Diligence on an owner-run business often goes the same way. The buyer's quality-of-earnings team is a week in when it finds an equipment lease that was never recorded as debt. Two weeks later it finds an earn-out still owed to the seller of a small business acquired four years ago. Then it finds that the owner lent the company $300,000 during a difficult year, on a handshake, and has been taking it back as "management fees". Each find is treated as debt, deducted from the equity value, and the price is cut. By the third, the buyer is wondering what else is there, and the cuts start to include a margin for whatever it has not found yet.
A lender behaves the same way, only earlier. Every claim that ranks ahead of the owners reduces the cash available to service new debt, and a claim the lender did not know about can turn a covenant that looked safe into one that fails.
Capital Structure File puts every such claim on one schedule before anyone else looks. It protects cash flow available for debt service by making sure the cash a lender counts is not cut later by obligations found in diligence. And it documents every claim on the equity, from a shareholder loan to an informal promise of shares to a long-serving manager, and puts each in its proper place.
Where Capital Structure File sits
Two drivers translate the business's cash into the lender's figure. This essay covers the second.
Free cash flow to the firm
- Lender ReportingProduces the lender's number every month on the loan agreement's definition, reconciled to the statements
- Capital Structure FileThis essayBrings every claim that ranks ahead of the owners onto one schedule, shareholder loans subordinated
Cash flow available for debt service
One schedule of every obligation
The schedule lists every obligation a quality-of-earnings team would treat as debt, each with its amount, its terms and its source document, classified consistently with the working-capital peg.
It starts with an inventory, and the inventory starts from contracts, because a ledger shows only what has been recorded. The ledger will not show the deferred payment in a purchase agreement nobody booked, the bonus promised in an employment letter but payable in two years, or the deposit clause in a customer contract that obliges the business to deliver work it has already been paid for. So the inventory reads every source: the ledger, every lease, every purchase agreement, every employment agreement with deferred pay, and every customer contract with deposits or prepayments.
Each item found is then classified, with the outside accountant, as debt, as debt-like, or as working capital, and each class is treated differently. Debt is deducted from enterprise value. A debt-like item, an obligation that will need cash after closing for something the business received before it, is deducted as well. Working capital is not deducted at all, because it is part of the peg the buyer expects to be delivered. A balance counted in the peg and on the debt schedule is counted twice, so the classification has to agree with the peg inspected at the start of this bridge, and the reasoning for every borderline item is written down.
Deducted, or in the peg?
Illustrative. Each item is classified once, with the outside accountant, consistently with the working-capital peg. Debt and debt-like items are deducted from enterprise value; working capital is not, because it is delivered in the peg. Guess which of these a buyer deducts, then select each to see why.
Select each item to see the verdict.
It behaves like a loan secured on the equipment, and a buyer treats it as debt.
Ordinary working capital. It is part of the peg the buyer expects the business to carry.
The stretch is borrowing from suppliers. The amount beyond normal terms is debt-like, and the peg should not absorb it.
Cash owed after closing for something received before it. Debt-like, and often missed because it sits in an old purchase agreement rather than the ledger.
The business has been paid and still has to spend to deliver. Outside the peg it is debt-like, at the cost to deliver, and it is counted once.
A routine accrual that turns over every month. Working capital.
Deferred pay for service already given. Debt-like, and found only by reading the employment letter.
A lender or buyer who receives that schedule can see every claim ahead of the owners, so it has no reason to hold back a margin for claims it has not seen. That margin is the discount for certainty, and the schedule is what removes it.
Shareholder claims papered and subordinated
The second half of the file deals with the owners' own claims: every shareholder loan papered with a subordination agreement a senior lender would accept, and a capitalization table that reconciles to the share register and the shareholder agreement.
