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We daily
receive calls from people asking how they can determine
the appropriate financing for various multi-unit business
transactions. As we explain to these people, determining
the appropriate financing is not so much a science as
an art. There are always certain key questions the multi-unit
operator should consider when looking at financing options.
After evaluation of these initial questions, determining
the "right" financing then becomes a subjective
assessment of how each of the different types of financing
would meet the specific needs of the business.
The three initial questions to consider in determining and selecting financing are:
1. What type of asset(s) am I trying to finance?
2. What is the predictable cash flow from the assets being financed?
3. What sort of personal exposure can I tolerate under a financing?
Before we discuss how these initial questions guide you to the correct financing option, a quick primer on the different types of financing is in order. People often refer to debt or equity types of financing. More recently the term "mezzanine" financing is included in the choices (which is a financing somewhere between debt and equity). In fact, a business in need of financing should think of financing as a continuum. The continuum can be viewed as follows:
Along the continuum, there are various identifiable points that should then be matched with the type of financing being pursued. Various financing in the continuum includes:
Common Stock/Membership Interests. Common stock or membership interests are the most common form of ownership in a corporation or limited liability company ("LLC"). It is a pure equity investment. This offers the highest potential return but is totally unsecured. Common stock or membership interests represent ownership in a company that is tied to the appreciation and growth of the company as the return. Sources for this type of financing include equity funds, individual investors and investment banks.
Preferred Stock/Preferred Membership Interests. Preferred stock or preferred membership interests are another type of equity investment that are paid out prior to the common stockholders or members and may carry a stated minimum return for the investment. Sources for this type of financing include venture capitalists and individual investors.
Mezzanine. Mezzanine is an investment vehicle that is a combination of debt and equity. The debt usually involves the payment of a higher rate of interest and also carried with it an appreciation right to the value of the company thus giving the mezzanine investor a higher rate of return that would be associated with pure debt instruments. Sources for this type of financing include mezzanine funds, large commercial banks and industry specialists.
Debentures. Debenture financing is totally unsecured debt that a corporation or LLC issues to investors. It carries an above market rate of interest. Repayment is dependent upon the ability of the company to provide adequate cash flow to service this debt. Sources for this type of financing include commercial financial companies, bond funds and institutional investors.
Junior Debt. Junior debt is secured debt that is subordinate to senior debt. It has above-market interest rates and is a second position in certain assets. Sources for this type of financing include funds, industry specialists and commercial banks.
Senior Debt. Senior debt is secured debt and is a first security interest in all or most assets. It has the lowest interest rates. Sources for this type of financing include commercial banks, commercial finance companies, securitized lenders and insurance companies.
Within each category of financing, there may be specific, specialized categories of financing. For instance, in the senior debt category, there are portfolio loans which provide greater flexibility, but offer a shorter term and a lower advance rate. This is in contrast to the securitized loans which have a higher advance rate, longer term and few personal guarantees.
In addition to the types of financing described above, there are also a number of ways an operator can do "off-balance sheet" financing. Off-balance sheet financing can be done through a sale/leaseback of the real estate or equipment leasing where the borrower can, in effect, get the full value of the asset financed under a long-term triple net lease.
With all of this information, what does a multi-unit operator do? As I stated above, the first step is to match the financing with the needs and assets available. Let me give you a theoretical case. A multi-unit operator is looking at acquiring 50 daycare facilities that generate approximately $30,000,000 in sales and have an EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) of $3,000,000. The purchase price for the acquisition is $15,000,000 plus $1,000,000 of transaction costs for a total cost of $16,000,000. The 50 units are up and running (seasoned units). In addition, the acquisition involves the purchase of 20 fee interests in real estate.
The first task is to divide the potential acquisition into components. There are four basic components:
1. Business enterprise component (intangibles, licenses, goodwill, etc.);
2. Fixed asset component, which would be any of the equipment, furnishings, fixtures, (i.e., tangible personal property);
3. Real estate; and
4. Soft costs / working capital.
Multi-unit operators will need to determine what kind of leverage they can reasonably obtain on the above-listed components. As to the business enterprise components and the tangible personal property, an operator is going to obtain minimal leverage (probably less than 50% of value). On the other hand, an operator may be able to secure 70% or 80% of loan to value for the real estate component. For the soft costs/working capital, an operator will probably need to contact a friendly bank (that will most likely require personal guaranties) or utilize equity or equity type financing.
Once available senior debt is determined, the gap needs to be filled with equity or some type of mezzanine financing (which we like to call "rented equity"). The combination of equity and mezzanine can take many forms. The key is to develop a solid base for the future. The senior debt will have priority over other financings and will have first interest in all assets. In many cases, the senior debt lender may also be the real estate lender, thus providing for the possibility of higher leverage on the business assets.
If the real estate is financed separately, there may be several options. The first option is to look at a sale/leaseback where 100% of the cost of the real estate is obtained through a sale and a leaseback. Traditional real estate lenders usually provide reasonable leverage of about 70% to 80% of the loan to value. The lenders in this area can be mortgage companies, sale/leaseback finance groups, traditional banks, as well as a number of niche lenders who do real estate (such as CNL, Captec or FFCA).
The key is to keep the leverage down to a reasonable level. In today's market, we would recommend for the multi-unit operator a leverage of no more than 3 to 3-1/2 times EBITDA. Another key element of leverage is the fixed charge coverage (the amount of cash generated to pay your debt on a current basis). We recommend something in the neighborhood of 1.4:1 to 1.5:1. Most operators will try to limit their guaranties; however, in today's market this may be difficult.
In general, once you have a plan, the lenders you should contact become evident. The next step is getting the funding commitment. A good plan with strong equity will always be well received by the finance community.
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