The following article was originally written by Alma Johns for Canadian Metalworking October 2014 issue, pages 104-105.Alma.Johns New Photo

As Canada’s aging business owners begin to transition into retirement, a new breed of entrepreneurial employees will take ownership positions in some businesses.

Members of managing teams who want to play a more active role in the business often consider buying—individually or in teams—the business from their previous employer.

Widely known as Management Buyout, or MBO, this method of business transition requires a significant infusion of financing, primarily in the form of bank loans, vendor takeback and private equity financing.

MBOs occur internally, so buyers have a strong understanding of the inner workings of the company they’re buying. Also, because they already are familiar with systems and processes required to operate the business, MBOs have a higher probability of success post-transition.

Further, retiring business owners often favor MBOs because they want to see the business remain viable after they leave.

WHAT TYPES OF FINANCING ARE NEEDED?

However, traditional financial institutions often deem MBOs particularly risky because the new owners may not have the same experience, business relationships and financial savvy as the previous owner. So the MBO team must often find alternative funding methods to finance the transition and execute the buyout plan.

These include:

  • buying shares with other key employees using their own equity
  • term debt financing from the bank
  • subordinated debt from sub-debt lending institutions
  • private equity funds
  • vendor take back (VTB)
  • earn out provisions embedded into Purchase Agreement

HOW MBO FINANCING MAY LOOK

We caution readers that the example outlined below is a simplified scenario and excludes VTB and Earn Out provisions. Also, we assume that the Management team is able to find a suitable Private Equity firm to co-invest.

In our example, the company generates an EBITDA (Earnings Before Interest, Income Tax, Depreciation and Amortization) of $2 million per year. If today’s industry standard valuation is 5x EBITDA, the company valuation is likely around $10 million. It’s assumed that the company has no debt and that the three-person management Team can raise $1 million of their own equity.

Accordingly, they need to finance the remaining $9 million from various sources. This creates the following typical capital structure.

Management’s $1 million Equity (16.7% of Total)

Private $5 million Equity (83.3% of Total)

Total Equity $6 million

Bank Debt $3 million

Subordinated Debt $2 million

Total Debt $5 million

At the time of transaction, the Debt-to-Equity ratio becomes 0.8:1 or 80 cents of debt for every dollar of equity. But a healthy Debt-to-Equity ratio typically used as benchmark by most banks is 2:1.

This financing structure changes with time. Assuming the Bank Debt has a repayment term of 7 years, the Principal-plus-Interest method of repayment equates to approximately $430K in Principal reduction per year. At Year 5, the Bank Debt reduces to $850K. If the Subordinated Debt has a 6-year repayment term with Interest Only in Year 1, and subsequent equal repayments of $400,000 annually, at the end of Year 5, the Subordinate Debt is paid down to $400,000 and the outstanding Bank and Subordinated Debt collectively goes down to $1.25 million.

So, at Year 5, the above structure may look like the following (using a 20% year-over-year growth in equity).

Management’s $3.11 million Equity (25% of equity)

Private $9.33 million Equity (75% of equity)

Total Equity $12.44 million

Bank Debt $850,000

Subordinated Debt $400,000

Total Debt $1.25 million

Ironically, this timing coincides with the period when Private Equity firms typically exit ownership of the company unless the firm decides to extend their “holding period.”

With Year 5 capital structure, the Debt-to-Equity ratio effectively becomes 0.10:1 or 10 cents of Debt for every dollar of Equity—considered by the bank to be low leverage. If the Private Equity exits at this point, the Management can either take on another Bank Debt to take out the Private Equity’s share in the firm or, together with the Private Equity, sell the business to a strategic buyer at a premium. The former will increase the Debt to Equity or Leverage Ratio to 3.4:1. While this ratio is off the ideal ratio of 2:1, most banks will tolerate the risk, especially if the company continues to generate a strong cash flow as it did historically.

CASHFLOW, EBITDA AND ABILITY TO SERVICE DEBT

We made an oversimplified scenario on the Capital Structure above. The company’s ability to service debt using the same scenario is also important. For example:

Bank Debt $3 million

Subordinated Debt $2 million

Total Debt $5 million

If the Bank Debt has a repayment term of 7 years at an Interest Rate of 5%, and the Subordinated Debt has a repayment term of 6 years at an Interest Rate of 15%, this gives us a total repayment of $880,000 in Year 1, assuming Principal + Interest repayment method.

Principal Bank Debt $3 million/7 years = $430,000

Interest Bank Debt  $3 million@5% = $150,000

Principal Subordinated Debt $2 million/6 years = $0 (Interest Only in Year 1)

Interest Subordinated Debt $2 million@15% = $300,000

Total Repayment $880,000

If the company generates an EBITDA of $2 million per year in Year 1, the Debt Service Coverage is 2.3:1 or approximately 2.3 dollars in cash flow for every 1 dollar of debt repayment (This can vary from year to year depending on the company’s performance). That should be added the Subordinated Debt Principal repayment of $333,000 per year.

Although simplified, we can use a similar equity growth rate of 20% above as our EBITDA growth rate in our projection. The Debt Service Coverage ratio will improve as the EBITDA grows since the annual debt repayment amount remains constant year over year.

Alma Johns is President of Bench Capital Advisory Inc., an independent corporate finance and debt advisory firm based in Toronto. She can be reached at alma.johns@benchcapital.

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