Chapter 4
Financing M&A Deals
In This Chapter
Getting a handle on financing and debt basics
Tuning in to types of investors and deals
Digging into EBITDA
Covering Buyers’ return metrics
Working out a deal on a troubled company
Before discussions between Buyer and Seller heat up — and possibly burn out due to lack of planning — Buyers need to line up their financing for acquisitions, and Sellers should ascertain Buyers’ ability to actually come up with the dough.
In this chapter I explore the various methods that help Buyers finance the acquisition of companies, including where Buyers get the necessary capital, what exactly they’re buying, and what those transactions look like.
Exploring Financing Options
To many, buying a company means an exchange of cash: Seller gets some dough, and Buyer gets the company. This transaction implicitly states that the payment is currency, to be paid now, and the price is fixed. Although that’s one way to finance a deal, it’s not the be-all and end-all of M&A transactions. Timing, currency, and even the amount of payment all affect a deal’s financing.
Although cash, especially the all-time favorite “cash at closing” variety, is the preferred payment, it’s not the only way to pay for a company. A better word for what Buyer pays Seller for the company is consideration. Consideration can be anything that a Seller is willing to accept in exchange for the ownership of her company, such as land, another company, or, yes, cash (be that dollars, pounds, Romanian leu, or whatever). Basically, consideration is anything of value (or, more accurately, anything that someone considers valuable). Heck, if Seller accepts a pizza, some seashells, and small island in the Caribbean as consideration for her company, that’s a deal, too!
Traditionally, the consideration used in M&A transactions consists of some combination of cash, stock, notes, and contingent payments (head to Chap-ter 12 for more on noncash payment options). For example, say a deal has a valuation of $15 million. Buyer may not actually be paying Seller $15 million cash at closing. Instead, the consideration may look like the following:
$5 million cash at closing
$5 million in a three-year note at 10 percent
$3 million in stock in the acquiring company
Up to $2 million in an earn-out, with the amount actually received based on acquired company achieving certain results
This setup is just one example of virtually limitless permutations of structuring a deal.
Consideration is limited only by your imagination, which is why creativity is so important during the deal-making process. I’m a firm believer that Buyer and Seller can almost always find a mutually beneficial transaction. Think of it as turning knobs on a stereo: You have a virtually infinite number of ways to twist a multitude of knobs. The following sections lay out a few such options.
Buyers, don’t provide Sellers with your financials, even if they ask. Instead, offer some sort of proof of your ability to complete a transaction. A letter from Buyer’s senior leader expressing support for Buyer’s acquisition strategy goes a long way on this front.
Buyer uses his own cash
The most obvious source of capital is for Buyer to use his own money. The benefits are obvious: a Buyer using his own money has total control over the situation. A third-party lender usually institutes hoops for the Buyer to jump through; using his own money removes those external limitations.
The downside is that money isn’t a bottomless pit, and a company putting money into an illiquid asset such as an acquisition ties up that capital such that the money can’t go toward other important expenses such as payroll and other operating expenses.
Using his own capital to finance 100 percent of an acquisition also means the Buyer is assuming 100 percent of the risk. Bringing in outside capital helps Buyer spread the risk.
Many Sellers incorrectly assume that Buyers are using their own money, and worse, that Buyers have an endless stream of money they’re willing and happy to throw around with little or no planning. Mentally spending someone else’s money like this is one of the biggest errors anyone can make. Being carefree with someone else’s wallet is easy, but think about how you’d feel if someone told you, “You have money; just pay more.”
Buyer borrows money
Because using up precious cash and assuming 100 percent of the risk of an acquired company often makes little sense for Buyers, many Buyers borrow money to help finance the transactions. Borrowed money comes in three basic flavors: senior debt, subordinated debt, and lines of credit. See “Understanding the Levels of Debt” later in this chapter for more on how debt plays into a deal.
