The vast majority of businesses have multiple owners. Since ‘things change’, instances arise in the life of a business where an owner wishes to leave the business, or the other owners wish he or she would leave. Examples of such situations include:
- the relationship among business owners has soured and one or more of the owners wish to buy out one or more of the other owners;
- for personal reasons, an owner wishes to leave or retire from the business; or
- a marital breakdown where the spouses both have ownership interests in a business and the spouse for whom the business is a principal occupation wants to remove the other spouse from the business.
As business owners consider their options in such situations they are impeded by the following:
- They don’t know the value of the equity stake that needs to go, and the professional expertise for assessing business value can be prohibitively time-consuming and expensive.
- The business stake at issue is often significant (e.g. 20% to 50% of the business), which can be difficult to finance if the business already has debt-financed operations.
- The solution often pitched to business owners is a sale of the business, but not all of the owners want to leave their business.
Often a better solution than selling the entire business is a refinancing that preserves the business intact, known as a ‘shareholder buyout’. The process can seem overwhelming but follow along through the following steps to see that it actually can be done in a cost-effective and expedient manner.
Step 1: Assess value of the departing owner’s equity stake
The first step is to determine the magnitude of the ‘financial challenge’ – the value of the departing owner’s equity position. This is generally done by valuing the business as a whole and then ascribing a value to the equity stake held by the departing owner. For this article, we will assume a simple common share structure.
Business valuations can be an arduous and expensive process, especially one in which a formal opinion of value is sought. As set out in a sample business valuation report by ValuAdder, business valuation professionals seek to determine the “price at which the subject business would change hands between a willing buyer and a willing seller, neither being under a compulsion to conclude the transaction and both
having full knowledge of all the relevant facts.” In order to determine this hypothetical price, a variety of assumptions are made to estimate future cash flows to be generated by the business, to which a discount rate is then applied that reflects a composite of market rates of return, risk adjustments, and growth rates. Wow, a lot of presumptions and guesses involved, many of which are made much more tenuous in a shareholder dispute situation.
If we stop and think about it for a minute, a “willing seller” may want a price, but a “willing buyer” cannot pay any more than the financing that can be arranged to pay for the business. The maximum financing that can be arranged for the business is a composite of debt and equity that can be brought to the transaction upon market terms for advance rates, interest rates, repayment terms, and financial covenants. That being the case, a business valuation can be seen as corporate finance analysis. Parametric Finance offers a number of online corporate finance programs that can be accessed at low cost to make these computations almost instantaneously.
Let’s say you had a business generating $12.088 million in EBITDA (“Earnings Before Interest, Taxes, Depreciation and Amortization”), expected to grow about 3% per year for the foreseeable future, and you had the financial statements handy. You could head over to the Parametric Finance website and in about 2 minutes you could see the estimated maximum amount that the business could be recapitalized for, in other words, its Enterprise Value (“EV”). In the example below, $41.8 million would be the maximum amount of financing that could be arranged that would satisfy general market parameters for advance rates, cost of capital, repayment terms, and financial covenants. Furthermore, we could see that a buyout financing would be a mix of roughly 50/50 debt and equity based on the financial profile of the business.
As the Parametric Finance website states, this is for a cash- and debt-free company, so if your financial statements contain significant surplus cash or finance leases, then it would be advisable to use the FinanceTester online corporate finance program under a free membership plan so that appropriate refinements can be made.
In addition to a few more numbers from the financial statements, the FinanceTester requires a little more information about the business. This additional information enables the program to provide better feedback about the maximum financing strategy, as well as potentially interested funders in the proprietary capital market database maintained by Parametric Finance.
In following exhibit presenting the FinanceTester T12M online corporate finance program, you can see that, using the same numbers as above, the maximum financing amount is $41.8 million. However, you can also see the breakdown of the financing in the “Sources and Uses” table (which bankers love), as well as an indication of the potentially interested funders that have been matched based on industry preferences, geographic preferences, financing size and financing parameters.
Based on the above financial assumptions, funding to acquire the business could be up to $41.8 million. Since there is no surplus cash, nor any debt obligations to be satisfied, this is an estimate of the maximum price that could be paid for the equity of the business, which could be funded by arranging the indicated financing facilities. If the departing owner’s equity interest was 20%, then $8.36 million (i.e. 20% of $41.8 million) is arguably the maximum price that should be paid for that equity stake in the business.
