Almost every succession strategy will require some amount of capital. Depending on the structure, internally-generated cash flow may be able to support the transition (e.g., next gen owners use distributions to buy ownership) – or you may need to turn to external sources. Generally speaking, there are two external options: debt and equity.
Most of us are familiar with debt. It’s money that’s borrowed from a third party with an agreement to be paid back over time (at an agreed-upon interest rate at agreed-upon intervals). Equity is a little trickier and involves the sale of an ownership interest to a third party.
Debt vs. Equity
Of course, there are advantages and disadvantages to each type of financing. The advantages of debt include:
- Debt financing is finite: the obligation to the lender ends when the debt and interest are repaid (the owner retains control of the business)
- Interest payments on corporate debt are typically tax deductible, making the effective cost of borrowing funds significantly lower than the stated interest rate
- Recent relatively low interest rates make debt financing even more attractive
- Flexibility: mezzanine, or subordinated debt, represents an alternative class of debt subordinate to the senior lender; though more expensive than senior debt, it fills the funding gap when senior debt cannot meet the funding requirements of a transaction
The advantages of equity include:
- Money received by the company stays in the company; there is no commitment to the shareholders that requires future payments of cash
- Multiple classes of shares (voting and non-voting) may allow companies to receive an injection of cash from outside investors without giving up management control of the company
- Some companies simply do not have the capacity to incur additional debt, leaving equity financing as the most viable alternative
These financing alternatives are the very simplest options. Within each category exists limitless variations and combinations. For example, preferred shares of stock can have coupons similar to bonds and offer repayment preference above common equity; warrants allow their owners to purchase equity shares in the future at an agreed upon price. The variations are endless.
What’s in it for the Lender?
The key thing to remember is that the goal of the external financier (regardless of the form of financing) is the same – to achieve a rate of return that is proportionate with the risk and duration of their investment. Every business involves certain risks that will equate to a return demanded by a third-party investor. To the extent possible, mitigating those risks will lower the cost of financing your succession plan.
The level of risk accepted by various capital sources varies dramatically with the nature of the financing that is offered. Debt financing is generally viewed as lower risk because it is usually secured against the assets (and cash flow) of the business with personal guarantees from the owner(s). If the borrower defaults and is unable to repay the loan, the lender has first claim on the assets of the firm or remuneration by the owner as guarantor of the loan.
As risks become greater though, the required rate of return expected by the lender increases. At some point, risk reaches a level where the firm may be unable or unwilling to pay the interest rate required to obtain third-party debt financing. In this case, it may be necessary to obtain outside investors by selling partial ownership of the business. By using the money from the sale of equity, the investors expect the company to be successful and the appreciation in its value will be greater than the interest that would have been paid on debt.
Equity investors vary considerably in the amount of risk they are willing to assume. Because their investment is not secured, they experience a much greater probability of a complete loss than do debt investors. As a result of such high risks, the rate of return sought by financial investors is much higher than would be acceptable to a lender or to an investor buying shares in a public offering. However, the fact that a firm is doing well does not necessarily mean it should not sell equity to finance its growth or ownership transition. Additionally, bankers may be unwilling to lend to a firm that is already highly leveraged (the amount of outstanding debt is already high compared to the amount of the owners’ money invested in the business).
The sources of financing available to enable business succession to occur are varied and the type of financing ultimately adopted by the business and/or the stakeholders will ultimately depend on their particular circumstances and preferences. This list is by no means comprehensive but should serve as an adequate educational starting point for the levels of variety and complexity that are available.