By: Nick Smith, Partner at 37th & Moss
Buyers, Sellers and Other Transaction Stakeholders
The core stakeholders in any business acquisition are the buyer and seller. However, the size and complexity of the deal structure may expand the stakeholder group to include Senior Debt Providers (Banks), Mezzanine Debt Providers (generally non-banks and debt funds), Equity Investors, and Government Provided Loans (specifically, the Small Business Administration or SBA). Every stakeholder seeks to mitigate risk through deal structure. Sellers, of course, want cash up front because cash in the bank mitigates risk. But buyers, also seeking to mitigate risk, may prefer deferred payments to keep cash in the business, which provides flexibility to invest in growth.
Debt providers (senior and mezzanine) don’t have ownership or control of the business and must mitigate risk through covenant structure and interest. The SBA is unique in this stakeholder group. This government program is dedicated to encouraging entrepreneurship, however the SBA process can be rigorous with large amounts of red tape.
Below we’ll walk through four sample deal structures. Note that these are illustrative, but provide a directional sense for how acquisitions are structured and how each stakeholder may view participation in a transaction.
Structure 1: The Elusive All Cash Structure
The all-cash (no debt) deal is not common for mature companies with profitable operations. From the seller perspective, this structure is clean (eliminates debt providers and may not require outside investors) and gives sellers what they want, cash! However, this structure can present challenges for the buyer.
Most buyers don’t have $30 million in a personal or business bank account to spend on a company. Even if they did, 100% cash up front leaves them with limited options should they need to invest in growth, meet rising supplier costs, or increase employee pay. To generate a return on the considerable investment, all-cash buyers buying mature, profitable companies will forgo the opportunity to realize returns by including debt in the capital structure, and may be incentivized to pursue aggressive growth to generate returns. In some cases, the all-cash deal may be appropriate for a small, cash-burning or barely cash-flow-positive company for which debt may not be available. The table below outlines the simplified sources and uses of capital for a hypothetical $10 million transaction. Sources detail where the cash in a transaction comes from, and uses detail how that cash is used in the transaction. Although it seems intuitive that the use of capital would exclusively fund the business purchase, line items such as deal fees or cash to the balance sheet are common in transactions. As we progress through structures, we’ll adjust the table below to illustrate sources and uses under various transaction structures.
Structure 2: Cash Plus Rollover Equity
Buyers often need to raise capital from investors. This may sound like a negative to some. Why wouldn’t a buyer have all the capital required to complete the transaction? Does this mean the buyer lacks sophistication or is inexperienced?
Raising capital from investors is extremely common, even for acquisitions as small as $1 million, because it’s an effective way for the buyer (and the investor group) to mitigate risk and gain exposure to potential upside in the business. However, in addition to equity contributed from a buyer and investors, it’s often appropriate for the current owner to “roll” equity in the acquired company. In other words, the seller will sell less than 100% of the company and retain a minority ownership stake in the company. This can benefit both the seller and the buyer. The buyer knows that the seller will be incentivized to successfully transition leadership of the company. This can be particularly helpful if the seller owns key customer or supplier relationships. The seller knows that they’ll retain involvement (albeit at a much smaller level) in the company they built and maintain ownership that will benefit, possibly in a meaningful way, from future company growth.
Note that in the structure below, although the business is purchased for $10 million, the seller receives $9 million at close, with the remaining $1 million remaining in the company as a 10% ownership stake.
Structure 3: Cash, Small Business Administration (SBA) loan and Seller Note
If a business has a history of profitable operations, the buyer will likely use some form of debt to finance the transaction. Debt is useful for the buyer for several reasons: 1) it can enable access to a larger transaction for buyers who otherwise wouldn’t be able to complete the transaction (most homeowners don’t buy houses with cash); 2) if the business continues to perform, it enhances returns for the buyer; and 3) it mitigates some of the up-front cash risk for the buyer. Debt comes in many forms. In a future post, we’ll cover details on the following three types of debt - Senior Debt (which can be further broken down into conventional and SBA debt), Mezzanine Debt, and Seller financing.
Below we provide a sample structure that includes Small Business Administration (SBA) debt as well as a seller note, which is a form of financing provided by the seller of a business.
A typical SBA transaction will have around 20% equity, some seller financing, and SBA debt. Seller notes (which will be covered in a future post) are common in SBA transactions even though the seller must depart the business within a year of the transaction (assuming they do not roll equity). New SBA rules as of 2023 allow the seller to roll equity and if they do, stay in the business for more than 12 months.
The transaction below includes a “cash to balance sheet” line item. The purpose of this item is to ensure an appropriate amount of cash remains in the business to fund working capital (current assets minus current liabilities). Buyers will expect to purchase the business with a healthy amount of working capital, otherwise the buyer will risk having to make an incremental investment in the business post-acquisition to fund working capital needs.
Structure 4: Equity, Conventional Debt and Seller Note
Without the SBA involved, financing a transaction may have fewer regulatory strings attached, but the terms of the loan can be more burdensome on the business. In today’s credit climate of rising interest rates and tightening credit standards, it can be difficult for a buyer to raise conventional debt - and even if successful in raising debt, interest rates are high. So why use debt at all? Why not raise a lot of investor capital and just buy companies with 100% equity?
Even considering elevated interest rates, debt is cheap when compared to equity. Equity investors are junior in the capital structure, meaning they are paid after debt holders are paid, thus they require specific and high returns, and as a result equity is expensive.
Banks, most of whom do not have exposure to any “upside” or future growth of the business but instead generate returns through interest alone, mitigate conventional lending risk through covenants. Covenants come in many forms but usually trigger default based on business performance (cash flow) or balance sheet composition. The bank may restrict a business’s ability to raise additional debt for growth or may prevent distributions to shareholders until the debt is paid.
Mezzanine debt (or “Mezz debt”) is junior to bank debt, but senior to equity investors when it comes to paying back capital providers from business cash flows. In a downside scenario, the mezzanine debt provider is unlikely to regain any of its invested capital. As a result, mezzanine providers charge very high interest rates.
Concluding on Deal Structure
Building a deal structure that mitigates risk for all stakeholders is an art. It’s important that buyers and sellers build a partnership that allows for a deal structure to accomplish the goals of both parties. The deal process requires trust building between seller and buyer. By working together to complete a deal that works for both parties, a transaction can produce a win-win scenario by creating value for the seller, who is seeking to monetize many years of work, and the buyer, who desires to carry forward the legacy of the business.
