What is acquisition financing?
Acquisition financing is capital obtained so that a company can buy another target company. Acquisition financing provides funding for a business transaction to take place. The funding sources can be debt, equity or mezzanine financing.
How acquisition finance works
When a company wants to buy another company, it needs extra money. This is where acquisition financing comes into play to finance the purchase price. The most common choices includes a traditional loan.
Companies can seek loans from regular banks or lending services specializing in acquisition financing.
Private lenders are an alternative if a company fails to meet the bank's requirements. However, loans from private lenders usually have higher interest rates and fees than bank loans.
Banks are more willing to finance an acquisition if the target company has healthy profit margins. They look for steady profitability with growing revenue and EBITDA and a strong balance sheet. Ideally, the target company has a competitive advantage that safeguards steady profitability. This way, the banks feel assured that the target firm has enough cash flow to repay its acquisition funding.
On the flip side, getting acquisition loans will be challenging if the target company has slim profit margins with weaker cash flow.
Different Types of acquisition financing
Let's explore some of the common types of acquisition financing:
Cash acquisition
A cash acquisition is the most straightforward funding method to acquire a target company. The acquiring company uses cash to pay the purchase price and, in turn, receives ownership of the company and its assets. It is as simple as that.
Cash transactions provide immediate liquidity to the sellers, which appeals to every seller. The acquiring company does not need to look for funding and convince acquisition financing lenders to give them money. On the downside, cash transactions can strain the acquiring company, as it is an all equity funding and requires a strong cash flow.
Moreover, a cash acquisition does not give the sellers a long-term incentive to contribute to the combined company. They don't own any company equity anymore and have received their payout.
Stock swap
A stock swap is another method used in acquisition financing, where shares of one company are exchanged for shares of another company during an acquisition. Instead of using cash, the acquiring company offers its own shares as currency to buy the target company. The ratio at which shares are exchanged is agreed upon by both parties and is based on the relative valuations of the two companies.
This way, the target company's owners become shareholders in the acquiring company. Stock swaps can be appealing as they allow the deal to proceed without cash, which can be especially handy if the acquiring company is short on liquid assets.
Stock swaps incentivize the sellers to continue contributing to the combined company after the acquisition. The sellers now own company equity and have an interest in the success of the new company. This alignment of interests works in favor of the acquiring company.
Debt financing
Debt financing is a popular avenue for funding the acquisition of another company. Debt financing is usually cheaper than equity financing. In a debt-financed acquisition, the company borrows money to purchase the target company. Simply put, you are taking out a bank loan to finance the acquisition.
Senior debt takes priority over subordinated debt and must be repaid first during a company's liquidation. This makes senior debt less risky, reflected in a lower interest rate. On the other hand, subordinated debt ranks lower in repayment priority compared to senior debt. Consequently, it carries a higher interest rate due to its increased risk.
However, acquiring funds through debt financing requires the purchaser to go through an acquisition financing process. Potential lenders must be convinced and will closely examine the business acquisition. They will discuss the company's cash flow, profit margins, and liabilities to assess the risk. Debt financing creates a repayment obligation that requires a steady cash flow for debt servicing.
Mezzanine debt or quasi debt
Mezzanine or quasi debt is a hybrid financing option that blends equity and debt financing features. It has the option to be converted into equity. It also allows interest payments to be deferred and rolled into the loan. The dual nature of mezzanine financing offers more flexible repayment terms than a traditional bank loan.
Mezzanine debt is typically subordinated to senior debt, meaning in the event of liquidation, senior debt is repaid before mezzanine debt. While senior debt usually offers lower interest rates due to its lower risk profile, mezzanine debt has higher interest rates, given its subordinated position and the increased risk to lenders.
However, mezzanine debt provides flexibility not often found in senior debt, such as the possibility of converting debt to equity and more lenient repayment terms, making it a more versatile but costlier financing option for companies.
Leveraged buyout
A leveraged buyout combines equity and debt financing to fund the business acquisition. It is an acquisition finance method used mainly by private equity firms. By doing so, the acquirer executes the business acquisition without having to invest much of its capital.
In an LBO, the target company and its cash flow are collateral to back the deal. The acquisition financing is similar to asset-backed financing.
LBO candidates are usually well-established companies with a clear competitive advantage with steady and predictable cash flows. The core notion of a leveraged buyout is to use the new company's cash flow to pay back the acquisition financing.
On the positive side, leveraged buyouts allow acquiring entities to make significant acquisitions without using all of their own capital. This increases the investment returns.
However, LBOs also carry a high level of risk due to the substantial amount of debt taken on. This can lead to financial instability if the target company doesn't generate enough cash to repay the acquisition funding.
Earn out
An Earn Out is a more creative way of acquisition financing, where the business owner accepts a deferred purchase price. Parts of the total price are deferred and determined based on the target company's future performance. Instead of paying the entire price upfront, the buyer pays a portion initially and then pays additional amounts later if financial targets are met. In a way, it is a type of acquisition financing that reduces the price you must pay today.
An earn-out reduces the risk for the buyer. They only pay the total price if the target company performs well after the acquisition. It also incentivizes the business owner to work hard to hit the agreed-upon targets.
Earn-outs also bring about challenges. They can lead to disputes between the buyer and seller regarding the targets. It requires precise and detailed agreements on how performance will be measured and how additional payments will be triggered.
What is the best way to finance an acquisition?
The best way to finance an acquisition depends on the specific circumstances and financial health of the acquiring company and the cash flow generating ability of the target company.
Equity financing may make sense for a business acquisition if a corporation has sufficient cash reserves. This way, the corporation avoids complications regarding acquisition financing, such as debt repayment, interest expenses and debt covenants.
Conversely, if a company doesn't have sufficient cash, acquisition financing may become necessary to fund the business acquisition. The final structure of acquisition financing largely depends on the debt capacity of the target company.
Debt capacity refers to the maximum debt a company can take on. Banks often assess debt capacity through metrics such as the debt-to-EBITDA and EBITDA-to-interest coverage ratios.
How much acquisition financing are banks willing to give?
Let's look at two ratios to give you a feeling of how much fans are willing to finance in a typical leveraged buyout.
Regarding debt to equity ratio, leveraged buyouts usually are funded with about 40-60% debt and 40-60% equity. This means we are moving from 40% to 60% debt-to-equity ratio to 60% to 40%.
Regarding the debt to EBITDA ratio, we see anything from 4.0x to 6.0x. Smaller deals tend to be lower, closer to 4.0x leverage. Larger deals can go up 6.0x debt to EBITDA.
These figures largely depend on the business's financial performance and cash flow. The more mature and stable a business is, the more acquisition financing it can carry.
