You may have heard it called "mezzanine financing", "junior debt", "structured equity" or "quasi-equity financing" but as Anthony Esposti, Manager of Subordinate Financing at BDC explains, the myriad of names all share a common principal - subordinate financing is basically a hybrid of debt and equity financing.
"It shares some of the characteristics of debt financing because the borrower has the obligation to repay," emphasizes Esposti. On the other hand, subordinate financing also mimics equity financing because repayment is based on cash flow rather than depreciating company assets. "What's important to remember is that the word "subordinate" basically refers to the fact that the security of BDC, for example, ranks behind or is secondary to senior lenders." Ultimately, the risk is shared.
So what's the key advantage of this type of financing for a small or medium-sized business? "Subordinate financing provides the capital necessary for a business to fuel its growth or secure its continuity. Repayment is not based on diminishing asset value but more on cash flow potential." emphasizes Esposti.
Expected cost
Entrepreneurs can expect part of the cost to be in the form of fixed interest, which is a deductible expense. The remaining cost comes in the form of a variable component such as a royalty, bonus payments or options to purchase shares in the company at a discount. "It's a higher risk so naturally a investor is looking for a higher return," he says.
Right now, if you're considering subordinate financing as an option, Esposti believes that talking to organizations such as BDC is important. "The industry is typically focused on larger transactions at $5 million and over. The Business Development Bank is a dominant player in the market for smaller transactions under $3,000,000," he says. "As Canada's small business bank, we truly understand the needs of SMEs."
Who's eligible?
Essentially, BDC would consider a small or medium sized business eligible if they have a sound management team, a record of profitability and an established line of credit. This means that start-ups are not considered for subordinate financing "We're looking for companies that have a proven track record and want to move to the next level."
However, he emphasizes that subordinate financing is not a formula-driven solution and can be customized to specific needs, depending on factors such as business seasonality, working capital requirements and the repayment structure. "The first step is to sit down with your lender, bring in your transaction and explain exactly what you're looking for. After that, a customized deal can be worked out," he says.
Typical investment scenarios
So what are the most typical scenarios when lenders consider subordinate financing as an option?
Management buy-outs/buy-ins
With an aging population, many 50+ business owners are looking for ways to exit their companies. Subordinate financing can provide the necessary funds for an existing management team to invest in the company. "Basically, we're helping entrepreneurs fill the financing gap in a transaction ," says Esposti.
CASE
Company X is an insurance adjuster in business since 1986, one of the fourth largest in Canada, showing $22 million in sales and very profitable. 14 senior managers in the company want to buyout owners who are 60+ and are looking to retire. The lender structured a deal that involved an equity injection by the new owners, a loan provided by the exiting owner and subordinate financing to round out the financing.
Mergers & Acquisitions
Mergers & Acquisitions naturally involve both fixed assets and more difficult-to-finance and intangible assets such as "goodwill." Subordinate financing can help companies purchase the goodwill while preserving their cash flow during a period where some uncertainty may exist.
CASE
An online research company has been in business since 1973 but has postponed its IPO due to market conditions. The company has expanded into the US and acquired businesses that will drive 25% growth over the next two years. The company has proven profitability, a strong management team and is a market leader with consistently retained earnings. The deal involves subordinate financing with payment at maturity, allowing the business to preserve cash flow.
Working capital for growth
Subordinate financing is often used to finance working capital for growth, which enables companies to increase revenues and profits. Entrepreneurs looking to invest money in market penetration, improve product R &D or finance additional headcount can take advantage of subordinate financing without compromising their regular cash flow used for daily operations.
CASE
A hardware company in business since 1981 has recently completed development of a proprietary technology. Financing was needed to help the company market this technology to existing clients and a broader market. This business needed to react to the market on a timely basis and to pre-build a one-month inventory of its products. The subordinate financing deal enabled this company to do just that.
Tuesday, May 29, 2012
Thursday, May 24, 2012
Looking to buy a business: Know what you're buying...
