M & A Matters: December 2014

There is money, believe it or not, for those individuals and companies with well-thought-out business plans. The money is looking for those that have a good understanding of their business and market. Money is attracted to people who put their own net worth on the line. Smart people with some capital to risk make successful businesses work. Not everyone is cut out to own or run a business.

Individuals who ramble on about great ideas are not heard over the roar of those willing to live or die by their own abilities and putting their own money on the line. No one is suggesting that it is an all-or-nothing society we live in; however, when you yourself are at risk, people stand up and take notice. Once you are ready to expose yourself financially, the search for capital becomes much more credible. There are many more dreamers than real entrepreneurs in Canada.

There are three primary sources of capital and a fourth that is becoming an ever-more-important source of equity to small to mid-market private companies.

The first source, internal equity capital, refers to the personal capital of the shareholders and the profits of the business. Owners put their money on the line.

Lenders are a second common source. Loans consist of operating loans, loans secured by accounts receivable and inventory, and term loans for equipment, buildings, land, etc., from a variety of financial institutions. Business loans are perfectly accessible, depending of course on the state of the company’s balance sheet and income statement. Some companies are not capable of taking on debt without a personal guarantee for the entire loan. 

A third, more common, source of capital is arranged with suppliers. A majority of businesses find it indispensable to have trade credit as a part of their financial structure.

A fourth and less-publicized method of providing capital comes from the use of investment angels. It is a non-traditional source of equity provided by a private individual with the funds to inject. The more traditional routes are fairly rigid in terms of financing. Because of the recent credit crunch, lenders have few tangible assets left to use as collateral. The deciding factor becomes the willingness of the owner(s) to further “share ownership” of the business. Where control is a priority, debt leveraging becomes the single outlet for financing company objectives. It should be noted, however, that in today’s economy, highly leveraged companies are often doomed from the beginning and carry a heavy burden of risk.

This burden of risk appears in two principal categories of debt: senior debt and subordinate debt.

Senior debt, generally the least restrictive of the debt categories, depends on a strong asset base-value of the company. Subordinate debt is a type of capital that is usually unsecured or ranks behind the security position of the senior debt lenders. Non-traditional capital providers, which include equity partners, are more conservative and risk-averse in their approach. There is, however, a trade-off in terms of control. The decision to provide capital hinges on the tension between control and leverage. Equity partners may not require the leveraging of assets but in return require a sharing of control. More often than not, those injecting significant capital from their pools of resources want a say in management decisions.

Equity investors expect to receive between 20 and 49 per cent of the equity of the investee company. They request this without consideration for the future performance of the company. Equity investors build their financial models based on getting an equity return of no less than 18 to 30 per cent. If the opportunity is a venture-based investment, they will seek an equity return of 40 per cent or more. This is based on the equity being invested for a period of four to five years.

In the case of a subordinated debt investment, investors will build in a warrant to “convert” to equity. It usually is in the vicinity of 20 to 25 per cent. They might collect interest in the range of 12 per cent in interest for the full term, or just prior to maturity convert their warrant into an equity ownership.