The Joy of Capital: A Gourmet Guide to Deal Making
There are many reasons why a brokerage seeks to raise capital, yet even the most well intentioned entrepreneurs with well researched business plans have difficulty obtaining financing.
To understand why, you have to first understand with whom (and with what) your firm is getting into bed. There are so many types of investors that the landscape can be confusing to those who do not interact with the capital markets—debt or equity—on a regular basis. Here are some types of capital providers who invest in insurance-related businesses:
Private Equity Firms—Companies that purchase ownership interest in established, privately held businesses are usually organized as limited partnerships with a 10-year life. Investing is done in the first few years of the partnership, leaving the remaining years for capital appreciation and an ultimate exit. There are generalist private equity firms (those that invest across a variety of industries and sub-sectors), and specialist private equity firms (those that invest only in financial services).
For the most part, private equity firms seek to enhance their returns through leverage and require that the businesses in which they invest borrow money to increase the returns on equity. Because private equity firms manage money on behalf of individual and institutional investors, they require liquidity and often build into the terms of investment the ability to control their exit. This can come in the form of controlling the board, having an option to require other shareholders to buy out their interests (known as a “put right”), or being able to otherwise force the sale of a company to provide liquidity for all shareholders (a “drag along right”).
Contrary to many beliefs, private equity (PE) never left the insurance industry. While not as robust as it was during 2006 and 2007, private equity has made a revival in the insurance industry and is expected to remain strong over the next few years as the economy recovers and as rates harden. PE funds have backed firms such as Hub International, USI and Alliant Insurance Services. There is no shortage of private equity firms that view the insurance industry—in particular, insurance agencies—as attractive investments. They tend to be non-capital-intensive and devoid of reserve risk and often generate strong cash flow.
Venture Capital Firms—Similar to private equity firms, venture capital firms purchase equity ownership in privately held businesses. They focus on early-stage companies and start-ups and, consequently, rarely employ leverage because the underlying businesses usually are not yet generating positive cash flow. Because these investments are risky, venture capital firms demand higher expected rates of return than do private equity firms, in many cases more than 50% annually.
Money-Center and Community Banks—These are traditional lenders to businesses. For most smaller companies, lenders often require personal guarantees from owners along with other forms of cash collateral, particularly for service-based businesses like insurance agencies and brokerages, which generally have few hard assets on their balance sheets.
Insurance Companies—In certain circumstances, insurers have been known to lend money to their customers. But insurers cannot tie repayment terms to minimum production requirements, so this is not as active a source of capital as it was many years ago.
Specialty Lenders—Similar to private equity firms, there are lenders with pools of capital established to lend money to private businesses. They also fall into generalist and specialist categories. Some funds lend only to insurance agencies and brokerages (often, just small ones), and others get into transactions involving private equity firms only. Loans from these firms tend to be more expensive than traditional bank loans and sometimes do not require personal guarantees.
Business Development Companies—These are publicly traded pools of capital that make equity investments and lend capital to businesses. Generally, they seek current returns on capital. Unlike private equity or venture capital firms that have finite partnership terms, business development companies have less pressure to seek liquidity and have generally held onto equity investments over a longer time horizon.
Friends, Family and High-Net-Worth Individuals—Often the only source of capital for entrepreneurs, these investors tend to focus on return on investment instead of annual internal rate-of-return hurdles.
Equity Versus Debt
Capital comes not only from many sources, but in many forms. Many entrepreneurs are looking for someone to buy a minority stake in their business or seeking to borrow funds without any personal guarantees. They want to have their cake and eat it too, either by giving up some upside without any fixed repayment or wanting fixed repayment terms without having to give up ownership or put their personal assets on the line.
For most small businesses, the capital markets impose a hybrid structure, and most investments fall between those two choices in the form of subordinated debt or preferred stock securities.
So how do you put a successful deal together?
|Type of Security
|Senior Term Loans/Revolving Credit
|Fixed payments of interest and amortization
|Requires collateral (stock of business and sometimes cash and personal guarantees); strict financial covenants; restrictions on issuance of other capital, etc.; borrowing capacity generally capped at 1.0x to 1.5x EBITDA
|Bullet loans with cash and/or accrued interest
|Rights to collateral are subordinate to senior lenders; may impose restrictions on certain activities beyond senior lender; may include warrants to purchase in addition to interest payments; borrowing capacity generally capped at 0.5x to 2.5x EBITDA
|Specialty lenders, private equity, stock firms, individuals
|Equity with cash and/or accrued dividends
|Participates in any proceeds after senior loans and subordinated debt are satisfied but has liquidity preference ahead of any common stock; may be convertible into common stock or may include attached common stock; may include rights to participate in corporate governance
|Private equity firms, individuals
|Participates in any proceeds after all debt and preferred stock are satisfied; has voting rights
|Management, founders, private equity firms, individuals
Step One: The Business Plan
Whether you are a seasoned issuer or new to the capital markets, whether you are seeking $5 million or $500 million, you must have an organized and engaging business plan that explains why you need the capital, what kind of capital you need, the uses of the capital and, most important, how you’re going to pay back the capital and provide an attractive return to investors.
Whatever the reasons for needing the capital, it’s critical that your business plan convey your company’s story in a concise way that appeals to investors. Among other elements, your plan should:
- Articulate very clearly why you need the capital; investors will never give carte blanche and always want to know how their money will be invested.
