I have found that many owners of lower mid-market businesses lack adequate knowledge on how a business sale is actually financed by a potential third-party acquirer. This is understandable given that most business owners will only go through the process of selling a business once. Unfortunately, this lack of knowledge is a contributing reason many deals are not consummated. Sellers are not the only ones to blame, though. Many buyers, and even their advisors, don’t realize what it takes to finance the purchase of a business in the lower middle market. Buyers make unrealistic offers and when they approach a financing institution, the deal is rejected. Here we’ll take a look at the specifics of financing in middle market business acquisitions.
Lower Mid-Market Deals 101
The lower middle market accounts for more than an estimated 90 percent of the total number of all middle market companies in most global economies, so the lack of knowledge on deal structures is a significant succession planning issue.
Businesses in the lower mid-market, especially those with enterprise values between $5 and $25 million, are often stuck in no man’s land. They are too small to be an impactful acquisition target for sizable strategic buyers or private equity groups, but too large for an individual buyer to finance. Typically, a competitor of relative size, high-net-worth individuals or investor groups are the most likely potential buyers. For these buyers, capital is not endless and they want to stretch their own equity investment as much as they can.
When assisting clients in the acquisition of a business, the starting point is to assess an appropriate valuation, while at the same time determining a financing structure that is believed to be achievable. All financing structures will consider some level of the following:
The appropriate amount of each source of capital is based on the specific circumstances of the deal.
Bank Financing
The level of bank financing that can be obtained on the purchase/sale of a business is based on two things:
- The amount of tangible assets that can be pledged as security on the loan. This debt will be senior debt.
- 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.
Let’s take, for example, the purchase of a business with a negotiated purchase price of $10 million. If this company has $8 million in assets, an acquirer will be able to obtain more bank financing than if the business had $5 million in assets. Similarly, if this business has $4 million in EBITDA, the purchaser will be able to get more financing than if there was only $2 million in EBITDA. This is a pretty obvious and straightforward concept.
At a very high level, banks will require the acquired company to maintain a number of specified covenant ratios. Covenants that I have commonly encountered are debt to equity of 2.5:1 and a debt servicing coverage of 1.25:1. A financial model that forecasts profitability, asset levels and free cash flows will assist in determining the right level of bank financing that can be obtained. The allowable level of bank financing in a deal is a very mathematical calculation, but it is based on very subjective future projections. Having clear and defensible assumptions within these projections will go a long way toward obtaining the necessary level of financing from a bank.
Vendor Financing
The right level of vendor financing is not as easy to quantify as bank financing. From my experience, vendor financing on lower middle market deals range from 0% to 30% of the purchase price. This level moves up or down depending on a number transactional risk factors including, but not limited to:
The appropriateness of the amount is based on qualitative characteristics and, of course, is negotiated between the vendor and purchaser. Banking institutions also like to see a certain level of vendor financing in a deal because it ties the selling owner to the business and ensures (to some extent) that they are committed to a successful transition.
Vendor financing is one of the most contentious issues in closing the sale of a lower mid-market business. Vendors raise concern over the security (or lack thereof) available for a seller’s note because bank financing will always take priority. The banks will also most likely ask for assignment and postponement, which will place restrictions on the repayment of the seller’s note if the company is in breach of its covenants.
No doubt there is risk for the seller around vendor financing, but buyers require a certain amount to compensate for the transitional risk items noted above. If a vendor is adamant about reducing the level of the vendor financing, they will need to provide evidence on how the transitional risks can be mitigated.
Equity
The appropriate equity level is the easiest amount to figure out because it is just the remaining required capital to close the deal. Unfortunately, you must first nail down both the bank and vendor financing, which is sometimes difficult to do.
A bank will always require the purchaser to have some skin in the game. Much like vendor financing, banks want to ensure that the buyer is committed to making the deal work. From my experience, the lowest level of equity from a third party purchaser that a bank will allow is 15%. This might be lower in the case of a management buyout where the bank is already comfortable with the expertise and commitment levels of the existing management team.
Buyers will usually stretch to use the least amount of their capital in order to increase their return on equity. Sophisticated buyers are looking to generate equity returns of 25% to 35%. No buyer (at least in my experience) will use all of their own cash to finance a deal.
Understand Financing Structure to Get Your Deal Done
Most business owners don’t understand how a business for sale is financed by a third-party acquirer. Unfortunately, this lack of knowledge can be the fundamental misunderstanding that causes such deals to fall through. If your mid-market business is on the auction block, take some time to learn about how potential purchasers will pay for it. It can make all the difference in getting the deal you want.