Debt, or leverage, is a double-edged sword: It can help a company diversify its risk and make an acquisition easier to swallow. But the borrowing Buyer becomes beholden to the creditor and has to jump through hoops to obtain the capital and keep from defaulting on the loan down the road. If the Buyer’s business declines, he may not be able to the meet loan terms, and a Buyer who can’t repay the loan at that time may lose the business — the entire business, not just the acquired company.
Sellers should keep in mind that Buyers may have limited ability to adjust price or conditions of the acquisition; the Buyer’s overlord, the lending source, has an enormous say in these transactions.
Buyer utilizes Other People’s Money
Although I warn against spending someone else’s money earlier in the chapter, getting other people to give you money to finance a deal is actually a good strategy. Securing Other People’s Money (as I like to call it) is easier said than done, of course; no Other People’s Money shops exist, so you have to be creative.
Private equity (PE) firms can be a good source of Other People’s Money. A Buyer unable or unwilling to utilize bank sources of capital may be able to turn to a PE firm to help with the acquisition, although PE firms often exact a high price in return for using their money.
A PE firm often wants a controlling interest in the entire company (not just the acquisition) in exchange for helping finance the deal. If the acquisition goes wrong, the PE firm may be able to take over the entire company.
Bringing a PE firm also means bringing in debt. Although the PE firm acquires an equity stake in the business in exchange for providing the capital for making the acquisition, the company’s balance sheet becomes loaded with debt. The benefit is that the company can essentially borrow money on the PE firm’s credit, thus opening a world of finance previously unavailable to the company.
Buyer seeks financial help from the Seller
Seller financing — why would a Seller do such a thing? Oh, that’s right: to help get a deal done! A Seller willing to provide financing to a Buyer gains the benefit of being able to move on to the next phase of life — retirement, hobbies, charity work, or perhaps starting another business — while receiving consideration as the result of the sale.
Although cash is always king, a Seller who wants to get out of running the business may find that extending financing (in other words, accepting a promise from Buyer to pay Seller later) helps achieve that goal. Seller financing also can be a way for a Buyer and Seller to conclude a transaction where Buyer is having difficulty obtaining outside capital. Instead of paying back a third-party lender (a bank, for example), Buyer pays back Seller. Seller is taking on the role of the lender.
The typical forms of Seller financing include
Seller note: Seller effectively loans money to the Buyer in order to help with the financing of the acquisition. Money doesn’t flow from the Seller to the Buyer and then back again. Instead, Seller agrees to allow Buyer to pay a certain portion of the transaction price at some later date. Typically, these notes earn interest, either paid on a regular schedule (such as monthly, quarterly, or annually) or accrued and added to the loan, thus repaid when the loan is repaid.
Earn-out: Any kind of payment tied to some future measure of the acquired company’s performance is an earn-out. If Seller believes the company is worth more because she believes future earnings will reach a certain level, Buyer may agree to pay that higher price if the company achieves that certain goal. Earn-outs may be based on top line revenues, operation profit, EBITDA, gross margin, gross profit, sales increases, and so on (see Chapters 12 and 21 for possible earn-out options).
If you agree to an earn-out, keep it as simple as possible. Overly complicating an earn-out is a sure recipe for a disagreement. For Sellers, the best measure of an earn-out may simply be sales. Post-closing, Seller won’t have any control over expenses or allocated expenses, so any target based on profitability will be tough to measure.
Delayed payments: Because time is effectively a part of consideration, delaying payments may be a way for Seller and Buyer to bridge a valuation gap. Simply allowing Buyer to make payments over time affords the Buyer with the ability to pay the price that the Seller wants to receive. Although as Seller you’d prefer $10 today, perhaps you’d be inclined to take $1 per week for the next 15 weeks.
Consulting agreement: An effective way to increase the deal value to Seller is to offer her a consulting agreement that pays her money over some period of time.
Any or all of these plans may be good options for a highly motivated Seller who trusts Buyer to hold up his end of the bargain.
