Why Use Reverse Merger to Raise Money
The first question that must be answered prior to obtaining funds from another party is: Why do you need the money? There are many reasons why companies seek outside financing. This section covers the most common.
The most common use of financing is to fund a company's growth. Many companies reach a point in their growth at which they need outside financing to expand to meet their potential. In this case, we assume that the current owners of the business are not seeking to liquidate some or all of their stake in the business, but rather are looking for financing to augment the cash flow of the company during a period of anticipated rapid growth. This growth can result from an expansion of the company's physical plant or through sales growth that requires additional working capital. The three most common reasons for needing access to growth financing are the following:
Physical expansion can be the easiest form of growth for a company to finance through outside sources. The company is normally increasing its asset base and therefore its borrowing capacity. Expansion scenarios can be located on a spectrum. At one end of the spectrum is the project in which all of the costs are associated with the purchase of fixed assets. The most obvious example is the purchase of a new vehicle used in the core business of the company. These projects are good candidates for low-cost financing -- asset-backed senior debt being but one possibility. The rise of lease financing as a tool for businesses provides another low-cost, off-balance-sheet source of capital that in certain situations may enable the company to finance 100% of the cost of the asset. Even if lease financing is not available, the company may be able to use some of its own excess borrowing capacity to collateralize that portion of the debt in excess of the amount a lender is willing to advance.
At the other end of this spectrum are projects in which a substantial portion of proceeds will be spent on soft costs, generating little in the way of fixed assets to collateralize the loan. If the company has little or no debt on its books, it may be able to use its borrowing base to fund the soft costs. If the company has borrowed against those assets for its own purposes and additional asset based loans are unavailable, the companies must turn to junior capital - equity or subordinated debt or both - to fill the gap.
Somewhere in the middle lie those situations in which the collateral values are too low to secure asset-backed financing for the entire transaction but in which the historic cash flows of the business are sufficient, or the likelihood that the expansion effort will succeed are so great, that a senior lender will make what is termed a cash flow loan. This loan, often structured with accelerated amortization and a cash flow sweep provision, is also referred to as an "air ball". The lender holds his or her breath for the period of time this loan is outstanding, hoping that those cash flows hold up and the loan is repaid. Cash flow loans are always more expensive than asset-backed, or secured loans, and are generally available from larger, more sophisticated banks and financial institutions.
Working Capital for Growth:
In some situations, a company can grow without purchasing additional assets or expanding its physical plant. Often, this growth requires additional working capital to finance inventory purchases and accounts receivable that may grow faster than payables, putting the company in a tight cash position. Provided this growth follows historic patterns and is built on business relationships with customers roughly similar to the company's current customer base, an existing revolving line of credit can generally be expanded to accommodate the new credit needs of the business.
In situations where the company is branching out into uncharted territory, or is contemplating growth that does not necessarily create a larger current asset base against which to borrow, the company may find itself in need of subordinated debt or equity. In those situations, the analysis the company will be subject to is identical to situations where they require subordinated debt and equity financing. The risks of the business as it is and the risks that the growth efforts will fail are weighed by a lender or investor relying on continued cash flows and equity growth to realize an appropriate return.
Refinancing to Replace Restrictive Lenders:
There are situations when a company is poised for growth and is held back by a reluctant financial partner, most often but not exclusively a conservative bank unwilling to bear the risks of growth. Banks are often in the position of curbing growth if only because they generally do not price their loans to account for the risks associated with change. In some cases the company will require both additional senior debt from the institution in question as well as junior capital which will complicate the company's balance sheet and introduce a new party into the lending relationship, the bank may elect to exit the loan.
The most important insight an entrepreneur can take into a refinancing situation is that the same amount of senior debt can look very different depending on the other elements of the balance sheet, even without any changes in the company's base business.
The opportunity to complete a strategic acquisition is one of the best ways to enhance the value of a company, since an acquisition may enable you to leap frog competitors, open new markets, develop new product lines, etc. However, a poorly executed acquisition can weaken a company's balance sheet and distract key management without providing the anticipated value.
All acquisitions have unique characteristics and, therefore, unique financing requirements. Much depends on the company being acquired (the "target") and the Acquirer's strategy. We have highlighted below the three basic types of financing and their respective pros and cons. Depending on the financial health of both the target and the acquirer, the financial structure can be any combination of (I) debt, (II) equity and (III) the acquirer's stock. Three primary issues to address when structuring the acquisition are:
- The amount of debt which should be raised.
- Creating a capital structure that is appropriate for the combined Company's future.
- The cost of funds.
Debt is the cheapest method of financing an acquisition bid and can take many forms. The amount of debt that can finance an acquisition depends on the projected cash flows of the combined company. This will depend on the financial health of both the target and the acquirer.
If your company is interested in a leveraged buyout, it may be able to finance all or most of the purchase price with debt. Under this structure, the assets and cash flows of the Target collateralize the debt. This transaction is very similar to a home mortgage, in which the underlying asset backs the loan.
Banks usually provide the cheapest and most common form of debt: senior debt. However, there are many other providers of senior debt who employ different methodologies for structuring loans. Subordinated debt lenders are more aggressive in the amount of debt they provide. Accordingly, these lenders charge higher interest rates and often require a piece of the equity of the combined company.
While debt is cheaper than equity, the interest and amortization requirements as well as possible financial covenants can limit a company's flexibility. Large amounts of debt are more appropriate for mature companies with stable cash flows which will not require much capital for growth. Companies that foresee rapid growth, require substantial capital expenditures and compete in turbulent markets are often better off financing acquisitions with more equity than debt.
