Capital Raising in the Middle Market

Financing Options Across the Risk Spectrum February 2014

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Agenda

• Overview • Shifts in the U.S. Economy • Lender Types • The Capital Raising Process • Conclusion

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Overview

• Following the 2008-9 recession, the U.S. economy has experienced the weakest recovery in the post-WWII period.

• This is in large part due to the fact that the last recession was a balance sheet recession, and as such was fundamentally different than the cyclical recessions that most seasoned business professionals are accustomed to.

• A noteworthy feature of the current recovery is that lenders recovered first, and as a result, the availability of capital across the risk spectrum has outpaced demand.

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SHIFTS IN THE U.S. ECONOMY

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The rate of Real U.S. GDP growth has been declining throughout the post-WWII period.

Declining U.S. GDP Growth

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The strength of recoveries, measured by peak-to-trough Real GDP swings, has declined dramatically over time.

Weakening Recoveries

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0.0%

4.0%

8.0%

12.0%

16.0%

Peak to Trough GDP Growth

Shift to a Knowledge Economy

• Another factor strongly impacting lenders is the reorientation of the U.S. to a knowledge-based economy.

• Unlike industrial companies that require considerable investments in working capital, plant, and equipment, knowledge-based companies are relatively capital efficient, and so require less funding per dollar of revenue.

• Furthermore, most lenders have a preference for tangible loan collateral (inventory, equipment, real estate), and are uncomfortable with collateral such as intellectual property, posing a challenge for asset-lite companies seeking financing.

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Collateral Disconnect

Preference of Most Lenders

• Accounts Receivable – 80 – 85% of the value of eligible accounts

receivable

• Inventory – 50 – 55% of the value of eligible inventory

• Commercial Real Estate – Targeting a loan to value (LTV) of ~80%

• Machinery & Equipment – 70 – 80% of forced liquidation value

• Intellectual Property – Many lenders, particularly banks, remain

uncomfortable lending on IP

Knowledge-Based Companies

• Business to Business companies often have Accounts Receivable that is attractive to lenders

• Generally little to no inventory

• Frequently lease office space but have no need to own

• Shift to cloud-based services has reduced the need for large equipment purchases

• Intellectual Property comprises the majority of the value in most knowledge-based companies

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Collateral Disconnect - Example

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This example posits two companies, one industrial and one knowledge-based, that both double sales over a five-year time frame. The knowledge company requires less than half the working capital of the industrial company, and its balance sheet supports only two-thirds of the borrowing capacity.

Industrial Company Knowledge Company

Year 1 Year 5 Year 1 Year 5

Sales 50,000 100,000 50,000 100,000

Cost of Goods Sold 32,500 62,500 25,000 47,500

Gross Profit 17,500 37,500 25,000 52,500 Gross Margin % 35.0% 37.5% 50.0% 52.5%

SG&A 10,000 21,500 17,500 36,500

EBITDA 7,500 16,000 7,500 16,000 EBITDA Margin % 15.0% 16.0% 15.0% 16.0%

Working Capital

Accounts Receivable 6,250 12,500 6,250 12,500

Inventory 5,417 10,417 - -

Accounts Payable 3,611 6,944 2,778 5,278

Net Working Capital 8,056 15,972 3,472 7,222

Borrowing Base

Accounts Receivable Availability 5,000 10,000 5,000 10,000

Inventory Availability 2,708 5,208 - -

Total Availability 7,708 15,208 5,000 10,000

LENDER TYPES

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A Lender for Every Situation

• In the current slow-growth economy, lenders ranging from the traditionally risk-averse (banks) to extremely risk-tolerant groups such as subordinated debt lenders, are straining their lending criteria in order to put money to work.

• This has created an extraordinarily attractive lending market for borrowers, in that it is increasingly the case that someone, somewhere, will lend to nearly any company of a certain size (sales of $20 million or greater).

• Increasingly, it is even the case that lenders will bend their criteria enough that banks will compete with subordinated debt lenders for the same loan, which in a more normal market would never happen.

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Lender Types

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Banks

• Low risk tolerance

• Lowest interest rates

• Focus on relationships

• Light to moderate monitoring

• Uncomfortable with troubled situations

Commercial Finance Companies

• Higher risk tolerance

• Higher interest rates (800 - 1000 bps above bank rates)

• Temporary capital (12-24 months)

• More stringent monitoring

• More comfortable with troubled situations

Subordinated Debt Lenders

• High risk tolerance

• Seeking equity-like returns (>20%)

• Temporary capital (12 -36 months)

• Stringent monitoring, may direct changes in management

• Very comfortable with "loan-to-own" strategies for troubled companies

THE CAPITAL RAISING PROCESS

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Positioning for Success

• The biggest adjustment for small and midsize companies seeking to raise capital is the intensity of the process.

