Everything you need to know about business acquisition financing
Acquisitions are a fast and exciting way to grow your business. They make companies stronger by helping them reach new geographies, achieve diversification, access cutting-edge technologies, and gain a competitive advantage. But financing an acquisition deal can be a complex process, especially for smaller companies.
Financing an acquisition or a merger is different from securing venture capital funding for growth. Venture capital is a form of financing available to startups or emerging companies with long-term growth potential in exchange for equity. By contrast, acquisition financing is available to all kinds of companies for inorganic growth through the purchase of a target company.
Your company can utilise more than one way of financing an acquisition and involve large financial institutions like banks and private equity firms. In this article, we lay out the top ways to secure acquisition finance so you can act fast when a valuable strategic opportunity presents itself.
Table of contents
- What is business acquisition financing?
- How does acquisition financing work?
- How to establish the value of the target in business acquisitions?
- What are the types of acquisition financing?
- Debt versus equity: what’s better for your company?
- Is investment banking acquisition finance?
- What happens to debt in an acquisition?
- How does a bridge loan work in M&A?
What is business acquisition financing?
Acquisition financing is the process of securing capital that is used to fund a merger or an acquisition. It is a range of financing structures used by a company to buy all or part of the assets or shares of another company.
How does acquisition financing work?
Various acquisition financing options are available, ranging from seller financing to private investors and conventional bank loans. Acquisition financing can help businesses grow with as little as 15-20% down payment for strategic acquisitions while you pay the rest over time.
As a business owner, it is important to find the right capital structure so that you can make a smooth transition post-closing the deal, and unlock future growth. This article discusses various acquisition financing options, so you don’t miss any strategic opportunities because of a lack of cash.
How to establish the value of the target in business acquisitions?
Here are some of the methods used to determine the value of a target business:
Building vs. buying
A good way to determine the value of any business is to assess how much starting a similar business would cost and compare it with the cost of acquisition. The starting cost of a business could include research and technology expenses, sales and marketing costs, borrowing and finance costs, fixed assets, and variable costs like staff wages.
Net asset value
The net asset value is the value of a company's total assets minus liabilities or financial obligations.
A target company's earnings before interest, tax, depreciation, and amortisation (EBITDA) are commonly used by buyers to estimate the potential sale value.
The general rule in mergers and acquisitions is that the buyer firm's price-earnings (P/E) ratio should be greater than that of the target firm for the deal to increase the acquiring company's earnings per share (EPS).
The P/E ratio is calculated by dividing a company's share price by its earnings per share (EPS). For example, if a company's share price is £20 and the earnings per share are £2, the P/E ratio is 10.
Net present value
Another way to determine a good sale price is to estimate the target company's cash flow for the future, add discount factors, and arrive at a net present value.
What are the types of acquisition financing?
The challenge for companies making an acquisition is integrating the new business and successfully facilitating future growth. The right kind of acquisition funding can support this. Here are the top ways to secure acquisition finance:
You can fund your acquisition without any outside capital, but this probably means investing years of saved-up profit in one deal. If a company doesn’t have cash on its balance sheet, it can raise money by offering bonds or equity, or taking a loan.
Even if your company has the funds, you should still consider a hybrid financing deal to cut the risk of lowering liquidity. It isn’t always practical to finance your acquisition purely with cash because you’ll need liquidity in the post-acquisition period as you integrate the new business.
Using cash, however, can give the acquiring company a leg up if they’re in a bidding war for a target company. An all-cash transaction also means a simple acquisition where the buyer fully owns the target company.
Buying a company or merging with another firm doesn't always mean someone has to pay cash. In acquisition through equity, a buyer uses equity as a currency instead of cash to acquire shares in the target company.
It includes paying the target firm's shareholders with equity in the acquiring company or the new, combined entity. This works in situations when the sellers want to retain some control.
A seller note is a financing instrument where the seller offers not to take all of the payment upfront. It is a kind of a loan that the seller agrees to give the buyer, which will be paid back with interest plus the principal amount over a period of time.
As an example, the buyer may pay 50% of the total price at closing, and the rest is paid in a seller note over a few years. If you, as a buyer, are taking a bank loan to fund the amount you’re paying upfront, you will need to make the bank and target firm aware that you are taking on additional debt.
Private investors can cover all sizes of acquisitions. These could include family offices, private investor groups, pension funds, or private equity groups. This type of financing can be structured in various ways, including private investors coming in as shareholders in the new entity. This can be a flexible option too, as private investors don't have the traditional underwriting process like banks.
If your balance sheet doesn't allow you to pay cash, you can try to go to a bank. Banks, however, can be picky about the sectors they want to lend to. They will analyse cash flow trends, profit margins, and liabilities.
