A reader, Nicolas, recently asked the following question:

While the use of the fixed charge ratio seems to be quite straightforward (FCF / Debt Service), I was wondering why didn’t we also use FCF / Interests Expense (instead of EBITDA / Interest Expense) when calculating interest coverage.

It seems more natural to use FCF and more logical to be homogeneous in the numerator used. I might be mistaken on that but these are my thoughts. Do you have any explanation on that?

This could also be applied to EBITDA / Net Debt no?

In calculating interest cover, we must make sure we’re not double counting interest by using a numerator that has had interest taken out already. Let’s look at an example.

Say my interest expense is $10 and I have $15 spare to pay the interest. My interest cover is 1.5x. The problem with using net cash as the numerator, is that it has already had interest removed (and a tax shield applied and whatever else affecting the result). So in the example, it would look approximately like ($15-$10)/$10, which is only 0.5x.  This suggests I don’t have enough to pay my interest.

With that said, FCF can mean different things. Some people calculate free cash from an equity holder’s perspective, some from the deb holder’s perspective, and others from the firm’s perspective. The reason I mention this is that if your “FCF” is pre-interest, then it’s much more suitable for the interest cover calculation than FCF post-interest. In most textbooks, the method of calculation is indicated by the acronym, e.g. FCF, FCFE or FCFD, but in practice it’s worth checking.

Now back to your question: what about the debt service ratio? Why does it use FCF rather than EBITDA. Again, it comes down to timing and classification. Principle repayments and interest expenses are rarely classified in the same manner. And FCF is often calculated before principle repayments are removed, making FCF a valid numerator. But it’s not perfect when you get into the detail and when it comes down to it, the banks have all the say and they generally try to take a conservative view of practical applications.

I hope that helps Nicolas, but hopefully other readers can add some colour.

This guest post is written by Mike Gasparro of AxialMarket. You can also view the post on AxialMarket’s blog.

We recently sat down with several middle market mezzanine funds to discuss market views. We wanted to share perspectives on current market conditions and the impact on entrepreneurs. Consensus is, if you are looking to raise capital, but not happy with current equity valuations, mezzanine capital is likely worth considering.

If you need an intro or refresher on mezzanine finance, Peter [from AxialMarket] wrote a helpful post, “A Tutorial on Mezzanine Finance for Entrepreneurs“. In the current marketplace when equity valuations are down, mezzanine capital provides several potential advantages to business owners looking to raise capital:

1. You can use the capital for things that a typical commercial loan will not allow, such as growth capital, a dividend/special distribution, a recapitalization or buying out current shareholders.
2. The covenants/restrictions placed on the company are less stringent to those of the typical commercial loan.
3. Mezzanine capital is much less dilutive than private equity/venture capital since only a portion of the mezzanine investment has an equity component. At a time when valuations are below average, this can be a big deal for entrepreneurs who want to preserve their equity.

Generally speaking, mezzanine funds look for the following when considering an investment:  

• A Credible Debt And Exciting Equity Story: Mezzanine funds must be convinced that the company can meet its interest payment obligations (just like your commercial bank loan officer), but they ALSO want to be excited about the future growth prospects of your company (similar to an equity investor).
• Clear Use of Proceeds: Make it clear what you plan to do with the capital, and the impact it will have on your company’s P/L and cash flows over a 2-4 year period.
• EBITDA Greater Than $5 Million: There are mezzanine lenders that will focus on companies with lower EBITDA, but $5 million is the typical minimum size for most mezzanine capital providers.