• While healthy, profitable companies can easily find lenders willing to work with them, and in the current market even troubled companies can generally attract interest absent an orderly process, all companies benefit from an organized, well-run process focused the optimal on match of borrow and capital provider(s).

• Management teams should not underestimate the time and effort necessary to navigate through the due diligence process.

• Depending on the complexity and/or urgency of the situation, a capital raise may require a large or a small advisory team, but it is important to align the advisory team with the targeted outcome.

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Tell a Compelling Story

• While capital raising is in the end about numbers, there is a crucial qualitative component that is too often overlooked.

• Once an appropriate advisory team is assembled, management should devote time to the overall narrative, with a focus on the following:

– What is the money sought to be used for? – How has the company performed recently? – What are the key drivers of its success or under-performance? – If the company has under-performed, what changes will be made to ensure

improvement? – Of these changes, are any in progress? What is the timing of those not yet in progress? – What is the background of the management team? – What competitive dynamics does the company face in its industry/niche? – What does success look like?

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The healthier the company, the more the capital raising / refinancing process can be internally driven. Troubled companies, however, benefit considerably from a team of restructuring professionals guiding them

through the process.

Situation Determines Tactics

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Profitable

• Internal staff to prepare due diligence packet and projections• Casual process (primarily banks contacted)• Company CFO to lead lender outreach, potentially supplemented by an

investment banker

Under-Performing

• Investment banker to oversee preparation of due diligence packet and projections

• More up-tempo process, with both bank and non-bank lenders contacted• Management team to be prepped for meetings with lenders, likely with

investment banker present

Distressed

• Advisory team to oversee preparation of due diligence packet and projections

• Intensive process, lenders across the risk spectrum contacted• Management team to be prepped for meetings with lenders, generally with

both restructuring advisor and an investment banker present

Generally, a well-run process can be completed in 90 days, though more difficult situations can take considerably longer.

Steps in the Process

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Review incoming LOIs and develop scoring system

Hold management meetings with top prospects

Close on new financing

Review and Close

Benchmark prospective financing with recent deals

Develop and share "teaser" material with top capital provider prospects

Develop and send out final CIM

Market Testing

Hire advisors (if necessary)

Organize financial information

Create detailed financial forecast

Preparation

Advisor Roles in a Capital Raise

• Legal Counsel – Necessary in all situations – Protects client from unnecessary risks, negotiates intricacies of structure and terms – Particularly important in distressed situations

• Investment Banker – Most necessary in complex or urgent situations – Manages outreach to the market – Key point of contact for all capital providers

• Restructuring Advisor – Most necessary in under-performing or distressed situations – Responsible for overseeing the crisis while management oversees normal operations – Manages liquidity and develops restructuring plan in concert with management

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Minority Equity

• There is often a considerable disconnect between the value owners place on their company and the value an objective third-party might place on it.

• In troubled situations, small and midsized companies will too often waste considerable time and resources seeking capital at below-market rates. This often takes the form of owners pressing for a search for a minority equity partner.

• Owners forget that in these situations there is often little or no equity value at prevailing market valuations, and as such a risk-tolerant lender is often assuming equity-like risk.

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Illustrative Example

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A comprehensive restructuring plan, featuring both adjustments to the capital structure as well as rationalized operating expenses, can and often does result in considerable increases in enterprise value.

Illustrative Restructuring Example($000s)

Adj. fromCurrent Restructuring Pro forma

EBITDA 3,500 1,000 4,500

Senior Debt 15,000 (6,000) 9,000

Subordinated Debt - 8,500 8,500

Total Debt 15,000 17,500

Leverage 4.3x 3.9x

Enterprise Value / EBITDA 5.0x 5.0x

Implied Enterprise Value 17,500 22,500

Less: Total Debt (15,000) (17,500)

Implied Equity Value 2,500 5,000

CONCLUSION

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Key Takeaways

1) Shifts in the U.S. market, both short and long-term in nature, have driven increasing competition among all lenders for deals. For companies seeking capital and their advisors, this is a good market.

2) Different lenders across the risk spectrum have widely divergent goals, and advisors must keep that in mind as they work with their clients to guide them through their financing options.

3) Capital raising is a process, and companies must treat it as such.

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David Johnson • David Johnson is a founding partner of ACM Partners. His

advisory experience spans North America and ranges from pre-revenue startups to Fortune 500 companies.

• An active member of the Chicago business community, David currently serves on the board of directors of two Chicago-area nonprofit organizations as well as on the board of Movere, a performance-improvement firm focused on sales maximization.

• David’s writing has appeared in several industry publications, and he has lectured widely on issues of performance improvement, turnaround and restructuring.

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About ACM Partners

• ACM Partners is a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services.

• David Johnson can be contacted at: – Email: david@acm-partners.com – Ph: 312-505-7238

• For more information visit: www.acm-partners.com.

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