Four routes to capital. Why decisions made two or three years earlier determine how a mid-sized company is financed

In February, the owner of a manufacturing company came to see us. He had run it for fourteen years, and run it well. He brought a three-year growth plan, a carefully calculated capital requirement and one question. He wanted to know which route to choose: a bank loan, mezzanine, bringing in a fund or the stock exchange.

We knew the answer before he had finished describing the plan. The plan was good. The company, however, had lost its borrowing capacity. For several years it had financed growth with short-term working capital loans and revolving credit lines. That debt had taken up the room that was now missing to finance an acquisition or a major investment. Banks measure a safe level of debt by the ratio of net debt (loans and leases less cash) to annual EBITDA, that is, operating profit plus depreciation and amortization. When net debt approaches 3–3.5 times EBITDA, the bank will not grant another loan until the company repays part of the old ones.

The building that housed the plant belonged to the same company as the manufacturing business. Before investing, a fund would have had to separate the two, and every complication of this kind lowers the price. For years, the company’s financial statements had also been audited by the same small, local audit firm. Any serious investor would demand a change. Yet a change of auditor in the year of a transaction looks suspicious to an investment committee, like an attempt to hide some problem. I have changed the details so that neither the company nor the parties can be identified.

Of the four routes he asked about, only one was really open. And it was the most expensive.

Most owners of mid-sized companies believe that the way to finance the business is chosen when the money becomes necessary. In this picture, the owner sits down with an adviser and picks the best of the available options. In practice, what was left to choose from had been settled by decisions made two or three years earlier. The owner made them himself, when he decided how to organize the company, how to finance day-to-day purchases, which company should hold the production hall and warehouse, and whom to hire to audit the financial statements. At the time they looked like operational matters. Today it turns out that each of them was a financing decision.

Bank loan

A company closes the route to a bank loan itself, quietly, through the way it finances its day-to-day operations. Every zloty of borrowing capacity used for inventory and receivables is a zloty that will be missing for an acquisition or a major investment. Covenants, the provisions of loan agreements that set the permitted level of debt, work the same way. A company that has come close to that threshold will not take another loan until it repays the old one or negotiates a change of terms with the bank.

A lack of unencumbered collateral also closes the route. If all of the company’s assets are already subject to mortgages and pledges securing the working capital lines, a new bank will not get security over the buyer’s assets. The assets of the target company alone are rarely enough for the bank. Borrowing capacity on the day of the capital discussion is therefore the sum of the decisions made in every previous year.

Bringing in a fund

The route to a fund is opened or closed by the company’s ownership structure and transparency. A fund that takes a minority stake, usually between just over 10 and just under 40 percent of the shares, needs a clear group of shareholders with whom decisions can be made efficiently. It also needs a shareholders’ agreement that protects its money. The fund writes into it a requirement for its consent to the company’s major decisions and a pre-agreed way of exiting the investment after a few years. Often this is the right to sell the whole company, together with the owner’s shares, if a joint sale has not taken place by the agreed date.

A company whose shares are scattered across the family, and where no one has ever settled who is responsible for what and who has a say in decisions, is a problem for a fund. The fund approaches it with caution or walks away. Mixed assets have a similar effect. Assets unrelated to the business have to be carved out before the transaction. The production hall is harder. A fund values a company as a multiple of EBITDA and expects a high return on the money it invests. The hall earns a much lower return than the manufacturing business, so the fund will not pay for it as it pays for the operating business. If the hall stays in the company, the fund will also acquire part of the property along with the shares. An owner who wants to keep the building for himself has to move it in good time into a separate company and lease it to the manufacturing company. Assets that have not been sorted out lower the price or drag out the talks.

Mezzanine

With mezzanine, owners most often fail to see the entry threshold, because they treat it as a more expensive loan. Formally, mezzanine is debt, but it costs and behaves more like equity. It usually costs between 10 and 20 percent a year, two or three times more than an ordinary bank loan. Part of the interest is paid as it falls due, and part is added to the debt and repaid at the end. A mezzanine investor comes in where debt already exceeds the ceiling the bank will accept. This debt is repaid only after the bank loan, which is why bringing in a mezzanine investor requires a separate agreement with the bank. The investor therefore takes on more risk. On top of interest, it expects a premium linked to the growth in the company’s value or the right to take up a small stake at exit.

That is why it checks two things. The first is predictable operating cash flow, because that is what the company pays interest from. The second is a realistic exit point, for example a sale of the company or a refinancing, because the part of the return that comes from sharing in the growth in value depends on it. A company with uneven cash flows that depend on individual projects will get mezzanine at a high price or not at all, even if the investment it wants to finance is very sensible. I will write about mezzanine separately in my next article, because in Poland this instrument is most often misunderstood.

