The Weekly: Edition #48 - June 5th, 2020
Debt: Risks, Types, and Sources
The most important benefit of keeping debt to a minimum is the flexibility it affords. With little or no debt and healthy cash flow, a company has the optionality to reinvest for growth, stockpile cash for a rainy day, make distributions to shareholders, self-fund acquisitions, decrease prices, gain favorable terms from suppliers, or spend on employees. With lots of debt options decrease and quickly, which is why most business owners carry minimal debt.
That being said, debt, prudently applied, can magnify outcomes – both good and bad – and it is worth exploring how various forms of debt function for business owners contemplating selling their business. As a business owner, when you are selling your business, the more leverage employed in buying your business, the greater number of parties involved, and the more financing risk you introduce into the transaction.
Generally, you can think of debt falling into two categories – traditional debt (bank debt, high yield debt, and mezzanine debt) and more creative forms of debt (seller financing, factoring, asset-backed financing). Traditional sources range from senior debt that has a shorter term (4-8 years) and is secured by the assets and cash flows of the company to more junior forms of debt that can be non-recourse, sport longer terms (7-10 years), and allow much more flexibility in terms (interest-only, paid-in-kind, warrants). The more creative forms of debt can be used to bridge valuation gaps, increase liquidity for working capital needs, and leverage hard assets on the balance sheet.
As a seller potentially exploring the sale of your business, the main risks to a transaction falling through on the financing side are 1) how much leverage will be used and 2) what types of debt will be employed, besides the obvious fundless sponsor who doesn’t have the equity available. Higher leverage may mean a higher purchase price, but always comes with a lower chance of closing and greater post-close stress.
In challenging economic times, credit markets tend to tighten or lock up, like they are now, and limit the amount of lending that occurs. The Fed’s unprecedented actions in the debt markets have spurred record debt issuances in the public markets by acting as a ‘lender of last resort’ and assuring credit investors of their role as a ‘purchaser of last resort’. But availability of transaction debt in the private markets is largely non-existent. Recently a friend tried to finance a transaction for a sub-$10M earning business that was positively affected by COVID. He was using low leverage and the business prospects were strong. They went to get bids from over 30 banks and had zero responses. Zero. The markets are frozen.
Permanent Equity typically uses little or no debt because we want surety of close, simplicity post-close, and the optionality to use cash flow in whatever way best positions the business long-term. That’s our way, but certainly the odd way.
Traditional Sources
Revolving Credit Facility
- Senior debt (top priority in the case of a liquidation)
- Capped at a maximum amount
- Generally acts as a working capital line of credit to be accessed when a company needs short term funding
- Typically this form of debt is non-amortizing, interest-only
- LIBOR-based (plus a premium) rate
- Sources: Banks
Bank Debt
- Senior debt (top priority in the case of a liquidation)
- Based on asset value as well as cash flow
- Can take the form of Term A (amortizing, 4-6 year term) or Term B (non-amortizing, with a bullet payment at the end of the life, 6-7 year term)
- LIBOR-based (i.e. floating rate) term loan
- Secured by all assets and equity
- Sources: banks, syndicated investment groups
High-Yield
- Generally unsecured
- Fixed payments with no amortization and a bullet payment
- Can be senior (top of the capital stack), senior subordinated (next to top of capital stack), or junior subordinated (bottom of the debt stack, but before the equity)
- Longer maturity than bank debt (7-10 years, with no amortization and a bullet payment)
- Sources: institutional investors, hedge funds, private investors
Mezzanine Debt
- Can be convertible into equity
- Can come with warrants for the right to purchase equity at a certain price
- Can come with PIK features
- Sources: institutional investors, private equity funds, hedge funds, credit funds
Creative Sources
Seller Notes
- Buyer issues a promissory note to seller to repay the portion of the business that is financed
- Generally fixed period of time
- Generally cheaper than other forms of junior debt
- Can be attractive to a seller when credit markets are not as leverage-friendly or where obvious risk should be shared
- Sources: seller
Asset-based financing
- Can utilize fixed assets on the balance sheet as collateral for fixed, amortizing payments that will reduce the need for cash equity as well as other forms of debt
- Generally can be in the form of fully-amortizing debts with balloons at the end of a specified term
- Sources: banks
Factoring
- Securitization of cash flows that are attributable to assets such as receivables that can be liquidated for quick cash in a business transaction
- Generally these will not account for a large portion of the business transaction and may be used to provide early working capital and liquidity needs for the buyer
- Sources: factoring companies
Amazon is the fourth-largest US delivery service and growing fast (Digital Commerce 360)
+ “Since 2014, Amazon has spent $39 billion to build out a massive delivery network, according to Bank of America Global Research, a unit of big U.S. financial institution Bank of America Corp. And that investment soars to $60 billion when including capital leases for such items as warehouses and aircraft, the report says. (Amazon leased 97% of its fulfillment and data center space in 2019, the retailer said in its annual report).”