Before purchasing a business, you need to be sure you understand exactly what you're buying. That can be difficult. Valuating a business is not a simple exercise or an exact science. It simply provides a theoretical figure that will give you an idea of a fair price to pay.
Perform due diligence
The first thing to do when considering purchasing a company is to assess its financial statements, legal status and assets, including inventory, equipment and accounts receivable. You should use the services of in-house and outside experts to do this.
You should also confirm the vendor's good faith and the soundness of the business. If most of its sales are generated by only a few customers, for instance, you will need to confirm that they intend to continue doing business with the firm once you have acquired it.
You must also take into account any changes you intend to make to the company after acquiring it. No matter how essential these changes may be, keep in mind that their cost may substantially reduce the return on the capital you have invested.
Evaluating assets
The vendor should supply you with a detailed list of what is up for sale. These assets may include land, buildings, equipment, inventory, the name of the business, its customer list and any contracts it has with employees and suppliers, as well as prepaid expenses and intellectual property.
When assessing the value of a company's equipment, make sure you have model numbers, dates of purchase and a record of how well the machinery is working, along with maintenance schedules and warranty details. When appraising inventory, check the age and condition of the stock. Are any of these items obsolete? If they're perishable, are they still well within their best-before date? When assessing accounts receivable, you'll need to determine how likely it is the amounts owing will be repaid. Are the receivables old? Are they collectible? Has adequate provision been made for bad debts? Are there any disputes involved?
Company liabilities
Depending on the nature of the assets, a company's loans or unpaid liabilities may become your responsibility as a buyer. A previous lender might even be in a position to seize the company's assets as repayment for an unpaid loan, leaving you with nothing. You need to know if the company has signed agreements that might lower the value of the assets or limit your freedom of action.
Determining fair market value (FMV)
There are a number of ways to determine an asset's fair market value. A specialist's appraisal may be needed for assets such as real estate, major equipment or specialized inventory. Likewise, a collection agency can help you evaluate the true value of accounts receivable, especially when assessing a company with many customer accounts.
Never rely only on the judgment of your accountant or the seller. It's always best to obtain an independent report from an expert specializing in business valuations. This is an unregulated field, but the Canadian Institute of Chartered Business Valuators provides guidelines and a code of ethics.
There are two main methods of valuating a business: one based on assets, the other on earnings and cash flow. An asset-based valuation can be based either on its book value - the company's assets minus its liabilities, as shown in financial statements - or its liquidation value: what a business could expect to fetch if it sold all its assets, paid down all debts including taxes, and then distributed the surplus to shareholders. An earnings-based valuation looks more closely at a company's current and projected future cash flow.
Although it's ideal to try to compare your potential acquisition with a similar transaction, in reality you will rarely be able to do this. In general, little information on such deals is publicly available, and the terms of any deal are often too closely tied to conditions in a particular economic sector to make them truly comparable.
Implications of buying shares
Anyone buying shares in a company takes a stake in the business, together with all of its assets and liabilities, whether they are recorded on the company books or not. A purchase agreement can include a provision that involves a buyer directly in the management of the company, or the purchaser can remain a silent partner. This latter option can smooth the transition between owners, lowering the price paid by the purchaser and allowing existing owners to show buyers how a business is run. The purchaser sometimes has the option of buying out the remaining shares and becoming sole owner later. Such a scenario is more likely if the target business is publicly traded and if the buyer has purchased enough shares to have some influence on how it is run. If a business is privately owned, the owners may prefer an outright sale.
There are always risks. Deals like these can sour if the buyer does not get along with the original owners or if the new and original owners have conflicting strategies. A purchaser may also unwittingly become responsible for liabilities such as unrecorded income tax reassessments, lawsuits and warranty claims that were not recorded in the financial statements. The new owner should also avoid being bound by the previous owner's depreciation schedules, which can be altered based on the purchase price.
Perform due diligence
The first thing to do when considering purchasing a company is to assess its financial statements, legal status and assets, including inventory, equipment and accounts receivable. You should use the services of in-house and outside experts to do this.
