IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog has been provided by Wade Stringfield of SaviBank (www.savibank.com).
Debt vs. Equity, Why Business Buyers Should Care About Leverage
I’ve seen it countless times, buyers come to me looking to purchase a business with little to no cash to inject. They are completely oblivious to the world of pain they are asking me to usher them into. Now, generally speaking, I’m in the business of lending money so I should be joyful at the prospect of boosting loan volume whenever possible, but not in this case. Here’s why…
The Small Business Administration has already established an extremely aggressive baseline that requires a 10% equity injection to comply with their loan guaranty program. Furthermore, half of that required 10% can be contributed by the seller in the form of a note to the buyer with payments on full standby for the life of the SBA loan, which means that a buyer could technically qualify for purchasing a business with as little as 5% down. Great news right? Well…maybe.
Let’s look at the 3 major components of a balance sheet: Assets, Liabilities (Debt) & Equity. As I previously mentioned, in an eligible SBA acquisition scenario, a buyer could borrow up to 95% of the cost to acquire the subject asset. For example, if the cost to acquire a business was $1.00, the closing balance sheet would look like this: Asset = $1.00, Debt = ($0.95), Equity ($0.05).
That’s a leverage position (Debt/Equity = 95/5) of 19:1. Yikes!
To provide some perspective, conventional lenders typically look to lend to companies with leverge ratios of no more than 3:1…maybe 4:1 if you are a good borrower. So what do conventional lenders understand about leverage? They know that leverage can be good or useful if it is used strategically, but they also understand that leverage can lead to financial ruin if not well managed. In a publically traded company, at an ideal level of financial leverage, a company’s return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.[1]
In a closely held company an ideal level of financial leverage would increase the potential return of an investment. Along those lines, “good” leverage increases productivity, while “bad” leverage merely sustains productivity for the current level of consumption.
Now at this point, two things immediately come to my mind:
#1 what does the future of the subject business look like? Is there compelling growth in revenue trends, or at least the opportunity for such? Are there opportunities to increase operating efficiency and drive more money to the bottom line? Where is the subject business in terms of lifecycle? What about the industry? Hold that thought…
#2 many buyers are interested in owning a business because they get to be their own boss, the de facto American Dream. And, if a buyer intends to use an SBA loan to facilitate the purchase, they are allowed to stretch the cost of the acquisition over a 10 year loan term.
With a leverage ratio of 19:1 it’s hard to argue that you are your own boss. In fact, the very definition of Owner’s Equity is a residual claim on assets. Residual meaning what’s left over…whereas your debtholder(s) have the first claim on assets in the event of a default. So unless your business can pump out significant cash flow (hence all the questions presented in #1) to expediently pay down the debt incurred to acquire the company, be ready to strap in for 10 years of the hardest work of your life with potentially less to show for it than you expect.
For example, a buyer approached me to discuss the purchase of a professional services business. The business was well established and had a history of profitable operation. It was in a mature industry and growth trends were positive, but scant at less than 3% per year. Although the sales price was pegged on the high side of the range, by all accounts it was reasonable based on accepted industry rationale. The buyer had the requisite skills, abilities, and experience. In fact, he owned a smaller business in the same industry. He was interested in augmenting his annual compensation and thought the easiest way to accomplish that would be to “trade up” as opposed to growing his own business organically.
Initially the buyer requested to borrow 90% of the cost to acquire the subject business. When cash flow model was completed, I had to explain that the business could indeed generate sufficient cash flow to adequately cover the proposed debt, but that would leave him with a very modest annual salary – literally a fraction of what the seller had historically disbursed for compensation. Even when we factored in the annual growth rate, the prospects of enhanced owner compensation did not improve.
At first, the buyer struggled with the juxtaposition of the owner compensation figure enjoyed by the seller vs. the modest picture that I painted for him, but when I explained that most of the free cash flow generated would be used to service the proposed debt it became clear. He eventually agreed that in this case, injecting more money and borrowing less money may actually help him achieve the goals he set out to accomplish with the acquisition.
The SBA 7(a) program provides a tremendous amount of flexibility for borrowers looking to purchase an existing business requiring as little as 5% down in some circumstances. However, it is important for buyers to think through the impacts of their proposed financial leverage before finalizing a decision on equity contribution.
Wade Stringfield is the Vice President and SBA/USDA Business Development Officer at SaviBank with 15 years of experience helping small businesses meet their financing needs with specialization in SBA backed acquisition finance lending. If you have questions about the content of this article or would like to obtain information related to SBA or USDA government backed loans, Mr. Stringfield would welcome communication at (360) 820-0955 or wstringfield@savibank.com.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.
[1] “Thinking About Financial Leverage,” Lumen Boundless Finance, https://courses.lumenlearning.com/boundless-finance/chapter/thinking-about-financial-leverage/