You would probably have heard the expression “leverage it” in the context of using debt secured against fixed property. However, you might not be aware of what “leveraging” means in the context of succession planning for owners of private companies.

Before going into why bank debt can provide an owner with a core piece of a brilliant succession plan, let me share with you the principle of this cash strategy.

PRINCIPLE:

To achieve higher returns on your business-equity increase the proportion of debt relative to equity. But why does increasing debt increase your return on equity, I hear you asking. The short answer is because debt is secured against business assets and cash flow. And because of this security your new debt must be a lower risk than your equity in the business. To further understand this principle ask your accountant to produce a cashflow forecast with debt added and then show you how using your own numbers that the debt increases your return on business-equity. If you want our help, obviously we would be more than happy to help put the cashflow model together for you!

Now returning to the brilliant succession plan tip.

I know there will be some of you reading this that would like some detail around the pros and cons of debt to equity – so here it is in the table below:

Hopefully now we’ve addressed the pros and cons of debt vs. equity, you’ll allow me to explain how taking on debt is a good cash strategy for succession planning purposes.

REAL LIFE SCENARIO:

Consider a scenario where a business owner aged 55 has a business with $1m in EBITDA (earnings before interest tax and depreciation) and wants to step away from the day to day operational management. The business has not had an active cash strategy and consequently has not invested in marketing and recruiting senior managers who can immediately take over the management responsibilities. The likelihood of maximising the sale price in the near term is slim to non existent. There is no one in the company who can afford to buy the business off the owner without the owner providing a vendor loan. And the owner doesn’t think the staff could run the business profitably without his/her involvement. So a sale to existing staff is out of the question.

Here’s where leveraging the business with debt – and deferring the trade sale event – can provide the owner with the option to take some cash out now whilst also increasing the growth capital in the business.

With $1m of EBITDA (year on year regularly) the business possesses strong cash flow for a bank to lend against. If the owner wanted to leverage the company with $2m in bank debt, then the interest payments at say 8% would be $160k in the first year. If the period of paying back the debt was 5 years then $400k per annum ($2m divided by 5 years) needs to be repaid to the bank - in addition to the (reducing) interest payments. You can see that this cash strategy would be achievable, i.e. $1m EBITDA less $560k in the first year.

The goal is obviously to grow the profits of the business and to remove the owner-manager from day to day operations. Hence the owner-manager needs to recognise that he/she wears two hats and to achieve his/her goal will now need to take off the manager hat whilst keeping on the owner’ hat. Growth capital will be needed to pay for new managers to come into the business, take over day to day operations, and push for growth. (Although not part of this example, in parallel a management buy-in could form part of this strategy).

AND NOW THE NUMBERS:

Outcomes of private business-owner using a leveraging  strategy prior to a trade sale:

1. $1m cash out upfront to owner
2. $1m growth capital put into the business – used to recruit managers and increase marketing and product development
3. Probable company valuation today of $3m (EBITDA multiple of 3 X $1.0m EBITDA)
4. Develop a revamped business model in conjunction with new management team
5. Align interests of new management with owner via share options
6. Sell the business in 3 years for $7.5m (EBITDA multiple of 5 X $1.5m EBITDA) – noting that 5x EBITA-multiple and only $500k of additional profits might be a conservative estimate

EQUITY PARTICIPATION:

Now I know some of you will be thinking, but how much equity should the owner ‘give up’. Well, I like to think of it differently and shift perspective to that of the new management team. The way I think of this is to ask ‘what currency does the business owner have to trade with other than cash’. The objective is to recruit managers incentivised for the payout not for the paycheck! Share option plans provide the currency answer and are a proven mechanism in many fast growth startups. Share option plans will become more and more common for driving succession planning deals.

CASH RESULTS:

Let’s finish this off and imagine that the owner is prepared to “give up” 20% of the company if and only if the company is sold for equal to or above $4m. Yes, you did read the correctly. You can structure share option plans such that 100% is retained by the owner unless the company valuation objective on a trade sale has been achieved. Morgan Cradock can help you with this.

• $7.5m sale price
• Owner gets $1.0m upfront (cash from debt secured against company assets and cashflow)
• Owner gets $6.0m (80% of $7.5m)
• TOTAL CASH (pre tax) TO OWNER = $7.0M
• By using this strategy the owner is better off than selling today by $4.5m ($7.5m less $3m) – in my view worth the ‘perceived’ loss of control and bank financing risk

And on the other side of the transaction, the new managers with their share options receive:

• $7.5m sale price
• New managers get $1.5m (20% of $7.5m)
• A handsome “salary” for 3 years work!

SHARE THE WEALTH:

Hopefully, you might think of someone who should know about this cash strategy or it might even be you.

My view is that the leverage method pre-trade sale needs to be used more frequently for owner-managers to maximise their trade sale price on a future exit. When used in conjunction with a fantastic new growth strategy the wealth outcomes are trully amazing.

I’m hoping that taking the first step is now a bit easier. Good luck with your leveraging-before-exit cash strategy!