You should also confirm the vendor's good faith and the soundness of the business. If most of its sales are generated by only a few customers, for instance, you will need to confirm that they intend to continue doing business with the firm once you have acquired it.
You must also take into account any changes you intend to make to the company after acquiring it. No matter how essential these changes may be, keep in mind that their cost may substantially reduce the return on the capital you have invested.
Evaluating assets
The vendor should supply you with a detailed list of what is up for sale. These assets may include land, buildings, equipment, inventory, the name of the business, its customer list and any contracts it has with employees and suppliers, as well as prepaid expenses and intellectual property.
When assessing the value of a company's equipment, make sure you have model numbers, dates of purchase and a record of how well the machinery is working, along with maintenance schedules and warranty details. When appraising inventory, check the age and condition of the stock. Are any of these items obsolete? If they're perishable, are they still well within their best-before date? When assessing accounts receivable, you'll need to determine how likely it is the amounts owing will be repaid. Are the receivables old? Are they collectible? Has adequate provision been made for bad debts? Are there any disputes involved?
Company liabilities
Depending on the nature of the assets, a company's loans or unpaid liabilities may become your responsibility as a buyer. A previous lender might even be in a position to seize the company's assets as repayment for an unpaid loan, leaving you with nothing. You need to know if the company has signed agreements that might lower the value of the assets or limit your freedom of action.
Determining fair market value (FMV)
There are a number of ways to determine an asset's fair market value. A specialist's appraisal may be needed for assets such as real estate, major equipment or specialized inventory. Likewise, a collection agency can help you evaluate the true value of accounts receivable, especially when assessing a company with many customer accounts.
Never rely only on the judgment of your accountant or the seller. It's always best to obtain an independent report from an expert specializing in business valuations. This is an unregulated field, but the Canadian Institute of Chartered Business Valuators provides guidelines and a code of ethics.
There are two main methods of valuating a business: one based on assets, the other on earnings and cash flow. An asset-based valuation can be based either on its book value - the company's assets minus its liabilities, as shown in financial statements - or its liquidation value: what a business could expect to fetch if it sold all its assets, paid down all debts including taxes, and then distributed the surplus to shareholders. An earnings-based valuation looks more closely at a company's current and projected future cash flow.
Although it's ideal to try to compare your potential acquisition with a similar transaction, in reality you will rarely be able to do this. In general, little information on such deals is publicly available, and the terms of any deal are often too closely tied to conditions in a particular economic sector to make them truly comparable.
Implications of buying shares
Anyone buying shares in a company takes a stake in the business, together with all of its assets and liabilities, whether they are recorded on the company books or not. A purchase agreement can include a provision that involves a buyer directly in the management of the company, or the purchaser can remain a silent partner. This latter option can smooth the transition between owners, lowering the price paid by the purchaser and allowing existing owners to show buyers how a business is run. The purchaser sometimes has the option of buying out the remaining shares and becoming sole owner later. Such a scenario is more likely if the target business is publicly traded and if the buyer has purchased enough shares to have some influence on how it is run. If a business is privately owned, the owners may prefer an outright sale.
There are always risks. Deals like these can sour if the buyer does not get along with the original owners or if the new and original owners have conflicting strategies. A purchaser may also unwittingly become responsible for liabilities such as unrecorded income tax reassessments, lawsuits and warranty claims that were not recorded in the financial statements. The new owner should also avoid being bound by the previous owner's depreciation schedules, which can be altered based on the purchase price.
Wednesday, May 23, 2012
Business valuation 101
How do I go about evaluating the asking price of an existing business?
No 2 valuations are the same, even for companies in the same industry. Unfortunately, there is no table of factors based on company size, profits and industry.
First, you will need to be clear on your definition of revenue versus profits. Revenue refers to gross sales before deducting any expenses, and net profits or net earnings represent what is left after deducting all the expenses of earning that revenue. When valuing a business as a going concern, one of the most important factors is calculating normalized net profits or net earnings.
There are 2 basic methods of valuing a business: breakup value and going concern value.
