Last month, I wrote in my column about the reluctance of the owners of family and entrepreneurial owned companies to sell their businesses.
With income tax increases fast approaching, company earnings improving, and acquisition capital readily available, now would seem like an ideal time for owners to diversify their assets and seek liquidity. But one reason these owners often cite for not wanting to sell is their concern about what to do with the proceeds from the sale. With interest rates at historical lows and continued economic uncertainty, potential sellers often suggest that, despite the desire to redeploy their assets, they feel more secure, and can expect a higher yield, by continuing their ownership rather than selling.
So what if there was a capital structure that addressed these concerns?
Almost every buyer is happy to have the seller take back some paper. The advantages to the buyer are obvious, i.e. the buyer has to raise less cash, the former owner stays motivated to ensure that the business remains a success, and an easy offset, should one be needed, to satisfy indemnification issues is right there for the taking. But in just about every case, the seller is asked to take back either the most junior tranche of debt, or equity, and sometimes the rollover equity is even junior to the cash equity invested by the buyer.
But why would a seller go for this? He has taken his most precious asset and, while getting part of its worth in cash, is now asked to take the remaining piece and convert it into the riskiest part of the capital structure while simultaneously being asked to give up control over his destiny.
We previously discussed how many sellers are concerned about where to redeploy their capital once they get a big influx of cash from the sale. Protecting principal is of paramount importance to these owners. So perhaps when trying to motivate a private owner to sell it might be wise to allow them to roll over in to the senior tranche of debt rather than the junior tranche.
In today’s financing market, there’s an argument that there is more junior debt available for middle market companies than cash flow senior debt. Particularly for companies with less than $10-15 million of EBITDA, attracting senior lenders can still be a challenge. So, why not have the seller become the senior lender with third party junior debt and equity below?
This innovative structure has several advantages. For sellers, it gives them the opportunity to rollover some proceeds in to the safest tranche, rather than in the riskiest part of the capital structure. And by offering the seller an interest rate slightly less than a traditional cash flow loan, the borrower gets a cheaper cost of capital, while the seller still achieves better returns than he would receive elsewhere and in a very familiar entity.
Obviously there are issues surrounding covenants, defaults and intercreditor agreements. But if the likely alternative is that the seller will decide against selling, getting through these hurdles should be worth the challenge.
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