LBOs for Smaller Companies

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business press to the contrary, most LBOs are not management-led megabuck deals for billion dollar companies. Entrepreneurs have used leverage to buy smaller, privately held businesses for years: whenever a buyer lacks the requisite cash and […]</p> ">
business press to the contrary, most LBOs are not management-led megabuck deals for billion dollar companies. Entrepreneurs have used leverage to buy smaller, privately held businesses for years: whenever a buyer lacks the requisite cash and […]</p> ">

If you want to buy a company but don’t have the cash, consider a leveraged buyout. Headlines in the business press to the contrary, most LBOs are not management-led megabuck deals for billion dollar companies. Entrepreneurs have used leverage to buy smaller, privately held businesses for years: whenever a buyer lacks the requisite cash and borrows part of the purchase price against the target company’s assets (receivables, equipment, inventory, real estate) or cash flow (future cash), that’s an LBO.

When I wrote my first article for HBR on leveraged buyouts 11 years ago, assets were all that buyers of smaller companies could borrow against.1 Banks and finance companies were the principal LBO lenders then, with the owner taking back a subordinated note for the difference between the purchase price and the amount the buyer could borrow on the assets.

Today the LBO is common and multiple financing sources and mechanisms abound, though “cash-flow” leveraged buyouts for under $5 million are still unusual. Most financing continues to be asset based, but the cash-flow LBO has helped complete a lot of deals exceeding $10 million when the target company’s assets have been thin. (See insert entitled “The Limitations of Cash-Flow LBOs.”)

Here is advice to help you avoid some common pitfalls as you prospect for the best LBO deal; my main goal is to keep you from breaking your pick digging for a deal that in fact is not there.

Cash Flow, Assets, and Price

In every LBO, whether cash-flow or asset-based, the first priority is to satisfy the lender’s requirements for the deal. Among a host of other factors, lenders look at the relationship among assets, cash flow, and price. As in a good recipe, all of these must be in sync for the deal to work. The assets must be sufficient to protect the loan, the cash coming in must be enough to service the debt, and the price must be in line with both cash flow and assets.

I know of a specialty printer that was for sale. It had two factors in sync but not the third. The company, doing about $5 million in sales, had reported a high pretax profit in the last year of 22% of sales, or about $1.25 million. The price was quite reasonable at $5 million, four times pretax income. The problem was a lack of assets. Unlike many printers, the company had equipment that was small, simple, and inexpensive. This made the company efficient, but a buyer borrowing against its assets (receivables, inventory, and equipment) would scarcely net $2 million, leaving a huge gap of $3 million. Clearly, this was not a doable asset-based LBO. The business finally sold through a variation of a cash-flow LBO with the buyer getting together a group and offering substantial collateral for the loan.

Remember that the cash flow must be used for at least three purposes: to service the senior debt; to service the junior, subordinated debt; and to pay the entrepreneur.2 If this stream is so small that what’s left over for the entrepreneur’s salary is less than what’s necessary to live on, there’s little sense in trying to do the deal. In the excitement of the prospect of buying your very own company, this not-so-minor detail can be forgotten. But don’t jump into a situation that is just too small for even the near term.

If the asset value is high for the price and cash flow, you can effect an LBO by selling off the assets, using the proceeds to reduce the debt, and then running the company with what’s left. In larger deals, this is called breakup value, which means that the value of the parts is greater than the value of the whole.

One acquisition-minded group learned of a possible West Coast divestiture by a New York corporation that apparently didn’t know its subsidiary held valuable real estate. The group bought the subsidiary, then separated this hidden asset value from the manufacturing business. Next, it sold the manufacturing business for as much as it had paid for the whole package, including the real estate. The group was left owning ten acres of desirable property at a zero cost basis! But before you get your hopes up, let’s put this deal in perspective: this was an extraordinary coup. The reverse situation, too few assets, is much more likely, calling for a cash-flow LBO.

What Are Hockable Assets?

Accepting the fact that there must be order in the cash flow-assets-price trinity, the next question is how much of those assets you can actually borrow against. Balance sheet entries for accounts receivable, inventory, and fixed assets can make it appear that a company has more than enough assets to support an LBO, but some assets tend to shrink in the eyes of the lender. I call the assets that financial institutions lend generously against (and which are therefore crucial) hockable assets. Cash, accounts receivable, inventory, equipment, and land and buildings are, to one degree or other, all hockable assets.

Cash. The most hockable. If you buy a company through acquisition of stock, naturally you get all the assets, including cash. This cash, of course, can be used by you to pay the owner. Given the impending demise of the capital gains tax, however, the idea of leaving cash in the business and selling it at capital gains tax rates is going by the board. Nevertheless, the hockability of cash is always 100%.

