Consider this: By purchasing a small, blossoming company, you become its CEO right out of the gate. Sounds pretty great, right? It’s quite possible to achieve. In fact, it’s the basic idea behind search funds, a growing model for acquiring and operating a small company, that’s gaining serious momentum.
A search fund is essentially an investment vehicle. A CEO searcher identifies potential acquisitions of privately held businesses — sometimes with the help of an accelerator (an organization that facilitates the search process and provides equity funding, as well as Board oversight during the operating period). For traditional search funds, investors will review the opportunity, and once the investment thesis boxes have been checked, and the business’ unique risks thoroughly vetted, they’ll back the acquisition. For a self-funded search or independent sponsor model, a CEO searcher potentially uses more of his or her own equity capital to finance the search process (and the ultimate acquisition) and as a result, will typically end up owning a larger share of the business. As the idea has gained traction in the acquisition marketplace, hybrids of the search fund model continue to surface.
Search funds give individuals without experience as an entrepreneur (especially those with limited finances) an avenue to manage and grow companies of which they hold a significant level of ownership. However, search funds aren’t just for the new kids on the block: Even executives well into their careers are following the search fund model more and more. Either way, as is the case with any new endeavor, there are best practices to follow. Here are nine questions new search funders and independent sponsors should consider when choosing their debt partners:
- Is there an ideal ratio of bank financing to equity to enterprise value? Should subordinated seller financing be included?
For an SBA loan, the minimum ratios for a sound, successful transaction are:
- 10% equity (which can be from the CEO and investors)
- 15% seller note (five-year loan or longer term)
- 75% bank SBA loan, which is a 10-year amortization and term
If the multiple being paid is three to four times the earnings before tax, interest, depreciation, and amortization, this formula will usually result in an acceptable debt coverage ratio.
Ideally, for conventional loans, a senior lender shouldn’t exceed 50% of the enterprise value (with the remainder being seller financing and equity). In some cases — subject to debt coverage ratios — mezzanine debt may also be an acceptable way to round out the capital stack.
- If I’m a self-funded searcher, should I seek a debt partner who will help me locate and contact potential investors to supplement bank loans?
Lenders and investors share a similar viewpoint on risk, and they often collaborate. A good lender can facilitate communication with experienced investors, and this should be part of a searcher’s criteria when selecting a debt partner.
- Are debt partners capable of mentoring and advising me throughout each stage of the search — including closing on the deal and, later, operating the business?
A good debt partner will be able to share insights on all stages; he or she can be particularly helpful in early searching stages when it comes to helping a searcher understand how potential deals look through a lender’s eyes. Lenders with significant experience can advise on all aspects of the deal-making and debt process.
- How much information (and what kind) should I expect to provide to a bank?
Admittedly, the information needed to complete financing of an acquisition can be a lot — but for good reason. The lender will want to assess all backup materials and documents that speak to the risks of the business and transaction. Exactly what is needed will vary by business, and it’ll be tailored to critical risk factors. A good lender will add value to the process by asking the searcher to delve into areas of perceived risk; he or she may even be able to share “war stories” that help illustrate that risk.
- Should my debt partner help discern the amount and terms of seller financing?
In short, yes. The lender can model the effect of a seller debt structure, and he or she will often give advice on how to structure in ways that lower the buyer’s risk in the transaction (like tying the payments to business performance metrics). To help optimize your overall deal structure, experienced lenders can use various seller note terms.
- How many potential debt partners should I contact? How many term sheets should I consider?
Ideally, a searcher will use the early stages of his or her search to develop relationships with lenders and, through that process, narrow it down to three options. Good lenders want to know they have a reasonable chance of earning the right to be debt partners, and they won’t want to waste time if they sense searchers are pitting their proposals against other offers. When it’s time to submit a loan into formal underwriting, your chosen lender should know he or she is in the driver’s seat — resources are being fully marshaled without concerns of being shopped.
- If I’m turned down at one bank, is it worth looking for someone else at the same bank who might decide to take on the deal?
Lenders have different credit appetites. The declination of a loan may not have anything to do with the strength of a deal: For example, a bank with a particular industry concentration may decline any additional loans to businesses in that industry until the concentration is diluted.
Some lenders are more focused on assets and will decline a strong cash flow loan, simply due to a lack of collateral. Other lenders will approve that loan without hesitation. That said, it’s important to understand why a lender declines a loan. In some cases, the reasons may point to a risk factor the searcher should also be wary of.
- How can I get a clear idea of debt partners’ business methods? Do they offer standard loan commitments and documentation templates?
To get a feel for whether a lender follows through on his or her commitments, ask for a list of loans (similar in type to yours) that he or she has recently closed by industry or location. The search fund community is also a great source of word-of-mouth testimonials and referrals.
- What should drive my decision in choosing a debt partner, and at what stage should I make a final decision?
The decision on a debt partner should be made over time. This should begin with early stage introductory calls, followed by prescreening deals with the lender. And ask questions along the way. This is an excellent iterative process to get to know lenders, their points of view, and their communication styles and responsiveness. After several deal screenings, it will likely become clear which lender is the best fit (and partner) for you. For a deeper introduction into the world of search funds, contact us today.
Heather Endresen is a director for Live Oak’s Sponsor Finance/M&A lending team. Reach her at firstname.lastname@example.org or 714-404-3648.