As a Seller, accepting any kind of contingent payment involves an element of risk because you can’t be as sure you’ll be paid in full as you can when the cash is in your hand at closing. To mitigate some of that risk, demand some sort of premium for accepting it by making the contingent price higher. Simply put, pay me $10 million today, or $5 million today plus another $10 million in three years.
Understanding the Levels of Debt
Debt can help Buyer make an acquisition by leveraging Buyer’s existing capital. The following sections cover the different types of debt common in M&A, so dig in!
Surveying senior lenders and subordinated debt
A senior lender is usually a bank that lends a company money, often for the express purpose of financing an acquisition. As the name implies, this lender is senior to all other lenders, which means that the senior lender gets paid before the other lenders in the event the borrower goes bankrupt. A loan from a senior lender is called a senior loan.
Subordinated debt, often called sub debt, is a strip of capital similar to senior debt; however, the lender purposefully agrees to take a back seat to the senior lender. A lender willing to subordinate itself to the senior lender does so in exchange for a higher rate of return. Mezzanine debt (or simply mezz) is a form of sub debt that usually has some sort of equity component (usually in the form of a warrant, which is the right to buy stock in the future at a low price).
Looking at lines of credit
A line of credit (LOC) is simply a loan from a bank, often used to help finance acquisitions. Unlike a senior loan (see the preceding section), the borrower pays interest on the amount it has used. A company may have a $5 million LOC, but if it has only tapped $2 million to help pay for an acquisition, the company only pays interest on the $2 million, not the full $5 million available.
A revolver is a type of LOC designed to help with the short-term cash flow needs of a business. A revolver is helpful to a company whose cash reserves are low (perhaps because it just spent some money making an acquisition) and that needs to pay bills even though its clients are a wee bit slow in paying. Making payroll is usually the main reason for establishing a revolver.
To help during a cash crunch, a company may establish a revolver with a bank. If the company needs cash, it utilizes the cash on its revolver and then repays the revolver as clients remit payment to the company.
Taking a Closer Look at Investors
Investors come in all shapes and sizes. Sometimes they’re institutions (other companies, often called strategic investors), and sometimes they’re people. In this section, I detail the ins and outs of working with institutional and individual investors.
Institutions versus individuals
Most often, Buyers of middle and lower middle market companies are institutions (PE firms or strategic Buyers). Individuals can certainly buy these companies, but due to the size of the companies and the amount of money needed to buy them, individuals buying companies in these markets are somewhat rare.
Individuals seeking to acquire a company may be little more than dreamers with no money. Sellers should take appropriate steps to ensure individual Buyers can back a transaction.
Institutions usually have more money than individuals, greater access to other sources of capital, and a certain level of sophistication as compared to most individuals. The executives at a company or PE firm probably have more experience doing deals, more experience running a business, and greater financial acumen than an individual. Not always, of course, but usually.
Following the financing food chain
Investing in a company isn’t as simple as buying stock. Investors may opt to put their investment in the form of debt, which comes in myriad options with varying risk levels. The higher up the food chain the investor’s place on the balance sheet is, the more likely that investor gets paid in the event of failure, bankruptcy, or liquidation.
If a business fails, it faces liquidation, meaning its assets are sold to repay its debts. In an ideal world, the value of the sold assets would cover the value of the debts, but often that’s not the case. Because of that bitter reality, bankruptcy laws are very clear about who gets what and when. In the US, the liquidation order is as follows:
Employees: Employees, rightfully, are at the top of the list. In the unfortunate event of a business failure, employees who are owed back wages get paid first.
The IRS: Not surprisingly, Uncle Sam wants his cut, too, so any unpaid taxes must be paid in full before any of the remaining money is kicked down the food chain.
Secured creditors: After the employees and Uncle Sam are taken care of, secured creditors are next. Secured means the creditor has a lien or personal guarantee against assets, both of which mean that the creditor can go after the owner’s personal assets (home, cash, cars, and so on).