Accounts receivable. There are about as many plans for borrowing on accounts receivable as there are wholesale-oriented banks. But basically there are two approaches, factoring and pledging.

In factoring, the company sells title to the receivable, with or without recourse in the event of non-payment. One drawback is that factors charge a steep financing cost. If the sale is without recourse, the effective rate, including discounting the receivables, can be as much as 5% for 30 days, which is a whopping 60% annual rate. For that reason alone you’ll likely want to avoid factoring.

But on the positive side, factors usually don’t require an attractive balance sheet or substantial net worth. This is why factoring is common in companies with little net worth, such as apparel manufacturers whose equipment is mostly sewing machines. Factoring is rare in most industries, however, not only because of the steep interest rates but also because the sale of accounts receivable tends to frighten away customers.

Far and away, pledging is the more popular approach to borrowing on receivables in an LBO. With pledging, a bank or finance company gets a secured interest against the receivable by signing a security agreement with the borrower and filing a financing statement at the state capital. In so doing, the lender stakes out a claim against the receivable and lends against its secured position. Title to the receivable remains with the company.

To complete the deal, most buyers borrow every dollar they can. Banks usually loan 70% to 80% of “eligible” receivables, or less than 70% if they are leery. Be careful. Borrowing the maximum can get you into trouble if you have underestimated cash flow. If you’ve borrowed 90% of your accounts receivable and have to return to the bank with hat in hand, where will the borrowing base come from? But if 60% is loaned, the bank can raise that to 70%, 80%, or 90% if you need the cash.

To be eligible, a receivable usually must be no more than 90 days overdue and must also pass certain other tests. Note that this means overdue, not 90 days from the day of the invoice. In the hearing aid manufacturing business, receivables tend to be quite old in the usual sense because the retailer/customers—who are usually undercapitalized—must wait until they are paid before they can pay up. Because Medicare is involved, the delays can be long. One hearing aid maker trying to get a loan argued that its receivables were good collateral even though they were old; the company’s bad debt loss was only 1%. But the bank said no; it held the nearly universal view that a receivable older than 90 days is worthless.

Receivables must also pass tests regarding the “concentration factor” or its opposite, the “dispersion factor.” If a large percentage (whatever that means) of a company’s business is with one or a few customers, a bank might conclude that the company has a concentration factor. This is perceived as bad because if that customer stopped paying all of its invoices, even for a short time, the sudden halt in cash flow—for whatever reason—would spell potential disaster for the company.

There might be a way around this problem with receivables insurance (available in some states) or by financing with a finance company. One supplier I know did 90% of its business with Ford Motor Company; Ford was obviously a good credit risk but it certainly had a concentration factor. The banks wouldn’t touch the receivables, but the supplier got a loan from a finance company that knew and respected the owner. In some cases, a bank and a finance company may divide the loan until conditions improve and the bank is able to take over the whole credit.

The dispersion factor is a consequence of having lots of small receivables from many spread-out customers. Since collecting a small receivable might cost more than it’s worth, many banks will probably decline to loan on all accounts receivable, not just the little ones. One quick-printing company had more than 5,000 accounts with regular orders of between $50 and $300, resulting in thousands and thousands of invoices for tiny amounts. The company’s receivables didn’t comply with the cookie-cutter mentality of a couple of major West Coast banks, and they refused to do the deal. Eventually, a small but hungry wholesale-oriented bank extended a loan on 80% of the receivables.

Buyers of service companies may face banks that won’t consider lending on the receivables at all. The logic behind this practice, or nonpractice, is a bit tenuous, but, in general, banks think collection of a receivable is difficult at best when the product is a service. Whatever the reason, be forewarned that if it’s a service business you’re after, you might have trouble hocking the receivables, especially with a bank.

Note that while finance companies usually have less stringent requirements than banks, the rates they charge on hocked receivables generally start where banks leave off. Banks’ rates usually range between two and five points over the prime rate, while finance companies usually start at four or five points over prime.

Inventory. Of the three types of inventory—raw materials, work in process, and finished goods—only raw materials and finished goods need to be discussed. If a bank lends anything on WIP, it’s either a miracle or the bank is desperate to do a deal.

With raw materials, the hockability is basically a function of two factors: whether the commodity has a well-established market and whether the supplier of the item has a repurchase policy. One manufacturer of heating and air-conditioning ducts used standard-sized, coiled-sheet steel in standard gauges. The steel could be resold almost immediately by a local broker, and that meant excellent hockability with just about any bank.

When the raw material consists mostly of ready-made components, a lender will study whether the supplier has a repurchase policy, perhaps with a restocking charge. If the answer is yes, the hockability is excellent; if it’s no, the lender will probably decline the deal, even if the components could be sold to a competitor for as much as 50 cents on the dollar. Naturally, strictly custom-made raw material is virtually unhockable, except for its scrap value.

