Posts

Funding From the Private Capital Markets Can Help You Reach Your Strategic Goals Without Bringing in Equity or New Partners

CEOs may pursue multiple avenues to growth and strengthening their company’s strategic position. Investing internally via capital expenditures (CAPEX) or making key hires may be appropriate for some companies, while others may find more attractive opportunities in acquisitions.

A business owner may have as a priority the diversification of their personal wealth so as not to be overly concentrated in the business.

Other business leaders may need to reorganize ownership of their companies.  This could mean concentrating ownership through the buy-out of shareholders who no longer wish to participate in the company. It may also entail passing ownership to the next generation or an executive team.

These actions share a common denominator: the need for external capital.  For a company to achieve its fullest potential, a CEO and their advisors need to understand how much capital is available to them, from whom and at what price. This is especially true if shareholders do not want to give up equity or bring in new partners.

Many CEOs hold a now obsolete view that commercial banks are the best, preferred and perhaps only source of non-equity capital for their companies. Even trusted advisors such as attorneys and accountants can share this bias. And while commercial banks remain excellent sources for asset-based lending, they may not be able to provide cost-effective capital beyond what can be secured with tangible assets.

Funding alternatives abound for CEOs

The corporate landscape has evolved; a greater percentage of companies produce profits and cash flow uncorrelated with or disproportionate to their tangible assets. Essentially, there has been a shift from manufacturing toward services. Companies that provide services, such as technology, distribution, marketing, light manufacturing, healthcare and others, do not require heavy investment in property, plant or equipment, or other physical assets.

CEOs of such companies may find that their trusted commercial bank cannot provide capital beyond the liquidation value of their tangible assets, totaling no more than 1x or 2x EBITDA, even though their business is highly profitable and has a track record of high quality of earnings.

Fortunately, the private capital markets have evolved and grown in recognition of this shift in the U.S. economy.  In addition to commercial banks, debt capital can be sourced from a large and rapidly growing pool of institutional non-bank lenders.  Pension funds, insurance companies, business development companies, family offices, credit opportunity funds and hedge funds are among the capital providers in this market, which currently number over 6,000 participants providing over 50% of the private commercial credit in the United States.

These institutional entities are not bound by the same regulations as commercial banks, allowing them to lend against cash flow and quality of earnings, rather than the liquidation value of tangible assets.  A borrower EBITDA of $5 million is generally the minimum to attract this type of capital, with no upper limit. Types of financing range from senior secured all the way down the capital stack, and current market conditions provide borrowers access to senior debt of 1.75x to 5.5x EBITDA depending on the amount and stability of EBITDA.  The amount of additional capital available to companies can be significant.

Raising capital for the right reasons

 Regardless of the type of capital you wish to raise, it has to be in the context of a rational business strategy.  If your focus is growth, how would having 2x-4x your current presumed funding capacity impact the company’s strategic plan?  Would that increased funding allow for more aggressive organic growth?  Would it allow you to consider more significant acquisitions to fuel enhanced competitiveness, drive growth and increase the value of your business?

There are numerous situations where an owner would benefit from recapitalizing their business, but the limitations imposed by the false belief of needing to raise equity or sell their companies unduly narrow the array of perceived options.

For example: Imagine a CEO who is uncomfortable with having a disproportionate percentage of their personal wealth concentrated in their company.  A recapitalization could be used to fund a dividend, allowing for the de-risking of their personal wealth portfolio. Another familiar situation is a desire to buy out partners or other shareholders who no longer wish to have their lives and financial risk tethered to a private company.

Common wisdom might suggest selling the company or bringing in a private equity investor, even if the CEO has no wish to sell or take on new partners.  However, a debt recapitalization allows the buy-out of some or all such shareholders, concentrating ownership with the CEO and aligning shareholder interest while avoiding governance issues.

Knowing how much funding is available to your company may provide fuel to reach your strategic goals, and even recalibrate your vision.  Whatever your funding requirements, business owners and CEOs should know that they have alternatives.  The Private Capital Markets have the depth and flexibility to allow you to reach your goals without compromising control of your company.

Funding Your Company’s Organic Growth Plan

Step 1 in developing a strategic growth plan for your company is determining the scale and scope of its market opportunity. Expansion may come from taking market share away from competitors, participating in overall market growth, innovating superior customer solutions, geographic expansion or through other channels.