Breakup value is calculated by taking the current market value of all assets of the business, then deducting the liabilities and reasonable liquidation fees. The resulting value is what you would end up with if you sold off the assets and paid off all the liabilities. That is the value of the business on a "breakup" basis.
Going concern value is arrived at through a rather complicated process. This involves "normalizing" earnings, eliminating the impact of assets or revenue streams that do not form part of the core asset base or main revenue stream of the business. These assets and ancillary revenue streams are valued separately. Appropriate capitalization rates reflect reasonable levels of risk given the nature of the business.
The basic question to be answered in valuing a business is, "How much am I willing to pay someone for a business if in paying that amount, I will receive a stream of future income from that business of $X annually?"
In determining this value, review the historical earnings stream, adjusting for the financial impact of unusual events such as a one-time windfall profit or an unusually large non-recurring expense. Common adjustments may also be required to reflect such things as "normal" wages of the management, reflecting what the business would have to pay in wages if it had hired a manager at market rates.
Once you have determined what the "normalized" future earnings would likely be, based on historical data and trends, select an appropriate capitalization rate. Consider the level of risk associated with the business and the rates of return on other types of investments. To put this range into perspective, look up the current payout rate for Guaranteed Investment Contracts (GICs), which are risk-free and can be cashed in at any time. Compare that to venture capitalists who require annual compound rates of return in the 25% to 30% range, since they typically invest in high-risk, high-return businesses by way of unsecured equity investments. Somewhere between these 2 ranges is where most businesses fall.
Before making a commitment on this purchase, you should seek the advice of your accountant and a chartered business valuator (CBV).
First, you will need to be clear on your definition of revenue versus profits. Revenue refers to gross sales before deducting any expenses, and net profits or net earnings represent what is left after deducting all the expenses of earning that revenue. When valuing a business as a going concern, one of the most important factors is calculating normalized net profits or net earnings.
There are 2 basic methods of valuing a business: breakup value and going concern value.
Breakup value is calculated by taking the current market value of all assets of the business, then deducting the liabilities and reasonable liquidation fees. The resulting value is what you would end up with if you sold off the assets and paid off all the liabilities. That is the value of the business on a "breakup" basis.
Going concern value is arrived at through a rather complicated process. This involves "normalizing" earnings, eliminating the impact of assets or revenue streams that do not form part of the core asset base or main revenue stream of the business. These assets and ancillary revenue streams are valued separately. Appropriate capitalization rates reflect reasonable levels of risk given the nature of the business.
The basic question to be answered in valuing a business is, "How much am I willing to pay someone for a business if in paying that amount, I will receive a stream of future income from that business of $X annually?"
In determining this value, review the historical earnings stream, adjusting for the financial impact of unusual events such as a one-time windfall profit or an unusually large non-recurring expense. Common adjustments may also be required to reflect such things as "normal" wages of the management, reflecting what the business would have to pay in wages if it had hired a manager at market rates.
Once you have determined what the "normalized" future earnings would likely be, based on historical data and trends, select an appropriate capitalization rate. Consider the level of risk associated with the business and the rates of return on other types of investments. To put this range into perspective, look up the current payout rate for Guaranteed Investment Contracts (GICs), which are risk-free and can be cashed in at any time. Compare that to venture capitalists who require annual compound rates of return in the 25% to 30% range, since they typically invest in high-risk, high-return businesses by way of unsecured equity investments. Somewhere between these 2 ranges is where most businesses fall.
Before making a commitment on this purchase, you should seek the advice of your accountant and a chartered business valuator (CBV).
Friday, May 18, 2012
General aspects to consider before acquiring a business
What are some of the most important aspects to look for in buying a business?
The guiding principles of acquisition are called synergies, value and equilibrium. Synergies must occur between the 2 companies that are merging or between the buyer and the company being acquired. Ideally the companies that are merging should have similar or complementary product or service lines, and their marketing and sales methods should be in harmony.
There are 3 areas where synergies should occur:
A business that cannot create value should not be acquired.
