Post-Closing growth may be Stoopid.
An about why Hustling hard after an acquisition may be lethal.
I was listening to a podcast the other day.
A business owner who had bought a business about two years ago was explaining to the host about his trouble financing growth. This story takes place in the USA and the buyer had used a 90% financing loan backed by the SBA to buy the business. He was also given a line of credit based on the historical level of receivables that had been in the business under the previous owner. His big complaint- After the purchase, the business wasn’t able to get further debt in the form of a bigger credit line or equipment financing to fuel additional growth.
The people on the podcast talked about growth and getting new customers and how nasty those bankers are to ruin the party. Different solutions were proposed, and some had been used like buying new trucks personally and putting them into the business. But not one person actually talked about the reason for the problem or it’s solution. I’ll explain those to you today, but first, we need to take a little detour.
We need to explore something called the Opening Balance Sheet. What is this? It’s the balance sheet your new company will have after it has completed the purchase of the existing business. So, this will be a combination of elements from the existing business and your own debt and equity that you brought into the deal. In the US, the SBA offers loan guarantees that allow for up to 90% financing from a bank on the purchase of a business. So, the opening balance sheet of such a deal would feature some assets on one side including equipment, inventory and other stuff and maybe some cash for working capital and on the other side…
90% of that same amount would be there as a big debt and only 10% would sit in the equity section. If you look at the debt vs. equity as a ratio, this is a 9:1 (said out loud ‘nine to one’) debt:equity ratio. For anybody who has ever done a ‘conventional financing’ of a business purchase or, if you’re anywhere outside the USA, then you’ll realize that this level of debt is very high compared to what banks might normally like to do. Normally, with no government loan programs at play, most banks globally don’t like to lend more than $3 of debt for every $1 of equity that goes into a business operation. This would be a three to one debt to equity ratio or 3:1. If you look at those two ratios as percentages, like you might if we were talking about Loan to Value in a home mortgage situation, the 9:1 would be a 90% LTV and the 3:1 would be a 75% LTV. The difference between 75% and 90% is only 15 percentage points. No big deal, right?
****************************** No. you’re wrong. **************************************
The reason bankers look at business debt in terms of a debt-to-equity ratio is because it’s easier to imagine the difference in RISK. You see, bankers have TONS of data available about the relationship between debt and small business failure. They use this data in order to protect themselves and depositors from losses in the absence of a guarantee from a benevolent sovereign (aka SBA.) So, when we consider a 9:1 ratio vs a 3:1 ratio we need to think about the relationship between 9 and 3. Nine is three times larger than 3.
********************************** That translates into a 300% change. !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
9:1 debt to equity ratio companies have a 300% higher chance of failure than a 3:1 debt to equity ratio company. Those 15 percentage points of extra equity make the lower debt companies much more resilient and durable in the fact of hardship or sales fluctuations. When the entrepreneur in the podcast story did his deal, he took the reigns of this very risky business and immediately tried to grow sales and in doing so, needed more equipment, people, and also created a need to invest in more receivables. Yes, when you grow your sales and you wait to get paid, receivables grow and you need to ‘invest money’ in building them up. This means that he went looking for EVEN MORE debt. From any banker’s point of view, he was already risky, now he wanted to become even more so. What is the solution to the problem of growth in a newly acquired company? It never even occurred to the people in the story.
You need to strengthen your balance sheet. *****************************************************
How? The Equity section of the balance sheet needs to grow. There are only three ways to do this.
- Pay down debts while the assets remain the same or grow.
- Earn profits and retain the cash in the company.
- Find new equity to put into the company.
That’s it. So, what would this look like? It would mean backing away from the edge of the cliff. Increase prices if you can, keep costs under control, minimize any capital investments. Build cash, pay debts. Demonstrate that you are a good steward of the bank’s money and your own investment. Slow down, essentially. AND, this is not sexy. But it’s what being responsible looks like sometimes.
Let me tell you a story… I have a client in the medical industry. He had the chance to bid on a $2M contract. He understood his business well enough to know that in addition to new equipment and employees, he’d have to ‘invest’ about $250K into receivables because of the payment cycle of hospitals. What if he didn’t figure that last part out before making his bid? The growth could have killed him. This kind of growth has killed many small businesses over the years. In the podcast, the guest and host talked about how there needs to be ‘new financing solutions’ for such situations. They want to blame the bankers for saying ‘no.’ What is a wiser point of view is that if someone with access to vast data, knowledge and experience thinks what you want to do is too risky, and you think it’s just fine, maybe pause for a moment and try to understand their perspective.
What if bankers aren’t evil and mean?
What if they’re a canary in the coal mine?
If you lack clarity on what growth will really mean to your small business, then I’d encourage you to develop your cash flow forecasting powers.
If you need help with that, just comment below and I'll show you where to find the resources.
David C Barnett P.S. if you enjoyed this article and want to receive more inspiration, thoughts, ideas and how-to’s in your inbox daily, just sign up for my list at https://www.DavidCBarnettList.com