Lessons Learned in Capitalizing an Acquisition

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Among the myriad variables that must be carefully considered when acquiring a business is the question of how the acquisition is going to be financed. My intent in the material that follows is not to cover the countless options available to acquirors stemming from this question (that wouldn’t be possible in a single blog post of any reasonable length), but instead to provide you with an overview of the specific lessons that I learned when financing my own acquisition in 2014.

I will begin by discussing the importance of the link between capital structure and strategy, and will then discuss more specific lessons learned in raising the debt required to finance the acquisition of my company. Lessons learned in raising the equity will follow in a subsequent blog post.

Aligning Capital Structure and Strategy

There is one consideration in particular that I think is too often overlooked among acquirors, particularly less experienced ones: Namely, the importance of tightly aligning capitalization decisions with the general investment thesis in question. This is important because not all investment returns are created equally.

In some cases, to hit a given return threshold, investors might require target companies to open new locations, acquire new customers, enter new markets, or purchase more properties, plants and/or equipment (we’ll call these types of opportunities “Type A”). In other cases, to hit that same return threshold, those same investors might require different target companies to repay heavy debt loads, upsell existing customers, raise prices, or exit unprofitable lines of business (we’ll call these types of opportunities “Type B”).

All else being equal, the investment thesis underlying Opportunity Type A is growth-oriented, with the required value creation initiatives being quite capital-intensive in nature. In contrast, the investment thesis underlying Opportunity Type B is more cash flow-oriented, and the required value creation initiatives won’t require much capital at all. As a result, these very different investment theses should be financed through very different capital structures.

Though this may sound very obvious to you (I hope that it does!), too often acquirors make capital structure decisions that don’t explicitly consider the fundamental tenets of the investment thesis in question (that is, the unique levers that must be pulled to create value and thus generate their required rates of return).

Sources and Uses

In situations where an acquiring party is seeking external capital to finance the acquisition of another company, substantially all investors will ask for a “Sources and Uses” analysis, which aims to answer:

• Where are you getting the money from? (Sources)
• What are you planning to do with that money? (Uses) 

All else being held constant, in Opportunity Type A I would expect a primary use of the acquisition capital to be funding the company’s balance sheet with a lot of cash to finance the required growth initiatives in light of their capital intensity. In contrast, uses of the acquisition capital for Opportunity Type B are likely to be very different, and could include founder/shareholder liquidity or financing day-to-day working capital requirements, among other things.

Though the sources of capital can vary widely (and are impacted by the investor’s risk tolerance, their access to capital, and their cost of capital, among other considerations), all else being equal I would expect banks to be more comfortable lending more heavily against Opportunity Type B. This is so because lenders tend to value stability in cash flows more than they do company growth, and in most business models company growth tends to be quite “expensive” (i.e., negative pressure on profitability) and tends to consume a lot of cash that would otherwise be used to repay outstanding debt.

So What?

All of this is important because if an investor under-capitalizes an acquisition that necessitates capital-intensive sources of value creation, then they risk not only losing out on their desired rate of return, but they also run the risk of the acquired company running out of cash in their pursuit of growth, even for an otherwise profitable business. On the other hand, if one over-capitalizes an acquisition that necessitates only capital-light sources value of creation, then they also put their desired rate of return at risk through unnecessary dilution (assuming that they over-equitize their investment) and low returns on idle capital, among other things.

As an acquiror trying to maximize returns, it is likely not enough to simply identify an otherwise attractive company and take comfort in the fact that there are dozens of potential value creation levers for you to pull: This “wide net” approach not only introduces the risk of over- or under-capitalization discussed above, but can also be indicative of the acquiror not having a sufficiently nuanced understanding of what specific levers they should be pulling to create value within the acquired company.

