Raising funds

24 April 2008

In the September issue of AI we discussed the main techniques available to determine what a rental company is worth, and showed that in recent years a good starting point for a valuation of a cash-flow generating company is 4 to 6 times EBITDAR (operating cash flow) minus the company’s net debt.

Of course, putting a valuation on a company is related to the negotiation, and EBITDAR multiples are really just starting points for the negotiations. Linked to that is the amount of money that can be raised for the acquisition. This brings us to the central question: having valued a company, how do you go about finding the money to acquire it?

Asset Purchase

First, consider the example of an equipment rental company that isn’t very profitable, where the valuations are more related to the value of the equipment than a cash-flow multiple.

Types of assets to purchase

A rental company can own many different types of assets, each with their own individual financing and valuation characteristics. These can include:

• Rental fleet

• Stock of spare parts

• Stock of consumables

• Debtor book (or sales ledger)

• Depot and office real estate (freehold or leases on especially desirable property)

• Transport vehicles, lorry loader cranes and company cars

• Office equipment, IT equipment and software (or licenses)

• Brand name and trademarks

• Know-how and working practices

• Phone numbers

• Ongoing rental agreements

• Forward order book

• Godwill and/or cash generation capability

Who are you buying from?

Even if a company is making a loss, or indeed even if it is in administration or being liquidated, it is often possible to buy the equipment and other assets without the debts. The debts may stay with the old company, or with the old owners in the event of a sole tradership or partnership. Indeed you may find you are negotiating with a Liquidator or Administrator, or a bank or other lender.

Sources of cash for acquisitions

• Spare cash belonging to the acquirer

• Bank loans (or leases or hire purchase) - secured on assets to be acquired

• Factoring (or invoice discounting) to buy sales ledger

• Cash flow loans

• Mezzanine finance

• Private equity

• Equity from capital markets (this will be covered in a future article)

Buying assets from a banK

Often, in the case of a failed (or failing) rental company, you can find yourself buying assets (or even the whole company) from a bank. Years of financing equipment with banks, (as well as other types of finance houses) as well as buying equipment from them under all kinds of different circumstances, have established that the only rule that holds true in the long term is that banks are quite unpredictable in these situations.

The wiser banks will react quickly, often before a customer gets into very deep trouble, and can avoid losses in the vast majority of situations. They even make money when they repossess equipment and then resell; sometimes even scandalous amounts. In contrast, the bad banks will not even bother to write to, phone, or visit a customer even months (sometimes over a year) after they stop making payments.

The secret to dealing with banks in this situation is understanding what they want to accomplish, and understanding how the banks view their own options. Sometimes the bank will want to accept a quick offer, even at a low price, to be able to put the matter behind them. This can be especially true if the equipment was nearly paid for, and the bank is only trying to recover the last few payments on a finance agreement.

Cheap money and expensive money

Experience shows that banks will, if approached correctly, finance some asset categories much more easily and cheaply than others.

My definition of ‘cheap money’ is debt that can be borrowed, secured against the asset you are acquiring, without any additional security, guarantees or collateral. If you need to put a 10% deposit on an equipment lease, then 90% is cheap money, but the 10% you have at risk is ‘expensive money’. If you have to give your personal guarantee for 100% of the lease, then the lease is all ‘expensive money’.

The better your reputation with the banks, the more likely you are to get more ‘cheap money” at a lower price. Banks like to back management teams, especially those who have got into a business, improved it, and then exited.

Also worth remembering is that many banks and leasing companies will always ask for a personal guarantee, even if they will also carry out a transaction without it. From the bank’s point of view, if the extra security of any kind is available, at no cost to the bank, why shouldn’t they ask for it?

One reason that the bank will ask for a guarantee is not necessarily to ask for the guarantor to cover a shortfall (if the asset is sold for less than the outstanding lease balance), but rather to ensure that the bank’s assets never get lost, stolen or stripped of parts. (More on this in a future article on insolvency/restructuring.)

It is often much easier to borrow large quantities of ‘cheap money’ than small quantities. If your business plan and your reputation with a bank are good, it is much easier to get a bank excited about a €1m+ or €5m+ acquisition than a €200000 acquisition. The bank can simply charge more fee and interest per man-hour of analysis than for a smaller transaction.

Expensive Money

What if you are buying more than just the assets? Once the value of the company surpasses the value of the assets, banks and other investors will want higher returns, and are more selective on who they will back, hence ‘expensive money’ is called for. This can apply to transactions which have good collateral, but more often are ‘cash flow lends’. Most larger banks do lend expensive money, and often call it Structured Finance or Leveraged Finance.

