Small business owners are often apprehensive about the changes that may occur when their business is acquired by a private equity firm.  When Hadley Capital acquires a company we do not look to make immediate changes to the business.  However, financial reporting is something that does change after the deal closes.  This typically means two changes for a business: 1) monthly reporting is completed in a more timely manner and 2) additional financial reporting is required.  

Timely Monthly Reporting.

Hadley Capital receives monthly financials (income statement and balance sheet) from our portfolio companies within 30 days after month end.  Most small businesses are not used to producing monthly financials this quickly.  While this can be adjustment our portfolio companies eventually see the benefits of timely reporting.  It is much easier to manage a business when you have timely data.

Additional Financial Reporting. 

Borrowing Base Certificate. All of our portfolio companies have a revolving line of credit to manage working capital. A line of credit is supported by a borrowing base certificate.  A borrowing base lists a company’s eligible accounts receivable and inventory and dictates how much the company can borrow.  Many small businesses are not accustomed to providing monthly accounts receivable aging reports and monthly inventory reports.  However, the benefits of access to additional capital (via a line of credit) are greater than the administrative burden of creating these reports.

Financial Covenant Calculations. Banks and mezzanine lenders use financial covenants to monitor the performance of a borrower.  These lenders receive quarterly financial covenants calculations from the borrower.  Financial Covenants give the lenders a heads up if the financial standing of the borrower has changed over a given period of time.  For example, one common financial covenant is Total Leverage.   The Total Leverage covenant measures the Total Debt (senior debt + mezzanine debt) in relation to the trailing twelve months (TTM) of EBITDA.  So if the Total Leverage covenant is Total Debt must be less than 4.0x TTM EBITDA, the borrower has to perform this calculation each quarter and send the results to the lender in a covenant compliance certificate.  If the Total Leverage is less than 4.0x then the borrower is in compliance with the covenant. However, if Total Leverage goes above 4.0x, the borrower is not in compliance and the lender will want to sit down with borrower and understand why things have changed.  Covenant calculations are not difficult, but most small businesses are not used to completing them so it can take some time getting used to.

Individually none of these financial reporting requirements are a big deal, but collectively they can seem like a lot to a small business.  However, we have been through the process many times and we work with our portfolio companies to make it a smooth transition.  The lenders that work with our portfolio companies typically require our companies to submit a monthly borrowing base certificate and quarterly financial covenant certificates.

My last post on acquisition financing covered senior debt.  This post will cover Mezzanine debt.  Specifically, I would like to talk about how mezzanine debt is structured and what the implications are for small businesses that use it.  

The word mezzanine is defined as the "partial story between two main stories of a building".  In this case the two main "finance stories" of a company are senior debt and equity.  Mezzanine debt then is the middle level or "mezzanine" between senior debt and equity.  From a borrower's perspective, mezzanine finance is more expensive than senior debt and less expensive than equity.  Mezzanine debt is more expensive than senior debt because 1) it is subordinate to senior debt (meaning in a liquidation the senior debt lender will be paid in full before the mezzanine lenders sees a dollar) and 2) it typically does not require any principal payment until the end of the term loan.  This structure obviously creates more risk for the mezzanine lenders and as a result they charge higher interest rates. 

Mezzanine loans are typically priced anywhere between 15% and 20%.  There are three main components off mezzanine debt: 1) current interest 2) PIK Interest and 3) Warrants.  As mentioned, Mezzanine loans are typically interest only with the principal due at the end of a five or seven year term.  Current interest payments are typically due monthly or quarterly.  For example a $3 million 15% current pay interest mezzanine loan with a 5 year term would look something like this:

In some cases mezzanine lenders will PIK (Payment-in-Kind) a portion of the interest payment and add it to the principal payment of the loan. In this case, there will be two buckets of interest: current cash interest and PIK interest.  Here is what it would look like if a mezzanine lender offered a $3 million with 14% current cash interest and 2% PIK interest:

Mezzanine debt can also frequently include warrants, which are very similar to equity options.  Warrants give lenders equity upside when the borrower performs well.  Warrants typically represent 1% to 5% of the fully diluted ownership of the company.  

Due to the high interest rates associated with mezzanine debt, we work with management to pay it off sooner rather than later.  If a company is performing well and has plenty of cash, we will some cash to pay down the mezzanine debt.  We typically use 1x - 1.5X EBITDA (or cash flow) of mezzanine debt in an acquisition.  So if we buy a company for 5x EBITDA, a typical capital structure might be 2x senior debt, 1x mezzanine debt and 2x equity.  We feel 3x total leverage (2x senior + 1x mezzanine) is an appropriate amount of debt for a small company.

