One of the largest pieces of the acquisition entrepreneurship puzzle is financing. Most acquisitions cannot be done without some component of debt being introduced. That being said, there are a variety of shapes that this can take but the focus of this article is talking about what I’ve learned in over 17 years of transaction about debt.
(1) Debt can protect your ROI, if not even provide your ROI.
Let’s pretend that you buy a business for $100. Now, if that’s boring just add zeros until it gets interesting for you. You bought this company with a $50 cash infusion or $50 of equity and $50 in debt.
I’m not going to say that is normal but it’s also not abnormal in terms of how deals get done.
Some time goes by, the cash flow of the business eliminates the debt altogether. You paid a $100 and the cash flow pays off the $50 debt that you carried and you’re in at a pretty sizable equity infusion of 50% of the entire value.
Now let’s take an interesting pivot, while you’re managing this company, you completely blow it. Members of your team quit. Big customers don’t like you and they leave. The external economy falls to pieces. You end up exiting at a loss or less than what you paid for it. Let’s say $75.
You bought it for $100 and you sold for $75.
Keep in mind, we all know that you’re supposed to buy low and sell high; in this case, it didn’t work like that.
Now, think about it. You’re not actually in at $100, you’re only in at $50.
You put in $50, the business paid off the debt along the way, and you sold it for $75. That’s actually a gain of $25. A 50% gain in this case.
In very loose math, let’s say you owned it for five years then that’s a 10% annual return. Just as an example, in some cases, debt can protect if not provide your return on investment.
(2) Debt is attracted to value.
When something has intrinsic value, especially if it’s cash flowing, then it’s literally bankable. You can go to the bank and say, “this has cash flow and is generating value”. And the bank will say, “this has intrinsic and tangible value. We will give you the money.” Because it wants to be part of your mission.
Like a magnet, if you have something of value and want to acquire it, then it’s very simple. The money wants to come.
The opposite of that example would be raising equity funds. You’re getting cash investments in exchange for equity. These are people that are investing on the future potential of your project whereas debt wants to look at the tangible value.
(3) Debt is cheaper than equity.
A lot of times entrepreneurs like to think about raising a bunch of capital because that will give me the money to fund my acquisition.
In the private capital markets, angel investments, VC investments, search fund investors, any type of investment will expect a 35% internal rate of return on their invested dollars. This is the going rate for a high-risk startup. That being said, if your endeavor carries value like we discussed then you might be able to get it at a lower rate such as 25%. However, if you are looking to acquire using a loan to then it’s closer to 4%.
Even if it reaches 8% in a few years it is not 25 or 35%.
Also note that when you raising equity, gives away the very thing of value that you want to keep. Whereas when debt comes in you do have to pay it every single month but it significantly cheaper than the equity piece.
(4) There is bad debt and there is good debt.
Bad debt is tied to things that don’t carry tangible value.
Good debt is the inexpensive interest rates that are then generating cash flow and building assets for you.
When you have bad debt, it’s going to be either expensive or the most important defining characteristic is it’s either depreciating assets or it was experiences. For example, anything on your credit card is really bad debt possibly the worst debt because it’s meals, vacations, even your kids camp or something like that. It’s really expensive at like 18% plus or minus. It’s really expensive and it’s not contributing to your cash flow or your wealth or providing you to ability to build anything.
(5) It can afford things that you can’t.
In this example, pretend that you had $50 but not $100. You can go out and get $50 in debt in order to acquire the $100 item right now.
I bought my first company in 2006. I didn’t have any money of consequence at that time. It’s one of these where I was able to use leverage to buy that company. In turn, the company paid down that debt and ultimately I sold it.
If you own a business already and you want to grow through acquisition or you want to buy additional equipment then this debt provides the cash that will help you generate value.
(6) It’s faster to get.
Anyone that has raised equity knows that unless you live in Silicon Valley and you’re a repeat performer that has a series of investors you can call like Brad Feld that wants to invest and fill your whole round in a day, it’s extremely difficult. For north of 99% of the population, that’s not how things work.
If you want to raise equity, especially as a first-time entrepreneur, it’s so very hard and will take between 6 and 24 months. Keep in mind that equity raises are not revenue. So despite all of this hard work, you’re not actually generating anything of value yet. You’re just spending all of your time raising that cash.
In this situation, you really have two jobs: one raising capital and the second is growing the actual business.
It’s a full-time job raising capital, but you can get a bank loan in 90 days if you’ve got something that has intrinsic value and is bankable.
