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Step 1 in developing a strategic growth plan for your company is determining the scale and scope of its market opportunity. Expansion may come from taking market share away from competitors, participating in overall market growth, innovating superior customer solutions, geographic expansion or through other channels.
Step 2 in developing a strategic growth plan for your company is understanding how much investment you can fund. It’s great to have a fantastic plan, but if you cannot fund it, it cannot be implemented.
If you are not aware of what funding is available to your company, you may materially underutilize its resources and capabilities. If you agree that a CEO’s job is maximizing value for all stakeholders, underutilizing your company’s resources and capabilities must be avoided.
CEOs often believe that funds available for organic growth equals free cash flow and what a commercial bank will lend against tangible assets such as receivables, inventory and equipment. For successful “asset light” businesses, this is an untrue limiting belief.
As described in previous articles, approximately 40% of US institutional corporate lenders make lending decisions on the quality of a company’s cash flow rather than the liquidation value of tangible assets. The CEO of a company with $5 million in EBITDA, $5 million in receivables and $5 million in inventory may believe that their borrowing capacity is $6-$8 million, when in fact it might be $12-$20 million. This capital availability is in addition to your company’s free cash flow.
If your business has significant, realistic growth potential, a practical plan for addressing the market and a management team capable of implementing the plan, why be limited by a false belief that you cannot fund the plan? If your ROI is projected to be 2x or more than your cost of capital, why would you not put capital to work to make your company more competitive and profitable?
Based on the fact pattern above, let’s assume that a company has 1x EBITDA for a working capital revolving line of credit. Further assume the business can invest $1.5 mil in annual free cash flow. If you only consider asset based loans from commercial banks, it will be difficult to invest more than free cash flow and perhaps $1 million from an asset based borrowing facility.
That same company can go to an institutional cash flow lender and potentially arrange a $15 mil to $20 mil credit facility, including a $5 mil revolver. Let’s assume you do not want to fully extend the company but are willing to access debt of $12 million: $5 mil for your revolver and a $7 mil term loan to fund growth. Your company will invest $1.5 mil from free cash flow in each of two years and draw $3.5 mil on its term in each of two years to fund a growth plan.
Over a two year period, the company will have $5 million available for working capital and an additional $10 million to invest in growth. For this example, let’s assume that:
- Interest on all debt is 7%
- Mandatory amortization for the term loan is 5% of principal plus 50% of available free cash flow
- The company’s $5 mil baseline EBITDA has no growth
- EBITDA generated by new investment has no return the year it is made, 15% ROI the following year and grows 15% annually thereafter
In this scenario, the company’s Debt to EBITDA ratio rises from 1-1 to 2.4-1 at the beginning of year 1: with $3 mil to $8 mil of additional borrowing capacity. It will rapidly de-lever through both debt amortization and increasing EBITDA. This can be seen in the chart below:
In this scenario, your company’s Debt/EBITDA ratio falls to 2-1 by the end of year 1 and 1.4-1 by the end of year 2. Thereafter, EBITDA growth brings the company’s remaining working capital debt below the original 1-1.
Importantly, even with the reinvestment of cash flow and debt amortization, the company is still able to maintain moderate distributions to shareholders in years 1 & 2, with substantial increases in distributions in years 3-5.
Perhaps most significant, implementing the strategic growth plan will increase the profitability and competitiveness of your company. Those trends most often result in a substantial increase in the value of your business that can equal an additional 1x-3x EBITDA. In this example, the original company might be valued at 7x EBITDA, or $35 million. After growing from $5 mil to $7 mil in EBITDA, that value might be 8x EBITDA or $56 million.
If your company has the opportunity and ability to achieve significant growth and you as CEO want to maximize value for stakeholders, understanding the amount of capital that can be deployed to implement a well-structured strategic growth plan is a fundamental aspect to success.
If you have any questions, please reach out to me at firstname.lastname@example.org.
Mark Taffet is CEO of Mast Advisors, Inc., an M&A and strategic advisory firm focused on maximizing value for middle-market companies. Information regarding specific aspects of the private capital markets has been provided by SPP Capital Partners, an investment bank focused on raising funds in the private capital markets.
Securities offered through SPP Capital Partners, LLC: 550 5th Ave., 12th Floor, New York, NY 10036. Member FINRA/SIPC