If you can finish this three minute article, you will understand the below paragraph.
John and Mary are married. They own a business valued at $50 Million and they are selling it to a third party. A bank loans the company $30 Million, MBO Ventures loans the company $10 Million and the owner takes back a $10 Million seller note. MBO and the Seller will get warrants worth 30% of the company. And the $50 Mill they received for the company is tax deferred to John and Mary (Tax Free if done correctly).
What is Capital Structure?
When bankers speak about capital structure they are simply talking about what you own, and your loans. What you own is called equity. If you have zero loans, the capital structure consists of 100% equity. If you have a loan, the Capital Structure consists of your equity and the loan. Simple.
What is Equity?
Equity is ownership, while a debt is a loan. John and Mary equally own a business, so they each have 50% equity (50% ownership). If they owned a corporation, the equity would be in the form of common stock or preferred stock. Both common stock and preferred stock are just different forms of ownership. Preferred stock holders have no voting rights, while common stock owners have voting rights. Your next question might be – why are they called “preferred” then? If something goes wrong with the company, and it goes bankrupt, preferred stock holders will get paid before common stock holders.
We used to call loans IOU’s
In the world of banking, there are many names and products for loans. These names might sound intimidating, but they all represent “loans.” A loan can be called debt, or credit, and some businesses refer to it as leverage. A bond is a loan, and so is a mortgage. Other fancier loans like CLOs (Collateralized Loan Obligations) or CMOs (Collateralized Mortgage Obligations) are a bit more complicated but they are also loans. Simply, think of it as an IOU from the buyer of your company to you.
THE LENDING STACK
If you have loans outstanding on your company, who gets paid back first when things go horribly wrong. The Lending Stack are words that bankers use so they know who gets paid back first, second, etc. If you have senior debt and junior debt, who do you think gets paid back first?
Senior Debt
A bank looks at John & Mary’s company’s earnings, assets and cash flow. Based on their analysis, they decide to lend the company $30 Million. They will offer an interest rate of 5%, but they want to be higher (senior) on the debt stack (or Lending Stack).
The bank wants to be Senior debt. This means they will be repaid, before anyone else, if the company does poorly and has to go bankrupt. (In lending, the word “senior” means it gets paid first).
Each type of financing has a different priority level in being repaid if the company declares bankruptcy. If a company goes bankrupt, the issuers of senior debt are most likely to be repaid, followed by junior debt holders, preferred stock holders and then common stock holders
Junior Debt
Junior Debt has a lower priority in repayment than Senior Debt. Another term for Junior Debt is ‘subordinated debt.’ If something goes wrong with the company, Junior Debt gets paid AFTER Senior Debt. Because Junior Debt is lower on the lending stack, it has more risk. Junior Debt lenders can charge more money in interest for this additional risk.
Seller Notes
Since the bank will not lend the entire $50 Million, the company needs to go to another lender for the rest of the loan (junior debt).
This other “junior lender” can be a firm like MBO, or it can be the shareholder that’s selling the company. When the shareholder lends money, it is called a Seller Note. However, in a seller note, no actual money changes hands. The Seller Note is an IOU that the company gives to the selling shareholder, promising to pay back the money with interest.
In this example, MBO will lend $10 Million (Junior Debt), and the Selling Shareholder will take back a Seller Note (Junior Debt) for $10 Million.
Warrants
Both MBO and the Owner are Junior Debt holders. They are equal. The going interest rate for Junior Debt might be 15%. This means that the company:
- Would have to pay MBO $1.5M (15% of $10 Mill) and
- Would have to pay the selling shareholder that took back the Seller Note $1.5M (15% of $10 Mill).
This is a lot of money and could be stressful to the Company. To remedy that, instead of MBO and the Owner each receiving 15% interest each year, they instead elect to take 5% interest (5% X $10Mill = $500k) each.
OK, are you with me so far or have you fallen asleep? Here’s the part that can be confusing. These lenders are still owed 10% each year (that’s a total of $2M per year). Instead of paying the 10%, the company will give MBO and the Selling Shareholder the right to buy back a small piece of the company in the future. This “right” is called a warrant. The warrants in this company should be equivalent to 10% interest per year.
A Warrant gives the Warrant Holder the right to buy back stock in the company at a certain price. In our example, the warrant is worth $1 Million per year for MBO and worth $1 Million per year for the selling shareholder for a total of $2Million. If you assume MBO’s loan and the Seller Note can be paid back in 3 years, the value of the Warrants is worth about $6 Million. This means that MBO and the Seller will have warrants enabling them to buy back 30% of the company.
Let me dig into this math. The $50 Million company took a $30 Million loan from the bank and gave the $30 Million to the owners. This means that the equity in the company is now worth $20 Million. To find out the value of the Warrants relative to the equity, we take the Warrant value which is $6 Million and divide it by $20 Million value of the equity. 6/20 = 30%
To learn more, go to www.mboventures.com or contact me, directly Darren Gleeman to learn more: dgleeman@mboventures.com