Growth to multiple locations is one of the most effective ways to substantially increase the value of your business. A business with multiple locations improves your value proposition to referral partners, improves your ability to increase discounts with key vendors, makes you more attractive to other companies looking to grow via acquisition and when you reach an appropriate size, makes your business more attractive to private equity groups investing in the industry. But it is also risky and can be financially disastrous when done haphazardly (M2 is often cited as an example of a growth plan that failed spectacularly).
In order to create a business that builds generational wealth, something that generates enough wealth to pass to your children (or even grandchildren), it is important to understand the different options available to a business to achieve that growth. The exciting part about the collision industry is that the opportunity to build a business that creates generational wealth has never been greater. I firmly believe we are in the golden age of the collision industry.
If, on the other hand you are considering a sale, it is valuable to understand how companies finance growth. Understanding how growth is financed is important when it comes to negotiating the price and terms of a transaction. Understanding when and where an acquiring company can or cannot make concessions allows a seller to negotiate a more beneficial purchase agreement for both parties. There is an old saying in investment banking, “You set the price; I’ll set the terms.” Understanding how a company finances growth allows a seller to better effect the terms any purchase agreement.
Many companies have demonstrated it is risky to grow to multiple locations without the right financial management. A solid understanding of the options to finance growth is important to minimize the risk of failure. Understanding the trade-offs of these different types of financing and managing the overall capital structure of the business is one of the primary roles of the corporate finance professional.
In the collision industry, capital in the form of vendor financing through paint companies is often used. Frequently these companies will provide pre-bates, or pre-paid discounts in exchange for a commitment to purchase a specific amount of product over the term of the agreement. For companies just starting out on a growth path vendor financing often is an attractive choice because it tends to be easier to access than other sources and usually comes with less restrictions and covenants. Beware: vendor financing is rather tax inefficient and often is an expensive form of capital relative to other sources. Keep an eye out for a future article on how to analyze if a pre-bate is the right financial choice for your company.
In many acquisitions sellers often provide substantial financing to close the acquisition. The idea behind seller financing is twofold. First, often a buyer is unable or unwilling to provide the full amount to the seller at close. In order to close the transaction, the seller agrees to accept part of the overall purchase price as a loan to be paid back with interest by the acquiring company over time. The second reason is that it creates alignment between the buyer and seller. If the seller is dependent upon the future success of the acquiring company, the seller is much less likely to engage is fraudulent or misleading behavior during due diligence. Both parties have a vested interest to the company succeed post close. Seller notes typically pay higher interest rates than most other investment options. Seller notes have the added benefit of being tax efficient for the seller by deferring capital gains over the term of the note, and are effective for the buyer as they tend to be inexpensive, yet flexible sources of financing.
As the economy improves bank financing is once again becoming a viable option for business owners to finance growth. Bank financing at first glance appears relatively straightforward but has a fair share of complexity involved. Banks tend to be more conservative in lending money compared to both vendor and seller financing. They often require substantial information in the form of financial disclosures and often seek personal guarantees as collateral outside of the business. Because banks lend to a variety of businesses, they may not have a firm grasp on your particular business or industry. This often translates to a reluctance to lend or increased lending rates. It is important that you take the time to review your financial model in detail with your commercial banker so that they develop familiarity with your business and comfort in lending the appropriate capital required to sustain growth. A reluctant bank can lead to burdensome covenants can cripple a business when not managed appropriately.
Equity financing is distinct from debt financing in that a company sells shares to raise capital rather than borrowing money to pay back in the future. Equity financing can take a number of forms, and ranges from a raising a few thousand dollars from friends and family in exchange for a portion of the business to private placements to multi-billion dollar public offerings.
The benefit of equity financing compared to debt financing is that equity financing does not carry interest nor does it require future repayment. That does not mean equity financing is free, however. Selling equity dilutes existing ownership, and in pass-through entities, diverts cash flow to new owners. While there is no cash cost reflected on a P&L statement associated with equity financing, equity financing is actually much more expensive that debt financing. Existing ownership shares are diluted by selling equity and equity investors often demand substantial discounts to fair value when investing in privately held companies.
For companies of a certain size, in the US generally $50 million in revenues or $5 million in EBITDA, bringing on a private equity partner may be an option. Private equity groups are investors that invest in privately held businesses. The benefit of taking on a private equity partner is that these organizations often provide additional capital for a company to grow. We previously discussed private equity in the collision industry in this article and also in how private equity makes millions in the collision industry in this article. While private equity currently is sexy, it is not for most entrepreneurs. The transition from owner to CEO reporting to a board is one that many do not survive.
For companies of a certain size, there are additional financing options available through the use of private placements, mezzanine debt, asset-based debt and preferred debt. These forms of financing often blend components of both equity and debt financing. Often these instruments come at a higher interest rate and include equity warrants (the option to purchase equity at a pre-determined price, often at a discount), PIK (payment in kind – where the interest is deferred and added back to the principal of the loan), convertible (where debt principal converts to equity ownership) or interest only payments with balloon term payments. The options are endless and are negotiated deal to deal and lender to lender. These forms of financing are used when a company has exhausted traditional senior bank financing options. While often carrying high interest rates, as with all deals, rates and terms are negotiable and can be an attractive source of capital for certain growth companies. While explaining each option in depth is outside the scope of this post, please contact me directly if you want to discuss these in greater detail.
Growing a business successfully is much more than increasing sales and expanding locations. Managing the sources and uses of debt and equity financing ensures that a business grows in a sustainable and efficient manner.
If you are interested in discussing your financing options in more depth, please reach out to me via my contact page. I find the transformation in the industry fascinating. I also just like to talk to real humans in an industry I am passionate about. I keep all communication confidential.
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