For companies seeking acquisitions,
there are a number of financing options, such as cash, debt, sellers notes, stock or any combination of those items.
According to Glen Mastey, vice president
of Commercial Banking of Capital One
Bank in Dallas, the ultimate financing
structure is dependent on many factors,
including the objectives of the buyer and
seller, the state of the credit and capital
markets, operating and cash flow characteristics, industry dynamics and purchase
price. However, much of the capital
required to make an acquisition along with
required working capital comes from senior debt provided by a commercial bank.
An acquisition is often a litmus test for the
relationship between the bank and client.
Therefore, it’s important for company management to be aware of certain things
when dealing with its commercial bank.
Smart Business spoke to Mastey about
what a business needs to know to figure
out its ideal acquisition financing structure.
How important is it for a business and its
commercial banker to know each other well?
It’s very important because throughout the
relationship, your banker should have an
understanding that an acquisition may happen. He or she should understand how that
acquisition fits into the company’s overall
strategy, the characteristics of a potential
target, integration and synergy points, post-acquisition consolidated performance and
the impact on existing loan documents.
Management should understand its commercial bank’s overall lending preferences.
For example, many commercial banks
require clients to be fully secured, some
require clients to be partially secured, and
some are comfortable relying on cash
flows. Understanding this will allow company management to more effectively
structure the overall transactions and
allow its commercial bank to respond to its
financing request more quickly.
What’s the ideal rate of risk and return for
both parties?
An acquisition should have the appropriate balance of risk and return for both the bank and borrower. For example, a bank
generally operates with a gross profit margin of less than 3 percent, providing a thin
margin for error. However, if a bank is
smart, it will look for the risks and rewards
for it and its client. Since the post-acquisition combined entity will likely have higher
leverage than either of the participants had
prior to the acquisition, company management should be sure of the following:
- The acquisition size should be small
enough not to trip up the acquiring company in the event of poor integration. - A well-thought-out and documented
financial package consisting of historical
and projected financials on a stand-alone
and combined basis should be assembled.
The package should include projected cost
savings and required spending assumptions. It should demonstrate the client’s
ability to generate strong revenue. It
should also highlight profit margins and
cash visibility to service its interest and
principal debt payments. Additionally, balance sheet flexibility, asset valuation and
break-up value should be reflected. - Loan covenants should allow for
growth and flexibility but protect the bank
in the event of a significant misstep.
Acquisitions often require specialized
covenants as opposed to other senior bank
debt financing transactions. Although
these covenants vary from acquisition to
acquisition, they focus on servicing debt
and maintaining a strong balance sheet,
and they may include an adverse contract
and cost-reduction covenants, inventory
and accounts receivable turns.
Can companies expect banks to build the
same financial structures for all?
No, because there is no one structure that
fits all. Management needs to understand
that several factors including the inherent
profitability level of the company and
industry, cash flow and earning visibility,
and stability will generally impact the
financing structure. Companies in industries that are highly cyclical or subject to
rapid technological obsolescence may
experience unpredictable external forces
that have a substantial negative impact on
cash flows. Such companies are a poor risk
for high leverage. Competitive position is
important, too. Dominant market participants are likely to have control over margins and revenues, putting pressure on
smaller competitors.
What should management be aware of when
considering a financial structure?
Higher equity with less leverage should
result in less liquidity risk and less stringent terms, but the dilution of stock
reduces shareholders rewards. A higher
proportion of equity and subordinated debt
should result in less stringent bank loan
covenants and leave additional borrowing
capacity for unforeseen needs. A higher
portion of long-term debt versus short
revolving debt is generally a better financing match, improving working capital and
thus liquidity.
GLEN MASTEY is vice president of Commercial Banking of Capital One Bank in Dallas. Reach him at (972) 364-6999 or
[email protected].