This is exactly the trap that I fell into when I acquired my business in 2014. In retrospect, I wasn’t sufficiently clear on my own investment thesis, and as a result, my capitalization strategy at the time could best be described as “fence-sitting”. Though the ultimate return to my investors was a good one, I unquestionably lost out on providing them with a higher rate of return due to my lack of true upfront clarity. My capitalization decisions weren’t particularly reflective of capital-light growth initiatives, nor were they particularly reflective of capital-intensive growth initiatives.

Indeed, many inexperienced acquirors tend to make capitalization decisions in a more general way, usually through some combination of:

• A general acceptance of risk
• A general aversion to risk
• Hastily accepting capital regardless of its source (and thus its implications)
• Not having a sufficiently nuanced understanding of the specific levers that must be pulled in the acquired company to achieve their desired rates of return
• Focusing only on sources of capital, but not being sufficiently thoughtful about the uses of that capital
• Optimizing around the wrong things (for example: Taking too little equity to maximize a personal ownership stake in the acquired company, etc.) 

On Your Way In, Have a Plan for Your Way Out

Though it goes without saying that things can (and often do) change over an investment hold period as new information presents itself, in my opinion it is good investment hygiene to have a plan for your way out while you’re still on your way in: That is, when acquiring a company, you should have an idea of specifically how you’re planning to return capital to your equity investors long before the need to actually do so.

There are many different ways to return capital to investors, including: An exit event, dividends, share repurchases, and leveraged re-capitalizations, among others. The reason why getting early clarity on this issue is important is because without it, you will lack a “north star” that will guide your capital allocation decisions in the course of actually running the business in question.

For example, ~12 months after I acquired my own company, I found myself with ~$2M of cash on our balance sheet, but had no clear plan to allocate it. Because I didn’t have a clear plan on how I was going to return capital to my investors, I ended up dabbling in a number of different initiatives, which mostly included share repurchases, debt repayment, and re-investment in company operations. Though each action in and of itself was likely accretive to equity value, what ultimately manifested was more “fence-sitting”: We weren’t quite a growth investment (heavily re-investing capital in existing operations in anticipation of an exit event several years down the line), nor were we quite a cash flow-oriented investment (likely repaying debt, paying dividends, and/or repurchasing shares). This “half-pregnant” approach to capital allocation ultimately hindered the return that I was eventually able to deliver to my investors.

(For more insight into making capital allocation decisions when actually operating the acquired company, see my blog post “The CEO as Chief Capital Allocator“). (Author’s note: This link will not work until the relevant blog post has been published)

Lessons Learned from Raising Debt

Again, my intent here is not to cover every variable that prospective acquirors should consider when raising debt to finance an acquisition (that is well beyond the scope of this post). Instead, what follows are some specific lessons based on my own experience:

(1) If You Can, Consider Paying Two Commitment Fees

When a lender provides a prospective acquiror with a term sheet (a non-binding summary of the key terms and conditions of a proposed loan, to be further fleshed out in a legally binding credit agreement), they ask for a “commitment fee”. This fee can range anywhere from $20,000 – $50,000 or so, is paid by the prospective borrower to the prospective lender, and is meant to compensate the bank for the time and effort that they will expend in further evaluating the creditworthiness of your company and transaction. If financing is ultimately not approved by the bank, they often return the commitment fee to the borrower. However, if financing is approved in substantially the same form as was laid out in the term sheet, then the bank keeps the commitment fee whether you choose to borrow from them or not.

Though most prospective acquirors (i.e., borrowers) pay only one commitment fee, I would suggest considering paying two different fees to two different banks as a form of “insurance” to protect yourself against what happened to me in late 2013:

After receiving term sheets from several different banks, I decided pay a commitment fee to Bank A, with whom I worked exclusively in the weeks leading up to the closing date of my transaction. During this time, they performed extensive due diligence, and assured me that the terms in the final credit agreement would be substantially the same as those initially presented to me in the term sheet. 1-2 weeks before the transaction’s closing date however, the bank’s “credit” group (the group within a bank that makes final decisions on which loans the bank is willing to underwrite, and on what terms) changed the proposed loan terms to such an extent that Bank A no longer represented the most attractive option – now Bank B (with whom I had ceased communications several weeks earlier, because I wasn’t willing to pay them a commitment fee) had the most attractive offer.