We often talk with small business owners who are struggling with the decision of selling their business. It is a very difficult and emotional decision to make and as a result business owners spend a lot of time thinking it through.  We see people who sell for all different kinds of reasons, but certain patterns have developed over the years.  Here are a few reasons that we have seen:

Health Problems

This is never a good one to see, but it is fairly common.  As people get older, health problems tend to pop up.  Health problems usually result in an exit when a business is really dependent on the owner for its success.

No Passion

As business owners get older, the passion for the day to day management often fades.   This may mean they are ready for retirement or they are just burnt out from leading the business for 20+ years.  

New Interests

Some serial type entrepreneurs will want to move on to another venture.  Once the business is built and is stable, we have seen business owners sell in order to build new businesses or start new projects. 

Holding it Back

The skills you need to start a business and get it to $10 million in sales are not necessarily the same skills you need to get it to $20 million in sales.  Some owners realize they don't have the necessary skills to get the company to the next level.  They feel like they are holding the business back and look to sell. 

No Transition Plan

Mom was working under the assumption that her son would want to run the business some day. When mom finally asks her son, she realizes he wants to be a baker and has no interest in running the business.  

Spouse Says So

Here the spouse has usually seen their husband or wife obsessed with the business for 20+ years. The business owner promised that one day they would quit and spend more time with the family. That day has come.

Need to Diversify

Business owners often put all their money back into the business.  When it comes time for retirement, any financial planner will tell you it is never good to have all your net worth tied up in one asset.  

Partnership Differences

In this example there are usually two owners with significant ownership in a business and one is ready to retire.  When the owner who is retiring wants to sell his shares that means the business needs to be valued.  After the business is valued the business is more likely to be sold.

These are just some of the reasons we have seen over the years.  Sometimes it can be a combination of the above reasons.  When considering whether to sell a business, a business owner should do what is best for them.  If you are business owner facing one of the challenges above, please let us know.  We would love to talk to you.

We recently read Stage2Planning’s post “Is Private Equity For You?”  The post points out some things that companies should consider before selling to a private equity firm.  While we agree that business owners should think about what they want before selling their business, we don’t agree with some of the points the author makes about private equity.  Below are the points we disagree with and why:

“These stakeholders might be your employees, suppliers, the community, or the customers of your company.  Your job moves from only keeping stakeholders happy to maximizing the financial return of the company.”

These two things are not mutually exclusive.  The majority of business owners work to keep employees, suppliers, customers, etc. happy AND they maximize the financial return of the company.  This is not an either or situation. At Hadley Capital we think the company should do both.

“A private equity firm wants to usually hold your company for five to eight years and then find another buyer to cash them out with a very handsome return. This means you will have to grow your business very rapidly.  While growing the business you’ll have to understand that you will need to do this with little cash because the private equity people will not want to put more money than their original investment into your company.”

At Hadley Capital our first order of business after acquiring a company is to “Do No Harm”. We make little to no changes to the business in the first year.  We are not looking to make quick changes and then “flip” the company.  Instead, we look to make a couple small changes each year.  We also disagree that a company will have “little cash” to grow.  When acquiring a company we make sure the company is well capitalized to support growth.  We also often put additional capital into the company when making acquisitions.

“Are you aware of the capital structure of your company after you do a deal?  A typical private equity deal will have five dollars in debt for every dollar in capital the new investors put into your company.  Your company is now on the hook for this new debt.”

We would never do a deal with a 5:1 debt/equity ratio.  Our typical structure is 2 parts debt to 1 part equity. It is also disingenuous to suggest that “the company is on the hook for this new debt”.  In most of our companies, we own the business in partnership with management - we are all in this together. 

"If you have a bad year the private equity firm you thought was in your corner may quickly move to being an adversary.Your agreement with the private equity firm is likely to have a take over clause.  This means that if you don’t hit pre-arranged financial performance numbers you will be asked to leave and someone will take your place.  Many private equity firms will tell you that everything will stay the same after they make the investment in your company.  They will also say that their takeover clause is only reasonable since they have put so much money in your company.  Private equity firms have learned that for them to get the financial returns they expect, they will often have to change senior management, including and especially the founder of the company."

We determine who is going to run the company before the acquisition closes and we support management in running the company. We don’t put in a “take out clause” and the business owner goes into this process “eyes wide open”.  For selling a majority stake in their business, they receive millions of dollars.  In exchange for the millions of dollars the business owner gives up absolute control of the company but frequently retains a minority share in the business in order to get a proverbial “second bite of the apple”.