Banks are strange organisations. They usually refuse to lend money to someone, unless the borrower does not need it. The exception to this are the divisions that specialize in ‘expensive money’. However, this money is not easy to find.

The banks like:

• Deals that are big enough to be interesting – This often starts at €5m, certainly over €1m

• Management team with experience in the sector

• Predictable cash flow and good controls

• Participation from current management

– Management buy–outs have higher success rates than management buy–ins

– A “BIMBO” is a combination of the two (Buy

In – Management Buy Out)

• Specialising in certain industries

• Good advisors

– It can be a huge help if the ‘right’ advisors introduce the deal to the bank

– Non–executive directors can be a valuable addition to a board

– Expect to pay 2% to 4% of the money raised in fees, if agreed on a ‘success only’ basis

• Businesses with history

– This funding is usually not available for start–ups

• Management team is investing substantial sums

– Often referred to as ‘pain money’ making it painful to walk away, or get lured away by a competitor

– As rule of thumb, the shareholding directors must each invest around a year’s salary

A big loan (often called senior debt) on a Structured deal will probably cost 4 to 8% over the cost of funds, and the bank will often ask for a fee of 2% of the deal as well, although interestingly they will sometimes lend you the fee. These fees and interest, however, do add up to a great deal of money. The banks will often lend 1.0 to 2.0x EBITDAR (operating cash flow) in a Structured deal. This can be in addition to a different, secured loan on assets (as described previously).

What if you need more?

Mezzanine finance

As the name suggests, mezzanine finance sits in the middle between loans and equity or capital investment (more later). Usually the same banks do senior debt and mezzanine finance for structured deals.

If a bank lends €5m to a venture as a loan, and charge 4% above base, perhaps they will add another €1.5m as mezzanine debt, charging perhaps 4% to 8% more(!). This is often also called subordinated debt, or sub–debt, as the loan is ‘subordinate’ to other debt, which means if things go wrong, other (especially secured) loans get paid first. Some Mezzanine structures have a ‘kicker’ or a warrant or option over some of the company’s shares which give the bank a portion of the total increase in value of the company.

Equity or capital funding

There are a lot of myths about Venture Capitalists (VCs). These include: if you work with one, they own you, fire you if the weather changes, and make all their money before you do. My experience is that they often act less like loan sharks than some of the leasing companies acting in the plant business. They will take risks, but they need to make an un–capped return in order to pay for the fact that some of their investments will be total losses.

Expect A Venture Capitalist To Require:

• A return of 25% to 30% plus per year on their investment

• Shares in the company

– This may leave the management with a minority or a majority stake – more later

• A clear, controllable and predictable exit strategy

• – In 2 to 5 years

• – They will want to control the exi1t

• An industry with examples of successful exits

• A director they know and trust (perhaps a non–executive that they select)

• A company that is producing revenue, and ideally positive cash flow

– Very few Venture Capitalists will consider backing a start–up, contrary to myth

• Venture capitalists rarely get out of bed to look at investments of less than €1m

– This often means a total deal of several million including debt

It is not a myth that some Venture Capitalists read a business plan backwards – they want to know about the exit even before they know the detail of the business. However, not all VCs want to control your business, that is, own 51% or more of the shares. Transactions have been negotiated in the equipment rental industry, all over Europe, in which the Venture Capitalist has put in most of the cash, but with less than 50% of the shares of the business, provided they are convinced they will make their required +25–30% return.

In fact, in the UK, some funds are structured as VCTs, which have tax advantages for the individual investor into the fund; VCTs can only hold a minority stake in a business (less than 50% of the shares) That said, they will still want to make sure the exit happens on their timescale, under their control. Do expect that a VC will want the company financed with as much debt as possible, which will raise the VC’s rate of return by lowering the amount they invest.

Surprisingly, in the equipment rental business, it is often easier to find €5m to €10m for an acquisition than it is to find €200k to €500k. For €200k, you may have to satisfy credit scoring requirements of some computer, often with no room for judgment by your bank manager. The complexities of preparing a business plan, dealing with potential business partners, legal fees, etc, and difficulty borrowing small sums, tend to push entrepreneurs towards larger acquisitions. For larger transactions, banks and VCs will try to understand your business and concentrate on their own fees – rather than focusing (like traditional banks making loans and leases) on picking up the pieces if it all goes wrong.

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