This is my latest blog post -- link the blog post is in the comments below, some of the exhibits (excel screenshots) don't quite show up correctly here, so please visit that to see those in full. ----------------------------------------------------------- I think a lot about debt — how to use it well, when to not use it, how to tell what is “good” debt versus “bad” debt. While most readers think of me as a former private equity guy, the reality is I started my career as a professional investor in distressed debt markets while working at Bain Capital Credit’s Distressed & Special Situations Fund. This was a foundational experience in how I think about business quality, balance sheet strength, and the utilization of debt in general. Private equity came later. As a result, I’ve seen & worked on some hairy situations (like a multi-generational family business being over $200 million upside down on personal guarantees). The leverage profile of SMB transactions that use SBA debt is incredibly risky on its face. Folks like to dunk on private equity for using too much debt — self-funded searchers make private equity firms look meek. Before we dive into a discussion on debt, let’s clarify three key ways of measuring debt: - Loan-To-Value %: How much debt is on the balance sheet relative to total value of the business. - Leverage Multiple: How much debt is on the balance sheet relative to annual EBITDA or cash flow. - Debt Service Coverage: How much annual debt service there is relative to annual EBITDA or cash flow. ----------------------------------------------------------- Sponsor Information We’re proud to have Oberle Risk Strategies as our sponsor. Oberle is an insurance brokerage that specializes in serving search funds and acquisition entrepreneurs. I’ve known and worked with them for 5+ years, so can confidently say they are the firm you can trust for insurance due diligence — this is not an area to overlook in your deal. The service is fantastic, they give practical advice, and – the best part – their offering is free. ---------------------------------------------------------- PE vs SBA Self-Funded Deals Let’s look at a standard private equity deal versus a standard self-funded search deal along these vectors: [This is a screenshot of the deal math, please visit link in the comment below to see it.] For context, most private equity deals use 50-67% debt in their deals, with the remainder being equity. In other words, if you buy a $50M EBITDA business for 9x ($450M), you may be able to get 4.5-6x of debt (or $250M-$300M) and you have to put in 3-4.5x of equity ($200-250M). By contrast, SBA deals allow you to use 90% debt. A $600K EBITDA deal for 4.5x ($2.7m purchase price, but $2.85m including working capital) would allow you to put on ~4.3x debt ($2.6M) and only ~0.2x equity ($289K). Let’s look at the resulting measures of debt: - DSCR is safer in the PE deal - Loan-To-Value is safer in the PE deal - Gross Leverage is similar between the two deals Hopefully this shows how risky SBA-financed self-funded search deals really are from a debt standpoint. ---------------------------------------------------------- SBA Benefits vs Conventional In fairness, SBA debt has a number of lower risk terms than conventional debt: - 10-year amortization profile (vs 5-7-year profile in conventional debt) — the math above results in a bullet due for the PE debt, which they will have to refinance. So the higher DSCR does hide refinancing risk - No maintenance covenants (vs leverage ratios or debt service coverage ratios tested quarterly in PE deals) - No restrictions of how you use your cash once you’ve made your debt payments (vs excess cash flow sweeped to pay down debt or restrictions on dividends to shareholders) That said, I want to be very clear upfront that the “classic” self-funded deal structure is very risk. But there are a two key levers in your control to mitigate that risk: - Purchase Price Multiple - Cash Cushion --------------------------------------------------------- Purchase Price Multiple Your greatest downside protection comes from your purchase price multiple. Most searchers know this intuitively, but I thought laying out the math would be useful. It can be tempting to say, “Hey, this is a great business, I want to own it, and the math will work at 4x or 5x, or honestly even 6x purchase price.” I know I’ve said that. This is correct in theory. But in practice, when you’re using 90% leverage, even small increases in purchase price materially impacts your downside protection. The math is below, but the key row is Downside Sensitivity. In that line, I’ve back-solved for the % amount that EBITDA could decline while still being able to cover your debt payments. [This is a screenshot of the deal math, please visit link in the comment below to see it.] Key takeaway from the chart above: At a 3x purchase multiple, EBITDA could decline by 50% before your annual cash flow can’t cover debt. By contrast, at a 6x multiple, it can only decline by 9%. More concretely, that 9% decline is only $92K in actual dollars! At that level, it meaningfully hampers your business plan — maybe you want to hire two new salespeople at $95K each — you only have enough cash flow to hire one. Look, there’s obviously puts & takes to this — you’d never pay 6x for a business unless it has been growing and you expect it to continue to grow. Maybe your Year 1 EBITDA expectation is really $1.1M, not $1M, so you’re okay paying 6x based on trailing EBITDA. But that situation requires much more careful business & financial planning. If it’s a working capital intensive business, the growth from $1.0 to $1.1M might require real working capital build that chews up your cash. That all said, by & large, purchase price multiple is your greatest downside protection. --------------------------------------------------------- Cash Cushion When you’re looking down the barrel of a debt payment you can’t make, cash is king. That’s the worst time to go back to your investors and ask for more cash. My perspective is that self-funded searchers should over-raise their equity upfront, in the amount of 9-12 months worth of debt payments. That translates to roughly 12% extra equity. Crucially, I don’t mean to capitalize your deal as 22% equity / 78% debt (as opposed to 10% equity / 90% debt, the standard self-funded search deal). I mean to capitalize it as 22% equity / 90% debt (= 112%), with that extra 12% being cash sitting on your balance sheet to use for debt payments. Why increase cash as opposed to just reducing debt? This is a math question. Let’s take a very simple example from the very beginning — a deal with $2.6m of debt and $290K of equity. In that scenario, your annual debt service is roughly $395K/year. If you add another $290K of equity as cash to the balance sheet, that covers an additional 9 months worth of debt payments. By contrast, if you lower debt from $2.6m to $2.3m, your annual debt service changes from $395K to $350K…yes, it’s lower, but not in a way that will be a gamechanger for you if things go wrong. Said differently — I would rather have 9 months of debt payments in dry powder on my balance sheet rather than ~11% lower debt payments but no extra cash. If EBITDA goes down by 25%, which is highly possible, that 11% annual savings won’t stop your deal from busting. That 9 months of cash will save you. --------------------------------------------------------- Timing of Protection My view is that the first few years are by far the riskiest in any self-funded search deal. You’re going through ownership transition which can cause customer, vendor, or employee defections. If you can hustle your way through years 1 & 2, you should have generated some cash buffer to withstand further shocks along the way. The deal might not be a home run, but you likely will not bankrupt the business or get hit on your PG. So let’s stipulate that 2 years is the difference between a busted deal and a middling or upside outcome (obviously not quite that simple). Given that, it seems like a no-brainer to me to raise the extra cash and nearly one whole year of risk off the table. Said differently, the cushion provided by less debt is helpful across all 10 years…but years three onwards are lower risk already. Raising extra cash gives you the downside protection when you need it — in the first few years. --------------------------------------------------------- Conclusion SBA 7(a) debt is a powerful tool when it comes to SMB acquisitions, but we shouldn’t lose sight that it’s a double-edged sword. Purchase price is the most powerful downside protection, followed by excess cash cushion. I hope this post helped provide some structure around how you’re thinking about using debt in your acquisitions. My sense is folks have widely differing views on use & amount of leverage — I’d welcome your thoughts. Comment here on Searchfunder or find me on Substack & Twitter!