Valuing and financing a company is more complex than using a discounted cash flow model or market comparable EBITDA multiples. Unlike certain outliers (looking at you Tesla), debt compliance plays a major role in valuing a company. Fixed charge coverage ratios, leverage ratios, weekly or monthly borrowing base calculations, and capital expenditure caps all play a major role in determining how much debt can be borrowed versus the equity needed to close a transaction.
As a buyer, modeling the capital structure of a transaction goes beyond calculating the projected IRR of an investment. Rather, a buyer needs to understand the monthly working capital requirements of a business, its after-tax cash generation capabilities, and its liquidity. Businesses that are seasonal, cyclical, and have high working capital requirements, tend to be valued less because excess free cash flow is less, if not zero. A buyer needs to know (i) how much a business can draw on its revolving line of credit to fund growth, seasonality, or illiquidity, and (ii) can a business make its interest, principal and capital expenditure payments in an expanding or contracting market.
Buyers typically use a combination of revolving/asset-based debt, senior debt, and subordinated debt to fund transactions. Each type of debt has certain terms, costs, and covenants that must be met to avoid a credit default or a liquidity crisis.
Revolving or asset-based credit financing uses a company’s accounts receivable and inventory as collateral for the loan amount, and establishes a borrowing limit based on the assets quality, age, location, salability, and liquidation value. These items affect the borrowing capacity of a company because “advance rates” on “eligible” accounts receivable and inventory determines how much a company can borrow. For example, the Company may have a revolving/asset-based credit facility of $10 million, but based on the characteristics of the accounts receivable and inventory, the Company may only be allowed to borrow half of that amount or less. Revolving/asset-based credit is not permanent capital and is subject to limitations and quality restrictions. Having a line of credit does not mean you have access to it, nor use it to finance an acquisition.
Both senior debt and subordinated debt are considered long-term debt (greater than three years) supported by all the assets of the company, whether tangible or intangible, as well as a pledge of the company’s stock. Typically, senior debt lenders provide the revolving/asset-based credit and have first lien on all the assets of the company, while subordinated lenders are typically uncollateralized and considered having a second lien on all the assets and stock. Commonly, the amounts loaned are more than what the lenders could recover in an orderly liquidation. The lenders monitor the liquidity of the business and the cash flow generation capabilities with various financial ratios and restrictions, such as fixed charge coverage ratio being greater than 1.15, senior debt ratio not exceeding 2.50, total leverage ratio not exceeding 4.00, and many others. These ratios are based on the company’s negotiated adjusted and projected EBITDA for the business (please see April’s perspective Adjusting and Normalizing EBITDA for more details). For future years, the financial ratios become more stringent (increases or decreases based on the ratio), thereby holding a buyer accountable for the representations and projections that the business can generate the cash needed to meet all operational, tax, and debt obligations.
In summary, a buyer’s diligence of a company’s historical profits, quality of assets, and projected earnings provided by a seller affects the amount of debt a buyer can borrow, the amount of equity to be invested, and the potential equity return (IRR) on invested capital.