Though this may sound like a “re-trade” made in bad faith by Bank A, it was not: At most banks, term sheets are issued by Relationship Managers (or those with similar titles) and feature the terms and conditions that they suspect will be approved by the bank’s “Credit” group, who typically doesn’t get involved in the process at the term sheet stage. The credit underwriting group (with final say on any given loan) is often looped into the process closer to the contemplated funding date, and if they have a materially different view on the creditworthiness of a company/transaction, then they have the latitude to either not approve the loan at all, or approve it under materially different terms from those that had been originally proposed in the term sheet (as was the case in my own situation). From the perspective of the borrower, this is just an unfortunate reality of the credit underwriting process at many banks.

I can assure you that being two weeks away from the biggest acquisition of your life with no debt financing agreed to is a pretty stressful place to be. Thankfully Bank B was both willing and able to move extremely quickly and ultimately funded the loan on time, but those two weeks were among the most stressful of my professional life, and put the entirety of the deal at risk. For this reason, prospective acquirors may consider paying two separate commitment fees to two separate banks to “insure” themselves against something similar happening to them.

(2) Back-Weight Your Mandatory Amortization Payments, if Possible

This point is especially relevant for individual acquirors who are planning to assume active operational roles in the companies that they acquire, and in particular those who may not have a great deal of operational or leadership experience. 

Running a business (especially for the first time) is hard enough as it is, never mind running a leveraged business under the watchful eye of a creditor. For this reason, in your negotiations with prospective lenders, I’d recommend that you try to “back-weight” your mandatory amortization payments into the later years of the loan to provide you with a bit less pressure in years 1 and 2 where you will presumably still be finding your footing as a CEO. There are two ways for you to do this:

1. Have the loan amortization period exceed the loan term: Just like the mortgage on your home, loans to finance acquisitions feature both terms and amortization periods, and these aren’t necessarily always the same numbers (to illustrate: In a typical home mortgage, terms are often 3-5 years, with amortization periods as high as 20-25 years). A 5-year term loan with a 5-year amortization period would see the borrower make identical annual payments equal to 20% of the loan principal each year for 5 years. In contrast, a 5-year term loan with a 10-year amortization period would see a borrower repay only 10% of the loan principal each year, and in the fifth and final year they would have the option to either make a single balloon payment to retire the entire outstanding amount (in this example, 60% of the loan principal would still be due and outstanding at the end of year 5), or “roll-over” or refinance the outstanding amount into a new loan.

2. Back-weight the mandatory payment schedule: Even if you can’t have the loan amortization period exceed the loan term, you can still request a mandatory payment schedule that is “back-weighted” to the outer years. For example, a 5-year term loan with a 5-year amortization period could feature either of the following two mandatory repayment schedules:

	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Loan 1	20%	20%	20%	20%	20%	100%
Loan 2	10%	10%	20%	25%	35%	100%

In both cases the loan is fully paid off at the end of year 5, but the acquiror has a bit more breathing room in years 1 and 2 as they find their footing.

(3) Don’t Get Greedy on Fixed v. Floating Rate Debt

Just like your mortgage, terms loans to finance acquisitions can be of either the fixed or floating rate variety, and there is a risk/return trade-off inherent in both. As mentioned above, running a business (especially for the first time) is hard enough as it is, to say nothing of the additional challenges associated with running a leveraged business under the watchful eye of a creditor. For this reason, unless you have a meaningfully compelling reason to do otherwise, I would suggest erring on the side of fixed rate loans over variable rate loans. Any “over-payment” of interest that you may pay as a result of this decision will be more than justified by the certainty and predictability of the repayment schedule. There are much better ways to create equity value than benefitting from a few basis points of interest rate differential.