Terms are constantly changing and are always going to be situation-specific; however, a general guide to current middle market terms (as of April 2010) are:

• Maximum Senior Debt to EBITDA of 2.0 to 2.75 – This measures the how many years of EBITDA (the proxy for cash flow) it will take the company to repay its senior debt. Senior debt includes all the outstanding amounts on revolving lines of credit plus any other short term and total long term debt which is secured by a first lien on the company’s assets. It does NOT include accounts payable or accrued expenses.
• Maximum Total Debt to EBITDA of 3.0 to 4.0 – Same concept as the previous ratio, except it measures how long it will take a company to repay all of its debt. Total debt includes all senior debt plus all subordinated and mezzanine debt. Note, this is also includes the new mezzanine debt that the fund is considering investing.
• Cash Interest 10% to 14%
• Paid-in-Kind Interest (“PIK”) 2% to 6% – PIK represents a portion of the interest payment that is not paid in cash. Annually or quarterly, this amount is added to the principal.
• Includes some warrants – Warrants give the fund the right, but not the obligation, to purchase shares of the company in the future at a pre-determined price.

As with every piece of capital, there are pros and cons to raising mezzanine capital. During times when valuations are down, mezzanine capital can be a compelling alternative to raising equity capital.

When you or I request a loan from a bank, we’re faced with secured and unsecured loans. A secured loan gives the bank a charge over the asset you plan to purchase. So, if you buy a car using a secured loan, the bank, in effect, owns it until you repay the loan in full. An unsecured loan (normally at a higher rate) has no such charge.

Similarly in business, you can apply for funding using your assets or cash flow. Clearly, an asset-lend is less risky for the bank. However, many businesses don’t have the assets to secure the size of loan they need. Moreover, few businesses have the assets to back a loan anywhere near the size of what’s available if the bank approves a cash-flow-lend. Regarding what a bank will approve…

• For an asset-lend, banks typically offer a percentage of the total fixed asset value (an independent market valuation)
• For a cash-flow-lend, banks typically offer a multiple (x) of maintainable cash flow (FCF) or earnings (EBIT); the multiple depends on volatility and similar factors

Imagine your EBIT is $10m and, if approved, the bank will lend 4x EBIT. That’s $40m. If the same bank would lend 70% on assets, you would need almost $60m in assets to raise a similar amount. Sure, certain businesses have those assets (at market value, not book or cost), but I’d say most don’t, and most don’t want their assets encumbered anyway.

One caution, made more apparent by the GFC, is that you shouldn’t rely on the amount a bank approves as a gauge for responsible gearing levels. If you borrow 4x earnings on an earnings figure that you know isn’t sustainable, you could easily end up with negative ownership. That is, the business is worth less than the debt it owes. Credit teams can be tough, but there’s always information asymmetry; you know much more about the business than they do.

Boring businesses are great for private equiteers because they attract less attention, ergo less competition during sale, ergo lower earnings multiples. I wrote about this in a post titled Borrrrrrrrrrring… but we love boring in private equity. However, there’s a problem with boring businesses… or a consideration, if you will.

A private equiteer’s boring business is also an employee’s boring business. And about the only time employees want to work for a boring business is when they need to be paid while doing other unpaid things (such as studying for school, writing a manuscript or using Facebook). But, this doesn’t nullify the boring business theory, it just poses considerations.

Anything to do with employees must be considered in a different light. Firstly, in a business where passion isn’t obvious (i.e. boring), you can’t expect people to work 80-hour weeks for 40-hour salaries. Secondly, you shouldn’t assume anywhere near as much loyalty. A glue packer will go elsewhere for a 20% pay increase, whereas an F1 engineer may stay even after a 50% pay cut. Lastly, you’ll be limited in terms of the talent pool; a regional GM of Apple won’t accept a CEO role at a glue factory for a 70% pay cut, but they may do so for an internet startup.

However, all is not lost. Focusing on productivity, efficiency and working with what’s available, has been a godsend to many a boring business. Oftentimes, you don’t need the big-name CEOs or loads of employee innovation. Sometimes, you just need a well-oiled machine that supports quick and easy bolt-on acquisitions (and as much as that may make us cringe, it really can create long-term value in boring industries).

P.S. I really don’t like using the word ‘boring’, but let’s not sugar-coat more than we have to.

