HAVING YOUR CAKE AND EATING IT TOO:                     View PDF

By Andy Stockett

Let’s say you’ve grown your company to $10 million in revenue with adjusted cash flow (or EBITDA - Earnings before Interest Taxes Depreciation and Amortization) of $ 1.5 million.

Going to the “next level” requires additional debt (i.e. a loan from your bank with your personal guaranty on it).  Competition in your industry is fierce and to stand still is to die a slow death.  So, the question becomes whether you should push all your chips back onto the table with additional debt or pursue the alternative of “partnering” with a Private Equity Group (PEG)?

First, what is a Private Equity Group? PEGs assemble a pool of funds from a variety of sources – college endowments, pension funds, wealthy individuals, etc. – to make investments in privately held companies.  Their number one condition in determining whether to invest in a company is consistent and stable revenue growth.  A close second is an EBITDA margin of over 10%, followed by an experienced management team that is committed to the company and willing to invest with the PEG in moving the company forward.

Ten years ago most PEGs looked for companies with a minimum of $10 million in EBITDA. About five years ago PEGs emerged willing to invest at $5 million.  Now we find a number of firms stating that they focus on companies with EBITDA as low as $1 million.

So for the entrepreneur who has no succession plan in place and would previously have had to sell to a third party through a business broker, PEGs can present an attractive alternative.

For years stories circulated about the entrepreneur who sold out to the Wall Street guys who then fired everybody, broke the company into pieces and tried to sell the assets shortly thereafter to the “greater fool”.  While this sequence of events has certainly taken place, it is more the exception than the rule.  PEGs have matured over the years to the extent that they frequently hire ex-CEOs as part of their core team or as part of an advisory board.  In turn they analyze companies from an operating perspective as well as from a financial perspective.  While their end objective is to sell to another PEG, have an IPO (Initial Public Offering) or sell to a larger company, they typically intend to grow the company for at least five years after a transaction takes place.

Typically the transaction works such that the PEG values your company at a multiple of cash flow (EBITDA), usually ranging between 4-6x.  Any long term debt and out of term payables are deducted from the valuation and any excess cash is added to determine the “equity value”.  The PEG then proposes to pay the owners 70-80% of that value and let the owners retain the balance.  As part of the transaction, the PEG secures a new lender to replace any existing debt, and the owners no longer have to be personally liable for any bank debt.  The owners are able to take the cash proceeds from the sale of their interests and reinvest into a variety of diversified assets such as stocks, municipal bonds, real estate, etc. and minimize the risk they had from being solely invested in their company.

The PEG has made this investment because it believes in the company, its products and its management team.  The PEG does not want to run the company.  Together the PEG and the management team devise a plan to grow the company.  Any additional debt is backed by the company’s assets and that of the PEG.  If the plan is successful, in many cases the residual 20-30% ownership of the original shareholders becomes worth more than they received in the initial transaction.

© 2010 FourBridges Capital Advisors

FourBridges Capital Advisors is a middle market investment bank providing sell-side, buy-side, capital raising, restructuring, and strategic advisory services primarily to closely-held and family-owned businesses. FourBridges is based in Chattanooga, Tennessee and serves clients across the Southeast, including Atlanta, Nashville, Birmingham, Memphis, Knoxville, and Huntsville.

Past performance is no guarantee of future results and there can be no guarantee that these types of results will be duplicated in the future.