Debt Vs. Equity: Funding an Expansion

LegalLast week, The Ambulatory M&A Advisor presented an article about the inner workings of Private Equity groups and their approach to funding an expansion in your healthcare business.  Although experts say that currently private equity funds are appealing to physician owners looking to expand, before a decision is made to go with private equity, the prospect of debt lending to finance your venture should also be taken into account.  The Ambulatory M&A Advisor examines how the two are different, similar, and how to determine which route to go when funding an expansion.

Marta Alfonso, principal with MBAF says that when considering the route to go when expanding one’s healthcare business, there are several differences that need to be examined.  The first area that needs to be considered is how much ownership the physician owner is wanting to obtain after the ink has dried.

“When you are dealing with somebody who is going to give you debt, as an owner you retain full control of the business.  What you are going to be paying over time is, of course interest for the use of somebody else’s funds.  It does mean that you are going to basically be the sole owner, be driving the business, and therefore that control that you retain has value to you in that sense.  You pay for that by paying for the interest,” Alfonso says.

This lending route is different when compared to having an equity partner at the table.  Typically, Alfonso says, that kind of a partner comes in the form of a majority ownership.

“For example when a private equity firm comes in, they make an investment in the company, and what that allows you to do is to take the money out of the company.  Unlike in the debt component; the debt component will typically require you to keep the money in the company,” Alfonso says.

“In the case of the equity owner, you are really going to be taking that money for your share of the business and then they are going to put up other money for the business to be able to grow or develop as strategically intended to.  In the case of the equity ownership, it’s a different dynamic because they are going to want to have an active role in helping lead the company.  They will likely retain you to keep the operation going, but they are going to expect to have influence.”

Ann Bittinger, attorney and owner of The Bittinger Law Firm agrees that what it all comes down to is really an issue of control.

“When I am advising someone who wants to start a surgery center, one of the main issues that I discuss is that of control.  In some ways equity financing seems like free money in that you don’t have to pay it back.  However, the long-term cost of equity financing can sometimes outweigh the costs of securing debt to finance a transaction,” Bittinger says.

“Usually if you get investor financing you have to relinquish some level of control.  You have to give stock to the investor, and sometimes that can be significantly more costly in terms of operations and control in the long run.  I think that is especially true given today’s low interest rate environment.  What we are really talking about is the dilution of control in order to get what seems like free money.”

Another issue that Bittinger says should be examined are interest payments on loans.  Bittinger says interest payments on loans are usually classified as business expenses so the owner can write off the interest.

“That makes debt financing more favorable than investor financing.  Investor financing is usually an after tax payment as opposed to a deduction.  That makes investor financing less favorable,” She says.

When examining the risk of the two capital raising methods, Alfonso chooses to begin with a a look at the borrowing relationship with a creditor.

“If you don’t pay, they can accelerate the debt and cause the business to go upside down from a liquidity standpoint.  That can create a real crisis for the company as an operating crisis,” Alfonso says.

According to Bittinger, if the lender has the unilateral right to accelerate the payments or there is a balloon payment in the end or at any time based on certain conditions happening, that is highly problematic because it seizes control of financial operation.

Bittinger says that acceleration of the debt is very common and plays out like any other loan situation.

“If you don’t pay your car payment they are going to repossess your car.  If you don’t pay your loan payment they are going to accelerate it completely and then file for the full amount,” Bittinger says.

What’s also concerning is what conditions cause the acceleration and that is what owners need to be careful of.  Bittinger says it is easy to make monthly payments as long as the center is making money however, other conditions that would trigger acceleration like a change of control in the company, failure to maintain certain revenues need to be reviewed closely and negotiated with the lender.

Alfonso says debt lending may require personal guarantees of the individual.  It may require taking on guarantees or indebtedness against other assets that they owner or the company owns.

“It’s not something that they are just going to give you the money free and clear.  They are going to do a lot of due diligence to make sure that they are adequately secure in the event that the entity can’t repay,” Alfonso says.

As far as collateral, Bittinger says a lender can require just about anything they want, and that is where the scary patterns start to come into play.

“The fact of the matter is, that if it is a new venture and the loan is being given to an LLC, the owners of that LLC can expect to have to give a personal guarantee for certain.  Usually in that case if the folks starting the operation don’t have a lot of collateral, I usually suggest a mix of investor and debt financing.  That way, there is some money that is going into the company that could perhaps be used as collateral which I would then use to negotiate a decrease in the personal guarantee,” Bittinger says.

In the case of an equity owner, depending on how they structure their relationship with the owner, the owner can be in a situation where they are going to have to pay some management fees to the equity investors, Alfonso says.

There is also the possibility of having to absorb some of their investor related expenses like lawyers, travel, management fees which would be a series of things that weren’t part of the structure of the company before, but are after the deal.

“The board involvement in the company with respect to a private equity firm brings a lot of positive to the table, but like I say, it’s an adjustment for an owner that has decided before who their CFO is going to be or who their compliance officer is going to be, or who they selected to provide certain advice to the company,” Alfonso says.

“The other thing is that in an equity play, typically what happens is the payment for the interest is structured in a couple of parts.  You get a piece of it when you sell that interest, but a piece of it because they are being compensated for the value of the interest, which has an earnings component to it.  This means that you may not get the full value of the retained interest until that private equity firm exits themselves within the window of a five to seven year period.”

Candace Rooney, vice president of Commercial Lending at Frost Bank says that when deciding which way to go, some opportunities are better suited for venture capital funding and others are a good for the bank.

“Borrowers should take the time to look for the best financial partner with a solid reputation and proven expertise to understand the challenges in the healthcare industry,” Rooney says adding that the banks will also take the time to look at lenders to see if they are the right fit.

“We look to see that they have demonstrated cash flow with the ability to service the proposed as well as the existing debt. We want to be sure the loans help the client to achieve their strategic objectives.  This can be achieved through conventional commercial loans, SBA loans, or special professional investor programs,” she says.

When asked about which route is typically chosen, Alfonso says the decision is pretty clean cut.  According to Alfonso, a person that wants a partner at the table to come in and is looking for a succession plan, or somebody that can help them really grow, then they are looking for the strength of an equity investor.

Or, the owner could be somebody that is a younger entrepreneur that has a great concept but is constrained and really wants to grow.

“I see a debt play; let’s say you can’t find a private equity partner with your business plan, but you still have an idea that is worthy of taking on an investment to help you and the owner is unwilling to give up ownership.  He or she wants to keep control of the intellectual property that they have developed.  Then, the debt play is the way to go,” Alfonso says.

If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.

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