The way A.P. Giannini built Bank of America shows that hard times can breed the upstarts who fuel the next boom (Wall Street Journal)
+ ““I might never have gone into the banking business,” he later recalled, if he hadn’t gotten into a shouting match with the head of a local bank about its reluctance to make small loans to individual borrowers. In 1904, Giannini founded a bank of his own in San Francisco, called Bank of Italy, to do just that. Then, on April 18, 1906, an earthquake struck the Bay Area, killing more than 3,000 people and setting the city ablaze.”
Learning from Copart’s Willis Johnson (Masters Invest)
+ “Think of us [Copart salvage auctions] like the local sewer system. We’re a utility. Nothing can get rid of us - nothing. Two of the biggest businesses in the world are car manufacturers and insurance companies. If insurance companies don’t write insurance policies on cars, then they’re out of business. If manufacturers don’t make cars, then they’re out of business. They’re always gonna make cars, and they’re always gonna insure them. We’re the guy in between. As long as we’ve got the land in the right place to put the cars on, we can’t fail. We are like the septic tanks of the sewer system. You can’t have the system without us.”"
Meet the secretive German family behind the $2.5B Peet’s Coffee IPO (Yahoo! Finance)
+ “Shares of JDE Peet’s surged 14% in their debut on Friday in Europe. The company, resulting from the merger of Jacobs Douwe Egberts and Peet’s last December, is the world’s No. 2 coffee player, with a portfolio that includes Jacobs Coffee, Douwe Egberts, Peet’s, L’OR, Senseo, Tassimo, Pickwick and more. But most consumers still know very little about JAB Holding, the investment firm that pulled off the Peet’s IPO, or the family behind it: the Reimanns of Germany. Many coffee lovers are likely not even aware that one company is the owner or majority owner of Peet’s, Panera, Krispy Kreme, Dr. Pepper Snapple, Keurig Green Mountain, Caribou Coffee, Mighty Leaf, Stumptown, Intelligentsia, Espresso House, Baresso, Au Bon Pain, Bruegger’s Bagels, and Einstein Bros. Bagels.”
San Francisco, Silicon Valley rents plunge amid downturn (San Francisco Chronicle)
+ “Rents for a one-bedroom apartment dropped most in the cities richest in high-paying tech jobs, falling 9.2% in San Francisco compared with May of 2019. In Mountain View, home to Google, rents fell 15.9% year over year, while in Apple’s hometown of Cupertino rents dipped 14.3%, according to the rental search engine Zumper. In San Bruno, where YouTube has its offices, rents tumbled 14.9%.”
The 2020 Customer Experience Report (CX.Report)
+ “The CX Report gathers trends on how business happens in the computational era by examining the tech stacks for marketing and products in the context of digital transformation.”
The business of building Utopia (Outside)
+ “Nygren stumbled upon the lush landscape that would eventually become Serenbe in the early 1990s. At the time, he was living in Atlanta with his wife and three daughters, experiencing the numbing bustle of running a constellation of 36 successful restaurants. One weekend, the family took a day trip to the rural farms south of the city, resulting in the impulse purchase of a country home on 60 acres. The open space made Nygren realize that he was ready to get off “the treadmill of life,” as he likes to say. In 1994, he sold his business and moved the family out of Atlanta. By the late nineties, Nygren decided to create a bed-and-breakfast on the property, bestowing it with the name his wife had coined for their rural escape, Serenbe—a mash of serenity and being. When, in 2000, development threatened to encroach on Serenbe’s surrounding areas, Nygren bought up 600 neighboring acres. He worked with the local government to craft zoning laws to encourage conservation-minded, village-like developments rather than a sea of McMansions.”
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