Step 2 in developing a strategic growth plan for your company is understanding how much investment you can fund. It’s great to have a fantastic plan, but if you cannot fund it, it cannot be implemented.

If you are not aware of what funding is available to your company, you may materially underutilize its resources and capabilities. If you agree that a CEO’s job is maximizing value for all stakeholders, underutilizing your company’s resources and capabilities must be avoided.

CEOs often believe that funds available for organic growth equals free cash flow and what a commercial bank will lend against tangible assets such as receivables, inventory and equipment. For successful “asset light” businesses, this is an untrue limiting belief.

As described in previous articles, approximately 40% of US institutional corporate lenders make lending decisions on the quality of a company’s cash flow rather than the liquidation value of tangible assets. The CEO of a company with $5 million in EBITDA, $5 million in receivables and $5 million in inventory may believe that their borrowing capacity is $6-$8 million, when in fact it might be $12-$20 million. This capital availability is in addition to your company’s free cash flow.

If your business has significant, realistic growth potential, a practical plan for addressing the market and a management team capable of implementing the plan, why be limited by a false belief that you cannot fund the plan? If your ROI is projected to be 2x or more than your cost of capital, why would you not put capital to work to make your company more competitive and profitable?

Based on the fact pattern above, let’s assume that a company has 1x EBITDA for a working capital revolving line of credit.   Further assume the business can invest $1.5 mil in annual free cash flow. If you only consider asset based loans from commercial banks, it will be difficult to invest more than free cash flow and perhaps $1 million from an asset based borrowing facility.

That same company can go to an institutional cash flow lender and potentially arrange a $15 mil to $20 mil credit facility, including a $5 mil revolver. Let’s assume you do not want to fully extend the company but are willing to access debt of $12 million: $5 mil for your revolver and a $7 mil term loan to fund growth. Your company will invest $1.5 mil from free cash flow in each of two years and draw $3.5 mil on its term in each of two years to fund a growth plan.

Over a two year period, the company will have $5 million available for working capital and an additional $10 million to invest in growth. For this example, let’s assume that:

  • Interest on all debt is 7%
  • Mandatory amortization for the term loan is 5% of principal plus 50% of available free cash flow
  • The company’s $5 mil baseline EBITDA has no growth
  • EBITDA generated by new investment has no return the year it is made, 15% ROI the following year and grows 15% annually thereafter

In this scenario, the company’s Debt to EBITDA ratio rises from 1-1 to 2.4-1 at the beginning of year 1: with $3 mil to $8 mil of additional borrowing capacity. It will rapidly de-lever through both debt amortization and increasing EBITDA. This can be seen in the chart below:

Funding Your Company's Organic Growth | MAST Advisors

In this scenario, your company’s Debt/EBITDA ratio falls to 2-1 by the end of year 1 and 1.4-1 by the end of year 2. Thereafter, EBITDA growth brings the company’s remaining working capital debt below the original 1-1.

Importantly, even with the reinvestment of cash flow and debt amortization, the company is still able to maintain moderate distributions to shareholders in years 1 & 2, with substantial increases in distributions in years 3-5.

Perhaps most significant, implementing the strategic growth plan will increase the profitability and competitiveness of your company. Those trends most often result in a substantial increase in the value of your business that can equal an additional 1x-3x EBITDA. In this example, the original company might be valued at 7x EBITDA, or $35 million. After growing from $5 mil to $7 mil in EBITDA, that value might be 8x EBITDA or $56 million.

If your company has the opportunity and ability to achieve significant growth and you as CEO want to maximize value for stakeholders, understanding the amount of capital that can be deployed to implement a well-structured strategic growth plan is a fundamental aspect to success.

If you have any questions, please reach out to me at mtaffet@mastadvisors.com.

______________________

Mark Taffet is CEO of Mast Advisors, Inc., an M&A and strategic advisory firm focused on maximizing value for middle-market companies. Information regarding specific aspects of the private capital markets has been provided by SPP Capital Partners, an investment bank focused on raising funds in the private capital markets.

Securities offered through SPP Capital Partners, LLC: 550 5th Ave., 12th Floor, New York, NY 10036. Member FINRA/SIPC