Banks are also more likely to be interested if cash flow is north of £3-£4M, although some banks lend to companies with lesser cash flow.
Leveraged buyouts involve making a business acquisition using a significant amount of financing from a leveraged buyout lender. In leveraged buyouts, the acquiring company, usually a private equity firm, uses the target company's assets as leverage to secure financing – their assets and cash flow are used as collateral.
In a leveraged buyout, the buyer puts in a small percentage of equity, and the rest is borrowed. Firms use these to make big acquisitions without using too much of their own capital.
In merger and acquisition transactions, senior debt is secured against the company's cash flow instead of fixed assets. The term senior debt implies that it must be paid before any other debt if the company defaults.
Mezzanine financing is a layer of debt between senior debt and pure equity that a company can use for its growth needs. It is a mix of debt and equity financing, and if there is a default, mezzanine finance allows the lender to convert debt into equity in the company.
Mezzanine debt is typically used by companies when they have used their senior debt capacity but need additional capital for an acquisition or a shareholder buyout. In such a case, a company can either raise outside equity or use mezzanine finance. It can be expensive compared to senior debt, but it is less expensive compared to equity and less dilutive.
Mezzanine financing can be used to finance an acquisition’s total cost. Lenders will establish your company's creditworthiness on the basis of cash flow, and the loan size is set as a multiple of earnings before interest, taxes, depreciation, and amortisation (EBITDA).
An earnout is a financing mechanism that provides additional payments to the seller's shareholders if the business achieves certain financial metrics or milestones. An earnout is used when the acquiring company wants to buy a business for a lower price, but the seller believes the valuation should be higher.
In case of an earnout, both parties will agree to the transaction at the lower price, but the seller is guaranteed they will "earn" a portion of sales and profit over a period of time after the acquisition is closed. The earnout period is typically between 1-3 years but can last up to five years.
Traditional business financing based on cash flow is a good option for companies to fund their growth plans, but companies that don't have a strong or stable cash flow can consider raising additional funds based on their assets. This alternative form of lending is called asset-based lending (ABL).
Company assets like accounts receivable, real estate, intellectual property, product inventory, or specialised equipment can all serve as collateral for ABL. The main advantage of asset-based acquisition loans is that they are more flexible in covenants and can be secured at a lower interest rate than other acquisition funding options.
When companies borrow against their cash flow, they have to maintain certain levels of cash flow, which can be difficult in a tough business environment. ABL loans are ideal for companies with a strong asset base that need to unlock capital to grow but don't have enough cash flow.
Debt versus equity: what’s better for your company?
Using debt to finance a business acquisition is a cheaper option for a company than equity. A major benefit of debt is that it doesn't require issuing shares, which means there is no dilution of equity.
The downside is that there is an upper limit of the amount of debt available to a company, which can become a problem when a company wants to make a considerably large acquisition. Assuming too much debt can also impact your company's credit rating.
Meanwhile, equity financing is more desirable for some firms as it doesn't require mandatory interest payments, and there is no principal loan to repay.
It also won't impact your company's credit rating, and you will be free to assume debt in the future. If your company doesn't have a financial track record or a good credit history, equity is a more suitable option for you.
The downside of equity financing is that you have to share control of your company, and your investors will take a share in profits. However, this can be offset by the value your investors bring in terms of experience and expertise.
Is investment banking acquisition finance?
Investment banking is a specialised kind of banking focused on helping companies and other institutions execute financial transactions like mergers and acquisitions, underwriting, or issuance of securities. Unlike retail banks, which take deposits and lend money, investment banks act as intermediaries between companies that want to raise funds and those who can lend.
Acquisition finance is the process of obtaining the funding required for business acquisitions. In comparison, investment banks are financial institutions that facilitate mergers and acquisitions.
Investment banks also represent buyers and sellers. They help them establish fair valuations and act as financial advisors to help companies secure the right financing package.
What happens to debt in an acquisition?
When a company makes an acquisition, it will either assume the target company's debt on its balance sheet, deduct it from the total sale price, or repay it before closing the deal. The buyer can also negotiate with the lender and reduce the target company's debt to lower the total acquisition cost.
How does a bridge loan work in M&A?
Bridge loans are a means of quick financing to fill a gap until a company can obtain long-term financing. These are short-term loans secured by companies to fund a business acquisition, a leveraged buyout, or an Initial Public Offering (IPO).
For example, let’s say your company budgeted £50M for an acquisition. But the target company is now valued at £60M. In order to not lose the bid, your company will have to come up with £10M fast. This is where you can use a bridge loan as an effective method for a short period of time before your long-term financing comes through.
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