Unsecured creditors: Any money left over after the secured creditors are repaid goes to the unsecured creditors. These folks typically include vendors and suppliers.
Preferred and common stockholders: If all the creditors are repaid, any money left goes to the equity owners of the business. Preferred stockholders are repaid first, and then what’s left (if anything) goes to the common stockholders.
That setup paints a rather ugly picture for common stock, so why would anyone want to own common stock? Answer: Common stock is the only security that affords the owner unlimited upside potential.
Say a company is being liquidated and everyone else in the food chain is owed a collective $20 million before the common stockholders see a dime.
Although that sounds like a huge hurdle, and it is, suppose the assets sell for $100 million. In this scenario, the common stockholders receive $80 million.
Remember: Please note that for simplification’s sake, I haven’t included the numerous layers of secured and unsecured creditors, some of whom take precedence over others, or the fees of lawyers and other advisors.
Note, however, that a wealthy individual may be able to act more quickly than a company. An individual Buyer has far less bureaucratic red tape than an institutional investor Buyer.
An important distinction is an executive backed by a private equity firm, a situation that’s really closer to a PE Buyer than an individual Buyer. In this case, the individual essentially has the financing lined up and is simply seeking the right acquisition.
Private equity (PE) firm
A private equity firm (sometimes known as a private equity fund) is a pool of money looking to invest in or to buy companies. For all intents and purposes, the firm has no operation other than buying and selling companies, which go into its portfolio.
PE firms raise money from limited partners (LPs). LPs often include university endowments, pension funds, capital from other companies, and funds of funds (which are simply investments that invest in other funds, not in companies). Wealthy individuals also invest in PE firms.
As Seller, don’t assume a PE firm has money to burn. PE firms aren’t bottomless pits of money; they’re using Other People’s Money, so executives are beholden to their LPs.
General partners (GPs) manage the money from the LPs. The GPs oversee the day-to-day operations of the firm, making investor decisions and managing the acquired companies (which become known as portfolio companies after acquisition).
PE firms make money by charging an annual management fee of 2 percent to 3 percent of the money under management and then taking a cut (called the carry) of the profits when they sell portfolio companies. Most often, the PE firm’s carry is 20 percent. The LPs get their original investment back plus 80 percent of the profits.
Getting the founder of a company “out of the way” is often an underappreciated role of PE firms. The PE firm can step in and help bridge a company’s transition from an entrepreneurial firm to a company that better fits with a large acquirer. This role is especially important when the acquired company is a closely held company run by the founding entrepreneur because in that case the transition can be too big to otherwise handle.
Sellers, take time to understand the nature of any PE firm you’re dealing with. Not all PE firms are the same. Some investors are actually fundless sponsors, or Buyers without money. They look for a company to buy, work out a deal with the owner, and then they try to find the money to close the deal. These groups can and do complete deals, but most often, a fundless sponsor adds a layer of complexity to an already-complex subject.
The following sections clue you in on a few common types of PE firms.
Traditional (buy and sell)
A traditional PE firm wants to make an acquisition and perhaps fix up the company by streamlining operation, cutting wasteful spending, increasing sales, and maybe making some add-on acquisitions, all on a three- to five-year timeline. The traditional PE firm finances transactions by putting in as little of its own money as possible. In fact, I’m convinced the ultimate fantasy of most PE firms is to make acquisitions without having to use a dime of their own money!
Traditional PE firms need to eventually sell their portfolio companies. This sale is called a “liquidity event.” Why? Because the firm is taking an illiquid asset (ownership in the company) and exchanging that ownership for some sort of equivalent store of value, commonly called money.
Although PE firms talk about holding their investments for a few years, in reality, all their portfolio companies are for sale at all times, for the right price. The GPs love to brag about their return rates (see the later section “Internal rate of return”), so an early sale with a great return is fine by them.
