Debt & Downside Protection

June 30, 2021 | Issue #26

Big Deal Small Business: Debt & Downside Protection

June 30, 2021 | Issue #26

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Last call for filling out the SMB acquisition deal cost survey! If you’ve closed a deal for a <$3M EBITDA business, it’d be great if you could fill this in to help current & prospective searchers budget their own acquisitions.

We’re up to 15 responses now, so enough to give a good range for folks, but the more the better! Thank you.

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Today’s post is about debt, one of my favorite topics. As someone who has more than dabbled in distressed debt & restructuring, I’ve seen some hairy situations (like people being over $200 million upside down on personal guarantees).

The leverage profile of SMB transactions that use SBA debt is incredibly risky. Folks like to dunk on private equity for using too much debt — self-funded searchers make private equity firms look meek.

For context, most private equity deals use 50-67% debt in their deals, with the remainder being equity. In other words, if you buy a $50M EBITDA business for 10x ($500M), you can get 5-6x of debt (or $250M-$300M) and you have to put in 4-5x of equity ($200-250M).

By contrast, SBA deals allow you to use 90% debt. A $1M deal for 5x ($5M) would allow you to put on 4.5x debt ($4.5M) and only 0.5x equity ($0.5M).

In fairness, SBA debt has a number of lower risk terms than conventional debt:

• 10-year amortization profile (vs 5-7-year profile in conventional debt)

• No maintenance covenants (vs leverage ratios or debt service coverage ratios tested quarterly)

• No restrictions of how you use your cash once you’ve made your debt payments (vs excess cash flow sweeped to pay down debt or restrictions on dividends to shareholders)

That said, let’s get aligned upfront that SBA-financed SMB deals are very risky. But there are a two key levers in your control to mitigate that risk:

• Purchase Price Multiple

• Cash Cushion

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Purchase Price Multiple

Your greatest downside protection comes from your purchase price multiple. Most searchers know this intuitively, but I thought laying out the math would be useful.

It can be tempting to say, “Hey, this is a great business, I want to own it, and the math will work at 4x or 5x, or honestly even 6x purchase price.” I know I’ve said that.

This is correct in theory — I don’t intend to split hairs on purchase price for a good business. But in practice, when you’re using 90% leverage, each increase in purchase price materially impacts your downside protection.

The math is below, but the key row is Downside Sensitivity. I’ve solved for the amount that EBITDA could decline while still being able to cover your debt payments.

As you can see, if you buy a $1M EBITDA business for 3x, EBITDA could decline 50% and you’d still be able to cover your debt payments.

At the other extreme, if you pay 6x for a $1M EBITDA, EBITDA can only decline 9% before you run out of cash flow. That’s only $92K! At that level, it hampers your business plan — maybe you want to hire two new salespeople at $65K each — you only have enough cash flow to hire one.

Look, there’s obviously puts & takes to this — you’d never pay 6x for a business unless it has been growing and you expect it to continue to grow. Maybe your Year 1 EBITDA expectation is really $1.1M, not $1M, so you’re okay paying 6x based on trailing EBITDA.

But that situation requires much more careful business & financial planning. If it’s a working capital intensive business, the growth from $1.0 to $1.1M might require real working capital build that chews up your cash.

That all said, by & large, purchase price multiple is your greatest downside protection.

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Cash Cushion

When you’re looking down the barrel of a debt payment you can’t make, cash is king. That’s the worst time to go back to your investors and ask for more cash.

My perspective (feel free to disagree, hit reply to this email) is that self-funded searchers should over-raise their equity upfront, in the amount of ~1 year’s worth of debt payments. That translates to roughly 12% extra equity.

I don’t mean do 22% equity / 78% debt. I mean do 22% equity / 90% debt, with that extra 12% being cash sitting on your balance sheet to use for debt payments.

My view is that year 1 & 2 are by far the riskiest in any self-funded search deal. You’re going through ownership transition which can cause customer, vendor, or employee defections.

If you can hustle your way through years 1 & 2, you should have generated some cash buffer to withstand further shocks along the way. The deal might not be a home run, but you likely will not bankrupt the business or get hit on your PG.

So let’s stipulate that 2 years is the difference between a busted deal and a middling or upside outcome (obviously not quite that simple). Given that, it seems like a no-brainer to me to raise the extra cash and take one whole year of risk off the table.

The cost of that extra cash is small — probably a few more points of common equity, plus the pref return of 8-12% per year — relative to the amount of downside risk it mitigates.

Your reaction might be, “Why not just do 22% equity / 78% debt so you have less debt to begin with?”

Let’s take the 6x purchase price example, where we only had 9% downside sensitivity. If instead we only did 78% debt rather than 90% debt, we would need to raise an addition $809K of equity to fund the deal.

Our downside cushion increases to ~22%, or $220K vs $92K of EBITDA previously.

So the incremental downside protection is only ~$128K per year. This means in the first two years (the riskiest years!) we improved our cushion by ~$256K ($128K x 2).

Over the 10-year life of the loan, we have $1.28M of excess downside cushion ($128K x 10), but most of the downside protection is in years 3-10 of the loan, which is not when we need it.

By contrast, we could just take that $809K of extra equity as cash on the balance sheet. Yes, our debt payments are higher because we used 90% debt, so that $809K of cushion is lower than the $1.28M cushion above.

But we can use that $809K all in Year 1 and 2, when we need it most, so we actually have an extra ~$553K ($809 - $256) of cushion in the most important years.

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Conclusion

SBA 7(a) debt is a powerful tool when it comes to SMB acquisitions, but we shouldn’t lose sight that it’s a double-edged sword.

Purchase price is the most powerful downside protection, followed by excess cash cushion. I hope this post helped provide some structure around how you’re thinking about using debt in your acquisitions.

My sense is folks have widely differing views on use & amount of leverage — I’d welcome your thoughts. Hit reply to this email or find me on Twitter.

Thanks,

Guesswork Investing

P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, ideally located in the Northeast, West Coast, or Colorado).