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CHAPTER 12
Financing the Deal: The Different Options

Table represents the seven sub-playbooks.

The second component of the financial playbook is funding the deal. Your real investment is different depending on how you finance the deal.

True story. Someone (name withheld) agreed to pay $3MM for 100 percent ownership in a company within 1 month of the close of the sale. The day the sale closed, the company had $5MM in the bank. One month later, the new owner transferred $3MM from the company's accounts to the old owner.

You don't have to be a mathematical genius to figure out that new owner's real investment was not $3MM.

While funding for all your mergers and acquisitions may not be quite that favorable, do consider options for funding beyond cash including equity, seller funding or earnout, and debt, among others.

Cash

On one hand, cash is reasonable straightforward. You give the old owners money. They give you the company. Of course, there may be some wiggle room on when you give them the cash, what currency the cash is in, and other dimensions. And you separately need to source your cash, which may get into other areas of financing outside of the actual deal with the seller.

Equity

Equity deals essentially divide shares in the new, combined entity between the owners of the previous entity. Theoretically, no cash trades hands. There's no need for debt financing. The negotiation focuses the new owners' different levels of equity.

Seller Funding or Earnout

At some point, delaying when you pay the seller becomes a loan from the seller. Or if the seller has to hit some milestones or deliverables to earn part of their sale price, that becomes an earnout.

When Hal Reiter agreed to buy executive search firm Herbert Mines from its founder, Herbert Mines, they agreed on a firm price and 10-year transition. In 1993, Reiter purchased 25 percent of the firm and became president.

Over the next 5 years, Mines transitioned his main client relationships to Reiter. In 1998, Reiter purchased another 50 percent of the firm and became CEO.

Finally, in 2003, Reiter purchased the remaining 25 percent. When Reiter and Mines met for lunch for Reiter to give Mines the final check, Mines noted, “If I'd know how successful you would have been, I would have asked a higher price.”

Reiter didn't miss a beat and replied, “Let's renegotiate.” He ending up giving Mines substantially more money than the original contract in recognition of how helpful he had been during the transition.

Debt

Debt comes in different forms from general loans to bonds to credit lines to bridge financing to mezzanine or subordinated debt.

General loans are when banks or others loan money to organizations in return for interest payments. This is reasonably straightforward and a good idea if the incremental cash flows enabled by the loan more than offsets the interest payments. Expect these to come with covenants that may restrict your degrees of freedom.
Bonds are essentially public debt in which you sell bonds to the public instead of shares.
Credit lines are agreements to loan money that can be accessed when needed.
Bridge financing bridges the gap from deal announcement to close.
Mezzanine or subordinated debt are loans that get paid back after other loans and therefore riskier and carrying a higher interest rate.

Guest Contributor Aaron Darr

Capital Structure Management: Someone Decided to Borrow Some Money

Regardless of the specifics, someone want(ed/s) to buy something that they don't have the cash for. This could be anything: new inventory, new equipment, a shareholder's equity stake, or another entire business. The principal issue is that you need cash, and whomever is going to lend you money is going to need confidence that they are going to get paid back (plus some return on their capital). While this description seems pedestrian, every bit of complexity in capital structure formation and management results from this simple dynamic.

The person or entity that lends you money—let's call them the lender for simplicity—needs to be reasonably confident that you'll be able to pay them back plus some return, usually in the form of interest. If you don't pay them back, they want to be able to take something of value from you to be made whole. The type of loan you can get is going to be a result of what you have (that they can take and presumably sell for cash). Businesses usually use a combination of assets and cash flows to convince a lender they'll be paid back. Assets can be hard (e.g., land, equipment, inventory) or soft (e.g., intellectual property, patents).

If this all sounds simple, trust your judgment—it is. That said, simple does not mean easy.

For purposes of discussion, let's focus on what is required to maintain a capital structure following a transaction. There are a couple of practices for a finance leader that are good hygiene, so to speak.