Most of us are to blame for the recent global economic unpleasantness. We all overindulged and we all borrowed way too much money. But, rather than use our collective mistakes to learn from, the banks are using them to punish us. And, rather than picking on businesses their own size, they’re targeting small businesses, clearly because they’re the most vulnerable. Yes, these are the same small businesses that underpin our economies and give employment to the majority of people on this planet.

During the period of excessive gearing, we all signed up to relatively strict debt terms because, a) we had little choice, b) we had high hopes for the future, and c) these terms still allowed some room for movement. Then, the GFC hit and the usual multiplier effect of diminishing markets kicked in: sales fell, margins fell, earnings fell, free cash flow fell, and, we started to breach covenants. As a result, we all went into panic mode and tried to do everything possible to keep our heads above water.

So, what are you thinking if you’re a bank? How about, “let’s look at our lending book commercially; that is, we’re more likely to get our money back if our customers survive”? Or maybe, “as long as they pay our interest invoices, let’s be reasonable as a sign of good faith for our customers loyalty”? No, what they’re actually thinking is, “this is a perfect time to cash in on all of these breaches by increasing our margins, charging infringement fees and making our terms more burdensome.”

You may be thinking, “what’s wrong with that; they’re a business with shareholders and their customers agreed to these terms”. Well, that’s true, and technically they’re well within their rights to do this, but as I’ve posted ad infinitum, there’s more to business than the immediate bottom line. What this stringency is really doing is creating a GFC aftershock of similar magnitude to the real thing.

Let’s say you’re running a small business. You’re doing absolutely everything you can to survive. Even, laying off workers, taking short cuts and reducing service levels; all pretty risky stuff. Then, you get a letter from your banker (many of them lack the courtesy to call or visit). And, as if you’ve committed some heinous crime, in large letters it mentions the following:

you’ve breached covenants, your margin is doubling, you must pay a fee of $300k for the breach, you now have to report to the bank monthly until they’re satisfied, and, you must engage an accounting firm of the bank’s choice to perform an exploratory investigation of your accounts. Oh…and if you fail to do any of this, the entire facility may be called and you’ll have 14 days to repay the principal.

Do you remember that whole notion of just keeping your head above water? Well, drowning looks like paradise compared to what’s on the horizon. The increase in your interest expense alone is as if you’ve doubled your workforce, but of course the new recruits refuse to do any work. Then of course there’s the fine, which you simply don’t have the spare cash to pay. There’s the half a million dollars (and endless nights) to fund the bank’s criminal investigation. There’s the downtime for most of your crew to deal with the new demands. And, there’s the lost sleep from knowing failure is imminent.

You know, if we were all held at gunpoint and made to choose someone to blame for this whole GFC saga, we’d have to firstly choose ourselves. But, in a very close second place would come the banks. Now, to think they’re instigating this aftershock… well, it just smacks of the same insanity that caused this mess in the first place.

Then again, how many of you have let an investee off the hook come earn-out or equity-ratchet time? (Let’s just pretend I didn’t say that.)

Image: Thanks Banks [source: Shutterstock]

In a recent post about pre-money and post-money valuations, I talked about two primary uses of private equity in a business: 1) to replace existing capital, and 2) to invest new capital. So, this begs the question, what drives investments that swap capital and inject capital?

