Unpacking the Financials: Funding a Lower Middle Market Company Acquisition with a Focus on Executive Returns
Written By: Gerald O’Dwyer III
The PE Guru — Blackmore Partners, Inc | July 29, 2024
Introduction: Acquiring a lower middle market company, defined by an EBITDA of $3 million to $10 million, can be a lucrative venture for executives looking to leverage their industry expertise. However, financing the acquisition and understanding the return on investment for an executive with a minority equity stake requires a detailed examination of deal structures and their impacts on the company.
Case Study: Acquiring Company XYZ
Background: Company XYZ is a privately held firm with an EBITDA of $8 million. The total purchase price is valued at 5x EBITDA, making it $40 million.
Deal Structures and Executive Returns:
- Equity Financing: Let’s assume that an executive, John, has been brought in to run the company and has negotiated a 5% equity stake in the business.
If the acquiring company uses equity financing by selling 20% of its shares to raise the $40 million, the equity dilution will impact John’s returns. Assuming the company’s value grows at a rate of 10% per year, John’s 5% stake would be worth:
Year 1: $2 million * 1.1 = $2.2 million Year 5: $2.2 million * (1.1)^5 = $3.6 million
- Debt Financing: In the case of debt financing, the acquiring company borrows $40 million at an interest rate of 6% over ten years. The annual loan repayment would be approximately $5.4 million.
Assuming John’s 5% equity stake and the company’s 10% growth rate, his returns would be affected by the loan repayments. The calculation for John’s returns would be:
Year 1: ($8 million – $5.4 million) * 5% * 1.1 = $0.13 million Year 5: [($8 million – $5.4 million) * (1.1)^5] * 5% = $0.21 million
- Seller Financing: In this scenario, the seller provides a loan of $40 million at an interest rate of 7% over seven years. The annual repayment would be approximately $6.5 million.
Using the same growth rate and John’s 5% stake, his returns would be:
Year 1: ($8 million – $6.5 million) * 5% * 1.1 = $0.075 million Year 5: [($8 million – $6.5 million) * (1.1)^5] * 5% = $0.12 million
Conclusion: For an executive like John with a 5% equity stake, the choice of financing significantly impacts the returns on his investment. While equity financing offers higher returns due to the absence of loan repayments, it also results in equity dilution. Debt and seller financing provide more control over the company but may result in lower returns due to the burden of loan repayments. It is crucial for executives to thoroughly analyze the financial implications of each deal structure and work with financial advisors to optimize their returns while contributing to the company’s growth and success.