Equity is a more expensive form of capital than debt. This is because it carries the most risk since it has no claim to the company's assets. Acquisitions that have unstable cash flows require capital for growth and compete in turbulent industries often require a greater amount of equity. Equity provides more financial flexibility because it does not require scheduled payments.
Financing an acquisition with equity requires relinquishing some amount of ownership in the combined company. The equity investors will often assume some amount of representation on the Board of Directors. Equity investors can take the form of leveraged buyout funds, venture capital funds or corporations.
It is also possible to use the acquirer's stock to purchase all or some of the shares of the target. This is very common among companies whose stock is publicly traded. A stock swap is more difficult in private transactions because the acquiring stock is illiquid (i.e., cannot be quickly sold). However, if the owner of the target would like to retain some stake in the combined company, then exchanging shares is a sensible solution.
In order to complete a stock swap, a value must be placed on the equity of both companies and a share price must be determined. The investment banker on the acquisition team will be able to provide guidance in valuing both companies. There is a range of methods for valuing a private company, including:
- Comparable Valuation Analysis Public versus Private
- Transaction Valuation Analysis
- Discounted Cash Flow Valuation Analysis
- Leveraged Buyout Analysis
A stock swap is a valuable tool for retaining the involvement and expertise of the target's owner, if that is desired. If the owner is active in managing the target's operations and his or her expertise is important to the success of the combined operation, offering stock in the combined company will insure that the interests of the two parties are aligned.
A stock swap often funds some portion of the purchase price in roll-up strategy acquisitions. Financing a roll-up strategy usually requires an initial equity investment in the by the acquirer to position it for rapid growth. Subsequent acquisitions are then financed largely with debt. However, stock in the combined companies is not only an important currency to fund the purchase price, but also to retain the involvement of the management/owners of the Target.
Turnaround financing involves providing capital to companies that are performing poorly but that are expected to turn around and perform much better in the future. Often this kind of financing occurs in the context of a transaction or purchase of the company by a new owner and often a new management team is hired at the same time. Turnaround financing can include senior debt, subordinated debt and equity.
There are very few sources of turnaround financing. Turnarounds involve companies that for one reason or another (or a combination of reasons, more often) have fallen on hard times. Someone sees value in the business beyond what is obvious from the current and recent performance and takes on the challenge of turning the business around. These opportunities are fraught with risk - typically, if the company continues on its present course, it will not be able to remain a going concern; this is all the more true if the transaction that starts the turnaround involves debt financing. Against that backdrop - that the current state of affairs will lead to disaster - are the twin challenges of (a) accurately diagnosing what is wrong with the business and (b) quickly developing and implementing a turnaround plan that addresses those problems.
Managers often team up with private equity investors to purchase businesses or subsidiaries, divisions or product lines of corporations, using a combination of debt and equity financing. This is one of the most powerful methods for enriching the entrepreneurial spirit of professional managers.
Management buyouts represent the opportunity of a lifetime. After playing a critical role in building their company, managers often consider buying their company as the natural next step in the progression of the company's ownership. For most managers, a company buyout is the fulfillment of their dreams. However, successfully pursuing and implementing a management buyout is one of the most difficult jobs a manager will ever tackle.
Managers are experts at running their companies, but most managers have little experience making an acquisition. Management buyouts generally occur in a short time frame and require substantial and multiple sources of capital as well as legal, accounting, environmental and other professional support.
Employee buyouts are one of the most fascinating developments in the world of corporate finance. They had their beginnings in the early 1970s after Employee Stock Ownership Plan (ESOP) regulations were codified in the law as part of the ERISA legislation in 1974. An Employee buyout involves owners of a company selling a majority of their stock to its employees through an ESOP structured corporate transaction.
Employee buyouts can turn around failing companies, increase the cash flows of good companies, motivate employees to outperform their competition, reduce or eliminate corporate taxes for years, and provide a tax-advantaged investment for employees. In the highest of capitalist traditions, employee buyouts can also transfer wealth in a free market transaction to the employees who have spent their careers building the company.
Countless studies have shown that employee ownership motivates employees to improve their productivity, the quality of their work and the competitiveness of their company. ESOP financing provides a whole series of benefits to the owners of a company, to the company itself and to the employees.
Leveraged ESOP financing can allow an owner to sell all or a portion of his or her stock to the employees and indefinitely defer capital gains taxes. This has the added impact of reducing the company's taxes while it provides employees with tax sheltered ownership of the company's stock.
Every company that deploys a product or service through a large and expensive distribution system will be confronted over the next ten years with a major distribution dilemma. Should the company continue to market through its existing distribution system or should it dramatically reduce costs by turning instead to the Internet to distribute and market its product or service? A direct market distribution strategy will require significant investment in expertise, structures and systems that many executives today cannot fathom. Additional funding may be required to make the business transition.
There are many situations in which a company may need to be recapitalized. As the word implies, a recapitalization involves an infusion of capital and, potentially, certain parties taking money out of the company. This occurs when a shareholder sells his or her stake in the company or when existing debt providers are being replaced. In any recapitalization, the company must perform many of the same tasks as it would have in an acquisition or buyout.
A rollup is a strategy of buying several companies at once, or in rapid succession, in one industry to gain a variety of corporate benefits, such as economies of scale, broader product line, cheaper financing, greater diversity of customer base, etc. Rollups are very complicated transactions that should be implemented by a highly experienced team of professionals. Experienced sources of capital are critical to implement a rollup on the timetable necessary to achieve success. However, rollups can be considered to consist of a number of the above discussed transactions (or combinations thereof) executed within a narrow time horizon.