Debt or Equity? Why your answer might be neither.

The initial disruption that ensued in the wake of COVID-19 left many companies unsure of their future.

· Were they going to be on the list of essential businesses?

· How does operating in a pandemic impact day-to-day operations?

· How long is needed to weather the storm?

In the midst of this unprecedented uncertainty, financial planning and budgeting became less of a precise exercise and more like throwing a dart at a dart board. Businesses who were eligible applied for government programs like the Canada Emergency Business Account $40,000 loan, wage subsidies and payment deferrals.

These were helpful stopgap measures, but not long-term solutions. The question becomes – for those seeking additional capital to pivot or sustain their business, “Now what?”

Usually when companies need to raise capital, the two traditional options are debt or equity, but these measures have their downsides. Debt requires high securitization and precise financial budgeting. Debt servicing payments are still required even if a business does not perform as predicted. What if a second wave hits? In the event of missed payments, lenders then have recourse to claim the assets of the business or call the loan, which could lead to bankruptcy.

There is also equity, which provides flexibility and patient capital, but it means giving away the future upside of the business. Also, during these times, the equity valuation will likely be at a sizeable discount to the fundamental value of the company given the financial headwinds caused by the pandemic.

While some businesses may decide it is better to lose a limb to save the body, it is critical to fully evaluate options. There are various substitutes such as: hybrid instruments; royalty financing; joint ventures; and, other options that exist. One alternative that will likely be leading the charge is mergers and acquisitions. This is partly due to the ability to enter new products, or markets, through established businesses instead of needing to build from scratch. Additionally, consolidation is a word that will probably become a large part of the conversation in the capital markets over the coming months as management, shareholders, and lenders look to preserve value.

The problem? Mergers and acquisitions, like any other process or tool, is only as effective as it is planned for, properly implemented, and appropriately used. Many embark on a transaction anticipating a large realization of synergies, often on the basis of eliminating redundancies between the two companies once combined, only to be frustrated by the large time and costs requirements to integrate, as well as the incompatibility of cultures. Proper vetting upfront can help identify the true cost to realizing synergies, which may mean employees who are already familiar with the company and well trained to do their jobs are better left in place. All too often, employees are let go only to be replaced by more expensive consultants.

Many underestimate what a proper mergers and acquisitions process looks like, how to prepare, what elements to consider, and how best to set up all stakeholders involved for success. Mergers and acquisitions are not a typical part of a company’s operations and this is foreign territory for most. Accordingly, it is critical to ensure you bring an advisor to the table that you can trust to demystify the deals cycle, be an independent expert to ensure you are getting a good second opinion, and ultimately provide you with confidence in your deal execution. These advisors can ensure that management has not missed a technical accounting, tax, or valuation nuance that could amount to substantial losses or unforeseen costs.

As a first step, companies should critically evaluate their deal thesis – what are they looking to strategically accomplish for the business? This “why” should act as the company’s North Star that guides them throughout the transactions process. To borrow a phrase from Stephen R. Covey, “Begin with the end in mind”. Some thoughtful planning upfront, can save significant time, cost, and company morale down the road.

Join me on Wednesday, July 22nd as I will be the “Spotlight Speaker” for the upcoming Business 4 Breakfast Master-Mind event which runs from 7:00-8:45 am. Below is the link to register: https://jul22business4breakfastmaster-mindevent.eventbrite.ca

Kalos LLP is a boutique transactions advisory firm focused on financial due diligence for mergers, acquisitions, divestitures, and capital raises in the mid-market.