MANAGEMENT BUY-OUT FINANCING INFORMATION CHECKLIST

Tick box when information collated

The deal

Type of sale (share purchase or business and assets)
Purchase price
Expected working capital requirements following sale
Equity, grants, vendor financing (by way of deferred consideration or earn out) or other funding being put in (including details of MBO teams’ investments in the deal)

The business

Industry and nature of trade
Trading history covering three years (with last audited and current management accounts)
The business forecasts (with underlying assumptions)
If in difficulty, details of the turnaround plan

The management team

CVs for all key team members
Personal wealth statements (house values less mortgages, other assets)

The assets and liabilities

Property: freehold or leasehold, valuation and description, details of any environmental/contamination issues, existing mortgages
Plant and machinery: valuation (or if not, asset listing with sufficient information re machinery make, model, age and condition to allow ‘desktop’ valuation), outstanding HP/lease liabilities
Debtors: aged debtors, aged creditors, sample invoice, contract and delivery note
Stock and confirmed orders: list of finished goods stock and confirmed order list
Reproduced with permission from Creative Finance

Using an experienced broker to put together a funding package can make a real difference to the amount of cash you are able to raise.

Borrowings divide into short- or long-term funding. For accounting purposes, anything due for repayment on demand (such as an overdraft) or due within the next 12 months (e.g. trade creditors or the next year’s worth of lease instalments) will count as current liabilities on the company’s balance sheet, whilst money not due until over a year’s time will count as long-term liabilities.

Short-term borrowing

Short-term sources include:

Trade creditors

When suppliers provide goods and allow the company time to pay, this is in effect an interest free loan (although the supplier should have costed in the credit they will allow the company in pricing the job!). The more that the company is able to borrow from suppliers with their agreement in this way, the less they have to borrow elsewhere.

Overdraft

Much UK business funding has traditionally been by way of overdrafts as they tend to be the most flexible banking facility offered. An overdraft is a short-term facility intended by banks as a ‘revolving credit’ to cover temporary timing differences between payments you have to make to suppliers and receipts from customers. Banks will therefore expect to see the account swing back into credit on a regular basis and do not expect to see it used for purchasing long-term assets. As a short-term facility, an overdraft is usually repayable on demand.

The bank will also generally look to take some form of security for an overdraft by way of charges over a parcel of assets. Because of this approach to taking security over a range of assets (some of which, such as stock and debtors, will vary in value significantly from day to day), banks will take a relatively cautious view in assessing the real value of their security, while specialists in lending against specific types of asset may be able to lend more.

Overdrafts are also time-consuming for banks to manage so expect to see banks moving more and more customers across to factoring facilities as an alternative to overdrafts.

Factoring/invoice discounting

This allows the company to raise money against its outstanding debtors by assigning the outstanding invoices to the lender, who will advance you say 80% of the approved invoices immediately.

As the lender takes over the debtors as security, these are then not available for a bank to secure its overdraft. So completion of a factoring deal usually involves paying off the overdraft out of the proceeds of factoring the ledger being taken over.

In factoring, the lender takes over management of the sales ledger and actively chases payment, which can in itself be an advantage if the company’s credit control has been poor. In some cases factors will allow a CHOCs arrangement for key accounts (client handles own customers) whereby the company retains control of the contact with the customer.

Invoice discounting is usually only available to businesses with turnovers of greater than £lm and differs from factoring in that the company continues to run its own sales ledger and collect in the debtors. As the company is continuing to do the work, it is therefore possible to have confidential invoice discounting (CID) which means that the customers will not be aware of the arrangement.

Some invoice discounters will take stock into account and are then able to offer higher levels of advance against invoices (sometimes exceeding 100% of the debtor book).

The issues you need to consider are:

• With factoring you will lose control of how your customers are chased for payment.
• Your facility will be based on a percentage advance against approved invoices. The actual advance you receive as a percentage of your total debtors can be significantly less than this ‘headline’ percentage as the factor may disallow debts over three months old and overseas debts, or may set ‘concentration limits’ where individual customers’ debts cannot be more than a set percentage of your sales ledger. You need to look at the nature of your debts and ensure that you will not run into such problems with your factor.
• Some debts are difficult to factor. There are only a limited number of factors who will deal with ‘contractual’ debt involving stage payments (such as construction contracts).
• As the advance is tied directly to invoicing, factoring is well suited to fast growing companies – the financing automatically expands as the business grows, reducing the danger of overtrading.
• However, as the facility is tied to sales volume, if sales fall, so does the funding available (which may be just the moment that you need finance the most!).
• Once you have this type of facility in place, it can be extremely difficult to get to a position where you can exit the arrangement.
• There is still a stigma attached to factoring in some circles as it has been seen as financing of last resort. However, as banks have moved more customers to this form of financing, this stigma is disappearing (and of course is avoided with confidential invoice discounting).
• Factoring and invoice discounting are often perceived as expensive, although when comparing costs against bank facilities it is important to compare against the total cost of equivalent bank facilities including interest, management charges, etc. to get a fair comparison.