Lenders looking at finished-goods inventory can also be choosy. A product carrying a reasonably important warranty for the consumer will surely lack hockability; a manufacturer out of business means a worthless warranty, and consumers would likely buy only at a deep discount. If, on the other hand, no warranty is involved, lenders may feel reasonably safe in lending up to 50% of the finished goods’ value.

Incidentally, the Small Business Administration (SBA) gives loan guarantees on inventory financing. I know of a pot holder manufacturer that had a huge inventory of cloth: Experts on its bank’s credit review committee saw that cloth was involved and immediately said they would lend nothing against the inventory because its value was subject to the whims of fashion. When the manufacturer explained that the cloth was for pot holders and not dresses, and that the same material could be used for years, the bank reluctantly said it would loan 25%. After more negotiation, it agreed to 50% and said it would seek an SBA guarantee for the portion of the total loan represented by inventory.

Because 50% is about the most that can be borrowed on inventory, trying to do an LBO on a distribution-type company (where inventory is important) is difficult at best. The ratio of assets to purchase price is invariably large, so non-LBO buyers will probably be able to outbid the potential LBO buyer. Only if an inventory-rich company is distressed—which of course creates other problems—can an LBO be used to acquire it.

Equipment. The standard for lending on industrial equipment (usually including cars and trucks) is 80% of the quick-sale, or liquidation, value. Most banks will require an appraisal, and the appraiser will come up with both a fair market value for the equipment and a quick-sale value. The difficulty for borrowers is that what is meant by quick sale depends on whom you ask.

There are three types of appraisers for industrial equipment: standard appraisal companies like American Appraisal Associates and Marshall & Stevens, auctioneers or so-called liquidators, and equipment dealers. An appraisal company will usually define quick sale to mean the orderly disposition of equipment over a certain period of time, say six months. A liquidator, on the other hand, will guess what the equipment would bring if put on the auction block next week. (The logic of this escapes me because it’s inconceivable that any company would go broke that quickly. If you’re not talking about near-term liquidation value, then you’re referring to future liquidation value—but what future? And since equipment’s resale value stems from demand for the finished goods produced, what will that demand be? Even so, bankers and finance companies place a great deal of importance on the appraisal’s quick-sale value, and woe to the appraiser whose estimate can’t be realized if the company is liquidated.) It is this difference in definition that might make the appraisal company’s quick-sale price higher than a liquidator’s.

Equipment dealers represent yet another dimension. Their appraisals are likely to be higher still, because dealers tend to see themselves as serving the buyer that hires them rather than the bank, and will boost the valuation to help the deal go through. At least that’s their reputation. Given that fact, a lender probably won’t put much stock in a dealer’s appraisal for lending purposes unless it has great confidence in the dealer. Sometimes banks will demand that the dealer guarantee the appraised price if the equipment must be liquidated within, say, five years. That’s a risk most brokers are unwilling to take, but the rare bird might do it for a fee, such as 10% of the appraised price. Whatever appraiser you choose, however, first get the lender’s concurrence. It would be unfortunate to pay for an appraisal only to find that the lender you have in mind won’t accept it.

Land and buildings. Real property is probably the least complicated asset with regard to its hockability (once it has been appraised). The rule of thumb here: 70% or 80% of appraised value is hockable value, with 90% being quite rare. Either the bank or the buyer may get the appraisal, but if the bank doesn’t get its own, it usually will require approval of the buyer’s appraiser.

Be Careful of Debts, Losses, and Growth

Even if the target company has hockable assets, you should be wary of other pitfalls before pursuing the deal.

Debts. Equally important as the hockability of the assets is whether they are already hocked. Obviously, when the present owner of a business has already borrowed to the hilt, the lender will be unlikely to allow much more borrowing. Existing debt that is adequately taken into account when the company’s price is determined may not be a big drawback in evaluating an LBO. But many owners of closely held small companies conveniently overlook the existing debt when talking price. They want a multiple of pretax earnings for the company’s stock, and when you mention the debt, they’ll say, “What difference does it make?”

Of course, it makes a great deal of difference. The value of a company equals the value of its stock plus the value of its debt. If you subtract debt (often “spontaneous” debt like accounts payable and accrued wages is ignored) from a company’s value (as determined by an agreed multiple of adjusted pretax earnings), the remainder may be so little that a sale is not feasible for the seller. Often the seller wants to retire, so you must find out whether subtraction of debt will leave enough to permit the owner to do so.