"Private equity might be the perfect thing for you.  Before you take the plunge, spend some time running your company maximizing the return and economic value of your company.  If you enjoy doing this, then private equity could work out well for you.  If not, choose another path to having a liquidity event in your company."

We think it is condescending to tell business owners to “spend some time running your company maximizing the return and economic value of your company”.  The majority of businesses are already doing that (or at least trying!).  Profit is not a bad word.  Most business owners like to make one and we like to help them.

At the end of the day we always tell business owners to do research and due diligence on the buyer (private equity or strategic).  It is the only way to get evidence that a buyer does what they say they do.

Over the years we have evaluated a number of small company acquisitions where the target company was deciding between doing an ESOP or selling the business to a financial sponsor like Hadley Capital.

ESOP promoters are quick to point out the significant economic benefits to ESOPs, mostly related to preferential tax treatment of ESOP contributions and distributions. However, there are a number of problems with ESOPs that are not immediately transparent to small businesses. We have developed a list of problems with ESOPs based, in some cases, on first hand accounts of companies that we were evaluating.  Here are a few:

1. ESOPs are complex and expensive - ESOP is an acronym for Employee Stock Ownership Plan. ESOPs are qualified, defined contribution, employee benefit plans that are regulated by the Employment Retirement Security Act of 1974 (better known as ERISA) and, thus, subject to byzantine rules. The ESOP Association itself suggests that "plan sponsors consider the following":

- Seek professional help in designing the ESOP documents including the Plan Document.
- Strictly adhere to fiduciary structure and document all governance steps and decisions.
- Continually review the investment of employer stock and develop a list of factors to be reviewed. Follow and update that list as appropriate.
- Communicate accurately when discussing employer stock with employees and make sure they are clearly advised of the risks inherent with an employer stock investment.
- Consider engaging in an independent trustee to serve participant interests, or a qualified outside firm for plan administration and record keeping. Request indemnification from outsiders for any errors they may make and obtain evidence of their errors and omissions insurance policy.
- Purchase adequate Fiduciary Liability Insurance.

Sound simple enough? It's not. That's why promoters of ESOPs are paid handsome fees to establish ESOPs and to manage ERISA compliance on a going forward basis.

 2. ESOPs have repurchase obligations - Employees can require ESOPs to repurchase their stock when they leave the company. These repurchase obligations must be completed at the company's current ESOP valuation, may put pressure on the company's cash flow, and are out of control of company management. This can limit a company's operating flexibility and balance sheet capacity - rather than investing in attractive growth opportunities a company may be required to maintain balance sheet capacity to fund repurchase obligations.  

3. ESOPs can fail and create legal exposure for trustees - Many ESOPs are formed so small business owners can realize cash proceeds from an ESOP "sale". The tax advantages of ESOPs (tax deductibility of principal payments on debt) often result in ESOP "sales" that utilize a substantial amount of deb. Debt can restrict operating flexibility and, in conjunction with a recession or loss of a major customer, can lead to the failure of a company. In this outcome, the trustees of the ESOP (often the business owner that set up the ESOP) can face substantial legal exposure from members of the ESOP.

4. ESOPs are difficult to unwind - The unique structure of ESOPs make it incredibly complex to unwind or sell an ESOP company and/or to raise outside capital for an ESOP company.

Unlike selling a closely-held small company, selling an ESOP company can be like selling a quasi-public company. ESOP participants have broad voting and information rights and trustees of an ESOP are required to "maximize shareholder value" - a difficult concept to prove in the sale of small business.  If a single ESOP participant feels like any of the above requirements are violated, even a well conceived transaction can be derailed or squashed. A more detailed outline of these problems is available here. http://www.faegrebd.com/2646

5. Raising equity capital for an ESOP company can also be very problematic - ESOP companies must be valued on a regular basis in order to establish a value of the ESOP stock.  These valuations establish a baseline that must be considered when evaluating an equity capital raise. If the valuation is too high (from the perspective of capital sources), it will be difficult to raise outside capital. If the valuation is too low, the ESOP trustees may face disgruntled ESOP shareholders, who face dilution from the new equity capital, opening up the trustees for risks described in #3 above. 

ESOPs can be a nice exit strategy for some small business owners but they are not perfect for every situation. Small business owners should complete their own due diligence prior to entering into an ESOP arrangement - including talking to successful and unsuccessful ESOP companies. We'd also be willing to share our own experiences with ESOP companies and discuss other ways of addressing the exit goals of a small business owner. 

PDW