Family office (long-term holders)
These firms work in a similar fashion to traditional PE firms, except the money usually comes from one or an extremely limited number of LPs. Most often, the LP is an extremely wealthy family that set up an office to manage a portion of the family’s wealth.
Family offices are usually long-term holders of their portfolio companies. In fact, the term is so long that these entities are often called buy and hold. If you ask the typical executive at a family office when the firm expects to sell a portfolio company, the typical answer is a curt, “Never.” For this reason, a family office can make an idea financial partner for a Seller who is concerned about the company being bought and then rapidly flipped or otherwise dismantled.
Strategic Buyer
Strategic Buyer is simply a fancy term for corporate Buyer. As I discuss in Chapter 2, companies make acquisitions for a slew of reasons: growth, new markets, new products, buying out a competitor, and more. Strategic Buyers often focus their acquisition activity on companies that are a fit for their current (or future) strategic plans, often buying from PE firms (see the earlier section “Private equity (PE) firms”).
Strategic Buyers are often the end Buyer after a PE firm has made an acquisition. PE firms may be willing to get their hands a little dirtier than a strategic Buyer is; that is, a PE firm may be willing to take on a deal with some moving parts, replace management, fix operations, add on other acquisitions, and so on.
After the PE firm has spruced up the portfolio company, a strategic Buyer may have great interest in making an acquisition. Much of the heavy lifting, such as turning an entrepreneurial company into a professionally managed company, has been done by the PE firm, and a strategic Buyer recognizes and pays for that value.
Aside from the added value of professional management, strategic Buyers pay more for companies for a few reasons:
They need specific pieces for their puzzles. As the name implies, “strategic acquisition” is exactly that. The acquirer is buying a company that has an important strategic fit, so the acquirer may be willing to pay a premium to keep a valuable company out of the hands of a competitor.
They’re often not bound by the same limitations as PE firms. The investors in PE firms agree to invest only if certain parameters are part of the deal; not paying too much for a portfolio company is often part of the PE mandate. Strategic Buyers have more freedom to spend what’s necessary to get what they need.
They may be looking for a long-term investment. Strategic Buyers may be willing to pay a higher price because their strategy is to buy and hold long term. They aren’t seeking to earn a return on the investment; they’re seeking to earn a return on the cash flow of the acquired company’s operations.
Striking the Right Type of Deal
M&A transactions are basically variations on a theme: How much of the company is being sold, and what is Buyer buying — stock or assets? The following sections delve into these issues.
Exploring the differences among buyouts and majority and minority investments
When Buyers make acquisitions, those purchases can take the form of a complete, 100-percent buyout (mainly for PE firms), a majority investment, or even a minority investment.
As the name suggests, a buyout occurs when 100 percent of a company is sold to another company. A buyout results in a change of control, and although 100 percent of the outstanding stock may be acquired to effect the transaction, it’s possible for Buyer to acquire Seller’s assets (instead of buying stock) and still have a buyout. In other words, buying 100 percent of the stock means you buy 100 percent of the assets, but buying 100 percent of the assets doesn’t necessarily mean you buy any of the stock. Head to the following section, “Choosing an asset or a stock deal: What’s Buyer buying?”, for more.
The new owners may allow the management of the acquired company to acquire the new shares either for a discounted price or as a part of some sort of stock option plan.
A majority investment is when Buyer acquires greater than 50 percent of the company. A minority investment is when Buyer acquires less than 50 percent of the company. Regardless of whether the transaction is a majority or minority investment, in most cases Buyer buys the stock of Seller. If the acquired stock is sold by an existing shareholder, that transaction is called a recapitalization. In this case, no new shares are being created; existing ones are simply changing hands.
If the acquired stock is the result of a new issuing, however, the money raised from selling those shares goes to the company. This setup is often called growth capital because the company retains the money for the purposes of facilitating growth.
Choosing an asset or a stock deal: What’s Buyer buying?