Equilibrium is striking the right balance. With regard to synergies, the acquisition should be feasible operationally and financially. In other words, a very small company should not acquire a very large company, and a company that manufactures widgets should probably not acquire a company that manufactures clothing. Another kind of equilibrium is in the potential to create value: the investor should be able to add value to the company being acquired and vice versa.
An acquisition that is not in equilibrium with positive synergies and value should not be made.
There are 3 areas where synergies should occur:
- Marketing and sales (new products and services, new clients or new markets should create more revenues)
- Operations (there should be volume discounts or better ways and means to create and deliver products and services, or both)
- Finance and administration (the merger or acquisition should improve cash flow and fuel additional business projects)
A business that cannot create value should not be acquired.
Equilibrium is striking the right balance. With regard to synergies, the acquisition should be feasible operationally and financially. In other words, a very small company should not acquire a very large company, and a company that manufactures widgets should probably not acquire a company that manufactures clothing. Another kind of equilibrium is in the potential to create value: the investor should be able to add value to the company being acquired and vice versa.
An acquisition that is not in equilibrium with positive synergies and value should not be made.
Tuesday, May 15, 2012
Question & Answer: Acquiring a franchised business
QUESTION:
We're looking to acquire a franchised business. Any tips or due diligence processes that may vary from acquiring a non-franchised business?
ANSWER:
The due diligence is the same for any other comparable business; however, the following are some franchise-specific issues.
You will want to thoroughly review the franchise agreement, and you should also have it reviewed by a good business lawyer who specializes in franchises.
Before thinking about signing a franchising contract, you should be able to answer the following questions:
Does the franchisee have an exclusive territory?
We're looking to acquire a franchised business. Any tips or due diligence processes that may vary from acquiring a non-franchised business?
ANSWER:
The due diligence is the same for any other comparable business; however, the following are some franchise-specific issues.
You will want to thoroughly review the franchise agreement, and you should also have it reviewed by a good business lawyer who specializes in franchises.
Before thinking about signing a franchising contract, you should be able to answer the following questions:
Does the franchisee have an exclusive territory?
- Is the franchise transferable? How long is left on the existing franchise agreement?
- Is the franchise renewable? For how long?
- Is it renewable at the franchisor's or the franchisee's option?
- What am I getting for the franchise fee? Accounting systems? Operating systems? Lower prices on supplies?
- What exactly am I buying? Am I buying the right to use the name? Is the building part of the deal, and do I own the real estate? Will I be paying rent?
Monday, May 14, 2012
Tax Tips: Addressing myths about CRA online filing
Did you know?
Many of the ideas floating around about filing online are actually not true.There are so many great reasons to file your income tax and benefit return over the Internet–more than half of the returns that come in to the Canada Revenue Agency (CRA) arrive electronically. Canadians know how easy, simple, and fast it is to file online, plus they get their refunds faster.
Why are some returns still coming in on paper? Here's a common myth:
"If I file online, I am more likely to be audited."
Not true. When you file online, the CRA may request a copy of one or more of your receipts to support the claims on your return. This is a routine verification, not an audit. When the CRA flags a file for audit, the criteria are broad, complex, and not based on filing method.
Sunday, May 13, 2012
Home owners – don't forget claim your tax credits
Did you know?
Home owners may benefit from certain non-refundable tax credits when filing their income tax and benefit return.
Important facts
First-time home buyer's tax credit: If you are a first-time home buyer, a person with a disability buying a home, or an individual buying a home on behalf of a related person with a disability, you may be able to claim a non-refundable tax credit of up to $750 when you buy a qualifying home.
- Non-refundable tax credits can only be used to reduce your federal income tax payable. If the total of your non-refundable tax credits is more than your federal income tax payable, you will not receive a refund for the difference.
- Other credits and deductions may be available to you. For more information, go to www.cra.gc.ca/myhome.
The CRA's online services make filing even easier
With the CRA's online services you can file your return, track your refund, and change your personal information. You can also sign up for direct deposit to receive your refund in your account at your Canadian financial institution – no more waiting for cheques to arrive in the mail. It's fast, easy, and secure. For more information, go to www.cra.gc.ca/getready.
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