Financing your succession plan

It is well known that a wave of baby boomer business owners will exit their businesses over the next decade.

Nearly 40 per cent already have a well-planned exit strategy or a robust succession plan in place, but the remaining 60 per cent are still in the process of planning, contemplating or, worse, have no plan at all.

Because the succession planning process typically takes at least two to five years, many of the remaining 60 per cent will have no plan by the time they wish to retire. Unfortunately, by then it is often too late. The owners are left scrambling and the business value could be driven down as a result. In some instances, this creates strife and potential conflicts among family members or management.

Here, we will focus on one particular and common aspect of this problem: financing a succession plan for the next generation of owners, whether children of founders or management.

The financing aspects, if not properly planned or executed, can not only create disruptions during business transitions but may leave both parties involved in the transaction with less than desirable outcomes.

There are two common ways to transfer ownership—sale of assets and sale of shares.

Various considerations determine which type of transfer takes place.

These are usually tax considerations and potential liabilities. The most common method to transfer ownership of small-and-medium-sized businesses is sale of shares.

There are various options or ways to structure financing during transfer of ownership via sale of shares method:

Cash Equity

Cash equity may be available from personal assets like bank savings, liquidation of non-registered marketable securities or stocks, personal lines of credit, refinancing a home, etc.

Senior Secured Loan

Senior loans provide access to capital by leveraging a company in order to acquire the majority ownership of a target company.

These loans can be obtained by borrowing against the fixed assets of a business. For example, a buyer can take out a certain amount of equity from the owner-occupied property by refinancing it, or by taking a term loan against unencumbered equipment. In both cases, an appraisal may be required to determine the value of assets the bank can lend against.

Typically, this can range from 50-70 per cent, depending on the type of assets and your company’s risk profile.

This financing option depends on the buying company’s leverage and cash-flow situations. Let’s use the scenarios below to demonstrate the impact of a new term loan on the company’s leverage ratio and cash flow.

Leverage Ratio

As an example, the company currently has debt to tangible net worth of 1:1, meaning that for every $1 of debt, there is a corresponding $1 of equity. Let’s assume that a buyer will take over the existing debt of $1 million under the line of credit.

Let’s further assume that line of credit usage fluctuates monthly and the interest payment on the line of credit is $20,000 per year. All things being equal, a buyer will need to borrow $2 million in term loan to purchase the company, payable over a 7-year period. Therefore, debt increases to $3 million in Year 1.

When all is said and done, the debt to tangible net worth ratio increases from 1:1 to 3:1. Banks consider 2:1 a healthy leverage ratio but will tolerate higher thresholds depending on other risk factors affecting the company.

Cash Flow

For simplicity, let’s assume the company’s EBITDA was $500,000 last year. On a Term Loan of $2 million over 7 years, the buyer will pay the following in Year 1:

$286,000 per year in principal +$80,000 per year in interest, assuming 4 per cent +$20,000 per year in interest on line of credit =$386,000 per year in total principal + interest repayment

As with any debt, interest payments gradually decline as the loan principal decreases. In Year 1, EBITDA of $500,000 against principal and interest of $386,000 results in a debt service ratio of 1.30x. Typically, banks will be looking at a minimum debt service ratio of 1.25x.

VTB

Vendor Take Backs (VTBs) are provided by the seller in the form of a promissory note and are paid over a mutually agreed upon time period.

There are various motivations for the seller to use VTB including, (1) Trust in their management’s ability to run the business properly and thus ensure they are paid; (2) Facilitate the friendly sale of the business; (3) Tax implications VTB loans are subordinated to the bank. In the event of liquidation or bankruptcy, the bank is paid before the seller. VTB notes can also impact your financial ratios — they are taken into consideration in calculating all of your financial ratios including debt to tangible net worth, debt servicing and working capital.

Earn-Outs

Earn-out is a common approach that partially pays the seller out of the future earnings of the business.

It is a condition whereby a portion of the purchase price is deferred and payments are conditional upon achievement milestones, i.e. sales targets. If the company performs well, the seller is able to benefit from the upside. At the same time, the seller continues to carry future risks associated with the business.

Therefore, earn-outs protect the buyer from downside volatility or any other unintended consequences upon purchase. Regardless of the company’s performance, earn-outs align the interest of the buyer and the seller.

Subordinated Debt Financing (Sub Debt)

Sub Debt is a hybrid of debt and equity in that the Borrower has to be able to afford repayment and the sub debt provider can participate on the upside via stock options or royalties. The structure provides more flexibility than senior term loans because payments can be structured based on the availability of cash flow. For example, the borrower may pay interest only for a period of 12 months or longer, or until the company can afford to make principal repayments. It bridges temporary gaps in cash flow during the transition process.

The sub debts provider ranks in priority behind secured lenders in that, in the event of bankruptcy or non-performance, the traditional bank has priority over the assets of the company. There are numerous factors that the sub debt lender will consider in extending this type of financing, primary of which are the historical performance of the company and the anticipated future cash flows that it will generate.

Because sub debt lenders participate in both the upside and the downside, they may impose more restrictive covenants than traditional banks.

Sub debt can be used in management buyouts and in most cases of buying and selling businesses.

This is due to the fact that these types of transactions have potentially large “goodwill” components (i.e. intellectual property) which traditional banks typically do not finance. Almost invariably, banks treat goodwill as “intangibles” and have the effect of increasing a leverage ratio beyond a threshold that banks are willing to tolerate.

Finally, sub debt is less dilutive than equity financing and it does not restrict access to financing due to lack of collateral in the form of hard assets.

There are other options to financing the purchase of your company including private equity financing, which we would rather leave for another time. The financing structure can include a combination of two or three of the above.

Please discuss your options with your banker. Otherwise, use an independent advisor who will negotiate your deal on your behalf. Also, be aware that fees for advisors vary significantly and may or may not be dictated by the level of involvement in structuring and negotiating the deal. Insist that fees are discussed up front and that there is clarity and transparency prior to engaging the advisor. The quality of advice you get and the probability of the financing process going smoothly will depend on the level of experience of your advisor.

Alma Johns is President of Bench Capital Advisory Inc., an independent financing consulting practice based in Toronto. She can be reached at alma.johns@benchcapital.ca or www.benchcapital.ca.