Debt Financing Questions

July 26, 2021

by a searcher from Harvard University - Harvard Business School in Detroit, MI, USA

I'm looking to build some general knowledge on financing an acquisition, It would be great to get your thoughts on these questions.

Does anyone have any thoughts or principles they use to determine the best capital structure (Debt / Equity) for a particular business?

Outside of interest rates, what are the key things to consider when evaluating debt financing options and potential lending partners?

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Reply by a searcher
in New York, NY, USA

Debt is also referred to as leverage - it multiplies the results of the business, for better or worse. A capital structure should accommodate not just the amount of earnings but also their timing, visibility, and dependability. A business that gets large chunks of cash once every few years is very different from a subscription business that gets almost-constant sums every month. Similarly, a business that performs well throughout the cycle has more dependable earnings through the cycle.

Generally, best practice in acquisition financing would have businesses with large, stable, recurring revenues (in industries that are not cyclical) lever up the most, while those in cyclically-exposed, non-recurring revenue businesses have less. But I also encourage you to think about the timing of cash flows and no just revenue/sales -- just because you made a million dollar sale today doesn't mean you have a million dollars of cash laying around. Your conversion of sales to cash is an important metric to also keep in mind.

Creditors will generally underwrite to a "worst case scenario" and I encourage you to also think about those scenarios as you agree to increase leverage in an acquisition. Each dollar of interest is adding a fixed cost onto your platform, so you need to be fully confident that the platform can pay off that cost and provide you a sufficient return (in terms of excess cash flow) to compensate for the embedded risk of that higher-cost model. The cost of debt will potentially impact your ability to price to peers and the time and effort of servicing your debt may detract from your ability to drive increased sales/profitability as a CEO. These are downsides to debt (beyond just bankruptcy risk) that you should consider when contemplating the downside of a lower equity injection.

Reply by a searcher
from Harvard University in São Paulo, Brazil

Hi Terrance, I recommend (i) evaluating the maximum flat-line downside Gross IRR your "baseline business plan" can sustain in relation to Cash-to-EBITDA after interest vs. debt/equity options you have, and (ii) maximizing seller's financing as opposed to bank financing. Example: assuming your structure is 10MM equity + 20MM seller's financing over 3 years + 10MM bank debt (25% equity / 75% debt), and assuming your Cash-to-EBITDA after interest is suffice to pay the yearly installments of seller's financing, then you have a Gross IRR of >60% on the equity invested in a flat-line business plan scenario. [(20MM seller's financing /3 years / 10MM equity - interest]. This exemplifies how 'deal structure' can be a powerful driver of IRR. This is amongst the reasons why Search Funds have an average net IRR >30%, because in many cases, its a combination of "downside protection" IRR + "upside potential" IRR. Achieving >30% IRR solely on upside potential is much harder and the risk-return profile also changes significantly for investors.

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