KEY ARTICLE TAKEAWAYS
Understand the relationship between increased debt financing and slower growth
Learn how to analyze the impact of debt financing on your company
Identify the right questions to ask your private equity buyer
Private equity buyers – how do they work?
Private equity firms raise capital from insurance companies, endowments, high net worth investors and other institutions to invest in companies they will ultimately later sell (a typical hold period for a private equity firm today is around five years – although hold times can be as short as two years or as long as ten years or longer).
Want to get a sense for what it takes to sell your company? Start with this exit checklist.
In addition, private equity firms often ask owners of the companies they buy to “roll over” or reinvest part of their equity into the new company going forward.
Why does the amount of debt financing matter?
If a private equity firm is the highest bidder for your business, you should ask some follow up questions to make sure you know how the private equity firm is going to finance the deal. If the private equity firm is going to use a large amount of debt, this will have an impact on both the risk of your rollover equity and the ability of the company to finance future growth (whether organic growth or acquisition growth).
Let’s take the example of a company that currently generates $50 million in sales and earns $5 million in EBITDA. If today the company has no debt, then the company will be able to use much of its EBITDA (after paying distributions to its shareholders to pay taxes) to finance future growth.
Let’s assume that the shareholders require $1.5 million in distributions to pay taxes, that will leave $3.5 million to reinvest in the business. This reinvestment could be in the form of new sales and marketing initiatives that might not have immediate payoffs, new product development, acquisitions, expansion into new territories, or new capital investment.
Now let’s assume that the private equity firm is the highest bidder, paying 10 times EBITDA ($50 million) for the business. The firm plans to use half equity ($25 million) and half debt ($25 million) to purchase the company (with the expectation that the current owners will reinvest $10 million, or 40% of the $25 million equity component).
If the company has $5 million in EBITDA, it must first pay $1.75 million in interest costs, leaving $3.25 million. Although too complex for purposes of this post, most private equity transactions will be structured to have more favorable tax treatment, so for our purposes let’s assume the effective tax rate is just 15% for the shareholders, or around $500 thousand for taxes.
After distributions for taxes, the company will have $2.75 million, of which the company will need to use $1.5 million to repay loan principal, leaving just $1.25 million for growth investments (compared to $3.5 million the company could use prior to the recapitalization). This will impact the rate at which the company will be able to grow using its own cash flow.
Conversely, when a private equity firm uses debt financing and you roll over part of your existing equity, your equity returns can be very attractive. We have had several clients make more money on the second sale of the company than they made on the first sale, but it does come with some operating and financial risk.
What questions should you ask?
If you are selling your business to a private equity firm, ask the following questions and then have your CFO or investment bank run several different scenarios to show you how things could turn out.
Questions you should ask your private equity buyer:
- How much debt financing do you anticipate using to finance your purchase?
- How much rollover investment do you expect from the existing shareholders?
- What is the expected interest rate on the financing you expect to utilize?
- What is the expected principal amortization schedule and term for the loan?
- What is your plan if the company cannot service its debt?
- What revenue growth rate are you assuming the company will achieve?
- What additional costs do you expect the company to have (management fees, board fees, etc.) that it does not have today?
Getting clarification on these questions and running different scenarios will enable you to have your eyes wide open as to how the business will be operated going forward and ensure there is no miscommunication between you and your new partner.
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As an Associate at Class VI, John is responsible for deal execution and board advisory services for clients in several industries including business services, food and beverage, distribution, consumer products, and energy. John also assists in Class VI’s marketing efforts through content development.