Block discounting

Where you have a long-term stream of income such as a rental income from property or machinery that is rented out, then you may be able to borrow what is in effect an advance against this future income through block discounting. This is a specialist market where each deal is very much a one-off so you are likely to need to use an independent broker to explore this if it is appropriate.

Bridging loans

These are normally short-term loans that typically allow you to spend money that is anticipated (usually from the sale of an asset such as a property), before the cash has been received.

There are some specialist funders who will offer ‘bridging’ loans against property essentially as ‘emergency’ funding. However, while this can raise say 70% of the security value of a property within two weeks, this type of funding is extremely expensive and interest rates can often run at 2% a month together with substantial arrangement fees.

Long-term borrowing

Long-term sources include:

Bank loans (term loans)

If you are looking to invest in long-term assets such as plant and machinery or property you should borrow over a period that matches the expected useful life of the asset being bought so that it repays the borrowing over its useful life.

Fixed rate loans offer you certainty over the payments you will make (but can therefore be inflexible and have repayment penalties built in).

Variable rate loans tend to be more flexible but leave you exposed to uncertainty as interest rates change over time. If you are borrowing significant sums (say over £250,000) you may be able to buy what is in effect an insurance policy against interest rates going up in the form of a rate cap.

Mortgages

A mortgage is essentially simply an example of a long-term loan secured against a property and all the points above apply.

Where a business has a property that is not fully lent against, remortgaging it is usually the cheapest and easiest way to obtain finance.

Hire purchase

Hire purchase involves you in agreeing to purchase an asset by making payments in instalments over a set period.

Hire purchase agreements vary widely in their terms, offering fixed or variable interest rates, and you need to check the rates carefully (particularly where there is an interest free period as rates for the balance of the term are likely to be high).

Some hire purchase agreements are structured with low ongoing payments and a large (balloon) final payment in settlement at the end. In general, while you will be responsible for maintaining and insuring the asset from day 1, legal ownership will remain with the finance company until the last instalment is paid.

Leasing

With leases, the finance company always retains ownership of the asset and there are two basic types of lease:

• Finance leases are usually used for major items of plant and equipment where the finance company buys the asset and the business pays a long-term rental that covers the capital cost, interest and charges and is responsible for insurance and maintenance. Once the capital is repaid there may be an option to purchase the equipment outright or to continue to rent it indefinitely for a small fee (peppercorn rent).
• Operating leases are typically used for smaller items such as photocopiers where the equipment is rented for a specified period and the finance company is responsible for servicing and maintaining the equipment. Contract hire is a type of operating lease where the renter is responsible for day-to-day maintenance and servicing (e.g. often used for motor cars).

You may need to pay an initial deposit in setting up a lease and from a tax point of view, while the rental can usually be treated as a cost, as you do not own the asset you cannot usually claim capital allowances on it (nor can you generally use the asset as security for other borrowings).

Sale and leaseback

As an alternative to borrowing against an asset, it is sometimes possible to arrange to sell the asset (plant and machinery or property) to a finance company to release cash and then to rent it back. The amount of cash you can obtain will depend on the value of the asset being sold. This is a specialist area (particularly in relation to property where this is only normally applicable to properties worth over £500,000) where you will need to engage a good finance broker.

Directors loans

Finally, there is nothing to stop you as a director putting money into the business by way of a loan rather than equity if you have the funds available. This should be considered when discussing the appropriate financial structure of the business with your advisers.

PG tips

Don’t, if you can avoid them. The taking of personal guarantees (PGs) from company directors by lenders is becoming increasingly common. By giving a personal guarantee, you are promising that if your company cannot repay whatever has been guaranteed, then you will do so personally.

If you have to give a personal guarantee then try to:

• have the guarantee limited to a specific amount (e.g. up to £25,000 of the company’s overdraft) rather than unlimited, which would mean that you are liable for the whole of the company’s borrowings
• avoid giving a supported guarantee (where the guarantee is backed up by charges over specific assets such as a charge on your home) and instead give an unsupported guarantee, not tied to any particular asset that can be seized
• ensure that you understand the circumstances under which the guarantee can be called; in practice you (and your spouse if there is to be a charge on your matrimonial home) will be advised by the lender to obtain separate legal advice.

