DSCR on $5-$10M deals and implications on growth rates

June 27, 2024

by a searcher from Dartmouth College - Tuck School of Business at Dartmouth in Boston Metropolitan Area, USA

Just read a great post from ^redacted‌ on financing deals in the $5-$10M ent value range.

I've been looking at deals in this range, and am surprised that banks are willing to go to a 1.25 DSCR. From my perspective, this much leverage removes any margin of safety. While I intend to grow the business I acquire, I am aware of the risks that revenue can drop in short term if key employee of customer leaves.

I feel more comfortable with###-###-#### DSCR. Or course once multiples get above 4.5X (with my equity plus sellers note getting into the 20-25% range with 70-75% bank financing at 10.5% - 11.0%) my cash flow model gets very tight, in the###-###-#### DSCR range

Are there any self funded searchers who think I am missing something? Or is the bottom line any deals above 4x adj EBIDTA simply require Year 1 growth?

Reply by a searcher
from The Johns Hopkins University in Houston, TX, USA

Thanks for starting an interesting discussion ^redacted‌. A DSCR of 1.25 would make me similarly anxious, even (or perhaps especially) beneath the $5 million to $10 million EV range you highlighted. I find smaller businesses that have been run "lean" are more likely to require early CapEx or OpEx increases just to maintain operations following the sale, with deferred maintenance and seller role replacement being two possible reasons why the historic EBITDA might exceed the cash flow actually available for debt service post close.

I recall ^redacted‌ and ^redacted‌ mentioning at last year's Self Funded Search conference that Live Oak might be considered by some to be relatively conservative with the DSCR they look for. I suppose it's my God given right as a red blooded American searcher to take on as much leverage as I can, but honestly I think a 25 percentage point increase DSCR would improve my sleep quality by 100% or more.

Reply by a searcher
from University of Pennsylvania in Seattle, WA, USA

Thanks for the tag. I think a lot of this comes down to personal risk tolerance and cannot just be summed up with DSCR. I do not think that it is realistic to expect 1.5 DSCR with 10% down in this size range. If you take a step back and think about that, you are expecting to have a highly levered deal with massive excess cashflow in our current higher interest environment - you can pretty quickly sensitize over interest rate, multiple, and leverage to see what you need to hit. I think you will need to either bring enough equity to get to 1.5 DSCR (or move down market where you current equity can get you there) or get comfortable with the increased risks of higher leverage.

All else being equal, risk can be lowered with the financing structure or type of target. Do note that these are not uncorrelated and targets with more durability or growth potential tend to have higher multiples.
-Lower multiple
-More equity
-More durability of revenue
-Higher likelihood of growth (as long as NWC or Capex doesn't need to grow)
-More cash on the sideline
-More flexible seller note such as standby term

Some gotchas to think about:
-EBITDA != cashflow
-If you are setup as a passthrough, don't forget taxes
-growth often eats cashflow
-EBITDA often doesn't have maintenance cashflow
-most deals have a reduction in cashflow post close before growing
-The list of improvements you probably want to make to the business often require cash to fund

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