Shareholder loans are common in owner-run businesses, and usually informal. The owner put money in when the business needed it, there is a balance on the ledger, and there may be no note, no rate and no terms. A senior lender will not lend behind a claim like that, because nothing stops the owner from taking the money back ahead of the lender. So each loan is papered with counsel, with a loan note that sets a rate and terms and a subordination agreement, in the form senior lenders commonly require, that puts the shareholder's claim behind the lender's. A loan that cannot be papered is converted to equity or repaid.
The capitalization table is reconciled at the same time. The share register, the shareholder agreement, every option or promise of equity made to staff, and the table itself must all agree. The hardest part is often the informal promise, such as the owner who told a valued manager, years ago, that they would "get a piece of the business one day." A promise like that appears in no register, but it can appear in a dispute after a sale. Each one is either documented or withdrawn in writing.
Does the capitalization table hold?
The checks counsel runs before a senior lender or a buyer relies on the table, in order. The first one that fails is the work still to do.
Once every equity and quasi-equity claim is written down and ranked, none can surface ahead of the lender or the buyer.
Why the finds cost more than they are worth
It would be reasonable to think that an obligation found in diligence costs the seller exactly its amount. In practice it costs more, for three separate reasons.
Part of it is arithmetic. A buyer valuing the equity subtracts every obligation it finds from enterprise value, dollar for dollar. An obligation the seller listed is subtracted at the seller's figure, agreed in advance. One the buyer finds is subtracted at the buyer's figure, and the buyer's figure is rarely the smaller.
Part of it is trust. A schedule that turns out to be incomplete stops being a schedule and becomes a starting point. The buyer's team now has to check every line and look for more, and the price begins to include a margin for what they have not found. The buyer may also ask for a special indemnity, a larger escrow or a longer survival period for the seller's warranties, and each of those has a cost to the seller that outlasts the sale.
And part of it comes through the lender. A leveraged buyer finances the purchase with debt sized to the business's cash flow after its existing obligations. An obligation found late reduces that cash flow, which reduces the debt available, which reduces what the buyer can pay, sometimes by more than the obligation itself.
What it does to value
The dollar amount of debt-like items that would otherwise be found in diligence is an error removed from the equity value at the closing table. The framework counts it there, once, as a correction to the price. It is not value created, because the obligations were always owed, and listing them earlier does not change how much the business owes.
What the driver does change is the probability of a breach. Obligations already in the leverage calculation can no longer surprise a covenant test, so the chance of a covenant failing unexpectedly falls. That fall, multiplied by what a breach would cost the owners, is the value counted, and on that basis the driver ranks eighth on the bridge.
What has to be in place first
The file extends work already done. The related-party schedule from Separation on the second bridge already lists the shareholder loans and owner arrangements, and this driver extends that list to everything else. The material contracts moved into the company's name under Relationship Transfer are where the deposits, prepayments and deferred obligations will be found. And counsel has to be budgeted for the loan notes and the capitalization review, agreed before the inventory is finished, so that whatever the inventory finds can be dealt with.
Knowing that it works
How complete the file is shows in the share of obligations found that sit on the schedule with a source document. Each quarterly sweep should find no obligations outside the schedule, and shareholder loans are measured by the share of those outstanding that are papered and subordinated.
The file is done when the owner will sign the schedule as complete, a statement that no debt or debt-like obligation exists outside it. A credit agreement and a purchase agreement will ask for the same representation, and an owner who hesitates to sign it now has found the reason the work is not finished. Walking the lead from enterprise value to equity value using the schedule alone, naming every item deducted between the two and why, shows the owner can use what they signed.
Why it slips, and what holds it
The file decays as debt-like obligations accumulate off the schedule. The operations lead signs a new equipment lease. A sales lead offers a customer a deposit arrangement. A senior hire is promised a deferred bonus. None of these feels like borrowing to the person agreeing to it, and each is a claim on the cash ahead of the owners.
So the safeguards catch obligations where they are created. Every contract with a deferred payment passes the finance lead before it is signed, which puts the obligation on the schedule the day it exists. And a quarterly sweep of new contracts against the schedule is a line on the quarter-end close, with anything it finds added the same week.