SESSION TITLE. Fall ESOP Forum Financing an ESOP Transaction. ESOP Feasibility

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1 Financing an ESOP: Seller Notes & Bank Financing Presented by: Shaun McGehee Prairie Capital Advisors One Lincoln Centre 18W140 Butterfield Road, Suite 800 Oakbrook Terrace, IL Financing an ESOP Transaction Arguably, the most important part of the ESOP transaction The financing structure is the foundation of any ESOP transaction and a poor foundation can lead to distress While valuation is important, if a bank won t lend you the money or if you can t pay it back. There is no deal! 2 ESOP Feasibility Analyzes transaction effects Answers does a proposed structure work Scenario testing can lead to structure changes 3 1

2 Understand Your Liquidity Needs How much cash is desired / required at close? Personal expenses 1042 investments Highly dependent on the individual If max liquidity is required, it may get expensive If liquidity requirements are flexible, seller financing can provide a fixed income return Remember Understand your liquidity needs along with the investment needs of the company 4 Borrowing Base / Senior Capacity The borrowing base is the total amount of margined collateral against which a lender will lend funds to a business An airball or over-advance is the portion of a loan that exceeds the amount supported by the underlying collateral and is dependent on support from the company s cash flow If collateral is limited, there may be personal guarantees or other arrangements Surplus debt capacity should considered to ensure the company can still operate and invest in the future 5 Building the Capital Stack A typical private equity structure may look like.. Low Risk / Return Senior Mezzanine Preferred Borrowers and Lenders typically fill the capital structure from the Top Down Appropriately maximize the most flexible, lowest cost Senior first High Common 6 2

3 Building the Capital Stack A typical ESOP equity structure may look like.. Low Risk / Return Senior Mezzanine Preferred Seller Subordinated Notes Deeply subordinated seller notes can be used to complete the capital stack If the seller seeks more liquidity at closing, mezzanine debt may be raised to reduce or eliminate seller notes High Common Structure must speak to maintaining 100% S- Corp status - if desired 7 Illustrative Senior Bank Financing The Revolving Facility Typically a 3-year term Extended one year at each anniversary of closing Outstandings may be re-paid and re-borrowed as needed May be governed by a borrowing base margined against receivables and inventories Lenders and borrowers are advised to maintain adequate unused flexibility for working capital needs Pricing LIBOR Spreads generally between 300 and 600 bps in the leveraged credit 8 Illustrative Senior Bank Financing The Term Loan(s) Typically a 5-year term Anticipate equal quarterly amortization through maturity Stronger credits may seek a 7-year amortization schedule with a balloon at maturity While sharing in the collateral pool, the term facility potentially may not enjoy tangible collateral support Borrowers with appropriate fixed assets may be good candidates for other types of senior financing i.e. mortgages, leases, sale & lease-back etc. Pricing LIBOR Spreads generally between 300 and 600 bps in the leveraged credit Fixed rates often available imbedded or via swaps or caps 9 3

4 Illustrative Senior Bank Financing The Term Loan(s) Airball Remember the airball is the portion of senior debt that is unsecured or not covered by collateral Banks will be more comfortable with airball loans with Company s that exhibit stable cash flows A bank will view the airball as a higher risk facility and require this be amortized first. Typically amortized over 12 to 24 months It may also carry a higher interest rate, depending on company characteristics and other factors 10 Basic Underwriting Guidelines 11 Basic Underwriting Guidelines Character Management history and depth Are there succession plans? Can management continue to execute post-transaction? What happens when a key person is gone? Customer concentration Stability of industry 12 4

5 Basic Underwriting Guidelines Capacity Stability and predictability of cash flow Cash flow cushion can you cover a what if scenario Have a plan regarding a material change in the business Many questions could be answered during the feasibility analysis Ability to meet covenants 13 Basic Underwriting Guidelines Collateral Collateral coverage / excess availability Advance ratios Magnitude and duration of the airball Personal guarantees 14 Basic Underwriting Guidelines Capital Understand competing demands on capital How seller subordinated debt impacts other sources of capital Access to other source of capital 15 5

6 Inside the mind a of Lender.. 3 Important Metrics 1. Fixed Charge Coverage 2. Senior Cash Flow Leverage 3. Asset Support of Senior Outstanding Lending is a multi-variate analysis 16 Inside the mind a of Lender.. Fixed Charge Coverage Pro Forma Fixed Charge Coverage TaxPayer 100% S ESOP (Cash Flow Coverage of Service Needs) 12/31/17 EBITDA $7,981 $7,981 Less: Taxes & Tax 40% (2,742) Less: Unfinanced CAPEX (15) (15) Net Cash Flow Avail. for Fixed Charges $5,224 $7,966 Senior Revolver Drawn $4,000 $4,000 Senior Term 15,000 15,000 Seller Notes 28,023 28,023 Can you pay back the loan over the prescribed term? Is there cushion for an unplanned event? Total Funded $47,023 $47,023 Pro Forma Revolving 4.00% $160 $160 Pro Forma Sr. Term 4.00% Pro Forma Sr. Term 5 Yrs. Amort 3,000 3,000 Pro Forma Junior 6.00% 1,681 1,681 Pro Forma Total Fixed Charges $5,441 $5,441 Fixed charge coverage ratios range from 1.15x to 1.50x Pro Forma Fixed Charge Coverage 0.96x 1.46x Covenants and collateral will be different by industry 17 Inside the mind a of Lender.. Senior Cash Flow Leverage Pro-forma EBITD A -Based SeniorFinancialFlexability Low Mid High SFD / EBITDA Tolerance 2.00x 2.50x 3.00x Est. 12 / 31/ 19 EBITDA 2,465 Pro Forma SeniorCapacity $ 4,930 $ 6,163 $ 7,395 Proposed SeniorAdvance $ 6,000 Maximum s typically range 2.25x to 3.25x Measured as SFD / EBITDAE Highly impacted on having clarity into the future Bankers will seek secondary support (collateral coverage) 18 6

