one of them gets let go. I think you need to be very tactical about recognizing who your key core team is, the nucleus team, and who the guys are that are replaceable. It’s recognizing that with that core team, you should get them on board early and get them involved in the strategy, and I would assume or I would hope if what you’ve been doing over the past couple of years is having strategy sessions with that group anyway or the fact that you’re planning to actually follow through on a purchase or a shift change in the business strategy shouldn’t be unexpected to that group.
The larger broader group, I think my personal perspective on that is they should find out after the transactions happen, because not all transactions happen.
Noah Rosenfarb: That’s for sure. In terms of the transactions that you are involved with, how often would you say things fall apart after there has been an LOI?
Davis Vaitkunas: It depends on the economy. In 2004, 2005, 2006, and 2007, people couldn’t buy fast enough. In 2014, there’s a lot of deflationary perspective were people aren’t rushing into transactions. The buyer thinks he can get a better deal, and the seller thinks he can get a better deal. Today, at this exact moment, we actually exist in the time when it’s more difficult to get a transaction done and there’s just a lot of deal risk.
Well, there’s no growth in the market. Like this is the problem. You can see that in the GDP or even the employment rate that without growth you’re not really compelled to do anything. Typically, that’s why you’re buying a business from why you’re trying to buy a business is because you have great expectations for what is going to happen the day after you own it. Today unfortunately, any of those expectations are just kind of muted. Obviously, it still means if you’re buying at the right price, it’s always a good day to buy a business.
Noah Rosenfarb: So for the advisors to owners that are listening that don’t have a great sense of familiarity with capital structure, bring in someone with your type of expertise, what should they do? Aside from calling you directly if they are in the Southeastern United States or up in New York metro area, how do they find someone to help guide them through this process? What would you recommend they do?
Davis Vaitkunas: I think a starting point is because we encountered this problem in our travels, we authored a white paper about mezzanine finance. If you look up on Wikipedia, under the definition mezzanine finance on the Wikipedia site, our white paper is cited there. It’s taught at the NYU Stern School of Business as well as they use it at the USC Law School. Just as a primer on finance. I think that paper and the reason why it has been so well received is we spent a lot of time just dwelling on the middle, the missing middle. These transactions where the bank says, ‘Well, I’ll do this much.’ And the owner says, ‘Well, I can only do this much.’ ‘Gee it doesn’t add up to what I need. What do I do next?’ So I think that paper is just a good starting point. It will give you a really good understanding of that middle piece.
In that world where the bank is doing enough and let’s say they’re doing 50% and let’s say this owner is a person of means and they’re doing 50%, well your life is pretty simple. The only reason you would use a third party like ourselves is because you had an expected higher return on equity and you’re using our money to accomplish them. I think beyond that, just recognizing that the right mix with the right partners can allow you to get more done.
Noah Rosenfarb: We’ll link up to that white paper on the transcript for our podcast. For those of you that are listening, feel free to visit the www.divestopedia.com website and not only do we get the link to Davis’ information and information about Bond Capital, but you also have a link to download that white paper.
So what else would you like to share with our listeners before we wrap up for today?
Davis Vaitkunas: I think there’s lots of good advice out there. I think you should be very selective in choosing who you take your advice from. You should check references and you should look to partner with people that have been there and done before what you are about to go do. There are a very, very few things that haven’t been done by someone else already. It goes without saying, if you can build a dream team, your chances of success are so much higher.
Noah Rosenfarb: Great advice. So, Davis, I want to say thank you for joining us today and to all of our listeners, please don’t forget to read us on iTunes and leave your feedback on Divestopedia or email me at [email protected]. I hope you join us again soon.