In this video, Matt Duckworth of Deal Camp talks about the three main ways people lose money when doing an acquisition, with a focus on the first way: too much leverage. Leverage can be a powerful tool, but it can also be a dangerous one if not used correctly.
Matt explains how to structure deals to avoid common mistakes and how to create a safe target for debt service coverage ratios. He also explains how other factors such as staffing, marketing, and equipment failure can lead to losses if not taken into account.
Debt Service Coverage Ratio
Debt service coverage ratio (DSCR) is a term used to measure the ability of a business to pay its debt. Banks typically require a 1.2 times DSCR, meaning the business's actual cash flows should be 120% of the loan payment. For example, at a 1.2x DSCR, a business doing a million dollars a year in cash flow would have debt service payments of $833,000. This leaves about 167,000 in what's called free cash flow to equity (i.e. the money you keep for yourself as the owner). If a business is doing 10 million dollars in revenue, it is easy for a bump in the road to suck up all 167,000 dollars remaining (and much more), leaving you unable to pay the full amount on the note.
That's the risk of leverage.
Creating a Safe Target
Matt recommends creating a safe target of 1.7 times debt service coverage ratio or better, and ideally 2 times. This gives you more wiggle room to make mistakes, hire a team, test new products and marketing and pay down debt. For example, if a business is doing a million dollars in free cash flow at 1.75 times debt service, that means it would have about 430,000 in free cash flow to equity available. This gives you the ability to continue to navigate the inevitable problems that come up as a new business owner and still pay yourself well.
Too Much Debt
Another way people lose money is by taking on too much debt as a percentage of the worst-case value of the business. For example, if you buy a business for two million dollars using a bank loand of $1.5 million and $500,000 equity and the worst-case scenario is that the business can be liquidated for a million dollars, you are underwater by $500,000 in that scenario. You would need to grow the business's worst-case value by $500,000 to get out without having to pay off the debt.
Many young entrepreneurs miss this important lesson, especially when buying "new economy" businesses such as websites, e-commerce stores, and software companies because there are far fewer case studies on how to handle the risk.
Conclusion
Leverage can be a powerful tool, but it can also be a dangerous one if not used correctly. It is important to structure deals to avoid common mistakes and create a safe target for debt service coverage ratios. Additionally, other factors such as staffing, marketing, and equipment failure must be taken into account to avoid losses. In the next video series, Duckworth will talk about paying too much in an industry.