However, what if the company had $1 million of excess cash and $11 million of long-term debt? The Enterprise Value would remain at $41.8 million, but the equity value of the business would be reduced by this “net debt” of $10 million, to $31.8 million as shown in the exhibit below. The fair price for that 20% equity stake would be $6.36 million (i.e. 20% of $31.8 million).
There are many refinements that can be made to potentially increase the financing capacity by accessing the Financing Parameters Panel in the FinanceStarter online corporate finance program, but let’s assume that this last screen shot is indicative of a satisfactory buyout financing strategy to be pursued.
Step 2: Determine appropriate financing to buyout the departing owner’s stake
We concluded in the previous section that, based on the financial assumptions and standard financing parameters, a 20% equity stake was fairly valued at $6.36 million. Let’s further assume that the soon-to-be-departed shareholder was offered $6 million and accepted the offer. Then the next step is to plan out a financing strategy that can be presented to prospective sources of financing.
We could spend countless hours building spreadsheets and guessing at potential financing strategies, or we could go to the Parametric Finance website and use their FinanceTester T12M online corporate finance program which can do all this virtually instantaneously.
Recall that the business had $10 million of net debt. This cannot be ignored in the shareholder buyout analysis. When the dust all settles, the existing net debt of $10 million will remain and additional financing of $6 million will have been brought into the business to buy out the exiting shareholder’s equity stake. But what will be the composition of this financing? Referencing the Sources side of the Sources and Uses Table above, you can see that this $16 million can be made up of a combination of senior term debt, cash flow or subordinated debt, operating debt, or equity. We’re big fans of keeping things as simple as possible because it saves time, cost and financing risk. Moreover, business owners typically favor low-cost debt financing over higher-cost dilutive equity funding (who needs another partner, right?). With these points in mind, the following exhibit reflects a $16 million term debt financing secured by real estate and equipment of the business.
You can see that the FinanceTester T12M online corporate finance program indicates 98 prospective senior lenders that have been matched based on industry preferences, geographic preferences, financing size and financing parameters. The relevant financing parameters to pay attention to would be the general assumptions for senior term debt facilities, as well as the general assumptions for financial covenants. It may be that you are aware of certain company or lender specific circumstances that would warrant a change to certain of these assumptions.
Step 3: Determine the transactional approach for the shareholder buyout
At this point, you’ve crunched the numbers, possibly in less than a couple of hours with the help of the Parametric Finance online corporate finance programs. The next step would be visits to your legal and tax professionals.
Probably the simplest way to effect a shareholder buyout would be to have the company arrange the financing and then repurchase the equity. However, there may be tax planning opportunities that warrant consideration. The form of organization (e.g. corporation, partnership, etc.) may require special consideration too.
Step 4: Undertake financing and repurchase transactions
When the financing and legal strategies have been determined, it is time to actualize it. You will need to ‘market’ the financing to the prospective lenders. If you have a good relationship with your primary bank, the exercise may be as simple as showing the output generated by the FinanceTester T12M online corporate finance software to your account manager. If he or she wishes to have a financial forecast showing the requested financing, this can be as simple as ordering the Financing Strategy Report from Parametric Finance, which presents the requested financing strategy graphically, as well as provides forecast statements of income, position, cash flow, financial covenant compliance, and loan coverage analyses, as well as detailed descriptions of assumptions and calculation methodologies applied.
If you doubt your existing banking relationships, all the more reason to order the Financing Strategy Report, because it also provides a list of the prospective financing sources that have been matched to your ‘financing opportunity’ based on industry preferences, geographic preferences, financing size and financing parameters. In the event that you wish to approach new lenders, it would be advisable to prepare special-purpose presentation materials, such as a Confidential Information Memorandum (CIM) and slide presentation designed to present the financing opportunity in the most relevant and favorable way. The Resources page of the Parametric Finance website contains a CIM template to work with, and additional support services can be sought if required.
A shareholder buyout is often a better solution than a sale of the business
In summary, problems at the ownership level can threaten the viability of a fundamentally good business. But fundamentally good businesses have options other than ‘selling out’. Business valuations and financing transactions are closely connected in that they are both based on earnings forecasts and capital market assumptions. That being the case, a shareholder buyout financing can be much less disruptive to (indeed, preserve) the value of the business as compared to a wholesale divestiture. In many cases, a shareholder buyout transaction can be financed if the ‘math makes sense’.
Parametric Finance offers online business finance programs and resources that make quick work of the math to overcome the impediments of valuation estimation and buyout financing. Sign up for a membership plan or contact us for a demo to see how the Parametric Finance online business financing programs can make quick work of your analysis and fast-track your transaction.