Swapping Capital

• Transition – many private equity transactions occur because, for whatever reason, there’s a transition of ownership and/or management. We know these transactions as MBOs, MBIs and, of course, BIMBOs (we’ve actually done one of these transactions). The drivers for transition can be anything from an outrageous offer to the current owner simply calling it a day.
• Succession – this is a form of transition, but more specifically involves an owner reaching pension age and passing the business on to family members or new owners. In either case, a private equity firm can sponsor the buyer to purchase the business from the seller. This often works well because the prospective buyer has an entrenched understanding of the business, but doesn’t have the funds to help pay the seller a hefty one-off pension payment.
• Privatisation – we hear about many private equiteers that exit investments via the public markets (i.e. IPOs). But sometimes, if a listed business is undervalued or the private equiteer has lost his/her mind, we also see them enter via public markets. We know these transactions as public-to-private deals. However, they’re not as common as other transaction types because the process can be painful. Apart from needing to convince thousands of stockholders to sell, you often need to pay a premium to convince them to sell.
• Consolidation – sometimes it can be a pain in the backside to have a fragmented stockholder base, even if there are only 5 or 10 investors. In this case, a private equiteer will sponsor a more enthusiastic stockholder to buy-out the less enthusiastic stockholders, giving him/her more control to drive growth. This may also be the result of a succession or expansion transaction.
• Equitisation – this involves changing the balance of debt and equity in a business. Often a private equiteer will invest to de-leverage a business by paying down some of the debt. This may be a turnaround situation or as a way for a business to bring in a private equiteer (for their skill, contacts, etc.) without burdening the company with new equity it doesn’t yet need.

Injecting Capital

• Expansion – this is the typical venture capital scenario, but also a private equity scenario, when a business needs more money to expand. The money may fund plant & equipment, working capital, staff, professional services, marketing, or any number of other needs. In this case, the investment requires the issuance of new stock, often with preferred status. This isn’t as common as one may think (in private equity) because typical private equity candidates already produce significant cash flows to fund growth or at least the interest payments on debt (which we know is much cheaper than private equity). It’s more common in businesses with unstable cash flows, already high gearing, a lack of financial sophistication, or a specific need for a private equity investor.
• Acquisition – this is simply a specific example of expansion funding, but it differs because it often requires capital that can’t be funded by maintainable cash flow. Acquisition funding is a very common driver for private equity funding, and unlike my comments above for expansion funding, it is often needed by businesses with stable cash flows and only moderate gearing.

As you can imagine, most transactions fit into more than one of the above categories. Expansion deals may consolidate the stock register, acquisition deals may involve ownership transition, and privatisation deals can often trigger some form of equitisation.

As a private equiteer, there are many tools in the toolbox, and by using these tools, we can structure deals that appeal to the most stakeholders while also delivering value to our funds.

Images: Capital injections are not the only form of private equity [source: Shutterstock]

Over at the Union Square Ventures blog, Fred Wilson discusses the failure rates expected in venture capital. He suggests a third of all deals are hit out of the park, a third are mediocre, and the last third fail (although his own firm’s empirical data suggests more of a 40/40/20 split). He also suggests that the overall cash return on such a portfolio may be 3-4x, which is pretty good if you can get it.

Private equity is quite different; we expect all deals to do well. Not out-of-the-park, but well enough to hit target returns (at least 20% IRR or 2x cash). Private equiteers generally believe this low-risk moderate-return approach is more successful than the high-risk high-return approach favoured by venture capitalists.

Image: Private equity, just sit back and relax [source: Shutterstock]

Now, although this difference in investment strategy may seem subtle, it actually means private equity and venture capital are miles apart in execution. Without decent growth, venture capital is toast. However, even with very low-growth, private equity can still bear fruit. How? Leverage, deal structure and multiple arbitrage.

This isn’t to suggest PE and VC are in any way substitutable. But, like all investments, we can analyse and consider the implications of each strategy.

One of the major implications, especially in mid-market private equity, is that we don’t mind skipping over high-growth businesses. We know there’s less competition for lower-growth businesses and that less competition means lower purchase multiples.  And, with an eye firmly on moderate target returns with very low-risk, we know paying a lower multiple is a great risk mitigator.

We also know that stable revenues are more conducive to leverage, and leverage amplifies our returns. While leverage also amplifies our risk, we know particular deal structures can transfer some of that risk to other investors in exchange for a taper on our returns above a specified target. This is okay for us, because remember, we are more concerned about mitigating risks than overshooting our target by orders of magnitude.

So, as you can see, lower-growth (aka boring) businesses can actually serve our cause more effectively. You may see larger private equity funds going crazy with mid-20s purchase multiples in public markets, but down here at the mid-market level, we have choice. We can invest in the most boring businesses you’ve ever seen, conservatively apply debt, structure the deal well, simplify and organise management, exit when the time is right at a higher multiple, and achieve our objectives, even without significant increases in revenue. In private equity, we love boring.