7 Inside the mind a of Lender.. Asset Support of Senior TotalAssetBased FinancialFlexibility $000s Ineligible Eligible Advance Available 3, % 3, % 3,096 Accounts Receivalbe (38 DSO) $ $ $ 50.00% 1,099 FIFO Inventory (35 days) 2, % 2,199 TotalW orking CapitalAvailability $ 4,195 Less: Outstanding Revolver (3,000) Borrow ing Base $ 1,195 Net Fixed Assets 800 n/m % 0 Proposed SeniorTerm $ 3,000 Lenders will want to understand exposure Estimated AIRBALL $ (1,805) The bank will not want to overextend if there is lack of secondary support. There is a risk / reward imbalance Risk tolerance is affected by stability of company (the 4Cs) 19 Illustrative Professional Mezzanine Financing Professional Mezzanine Notes 7-Year term is typical Balloon payment at maturity Notes may be redeemed (refinanced) in whole or in part prior to maturity after senior debt is repaid or leverage is reduced Notes are subordinated to senior bank debt depth of subordination TBD Investor will seek IRR in the 10 16% range via: Cash Interest Level dependent on company s ability to service interest in the normal course 6% - 10% Cash-pay interest is not uncommon Senior lender may have a voice in the level of cash interest given his perceived level of risk 20 Illustrative Professional Mezzanine Financing PIK Interest (Payment in Kind) Accrues to the note, payable at maturity or sooner Warrants Notional amount often scaled up or down with ultimate purchase price, availability of senior financing, and seller s desire for greater immediate liquidity It is not unusual for the seller to opt for a larger seller note as he considers his re-investment options vis-à-vis the risk/return of the professional mezzanine investment in the company 21 7

8 Illustrative Deeply Subordinated Seller Notes Deeply Subordinated Seller Notes Terms may mirror professional mezzanine Will typically rank junior to professional mezzanine that appears in the capital stack 7-Year term is typical Balloon payment at maturity Notes may be redeemed (refinanced) in whole or in part prior to maturity after senior debt is repaid or leverage is reduced IRR in the 10 16% range anticipated via: Cash Interest PIK Interest (Payment in Kind) 4% Cash Pay / 4% PIK is not uncommon Warrants 22 Illustrative Deeply Subordinated Seller Notes Subordination Seller must be aware of the deep and dark subordination of his notes necessary to support a 100% financed transaction While, notes will reflect a rights package similar to preferred stock minimal rights in default or bankruptcy. While reflecting equity characteristics, the OCC and some banks include seller financing in Total computations 23 Warrants What is a Warrant? A warrant is a financial instrument that gives the warrant holder the right, but not the obligation, to participate in the performance of the underlying security Warrants provide the holder the opportunity to gain greater exposure to potential returns on an investment At the time of the transaction, the seller may choose to have warrants attached to seller financing to increase potential returns Warrants can also provide potential estate planning tax strategies 24 8

9 Warrants How a Warrant Functions When the warrants are issued, a strike price is set Over time, the warrants build value as the stock price increases (i.e. current stock price - the strike price = warrant value) The value of the warrants will be paid to the holder on the expiry date or if callable by the company A holder of a seller note with warrants will receive principal and interest payments plus any value of the warrants, which may enhance the holder s return on investment 25 Illustrative Flow of Funds at Closing ESOP Transaction Process 1. Bank loans $6.0M to company, creating the external loan 2. Selling shareholders take on $22.0M in seller notes 3. Company loans $28.0M to ESOP to fund the purchase, creating the internal loan 4. Purchase shares are held in suspense as collateral for the internal loan 26 Cash Flow Pattern of a Well Structured ESOP 27 9

10 Some Final Thoughts The first 24 to 36 months are crucial post transaction Interaction between all capital facilities is important. Timing of potential refinancing The layering and timing of your capital needs is important Use the feasibility analysis as a testing ground fully understand any what if scenarios 28 Questions? Shaun McGehee Prairie Capital Advisors One Lincoln Centre 18W140 Butterfield Road, Suite 800 Oakbrook Terrace, IL smcgehee@prairiecap.com 29 10