Review credit documentation for critical operating items. Despite the core document usually being somewhere north of 100 pages, critical operating items center around (a) key dates, (b) definitions, and (c) reporting requirements. Leverage legal counsel to create a calendar of key dates and memo of key definitions, and review with them in detail at the onset. Beyond counsel's advice, work with your counterpart at the lender to review draft reporting prior to formal submission. In a majority of cases, any lender is aligned with initial reporting going smoothly (otherwise they look stupid, too).
1. Key dates: Reporting and payment dates occur on a monthly, quarterly, and annual basis with standard timelines (e.g., 30-, 45-, 60-day deadlines). Depending on the existing cadence within the finance organization, such requirements can represent a substantial increase in tempo.
2. Definitions: A number of non-GAAP terms will be key components of reporting requirements. Understanding how trial balance-level data maps onto such non-GAAP terms is important.
3. Reporting requirements: Some variation of compliance certification will need to be completed, signed, and submitted on a recurring basis.
Build and maintain supporting financial rigor. With additional financial metrics to monitor and manage relative to credit-related reporting requirements, it is important to build and maintain financial analysis to supplement whatever existing financial reporting is in place. With key definitions addressed in step 1, the next step is to put numbers to those definitions. With debt financing of some sort added to the capital structure, the business has assumed additional financial risk that needs to be appropriately managed. Said another way, debt service (i.e., interest and principal payments) has increased the amount of fixed costs in the business. The value of good hygiene here cannot be overstated.
1. Map trial balance-level data to non-GAAP definitions. Utilize the definitions reviewed in step 1 to build Microsoft Excel–based schedules to calculate non-GAAP terms. Certain non-GAAP terms have a number of sub-components to them. A good example of this is adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA itself is a non-GAAP concept of cash flow; adjusted EBITDA goes a step further and excludes one-time impacts to earnings that are thought to not be ordinary course so as to more accurately represent the true earnings power of the business. Two common examples of an adjustments are (i) merger and acquisition (M&A)–related expenses and (ii) one-time consulting expenses. Since these two categories can overlap, it is important to track them at the invoice level in an Excel-based file so that you can optimize the adjusted EBITDA figure.
2. Build Excel-based compliance certificate schedules. Once key definitions have been built into an Excel-based reporting package, the next step is to develop Excel-based schedules for credit compliance reporting. This is as simple as replicating the compliance certifications scheduled in the credit documentation. A common metric to certify compliance is net leverage:
  Net leverage = total debt – cash / adjusted EBITDA
  
  which is represented as a ratio or multiple (e.g., 3.75:1 or 3.75x). While it is common to complete a simple compliance form—literally check a box certifying that net leverage is less than 3.75x and sign the bottom—maintaining the precision of a bottoms-up build in Excel is a best practice.
3. Develop and maintain 13-week cash flow analysis. Debt service, often in the form of cash payments, increases the fixed cost in the business and presents significant monthly, quarterly, or annual cash uses that need to be planned for. A direct cash model to project weekly cash inflows and outflows 13 weeks (e.g., includes quarterly payments) is an incredibly valuable tool. Even with modest debt service on a business, there are times when payroll, rent, vendor payments, and debt service all align and require a finance lead to both plan ahead and manage timing. Paying a vendor a few days late is preferred to defaulting on a credit agreement by not remitting debt service payments. A 13-week cash flow model will need to be tailored to the specific cash flow profile and capital intensity of the business. That said, a few key dimensions should be considered standard: (i) cash receipts; (ii) disbursements related to fixed costs; and (iii) cash disbursements related to variable costs. The goal is to bifurcate cash receipts and disbursements into what is controllable (e.g., ability to impact timing such as paying vendors a few days late) and what has zero discretion (e.g., rent, debt service).

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Table of Contents for CHAPTER 12: Financing the Deal: The Different Options

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Cash

Equity

Seller Funding or Earnout

Debt

Table of Contents for
CHAPTER 12: Financing the Deal: The Different Options