The mantra of the private equiteer is maximum return for minimum risk. However, I can’t stress enough that the empahsis is on minimum risk. You see, the magnitude of badness associated with a poor performing fund significantly exceeds the magnitude of greatness associated with an exceptional fund. Maybe not so in venture capital, but definitely so in private equity.

If I achieve a 10x return on my fund, LPs, other PEs and most others will say “they were lucky”. If I achieve a 0.5x return for the fund, everyone will say “they suck”. Both terms are pejorative (hey, life’s unfair), but in one scenario you get to boast 10x returns and in the other you don’t get to boast at all.

So, back to the title of this post, equity returns for debt risk. Private equiteers essentially want all of the upside in a deal and none of the downside.

In public markets, you can achieve this by buying put options against a portfolio or through investing in call options. But we all know there’s a cost, and even with that cost, you rarely mitigate risk 100%.

To achieve the same in private equity, we invest via preferred stock, demand preferred coupons, have veto rights over many business decisions, take a board majority, have the right to fire  senior executives, demand that managers invest, sometimes even demand redeemable preferred stock, etc. We are simply hedging our bets. But, like option strategies in public markets, the hedge isn’t perfect.

Where this idea of equity returns for debt risk really matters, is within a portfolio of assets. Public equity fund managers invest in equity returns for equity risk and that equity risk means that some investments succeed and some fail (and then transaction costs ensure most fund managers achieve sub-market returns).

In a private equity portfolio, our quasi-debt investments don’t incur as much loss from poor performing investments, so portfolio returns can conceivably be above public equity portfolio returns without investee performance being above average. Of course, this doesn’t hold when private equiteers overgear their investments, but think about this one without above-average debt. Especially in current markets, I see private equity characterised more by strict legal terms than mountains of debt. We have made two investments this year that are completely debt-free.

This is just another aberrant thought (following my response to The Economist article) on how private equity can beat public markets.

This post belongs to a series on Working Capital (see the contents page here).

There are various methods used to value investees, but private equiteers tend to focus on earnings multiple valuations and discounted cash flow (DCF) valuations. Working capital affects these valuation methodologies in the following two ways:

1. The earnings or cash flow figures may be influenced by changes in working capital (delta) across periods
2. The net debt (specifically cash) position may be affected by the operational working capital requirements of the business

In a discounted cash flow (DCF) valuation, working capital is analysed to help calculate free cash flow (FCF) for each period (see right for equation). These free cash flows are discounted and summed to arrive at a valuation. This is simple textbook stuff, so I want to concentrate on working capital considerations in earnings multiple valuations for the remainder of this post.

Unlike a DCF, an earnings multiple valuation is based on maintainable earnings; that is, the level of earnings that can be maintained indefinitely. If all else is equal, working capital (from an analyst’s point of view, i.e. ex-cash) remains the same across periods and so there is no cash surplus or shortfall between periods. And so, there should be no working capital offset in the maintainable earnings calculation.

You may be thinking, “but we don’t expect earnings to stay flat and so there will be working capital consequences and since different businesses are affected differently as they grow, we need to consider it somewhere.” Well, you need to account for this via the applied price multiple. What does that mean? If the firm’s working capital profile spins off a lot of cash, investors will be willing to pay a higher multiple, and vice versa.

Remember, even though growth may increase the theoretical cash shortfall, growth also generates greater earnings and greater value.

So, the verdict on point 1 (from above) is that the earnings figure used in an earnings multiple valuation should not be adjusted for working capital delta because it is a maintainable estimate. However, you may account for a firm’s working capital profile in the multiple if it is abnormal or if the multiple is already assuming high growth.

The one exception is where you know of a material change to working capital that will create a material difference between current and future earnings figures.

