By JONATHAN L. SCHWARTZ
Management teams seeking to acquire a company often ask me, "What capital structure is right for this business?" This is an important question, as the landscape is littered with bankrupt and liquidated companies that failed because their capital structures were inappropriate.
Most often, that's because the capital structures were too heavily weighted to debt, created insurmountable performance hurdles for management, and did not take into consideration realistic projections for the company.
The capital structure used for an acquisition consists of three primary tiers: senior debt, mezzanine debt, and equity. The case of a loan on a million-dollar house is a good example of senior debt.
To buy the house, I would go to my senior lender and ask, "How much will you lend me to buy this house?" After telling him I can put $500,000 down on the house, he reviews my financial statements and says, "I will lend you 50 percent of the cost of the house and you will make payments of $5,000 per month." In turn, I look at my monthly income of $10,000 and figure I can pay $5,000 to the bank while fulfilling my other debt obligations.
This senior debt is the primary tier of my capital structure. When the house appreciates 10 percent, I will see a 10 percent return on a million-dollar asset, but a 20 percent return on the $500,000 I have invested. I successfully doubled my return on the house from 10 percent to 20 percent. Therein lies the magic of leverage.
In terms of cost, senior debt is the most affordable form of capital for your business. There are two types of senior debt: a working capital line and term debt.
A working capital line is a senior revolving form of debt that is secured by your inventory and accounts receivables. In general, the advance rates, or the borrowing base available, will be 70 percent to 80 percent against receivables and around 50 percent to 60 percent for inventory.
Term debt is secured by the company's hard assets property, plant, and equipment. Banks will lend against the hard assets based upon appraised value, liquidation value, or some range therein. Unlike the working capital line, term debt will require principal and interest payments that will be fully amortized over the life of the loan. Management can go to a bank, have the bank appraise the hard assets, and have a dollar amount lent to them against those assets.
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