Employee Ownership Trust transaction finance
One of the
first questions we often get from business owners looking into potentially
selling their company to an Employee Ownership Trust, or EOT, is how is the
sale financed? This is an important
question, as often the vendor is also looking at a third-party sale and he or
she needs to understand whether they will receive cash at completion and, if
so, how much. This allows them to make
an informed decision as to the best sale alternative. While there are a number of reasons to sell
to an EOT other than the cash received at completion, it is certainly an
important consideration.
To answer
this question, we need to look at several factors. First, is there any excess cash on the
balance sheet? Excess cash would be cash
in excess of that required to operate the business. If so, the excess cash would be added to the
equity value of the business and can be paid out as part of the purchase price
on a tax-free basis. While it’s always a
positive to be able to distribute cash on a tax-free basis, for most businesses
this won’t be significant enough to sway an owner’s decision on the type of
sale to undertake. The most important
factor in determining potential cash available at completion is the debt
capacity of the business. While lenders
look at debt capacity in several ways, the primary factor is the cash flow
available to support the repayment of the debt.
Understanding the minimum debt service coverage required by lenders will
then let you determine how much debt the company can support, given typical repayment
terms. As lenders typically require
repayment over a maximum five to seven year period, knowing the required debt
service coverage ratio allows you to back into the amount of debt the company
can support.
With
respect to the cash flow available to support repayment of the loan, lenders
use what is referred to as a Debt Service Coverage (in some cases, Fixed Charge
Coverage) ratio. This is a
straightforward calculation that compares the cash flow available to support
the repayment to the debt service required.
While it can be calculated in several ways, one common methodology is
shown below:
EBITDA (Earnings Before Interest, Taxes,
Depreciation and Amortisation)
Less: Cash Taxes and Cash Capital Expenditures
Equals: Free
Cash Flow
Free Cash Flow represents the annual cash flow available to
support debt service. For an EOT sale,
there will typically be two covenant calculations, assuming the sale is
financed with bank debt and vendor loans.
These are Senior Debt Service Coverage and Total Debt Service
Coverage. Senior Debt Service Coverage
compares Free Cash Flow to the principal and interest payments on the bank debt
and Total Debt Service Coverage compares Free Cash Flow to the principal and
interest on the bank debt plus interest payments on the vendor loans (banks
will generally not permit principal repayment on vendor loans while their debt
is outstanding).
The actual calculations for each ratio are shown below:
Senior
Debt Service Coverage – Free Cash Flow/principal and interest on bank debt
Total
Debt Service Coverage – Free Cash Flow/senior debt service and vendor loan interest
Typical covenant levels might be a minimum of 1.35-1.50x for
Senior Debt Service Coverage and 1.10-1.25x for Total Debt Service
Coverage. Please keep in mind these
levels may vary significantly based upon the type of business, historical and
projected performance, etc. All
situations are different and these numbers are intended as examples only. Debt service coverage is only one aspect of
any lender’s credit underwriting process, but it is the most important aspect.
By looking at the company’s debt service capacity plus its excess cash, a vendor may be able to get a good sense of how much cash he or she could potentially receive at completion. This allows for a more informed decision among potential sale alternatives. We would be happy to discuss your particular circumstances and analyse the feasibility of an EOT transaction that would meet your objectives.
Please contact Garry Karch via email at garry.karch@rm2.co.uk or via telephone at 020 8949 5522 (office) or 07576 914468 (mobile) with any questions, or consult our free fact sheet downloads for more information.