Onto point 2 (net debt position): working capital may affect the enterprise value (EV) because not all cash at bank can be used to repay debt. You may remember from the basic EV calculation that EV equals equity value plus total debt less cash; the idea being that cash can pay down debt. However, you shouldn’t simply assume that all cash at bank is excess cash to pay down debt.

There are numerous examples where cash is needed to support a firm’s operations and hence, is part of its earnings multiple valuation. The simpler way to think about it is, how much cash can I remove from the business without causing disruption? Since an earnings multiple valuation is theoretically based on future earnings, I personally believe that enough cash should be left in the business to support working capital gyrations for the first year.

This doesn’t mean that if cash momentarily dips $2m that the vendor should leave $2m for the new investor. What is does mean is that enough cash should be left to pay the finance/opportunity costs of supporting that $2m working capital requirement for the first year. I think this is fair since you’re valuing the business on future earnings and it will take a momentary investment of $2m to create those earnings.

There are also other scenarios in which vendors should leave cash in the business. In retail businesses for example, if all cash is taken from the tills, the business won’t operate properly. Ipso facto, the money required to adequately fill the tills is operational and included in the earnings multiple valuation (and shouldn’t be considered excess cash). It may be difficult to agree a number in this case, but theoretically I believe the reasoning to be sound.

So, the verdict on point 2 is that not all cash at bank should be thought of as excess cash in a earnings multiple valuation. Any cash required for the operations of the business and/or to subsidise the opportunity costs of cash shortfalls should be left in the business. In an EV calculation, this cash should not be used to reduce debt to arrive at a net debt figure.

This is a long post, but I hope it helps to form your own views on working capital and valuations. It should be a simple topic, but theories seem to change daily; depending which side you’re on in today’s latest deal. If you think I’ve left something out or if you have alternative views, please let me know.

The question: does an investment with negative equity, but positive cash flows, mean positive or negative value for the investor? Using the earnings multiple valuation method, if net debt is greater than EV, then equity value is negative for the investor. However, it also seems intuitive that if FCF is positive (after interest payments are deducted), then the investment should have a positive value. So, which one is correct?

This is a similar issue that VCs have with investees that don’t have positive earnings (or only slightly positive earnings). If they use an earnings multiple to arrive at EV (and hence equity value), then often they will see negative equity value. But, there’s usually value in patents or technology or products or people or distribution channels or other IP. VCs deal with this concept on a daily basis, but private equiteers don’t (well, they do now), so it all seems quite foreign to them.

The simple solution is to use another valuation method, such as DCF, comparables, or revenue multiples. But, this seems like finding a solution to give a desired outcome. Maybe, these investees are really worth nothing. Maybe, the inherent risk in them has a greater cost than the PV of the cash flows. Maybe, these cash flows represent a return less than the required return to the investor. In all honesty, I’m not feeling the need to change valuation methods; if the numbers are poor enough to show negative equity but positive cash flows, then I think I’d leave it for another investor or another day.

What men proverbially say about women also applies to private equity firms and credit providers. That is, you can’t live with ‘em and you can’t live without ‘em. With debt, private equiteers are able to create the returns they’ve become accustomed to (we’re talking pre-crisis here). But without debt, private equiteers would also live an extra 10 years from not having the stress related to covenants and disapprovals.

So while it really is a love-hate relationship, there is an implicit need for more love than hate. Anyway, this post is about the hidden value in getting the tick of approval from credit teams, so I digress.

Getting credit approval for an investee makes the deal much more likely since debt helps to achieve higher returns (if all goes well). But, there’s more value to credit approval than just funding for the original deal:

• Firstly, getting credit approval somewhat confirms your analysis and optimism around the deal. We all like to think we’re objective, but it’s good to get some confirmation from an independent team. 
• Secondly, if a bank is willing to extend credit now (especially post-crisis), then it’s safe to assume that the potential buyer of the investee in 3-7 years will also be able to get credit. Sure, there are a million and one variables, but it still gives some comfort around an easier exit or divestment. 
• Lastly, getting credit approval now gives comfort around the likelihood of a recapitalization. You may know my view on recaps from previous posts (do a search if you’re interested), but alas, it’s still an exit option and needs thought. So knowing you can get 3 or 4 times EBITDA in debt now will give you some comfort around recapping out of the investment if all goes well.  

