When companies are seeking strategic growth initiatives or shareholder liquidity alternatives, they often consider options that may not fully maximize shareholder value. Utilizing a manageable amount of debt, however, to fund such initiatives can be a prudent way to accelerate growth and/or generate liquidity with more flexibility and greater long-term shareholder value. Whether to fund organic growth, acquisition growth or shareholder proceeds, the use of debt offers many advantages.

Types of Debt
Asset-based lending (ABL) facilities, or lines of credit, are based on a company’s collateral value, which is largely based on a discounted value of qualified receivables and inventories, and typically do not amortize.  Term notes are often based on the liquidation value of fixed assets and generally amortize over a fixed period of time (such as five years). These two types of senior debt are generally the least expensive for a company.

Second-lien, subordinated and structured credit facilities are utilized if more debt is required than is available through senior financing, subject to constraints for interest coverage and leverage multiples.  This type of debt is riskier and therefore more expensive than traditional senior debt financing. In addition, subordinated debt may be accompanied by equity warrants, which equate to a small percentage of a company’s overall equity value.

The type and amount of debt utilized to fund company growth or liquidity transactions is highly dependent on a number of factors, including:

• Type, quality and value of collateral
• Revenues and growth rate
• Earnings before interest, taxes, depreciation & amortization (EBITDA)
• Gross margin and EBITDA margin
• Stability of historical cash flows
• Existing debt obligations
• Industry and customer-specific attributes
• Other related factors

Organic Expansion
For companies that are expanding organically, a revolving line of credit or similar debt facility can provide the necessary working capital to support expansion efforts and reduce the constraints that growth has on operating cash flow. A credit line may also be used to fund entry into a new market that requires upfront capital but does not generate immediate positive net cash flow. A debt facility may allow a company to grow at a much faster rate than would otherwise be the case.  This higher growth translates into larger operating profits as well as greater shareholder value over a shorter period of time. Moreover, it allows a company to penetrate a market more rapidly, reducing competitive risks and increasing operating margin through greater scale.

Acquisition Growth
Companies seeking acquisitions can utilize various types of debt structures to fund a large portion of the total acquisition and related expenses. The use of leverage to fund acquisitions is common and minimizes the need to use cash on the balance sheet or more expensive new equity. The assets and cash flows of the acquiror and target may be combined to determine the total debt available to fund a transaction. Any remaining consideration required to fund the acquisition may be sourced from (i) the acquiring company’s cash balance, (ii) a subordinated “seller” note where the seller acts as a note holder, or (iii) new equity from the acquiror or a third-party. The total cost of the acquisition includes the upfront consideration paid to the target’s shareholders as well as the acquisition-related expenses incurred by the acquiror. Without the use of external debt, making an acquisition would be nearly impossible for many acquirors and would result in significantly higher overall costs, lower returns, and less shareholder value created.

Shareholder Liquidity
For private company shareholders seeking liquidity, there is an alternative to a traditional company sale. In certain cases, shareholders may be able to generate partial, upfront liquidity from their businesses utilizing a minority leveraged recapitalization structure, which allows shareholders to receive an upfront cash dividend. The dividend is funded through external debt, which is borrowed by the company and collateralized by the company’s assets and, in some cases, its cash flow. The overall debt structure can be customized based on the shareholder’s desired goals as well as the company’s collateral base and operating cash flow, among other factors. Moreover, the debt may be comprised of multiple tranches, each having its own unique amortization schedule, rate structure, etc. Such a transaction is predicated on the company’s ability to grow at stable profit margins in order to service the debt. Note: A derivative of the minority leveraged recapitalization is an employee stock ownership plan (ESOP), which involves a newly created trust acquiring all or a portion of the equity from shareholders using debt to fund the purchase.

Unlike a sale to a strategic or financial buyer, the minority leveraged recapitalization structure allows shareholders to participate in a majority of the future incremental value that is created. Compared to an equity recapitalization, the use of debt to recapitalize the company is significantly less dilutive as a result of the lower cost of capital and typically does not result in any initial loss of control. In addition, the transaction process is typically less obtrusive and can be completed more quickly.

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Opus Advisory Partners professionals have significant experience in structuring and funding organic growth initiatives, acquisitions and shareholder recapitalizations.