Financing provided by commercial banks is generally more short-term and, as a result, may not be the most appropriate mechanism for longer term business needs. Short-term financing is appropriate for such purposes as inventory and accounts receivable but may not be the best mechanism to finance the buyout of a partner, acquisitions of other companies, or a recapitalization of the company in order to pay dividends to the company owners.
Bankers tend to focus on the products and services their bank provides. If those products do not solve the company's financing need, its bankers may not be able to offer alternatives.
Let's consider a business owner who wishes to buy out a passive partner. The banker might offer a loan with a five-year amortization schedule with an onerous impact on the company's cash flow. A more appropriate alternative might be subordinated debt that is interest only with the principal paid off at the end of five or seven years.
This example compares a $5 million, five-year amortization schedule with a $5 million subordinate loan:
Banks generally do not provide subordinated debt, so the banker may not offer that as a solution to the company's problem. Investment bankers generally are very familiar with all of the financing alternatives and, as a result, can be a good resource for company owners who want to explore alternatives.
When a business owner is seeking financing that a commercial bank may not be able to accommodate, he should consider engaging a team of advisers to assist in preparing for, accessing and documenting the appropriate financing mechanism to help to accomplish his objectives. That team might be comprised of the following:
Institutional lenders and investors are flush with capital with private equity (venture capital and subordinated debt funds reportedly have more than $1 trillion to invest). Though they are still very cautious in the loans/investments they make, they are very flexible in how they structure transactions and are even willing to provide capital for a recapitalization – allowing company shareholders to buy out partners or even to pay themselves dividends.
A business owner willing to consider selling controlling interest in his company can tap into an estimated $2 trillion on the balance sheets of domestic strategic investors.
There is a large amount of investment and acquisition capital available but few companies that meet the high quality demanded by cautious investors. As a result, companies that do meet the standards can often achieve a very high valuation multiple. Acquirers are willing to pay a premium for companies with consistent historic revenue growth, free cash flow in excess of $5 million and 10 percent margin, an experienced management team with depth, and little customer concentration.
A business owner selling his company is usually seeking the highest price possible on the most advantageous terms. At the same time, buyers are seeking the lowest price on the terms best for them. In this context, there are several problems with a business owner negotiating directly with a single potential investor:
An experienced team of advisers including an attorney and an investment banker can help the business owner increase the certainty of closing a transaction with the best possible terms.
Many owners of privately-held, middle-market companies are seeking alternatives for growth and liquidity. But they are not ready to sell their companies because they are still passionate about what they do or because the company's value is not high enough to get the cash they need if they sell.
Yet, they understand:
In these situations, a recapitalization is worth exploring. This is an investment mechanism whereby a subordinated debt fund lends or a private equity fund invests capital to acquire a majority or minority stake in the company. In either situation, the current shareholders maintain operating control and the current management team continues to run the business.
This strategy enables the shareholders to take some money out of the company and diversify their personal assets. At the same time, the new financial partner can provide additional resources to help weather the economic environment as well as to take advantage of opportunities for growth.
With a recapitalization strategy, the owners and the investors have the same objective: Improve the company’s operations to increase its potential for growth and maximize its value, so that current shareholders may take a second bite out of the apple in 3 to 5 years.