One often-overlooked area of M&A is the question of what exactly Buyer is buying. Companies themselves aren’t really sold, per se; instead, Buyer is acquiring either certain assets of the company (in an asset deal) or the company’s stock (in a stock deal).
Buyers prefer asset deals over stock deals because the former are a lot cleaner logistically. The assets involved may or may not constitute the entire company and often include intangibles such as company name, domain names, customer lists, work in progress, sales pipelines, and so on.
Asset deals are cleaner because Buyer is essentially picking and choosing what she wants to buy. She picks the good assets and leaves behind the bad assets and some (or perhaps all) of the liabilities. Most often, Buyer does assume certain liabilities relating to working capital. A smart Buyer makes sure any assumed liability is current (or within terms).
The big perceived advantage for Buyer in an asset deal is successor liability. If Buyer acquires the stock, any past misdeeds of the company are a liability for the new owner. In some cases, an asset deal may help shield Buyer from the past misdeeds of Seller, but that’s not always the case. Stringent representations and warranties (see Chapter 15) and an escrow account help mitigate this concern, but the risk never completely goes away.
The assignability of contracts (Buyer’s ability to enforce contracts originally signed by Seller) is often in question with asset deals. Buyer may want to consider the risk of losing contracts as the result of an asset deal. The contract is with the company, not the assets!
Sellers usually don’t like asset deals because those deals pose the risk of double taxation. Proceeds from the sale first go to the company, which may have to pay a capital gains tax on those proceeds. The remainder of that money is then paid out to Seller, who in turn may have to pay tax on that after-tax amount.
For that reason, Sellers prefer stock deals. In a stock deal, owners of the company’s stock sell those shares to Buyer and in most cases face just one layer of tax (which is hopefully the capital gains rate). Unless Buyers want to increase the purchase price to offset the higher taxes of an asset deal (and some Buyers will do that), they need to get themselves comfortable with the possibility of stock deals.
Regardless of which side you’re on, talk to your legal and tax advisors, who can advise you appropriately on a case-by-case basis.
Examining the All-Important EBITDA
In addition to being fun to say (I had a client who once referred to it as “EBITDA dabba do!”), EBITDA is a key M&A metric. Heck, it’s a key metric in all things business. EBITDA is a measure of a company’s profitability for doing what that company is supposed to do: selling a product or service. EBITDA effectively removes the profit-distorting effects of taxes, interest income, and expense and eliminates the effects of making capital investments in the firm. In other words, EBITDA is a measure of a company’s financial performance if that company were in a bubble, sheltered from the real world.
Because EBITDA helps measure the company’s underlying profit, banks and other sources of capital tend to use EBITDA when determining how much money they can lend. These institutions measure that amount in turns; one turn is equal to the business’s EBITDA. For example, if the business is generating $3 million in EBITDA, one turn of EBITDA is $3 million. If a company is being sold for $15 million, the Buyer needs to come up with five turns of EBITDA.
Buyer doesn’t necessarily come up with all the necessary turns from one lender. A senior lender may be willing to extend, say, two turns of EBITDA to Buyer ($6 million in this example). If Buyer gets a subordinate debt of one turn ($3 million) and chips in three turns itself, the acquisition financing is complete. (Flip to “Understanding the Levels of Debt” earlier in the chapter for more on senior lenders and subordinate debt.) Most acquisitions follow a financing model along these lines.
In years past, a Buyer may have been able to make that acquisition using less of its own money, but with the tightening of the credit markets in 2008 and the downturn in the economy from 2001 to 2010, most Buyers now find they need to put in more equity than in years past. As of the time of this book’s writing, these estimations are accurate and are subject to change as the economy changes; as always, check with your advisors for your own situation.
Making Buyers’ Return Calculations
Make no mistake: Buyers don’t act solely because of feel-good business-book babble like “the right fit” and “synergy.” They make acquisitions for one simple reason: profit. Besides EBITDA (see the preceding section), Buyers measure profitability in various ways. The following sections present the main methods.