If the value of debt (which most likely your lender will demand be paid off) is not subtracted, you as buyer may in fact be paying more than the talking price. I emphasize this point because in the excitement of buying your very own company, you may treat its debt lightly, only to find that the needed financing is not available. If a company is already “hocked,” no amount of enthusiasm will enable you to hock it again. Advice to current owners who anticipate selling the business soon: try to reduce or eliminate secured indebtedness before putting the company up for sale. If you don’t, the price may be disappointingly low, or the whole deal undoable.

No turnarounds. For some individuals, a turnaround—described as a company that is currently losing money but with proper management will “surely” make money—is the ultimate challenge, one they can’t refuse. And doubly enticing, turnarounds are usually priced “low.” But if you expect to do an LBO, you had better bypass turnaround situations. Lenders will look to the current and recent past cash flows for debt-servicing payments, and if the company is in the red, it can’t service its debt. Banks don’t loan on projections—especially rosy projections; they want to see a history of cash flow sufficient to service the debt, and no amount of “yes, but.” rhetoric will change their minds.

True, banks and other institutional lenders have acted strangely on some of the mega-deals you hear about in the press, but for smaller deals, this general statement holds. For the budding entrepreneur wanting to do an LBO, a healthy company is much more attractive than a turnaround. No turnaround can be priced low enough to be effective if the lender won’t lend any money for the deal.

Too much growth. Since growth eats up working capital, going into a growth situation via an LBO is likely to cause cash flow problems. Once a lot of debt is jammed into the company’s cash-flow stream, trying to finance significant growth internally may be overloading the system. If your plans for the target require capital outlays for growth, you may need to secure zero-coupon notes or interest-only loans from pension funds or other institutions in order to do the deal. Remember, don’t confuse net income plus depreciation with cash flow if you are assuming a growth scenario.3

A Compelling Reason to Sell

Of course, it’s always better to be the only bidder when a company is for sale. With an LBO, it is very important, especially if the LBO is asset based. When a number of potential buyers are eyeing a target company, some of the necessary conditions for an LBO become quite difficult, if not impossible, to satisfy.

The biggest threat is a possible demand by the seller for an all-cash deal. In an LBO, the owner usually takes back a subordinated note to cover the difference between the selling price and the loan. Because the note is subordinated to a bank’s senior debt, banks will regard it as equity when they calculate the debt-to-equity ratio to determine the loan amount. Without someone to take a subordinated note in lieu of the seller (a procedure called mezzanine financing), the deal will fail for lack of de facto equity.4

So a third party must be found if the seller won’t take back the note. This used to be difficult, but a few institutions and foreign financiers now buy such notes in small enough amounts (less than $5 million) to make this size asset-based buyout possible. Savings and loans are getting into the business of buying subordinated notes for $5 million or more, if they can get a yield of at least 25% a year. And some S&Ls are getting into the business of providing mezzanine financing for deals less than $5 million.

And finally—a “must” that ranks second to no other—find out why the company is for sale. Without a compelling reason to sell, an owner creates all sorts of problems for the buyer who wishes to do an LBO. First, the price may be unrealistic. “Well,” such owners say, “we thought we’d try it and see what happens.” Moreover, owners sometimes put up “for sale” signs just to test the market. Brokers will often solicit such hypothetical listings. In Los Angeles, hardly a day goes by without a call to the president of an attractive mid-sized company from a broker seeking a listing.

By a compelling reason to sell I mean circumstances like serious illness or even retirement at a normal retirement age. When an apparently healthy person of 40 or 45 wants to retire, you should question the motive to sell.

An owner without a compelling reason to sell may be reluctant to accept a note, particularly a subordinated, unsecured note. Some buyers have solved this security problem by offering a second or junior secured position on the equipment or other assets. The seller is usually well protected, even though in second position: the appraised quick-sale value is often much lower than the price the asset is likely to fetch in a real market. Besides, the buyer is paying off the first loan fast, often over three to five years, and therefore is gaining equity in the equipment.

For some time, leveraged buyouts have been a blessing for owners of small or medium-sized companies wanting to sell their businesses. But the LBO technique has developed dramatically in the past decade. True, buyers had the ability to borrow on particular assets, but banks had no appetite to lend against all the assets of a company. Of course, most business-oriented banks that will do an LBO have gone through several phases during the past ten years and today will probably take a hard look at any proposal. And most banks are asking the buyer/entrepreneurs to put up more of their personal resources. But if the whole deal is structured properly, a bank can usually be found to finance the purchase.

1. “Search for a ‘Leveraged Buyout,’” HBR July–August 1977, p. 8.

2. See my article, “When Is There Cash in Cash Flow?” HBR March–April 1987, p. 38.

3. Stancill, p. 38.

4. See William J. Torpey and Jerry A. Viscione, “Mezzanine Money for Smaller Businesses,” HBR May–June 1987, p. 116.

A version of this article appeared in the January 1988 issue of Harvard Business Review.

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