The stock exchange

The stock exchange is the route owners think of first and the one that least often suits companies of this size. Preparing a public offering costs money. It also requires a dispersed shareholding. On the Main Market of the Warsaw Stock Exchange (GPW), at least 25 percent of the shares must go to small shareholders, none of whom holds more than 5 percent of the votes. A lower proportion is enough only if they end up holding at least 500,000 shares worth at least EUR 17 million. On the smaller Parallel Market, small shareholders must hold at least 15 percent of the shares and, at the same time, at least 100,000 shares worth at least EUR 1 million.

What lasts longest is what comes after the debut: the obligation to report regularly and to explain every material decision to the market. A company without a finance department that can cope with this will go public only after several years of preparation. It usually begins that preparation before anyone calls the process preparation for a listing.

One mechanism

In all four cases, the way the company can be financed follows from its condition at the moment the money becomes necessary. That condition builds up over years, through ordinary, everyday matters. An owner who takes another working capital line for inventory does not think that in two years he will have no room left for acquisition debt. An owner who leaves the hall in the company, because carving it out would trigger tax, does not think that he is lowering the future price in talks with a fund. Each of these decisions is sensible on its own. The financial effect arrives two or three years later, and by then no one connects it with its cause. The bill is paid by someone who will be looking for capital in two years. That it is the same person becomes clear only in hindsight.

What can be done earlier

An owner who is thinking about raising capital within two years should review these matters now. In the quarter in which the money is needed, such a review will only describe a state of affairs that can no longer be changed. Done two years earlier, it produces a list of things that can still be fixed.

Headroom under the covenants can be rebuilt by repaying part of the debt from cash generated by the business or by releasing cash tied up in inventory and receivables. If short-term lines have financed the purchase of machinery or an extension of the plant, that part is worth converting into a long-term investment loan. The debt will stay the same, and the short-term lines will again finance only inventory and receivables. Assets can be separated, although this rarely takes less than a year. The audit firm can be changed in a quiet year, when no one links the change to a transaction. The new auditor should audit the financial statements for at least one full financial year before the talks with an investor. In the same period, it is worth clearing the company’s costs of expenses unrelated to the business. The investor’s advisers will check every EBITDA adjustment, as I wrote in my article on the EBITDA bridge. A finance department fit for a listed company takes several years to build.

At Capital One Advisers, we start with two checks. The first is the ratio of net debt to EBITDA for the last twelve months, set against the thresholds in the loan agreements. The second is a list of the property and machinery that is currently pledged as security for short-term lines. If the headroom to the threshold shrinks for another year in a row, the route to the bank closes faster than the plan assumes.

What preparation costs

Preparation of this kind has its price. Reducing working capital lines and converting some of them into long-term loans means fixed installments and cash kept in the company instead of paid out as dividends. Carving out property can be costly in tax terms and takes time. Changing the audit firm means a new fee and a new team that has to learn the company from scratch. Putting debt and working capital in order helps any company. In a company that will never seek capital, the money spent on carving out property, changing the audit firm and expanding reporting will remain a cost with no return. Sometimes, too, an opportunity comes suddenly. A competitor is looking for a buyer and gives one quarter for a decision, and in that time no one can prepare anything.

The bottom line

The owner I am writing about lost more than he would have lost in badly handled negotiations over a margin or a valuation. Yet no accountant will show this loss in the income statement. For two years before the financing discussion, the company operated in a way that closed three of the four routes. The one that remained was the most expensive. The difference between the cost of the capital he had to take and the cost of the capital he could have taken, had he started preparing two years earlier, will be spread over the coming years. He will pay it in higher interest and in a weaker position in every later conversation about money, because a provider of capital also prices in the fact that the company has no other option.

At Capital One Advisers, we often have this conversation with an owner two or three years before the first major decision about capital. We check which routes are still open and how much time is needed to open those that are closing. This is the first of several articles in which I describe, one by one, the ways mid-sized companies are financed.

One question remains open: up to what point do preparations that are useful only in a transaction pay off? The owner pays for them today and will benefit only when he actually seeks capital. A finance department fit for the stock exchange pays for itself only if the listing actually takes place. The cost of preparing too early therefore has to be weighed against the cost of closed routes. The result of this calculation depends on how certain the growth plan now on the owner’s desk is.

Service: Capital advisory: preparing a company to raise capital