Return on equity
Return on equity, or ROE for short, is simply the amount of income divided by the total amount of the company’s equity. If the company has $1 million in after-tax income and $10 million in equity, the ROE is 10 percent.
ROE is a measure of how well a company is able to generate profits from invested capital. It helps Buyers measure each acquisition’s profitability and continue to monitor whether acquired companies remain profitable enough. If the ROE is too low, management may decide that it can more profitably use the capital tied up in the company elsewhere and that selling the company is the best option.
Return on investment
Return on investment (ROI) is similar to ROE (see the preceding section), except it accounts for the acquisition price and the sale price of a business. You calculate it by subtracting the sale price from the acquisition price and dividing that difference by the acquisition price; the result is a percentage. If you acquire a company for $10 million and sell it for $15 million, the ROI is 50 percent.
Internal rate of return
Internal rate of return (IRR) is a favorite of PE firms and is the main metric investors use when comparing one fund to another. It’s a discounted rate of return; that is, the anticipated future earnings of a company are discounted. A dollar today is worth more than a dollar next year, so the more time that expires, the lower the potential IRR. That’s why PE firms are often very open to selling off a portfolio company sooner rather than later; keeping it may not be beneficial if the IRR is likely going to decline.
Financing a Problem Child
Not all companies go up for sale in the rosiest of circumstances. Sometimes, Sellers need to unload debt-laden or money-losing businesses. Working out financing for these so-called problem children is trickier than finding financing for healthy companies, but it’s not impossible. The following sections present some problem situations and suggest ways you may be able to finance such deals.
Debt is greater than purchase price
When the external debt of a business exceeds the purchase price Buyer is willing to pay (known as being underwater), Seller is in a sticky situation. To accept the price means Seller literally has to write a check for the honor of selling his business. Short of getting Buyer to pay more (always an option worth trying!), Seller has a couple of options for selling his underwater company:
Ask Buyer to pay more. Seller should explain the situation to Buyer; if Buyer is hot enough for the deal, she just may be willing to pay enough to cover all the outstanding costs and debts of the business.
Negotiate with creditors. This situation is tricky because informing a creditor that a company is in financial trouble may cause that creditor to put place a lien on the business or force a bankruptcy on the company. The key is to not say the creditor will get nothing but rather that the creditor will get something. If Seller in financial straits can get major creditors to agree to accept less than the full amount owed, he may be able to extract himself from this precarious position without having to bankrupt the business.
Buyers of troubled companies shouldn’t let Sellers repay all creditors. Instead, Buyers should take complete control of the situation, ask Sellers to submit a complete list of all the business’s creditors, and directly pay all outstanding debt of the business at closing.
The business has operating losses
If a business has operating losses, Seller is wise to ask Buyer to pay for the assets of the business, which may have more value than the business. Sellers are strongly encouraged to speak with their accountants and lawyers before pursuing this course of action.
Another method of selling a business with losses is to determine the contribution, essentially revenues minus direct costs associated with those revenues (typically cost of goods sold, salespeople, marketing, and so on).
Say Seller has $30 million in revenue and $32 million in costs, resulting in $2 million in losses. Assume the direct costs associated with those revenues is $22 million. Therefore, the total nonsales and marketing administrative costs are $10 million ($32 million – $22 million). In this example, Seller would provide $8 million in contribution ($30 million – $22 million = $8 million) to Buyer, assuming Buyer has sufficient existing administrative overhead to absorb Seller without needing Seller’s $10 million of nonsales and marketing administrative costs.
In this example, the question Seller should ask Buyer is, “What value does my company’s $30 million in revenue and $8 million in contribution have to your company?”
For the right Buyer, all or most of Seller’s $8 million in contribution would go to the bottom line. Even if Buyer figures it would need $7 million in overhead to handle Seller’s revenues, that still leaves $1 million that would fall to the bottom line. Any investment banker worth his salt should be able to make that case!