The real message in this post is that if you can’t get credit approval now, then maybe the deal isn’t the right deal. Current conditions have made debt harder to get, but at the same time, getting approval now may say something quite positive about your deal. Maybe you just don’t need to be doing those deals that are borderline with the banks. And, as I’ve discussed, credit team disapproval has underlying consequences regarding divestment. Do you really want to be entering deals that may be hard to exit? The exit crystallizes the value you’ve created; the exit directly affects your return; the exit is the Holy Grail.

In a previous post, I talked about the amplifying effect of diminishing sales. I gave a short example in which a company had sales of $100m. This company had variable costs of $40m and fixed costs of $40m; hence, EBITDA of $20m. A 20% loss equals sales now of $80m, variable costs of $32m (using the same gross margin), fixed costs of $40m (because they’re fixed), and EBITDA of $8m. In short, a 20% drop in sales led to a 60% drop in EBITDA.

I want to take this example a little further to show the amplifying effects of debt. So let’s use our two scenarios from above; Scenario 1 is the business with $100m sales and $20m EBITDA, while Scenario 2 represents some period later when sales drop to $80m and EBITDA is $8m. (Quick note: see how EBITDA margin dropped from 20% to 10%? That’s due to the fixed costs staying… fixed. And this isn’t an extreme case; it’s actually based on conservative numbers.)

Let’s assume the market is paying 5x EBITDA for this type of business. In Scenario 1, that means enterprise value (EV) is $100m, while in Scenario 2, enterprise value has fallen to $40m. When we made our investment into this business, we were quite conservative by employing debt of 3x EBITDA; so let’s assume net debt for the business is $60m. In Scenario 1, we invested $40m of equity with the $60m of debt to buy the business. But, now that sales have dropped, we’re worried about the value of our equity investment.

Well, you can probably see where this is going. With a drop in sales of 20%, which hypothetically led to a drop in EBITDA of 60%, we now have a business with an EV of $40m, with net debt of $60m, and hence, a negative equity value of $20m. That’s right, our investment is worth less than zero; it’s worth negative $20m. All of this, just from a 20% drop in sales. Quite a sobering thought.

Following on from my post on working capital, I want to make a quick mention of the financing (and factoring) available to businesses to solve working capital issues. With this type of financing, a company invoices a customer, sends a copy of the invoice to the finance company, and the finance company extends a loan, which uses the invoice as security. When the customer pays the invoice, it pays the finance company to settle the short-term loan against the invoice. The terms of the financing determine whether the customer pays the financier directly or indirectly and how much of the invoice will be lent (usually up to 80%).

This type of financing (called trade, debtor or receivable financing) is most suited to B2B or to B2C in which invoices are used. And, the distinction between debtor financing and debtor factoring is that the former involves lending against the debtors, whereas factoring involves the purchase of debtors at a discount. The discount in factoring represents a financing cost in the same way an interest charge on debtor financing represents a cost.

In some cases, debtor financing or factoring competes against private equity. The process of securing financing or factoring is much quicker and less involved than securing private equity. Both are arguably more expensive than other forms of capital, but of course, a private equity investment is more than just short-term funding. So, the decision between the two depends on the objectives of the business. And, there’s no reason you can’t have both, which is really the best of both worlds for most businesses.

An important side note is that debtor financing and factoring is a common source of business fraud. As you can imagine, it’s quite easy to manufacture fake invoices to have additional funding advanced. These fake invoices are fresh air invoices and the underlying fraud is fresh air fraud. The other important note is that the focus is on the creditworthiness of debtors rather than the business itself… for obvious reasons. So, it can be much easier to secure if you have solid customers, even if you are having performance issues.