(It’s worth noting that, as of this blog’s writing, the economy remains in a protracted period of low interest rates, which makes this decision all the more straightforward. In high interest rate environments, additional consideration may be warranted, though I would still proceed with caution).

(4) Add a Revolving Line of Credit to Your Term Loan

In addition to the term loans, most banks also offer revolving lines of credit that the borrower can draw down on (i.e., borrow from) and repay at their discretion. Even if you suspect you may not need one of these, I would recommend that you secure one in any case (no interest is ever due unless money has actually been borrowed from the facility, so there isn’t a great deal of downside). Not only do revolving lines of credit provide you with a valuable buffer against unexpected cash flow shortages, but they’re also particularly useful in the first 1-3 months after an acquisition is made. This is so because most companies are sold on a “cash free, debt free” basis, meaning that the seller typically sweeps all of the cash off of the company’s balance sheet immediately prior to the consummation of the sale. This can create unwanted cash crunches if, say, an unexpected expense presents itself shortly after the sale date.

(Note that expected cash outflows immediately following the closing date should be properly accounted for in the Working Capital Adjustment – more information on that here).

(5) Don’t Ignore Non-Bank Sources of Debt Financing

Though there are plenty of other sources of debt capital beyond just banks, I want to focus specifically on the seller as a potential source of debt financing.

In these situations, a “seller note” (also known as a vendor-take-back note, or “VTB”) is issued such that the seller become the lender, and the purchaser becomes the borrower. Consider the following example: A company is being sold at a $20M valuation, with an $11M cash payment upfront and a $9M seller note, at a 5% interest rate, maturing in 4 years. In this situation, the selling entrepreneur receives only $11M in cash today. They would then “lend” the acquiror the remaining $9M (by way of not taking immediate payment of it), and they’d charge the acquiror 5% annual interest, with payment due at the end of 4 years (there could be interim payments, for example, annually).

Seller notes can provide borrowers with several advantages relative to bank debt. Namely:

1. Optically, sellers demonstrate continued confidence in the business and its ability to generate cash flow to service the loan, as they effectively become a lender to it

2. Seller notes can often be a cheaper form of financing (i.e., a lower interest rate) than bank debt, even though they are less seniorin the capital structure relative to bank debt (because they are the most senior in the capital structure, loans from banks have to be paid in full before other lenders – like the sellers – and equity holders see a penny, should the company ever be dissolved or sold). Situations like these aren’t as rare as you may think, and typically present themselves when the seller isn’t aware of prevailing borrowing rates in capital markets. In this way, buyers can benefit from a sort of “interest rate arbitrage”.

3. Seller notes typically have no covenants associated with them, which bank loans almost always do

4. Unlike bank debt, seller notes are usually “non-recourse” in nature, meaning that failure of the borrower to make timely payments will not lead to the lender taking possession of the company and/or its assets to satisfy the outstanding amount of the loan. In saying this, I’m of course not advocating for simply not making the payments that you’ve committed to making – it goes without saying that you should make every effort to do so.

In Sum

Capitalization decisions ARE strategy decisions. Capital structure drives strategy, and strategy drives capital structure. As an acquiror, it’s not enough to simply identify an otherwise attractive company and take comfort in the fact that there are dozens of potential value creation levers for you to pull: This “wide net” approach risks over- or under-capitalization, and is often indicative of a lack of clarity on the part of the acquiror. Furthermore, when contemplating how you’re planning to return capital to shareholders, it isn’t enough to rely on the idea that you can do so through any or all of the available mechanisms: If you do, you may lack a “north star” that will provide you with necessary clarity when making capital allocation decisions in the course of actually running the business in question. The absence of this north star may cause your company to lack a true identity as an investment asset, and returns are likely to suffer as a result.

Finally, when raising debt to finance an acquisition, understand that loans are more multi-variable than they may initially appear to be. Though every loan is ultimately the result of a negotiation between borrower and lender (thus neither party is likely to get every term and condition that they’re seeking), there are many levers for borrowers to pull to make the loan as favorable as possible for them.