Question: Guidance on capital structure for a small business

I will appreciate some initial guidance on how to finance an acquisition for our manufacturing and retail business.

The acquisition will nearly double our size to about $12 Mn in annual revenue. Both companies do similar retail activities, with several stores in high-end art and crafts. We own our own manufacturing, but the target does not.

We have an option to take out a loan or add a silent partner. Or do a combination. I just need a framework or a reference, so I will not mention the exact terms.

The thing is, there is a lot of good material available for such decisions... but they usually relate to large corporations.

Thanks in advance.

2 Expert Insights

This is so timely as a reporter just reached out to me for an interview on a similar situation. Debt vs. equity financing is always a challenging topic. There are 2 main reasons for this: 1) most firms really haven't calculated the relative cost of each (hint, equity ALWAYS cost more than debt; really!) and 2) they haven't analyzed their risk appetite.

Let's address risk first since it is such a hot topic in the media & our economy. The more debt you have financing anything the higher the risk of not being able to pay it back if all your plans don't happen on schedule. If you are highly confident that the combined entities will generate more than enough "net" profits to repay all the loans on schedule over their lifetime than you may want to use debt to finance the acquisition as it will be cheaper than the alternatives. This assumes your financials will support your request with the lenders.

That said, are you comfortable with that level of debt? If yes, go for it. If not, you may want to look at a lower level of leverage (the proportion of long-term debt vs. equity in the business). Since equity investors take a greater risk of not receiving their planned return in the event of default or bankruptcy than lenders, they require a higher annualized return on their money. This is either in the form of cash distributions (dividends) or calculated value (increase in the value of the firm annually). The more equity (compared to debt) financing a firm the lower the risk of default but the higher the relative cost. The opposite is also true.

There is no perfect answer or silver bullet. You have to decide a) your risk appetite, b) your ability to secure long-term debt, c) your ability to repay that debt and d) the probability the combined entity will meet/exceed your financial expectations over the long run.

From what you wrote, I understand that this acquisition will give your production facilities a higher volume of business by having a greater number of retail outlets. Consequently, you are seeking to improve the return on the investment made in productive capacity instead of in retailing.

Assuming this is the motivation for the acquisition then you may have an undisclosed risk related to the acceptance of your target's customers of your products. That is, will this acquired market buy your products when they are used to buying those of a competitor.

In order to mitigate such a risk, I would suggest not buying the target but developing a strategic alliance with an acquisition option after X period of time to test the buy through. Failing this, I would recommend going the route of a JV in which both companies bring their retail businesses to the new company with a buyout option if things go well and a dissolution clause if they go badly. The JV would not require any cash until the buyout clause is activated which at that point could be the JV itself buying back its shares instead of the manufacturer buying them keeping the debt isolated where it should be. If this doesn't appeal to the seller then a seller financed acquisition would be the next option so in the case of a default the seller gets back their property. Whatever approach is used it needs to focus on mitigating that risk.