HOW MUCH CAN YOU BORROW?

To allow you to estimate how much you may be able to borrow against the target business’s assets from these different sources, Creative Finance’s ‘ready reckoner’ is given below. By completing this with estimates as to the value of the business’s assets, you can calculate how much you are likely to be able to borrow either from a mainstream bank or from a mix of asset based lenders.

Business borrowing ability ready reckoner

To calculate a business’s indicative borrowing ability, complete the form below using:

• the basis of valuation noted to calculate the ‘security value’ of the assets
• the percentages shown to calculate the likely borrowings available.

Actual borrowing ability will be determined by a number of factors and the table below can act as a general guide only.

In particular this form only takes into account the security value available from the business’s assets. It does not therefore make any allowance for other security that you may be able to provide by way of personal guarantees against personal assets or that may be available through schemes such as the Small Firms Loan Guarantee Scheme.

VENDOR FINANCE

A business for sale will typically have been valued at a multiple of its annual earnings. This can easily mean that even a relatively small business may come with a target purchase price of many hundreds of thousands of pounds.

This is likely to be a problem for both you as a buyer and the seller, as you or any other buyer will only able to afford to pay the amount of cash that you are able to raise. Not many people actually have hundreds of thousands in cash available with which to buy a business, even having taken into account the amount you may be able to raise from remortgaging your domestic property; while the funds that can be raised against the business’s assets may be limited as shown by the percentages given above.

This means that the only realistic source of payment to the seller for much of the business’s goodwill is likely to be from the future profits generated by the business under your new ownership. But because this does not provide any realisable form of security, you are unlikely to be able to borrow against this from banks or other lenders apart from the seller.

So sellers who are not prepared to allow you some degree of credit (’vendor finance’) are in effect reducing the amount of money they can be paid for the business.

But in allowing credit they are taking a risk that they will not be paid this deferred consideration, and so will want to look to cover themselves by charging interest and taking security.

Bonding insurance

There is a solution to this problem for business sales with a value in excess of £2m as there is now a service available backed by a major institution which will guarantee payment of up to 100% of the deferred consideration to the seller by way of an insurance policy. This bonding approach therefore eliminates the seller’s risk in offering such credit, covering up to 100% of vendor consideration of £2m-£50m in transactions of £2m-£250m with deferred consideration periods of up to five years.

The policy is non-cancellable and 100% underwritten by an investment grade backer with very limited exclusions covering vendor fraud or deliberate misrepresentation. It can also be combined with raising asset based finance against the business’s assets to fund payment of the premium.

This approach has benefits that can be shared by both you and the seller:

• the seller can have confidence that they will receive their payment whether or not the business is a success
• the seller does not have to take further security and the phasing of payments can give tax planning advantages
• agreement by you on the seller’s headline price is easier to achieve
• you can reduce the level of gearing needed to buy the business, reducing the financial burden on the business and the risk of failure.

FINANCIAL ASSISTANCE RULES

In many business purchases you’ll be acquiring significant business assets such as land and buildings or plant and machinery against which as discussed above you would expect to be able to borrow. And indeed if the value of these assets forms a significant part of the value of the business this would appear to be one of the most logical routes to raising the money with which to buy them.

However, this is to reckon without the Financial Assistance Rules of the Companies Act. These prohibit you from pledging the assets of the company to be brought as security to a lender for money to be raised to buy the company’s shares. They were designed to prevent ‘asset stripping’ where a company with significant assets could in the past be bought by someone with money raised from financial institutions on the basis that the business would be broken up and the assets sold off as soon as the deal had been completed, with the proceeds used to repay the borrowed money.

In practice the Act provides a mechanism whereby so long as certain procedures are met, you can borrow against the value of the assets being acquired in order to fund the deal. You will, however, need to instruct professional advisers to prepare what is known as a ’whitewash report’ to allow the borrowing to take place.

For a whitewash report the target company’s directors have to swear a statutory declaration that the company will be able to meet its debts in the year following the sale and this declaration has to be confirmed by the company’s auditors.

The Companies Act also imposes restrictions on the sale of substantial business assets from the business to the directors (designed to prevent directors looting a company’s assets without the knowledge of the shareholders). The effect of this is that if you are a director and you wish to buy either substantial assets (in effect anything with a value of over £100,000 or 10% of the balance sheet) then under Section 320 of the Companies Act, the transaction requires the approval in advance of the shareholders. This has obvious implications if, for example, you are looking to undertake a management buyout of part of your existing business.

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