- Explain how your operation is different or perceived to be different. Be as specific as possible. Elaborate on your competitive advantages relative to products, services, management talent, specialty niche, etc. and explain the dynamics of your specific markets.
- Provide an honest assessment of your challenges. No one is in a better position to assess your business than you, so pose a detailed review of your competitive threats.
- Promote your track record and the achievements of the management team. At the end of the day, investors are investing in people as much as they are investing in businesses.
Step Two: The Financial Plan, Structuring an Investment
What captures an investor’s attention? Investors want a business plan to include a detailed set of financial forecasts with credible assumptions. Generally, investors seek a three- to five-year forecast from which they can model their expected returns. As far as the details behind those credible assumptions, the more the better. These details demonstrate a command of your market and your competition, which helps inspire investor confidence.
Review your forecasts for growth rates and profit margins to see if they make sense compared to those of other brokers. If your growth and profit projections are better than your competitors’ or the industry generally, be sure you can defend your forecasts with supporting data. Bankers and investors have to justify their investment decisions to their own credit and investment committees. Anticipating what information goes into these committee packages goes a long way toward ensuring your success at raising capital.
A strong financial forecast also sets the baseline for negotiations with investors and helps determine an appropriate capital structure for your business. Successful businesses actively manage their capital structure to balance the use of prudent leverage with shareholders’ expected returns.
To determine whether your business should raise debt, equity or both, you should consider the following questions:
- How much debt can I raise? The answer is tricky and depends on a lot of factors specific to a borrower, but lenders typically use a rule of thumb of 1.0 to 2.5 times EBITDA, or cash flow, as a ceiling for total senior debt, depending on the size of the borrower.
- What are lenders seeking? First and foremost, collateral. Collateral can come in many forms. For smaller businesses, it is typically in the form of a personal guarantee along with a pledge of all stock and assets in the business. For larger businesses, lenders may waive personal guarantees and underwrite their loans solely on cash flow and ability to repay, placing strict financial covenants on the business while the loan is outstanding. In many cases, lenders want a third party (not management) to purchase equity that is subordinate to their loan.
- How much equity can I raise? This depends on a number of factors. Typically, equity investors are pricing their investment to achieve expected returns of at least 25%-30% annually—in some cases, as high as 40%-50%. Determining how much equity is in a business often becomes an exercise of modeling the expected overall value of the business in the future and discounting that value by an investors’ required rate of return to figure out how much equity they need to purchase.
- What are equity investors seeking? They seek alignment of interests, which generally involves board representation and co-investment by the management and executives. In addition, they generally seek to build liquidity options into their investment. This can come in the form of options to force the company to buy out their ownership after a certain period.
All too often, we have seen businesses and entrepreneurs approach the capital markets naively. They prepare a strong business plan and even a financial model, yet they approach investors without specifying realistic terms. Instead, they allow the markets to dictate what terms are available, and, often, they are left disappointed.
As advisors, we encourage clients to take the time to prepare a realistic proposal and think about how an investor or lender will look at your business.
Step Three: Process and Execution
Even if you have a well prepared business and financial plan and have thought through the appropriate security that will appeal to investors, completing a successful capital fundraising requires discipline and focus. Managing the demands of multiple parties who are considering investing in your business commands a lot of resources and time away from managing your firm. The typical process usually takes three to nine months.
Here are the basic steps:
|Phase I: Preparation
|Phase II: In Market
|Phase III: Due Diligence, Negotiation and Closing
|► Write business plan
|► Contact investors
|► Select investors
|► Prepare financial model
|► Make management presentations
|► Perform due diligence
|► Determine investment structure
|► Respond to follow-up requests
|► Produce documentation
|► Compile and screen potential investors
|► Solicit proposals and indications
|► Seek approvals of interest
|► Make announcement
|Timing: 4–6 weeks
|Timing: 2–6 months
|Timing: 30–60 days
Keys to a successful process include:
- Controlling information flow. Too often, businesses fall into the trap of letting the first investor who shows interest dictate information requests early in a process. This can be a fatal mistake. Sending out financials or forecasts that have not been vetted empowers the investor in a negotiation. Worse, it can lead to misinformation spreading in the marketplace.
- Approaching multiple parties simultaneously. Many business owners think they can raise capital on their own by approaching one investor at a time. But the prospects for success with this approach are very slim. Approaching multiple parties simultaneously will make the process more efficient, result in a shorter time frame and allow the business owner to compare the different investors and their financial terms and strategies.
- Preparation. In addition to creating the business plan, be ready to conduct due diligence and address potentially troublesome issues.
The private equity and debt markets are rebounding from two very difficult years. Investing activity is up, and momentum has built over the past several quarters. While the market activity is far weaker than in 2007, investing and borrowing is ramping up, and the insurance space will once again see increased activity from investors eager to put dry powder to work.
Embarking on a successful capital-raising or equity partner endeavor means entrepreneurs must be organized, consistent, detailed and, above all, realistic about expectations. Since most insurance brokerages are too small for most private equity firms, raising third-party equity capital is significantly more challenging than it would be for, say, a $100 million revenue brokerage. That said, many investors and capital providers understand the return propositions of the insurance industry and continue to find insurance investments attractive.
Regardless of your size and aspirations, the key to any capitalization or recapitalization is preparation and execution. Performed in a cohesive and professional way, a well planned capital campaign will not only increase confidence among investors—and your prospects for success—but will minimize the distractions that such a process entails.