If you find a valuable business but can’t afford it, you can run around for a while and give away equity at an expensive rate or go to the bank and get a loan buy the company and then generate cash, pay the debt down, pay the employees, use the cash flow to build more valuable things inside the business, et cetera.
It’s fast to get, and it saves so much of your time. Your time is not free. Do not make that mistake.
(7) You must actually be committed to what it is you’re trying to do.
In most debt-based acquisitions, there will be some kind of personal guarantee on the money that is being given to you.
Most people, at first myself included, spend a lot of time trying to figure out ways to get around this. What I’ve learned in the long term is that if you don’t have a personal guarantee on your debt, there’s usually some other piece of collateral being held.
For example, let’s just say, you’ve got $100 sitting in your bank account and you want the $50, but decide that you’re not going to sign a personal guarantee. They might agree but require you to collateralize it with the balance sheet of the company you’re buying and all of the equipment, for example.
There are ways to get around it but no matter how you slice it, unless you’re doing deals north of say $50 million using non-recourse debt, it is close to impossible to avoid entirely.
For most of us, you have to actually be committed to what you’re trying to do. The lender needs to see that you’re not going to throw them the keys when things get rocky. Consider it putting your skin in the game.
(8) The loan really wants to get paid.
All the loan wants is to get paid.
What do I mean by this? Equity is patient.
Debt is not. Every month debt needs to get paid.
If you have a rocky quarter in your business and cashflow gets tight and you’re trying to figure out how you’re going to pay either the employees or the bank.
That’s not a question you can ask because the bank has to get paid. There’s no tomorrow if the bank isn’t getting paid.
In really hard times, do lenders really want to execute on a personal guarantee? No, they want to work with you to get paid. In really bad times, negotiating with the bank to find a solution is what they really want because at the end of the day, they want a payment every month not your business or your assets.
If you look at their balance sheet, your loan is in the asset column and is generating cash for them. While they do have the upper hand in bad situations, if you do find yourself in a bad situation then most of the time they are going to do everything they can to work with you.
Be constructive in your conversations and negotiate what can be done such as moving to interest only to reduce the burden on cash.
The amount that you’re paying is so much smaller but also interest is expensed on your P&L so it’s reducing your taxable income on that entity whereas principal payments are a cash event, protected by depreciation and amortization.
(9) It comes in all flavors.
There are loans from the Small Business Administration (SBA), traditional loans, mezzanine debt, seller notes, equipment leases, etc.
All debt has different amortization schedules and different interest rates. A mezzanine loan might be interest only but at a high rate of 18%. Other financing options seen recently literally takes 15 or 20% of monthly revenue right out of the bank account until the until the loan is paid off.
My dad told me at a very young age, “Don’t make a bet unless you already know the outcome”. Some of these expensive debt vehicles for buying acquisitions remind me of that. Keep in mind that when you take high interest loans you really are decreasing your own margin of safety as an acquisition entrepreneur.
An SBA loan, for example, is a 10 years variable loan that will fluctuate with what the fed is doing to interest rates. Run the numbers and see yourself that even as interest rates go up, it’s still incredibly affordable. It’s still cheaper than equity and is still one of the best ways to build wealth off of assets that you can’t otherwise afford.
Traditional loans are more like a seven-year loan. If you get a building loan then it’s may be over 20 years. If you buy a business and a building together, they’re going to do a weighted average of the amortization schedule which could lead to an 18-year schedule.
My preferred personal approach is to buy the company, lease the building, usually from the seller for the first five years and then try to buy that real estate at the end of year five or year six. The thing is that buying the real estate in a business situation usually means you can keep more of the cash in the business. That’s actually generating the value for everyone so it comes in lots of flavors.
(10) I love getting out of debt.
As much as we can praise the value that debt can provide in terms of buying existing companies, growing our businesses or just being able to build wealth and equity across a number of assets, there is nothing like paying off a loan!
I love access to leverage because of all of the benefits that it provides but there is a freedom that comes with paying off something like your mortgage. There is a lightness of being that comes along with something like that.
When you pay off a loan that you had on a business, it not only removes the burden, but it is an immediate cash flow boost to the whole company. The feeling that you get when you do the whole story arc of having the asset pay off that loan… you realize that you were smart and did something that created a tremendous amount of value.
The bank was there to help you get this done but ultimately the bank only made 4-6% while you are now sitting with this asset, this box that is generating cash and more importantly, providing value of okay to its customers, to its employees, to you and your family.
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