It is beyond debate that more Australian businesses are being put on the selling block due to baby boomers nearing the retirement age; this topic has received a fair amount of coverage in recent years and it is not going to subside in the current buyer’s market. According to the September Quarter 2011 BizExchange Index (“the Index”), businesses for sale increase by over 350% and their prices halve.
The lack of funding in this space is further exacerbating business exits resulting in either business owners slashing the enterprise value of their business to be able to sell (and thereby impacting on their retirement funding) or alternatively deferring their retirement due to not being able to find a suitable buyer at the right price. This funding issue was highlighted in the Index where mention was made that “with Gen X and Gen Y unable to access their superannuation savings to purchase their own business, and already heavily in debt due to high housing prices, funding of the business purchase is going to be an ongoing issue.”
The current bank lending rule of thumb is 50% gearing with the incoming business owner expected to fund the remaining purchase consideration. Whilst this may be conceivable at the micro-business level, it is a major impediment in the small and medium business space for a business owner to come up with this amount of cash. There are numerous alternatives that the buyer can contemplate to ensure that the deal gets over the line (for instance deferred consideration or part cash/part equity). Most of those alternatives will require the vendor to maintain some form of ‘skin in the game’. The feedback that we have been receiving from vendors is why should we finance the buyers for the next 2-5 years and get paid out of our own profits. In short, vendors would generally want to cash out from day 1 and fully exit their business or maintain their current ownership for the next couple of years and fully benefit from the returns before exiting.
This means that buyers should consider other avenues of funding. With those businesses being revenue generating and having a trading history (cf startups), another avenue that buyers may want to explore is revenue royalty financing (“RRF”). The RRF is a funding mechanism that assists businesses to raise growth capital and has been used offshore (mainly in the US) for decades now. The same methodology can be replicated in the business exit space.
Broadly, the RRF investors will fund part of the acquisition proceeds and in return being entitled to ‘royalty’ payments computed on the (future) revenue of the business. This funding is akin to debt financing, with different permutations depending on circumstances, with the investor having a right to the revenue prior to the expenses of the business being funded.
The benefits of the RRF are:
• There is little or no equity dilution and therefore the incoming business owner will maintain full control of the business;
• The incoming business owner does not have to plan for an exit strategy (or be rush into one) since there is no third party equity investor;
• Little or no reliance is placed on the valuation of the business since no equity stake is being provided; and
• Generally no director’s guarantee is required.
The RRF avenue is worthwhile exploring to determine whether this may bridge the gap between bank funding and buyer’s equity contribution in a business exit scenario.
Buyers may potentially avail themselves of the funding they require to close the deal while investors may be attracted given they are arguably shying away from equity markets in the current economic environment and seeking alternative investment avenues.
For an overview on a securitised revenue royalty arrangement, refer to the following link: http://slidesha.re/t80Kyf
For further details on RRF or how you can make use of the RRF, contact Pennam Partners.
Pennam Partners is an investment house which focuses on: (1) M&A, MBO, MBI, divestment assignments and (2) designing capital strategies for unlisted and listed plays and raising capital where necessary. In addition, Pennam Partners acts as a manager for domestic and offshore funds (including VC fund) and work on investment mandates on behalf of investors.
P: +613 9221 6219