Consider debt for acquisitions.

Use of little-understood subdordinated debt growing

Financings that include subordinated debt are on the rise and show no sign of slowing anytime soon. The increasing popularity of this debt instrument is being driven by the continuing trend to growth-through-acquisition and the growing number of businesses being sold as their aging owners retire.

More than half of all Canadian businesses with sales in excess of $500,000 are expected to change hands in the next few years.

Despite its increasing use, however, subordinated debt remains one of the least understood forms of financing currently available.

Owners of companies involved in expanding, selling or acquiring. companies or who need to refinance owe it to themselves - and their businesses - to have a sound understanding of this financing instrument.

Sub-debt offers considerable flexibility and is an effective deal closer, particularly when there is difficulty in qualifying for secured loans.

It is essentially a high-yield investment in the form of an unsecured loan, which is subordinate to conventional financing.

Unlike conventional loans, which are tied to and determined by asset values, accounts receivable and debt-to-equity ratios, a subordinated loan is based on cash flow, earnings and management's track record.

The lender's only security is faith that the company will meet its performance targets. This means owners applying for subordinated loans can expect due diligence to ensure cash flow and earning targets will be met.

It also means subordinated debt is more expensive than conventional financing.

That said, subordinated debt is substantially less expensive than an equity investment. For owners of high-growth companies using sub-debt for expansion or acquisition, this form of financing can provide a cost-effective way to finance growth without giving up equity.

Subordinated loans are most commonly used to finance acquisitions, management buyouts, successions and major expansions when collateral insufficient to secure conventional financing, or when debt-to-equity is too high.

Here are three scenarios where subordinated debt makes good sense.

Suppose a majority partner in a logging company with strong cash flow wants to buy out his silent partner and requires $1.2 million. The firm's hard assets are sufficient to secure a term loan of $700,000. A subordinated loan for the remaining $500,000 provides the majority partner with a way to make up the difference and gain 100 per cent ownership.

Now suppose that a company wants to make a strategic acquisition to penetrate a new market. The owner identifies a target company and negotiates a price of $3 million. There is sufficient collateral to secure a $1.6-million term loan, and the owner arranges an equity investment for $1.2 million with a five-year repayment schedule.

But there's a catch. The seller is not willing to accept a vendor take back for the remaining $200,000.

By paying out the seller with a subordinated loan, the buyer can close the deal without having to give up more equity by attracting another investor.

An owner-manager can also use subordinated debt to keep debt-to-equity at manageable levels.

Assume that a mining equipment service company with strong cash requires 100 per cent financing for a major expansion. If the financing is structured exclusively with term debt, the company will be in default of its 3:1 debt-to-equity covenant with its lender.

Again, subordinated debt's unique characteristics provide the needed flexibility, to close the deal.

Because most lenders consider the long-term portion of sub-debt to be equity rather than debt, the company is able to finance 25 per cent of the expansion cost using sub-debt and still meet the lender's covenants.

In the right circumstances subordinated debt offers significant advantages, but it is not for everyone. Companies best suited to this type if financing are mature with strong cash flow, have proven management, a secure market position and low capital expenditure requirements that cut into cash flow.

Low capital requirements are important because high or unexpected capital requirements can strain cash flow and cause companies to become overextended.

Owners considering subordinated debt should protect against too much leverage of their cash flow. Some marking should be left for unforeseen events.

RoyNat Inc. is a specialist lender to the small and medium-sized business sector. Normand Meunier is assistant vice-president of RoyNat's Sudbury office, which serves northeastern Ontario.