Acquisition financing: a comprehensive guide for business growth

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Acquisition financing: a comprehensive guide for business growth

By iDeals
September 5, 2022
12 min read

Getting finance for a business acquisition is a tedious process. However, many funding options are available to businesses worth evaluating and comparing.

For example, according to a recent survey, private equity was the top choice for 24% of respondents, while non-bank lenders and cash reserves ranked second and third at 21% and 16%, respectively.

Which method to choose? How do business acquisition loans work? And how to prepare for financing a business acquisition? Find the answers to these questions in the article below.

Highlights

  • Acquisition financing involves the strategies and methods that companies employ to secure funds for mergers and acquisitions.
  • Business acquisition financing options include stock swaps, equity acquisitions, earnouts, cash acquisitions, debt financing, mezzanine or quasi-debt, leveraged buyouts (LBOs), seller financing, and small business loans.
  • When searching for acquisition financing lenders, consider factors such as experience, flexibility, competitive terms, transparency, reputation, collateral requirements, and approval timelines.
  • Preparing for financing a business acquisition involves developing a comprehensive business plan, creating a Letter of Intent (LOI), organizing financial documents, assessing personal finances, providing a personal guarantee, and ensuring regulatory compliance.

What is acquisition finance?

Acquisition financing refers to the various methods and financial strategies used by companies to fund mergers and acquisitions. 

Financing a business acquisition is a complex and strategic process that differs from typical purchases in several ways:

  • Different financing structures. Unlike traditional purchases, where the payment is typically straightforward, acquisition finance can take on numerous forms. Companies can use a blend of equity, debt, mezzanine financing, and even vendor financing to fund the deal. The choice of financing mix depends on factors such as the target’s financial health, the acquirer’s balance sheet, and market conditions.
  • Different funding sources. Companies often choose multiple sources of capital to meet their financial needs for the transaction. The options may include banks, credit unions, private equity firms, institutional lenders, small business administration (SBA), and traditional financial institutions. These entities can provide competitive interest rates for term loans or equipment financing.

Business acquisition financing offers several potential benefits for companies seeking to acquire other businesses:

  1. Strategic growth. By acquiring established businesses, companies can access new customer bases, product lines, or geographic markets, accelerating their growth and increasing revenue potential. For example, when Salesforce acquired Slack, it expanded its remote work software capabilities, reaching new customers and enhancing its overall competitiveness.
  2. Cost synergies. Typically, companies publicly announce cost synergies that fall within the range of 1-10% of the total combined costs, while one in ten executives aims for 10-25%. These synergies can result in substantial savings and increased profitability.
  3. Diversification. Acquiring businesses in different industries or sectors can help diversify a company’s revenue streams and reduce dependency on a single market or product. For example, Amazon, originally an e-commerce giant, got into grocery retail by buying Whole Foods in 2017.

How to finance a business acquisition?

If a company is searching for opportunities for financing an acquisition, there are plenty of strategies. The most popular business acquisition loan options are traditional business acquisition loans or lines of business credit. Good rates for acquisition financing can assist small business owners in achieving better financial results by expanding the size of their business operations. 

A business looking for the best business acquisition loans can choose among traditional bank loans or lending firms. There are also private lenders that provide loans to businesses that fail to meet a bank’s criteria. However, this type of financing acquisition may not be the most cost-efficient in the long term due to higher fees and interest rates. 

If the target company has steady profitability or increasing EBITDA (earnings before interest, taxes, depreciation, and amortization), that would help the parent company repay the costs involved in the acquisition and stabilize the financial debt. 

By showing sustained profits and ownership of valuable business assets for collateral, it’s more likely that a bank will approve financing. 

Types of finance for acquiring company

It’s unusual to obtain purchase funding from a single source. As mentioned above, it can be challenging to find the right combination of acquisition financing options with the lowest cost of capital due to the variety of business acquisition finance opportunities.

Here are the most commonly used financing types for mergers and acquisitions:

  1. Stock swap transaction
  2. Equity acquisition
  3. Earnout
  4. Cash acquisition
  5. Acquisitions through debt
  6. Acquisitions through mezzanine or quasi-debt
  7. Leveraged buyout (LBO)
  8. Seller financing
  9. SBA loans

1. Stock swap transaction 

A public company with a publicly traded stock has the option to swap shares with the target company. Private firms also engage in stock swaps when the target company’s management wants to keep a share of the merged company’s stock, as they are likely to be actively involved in operations. 

It’s crucial for the target company’s owner to manage all procedures involved efficiently, as it’s also beneficial to the acquiring company. 

In a stock swap, a careful stock valuation is extremely important. Investment banking professionals use a variety of stock and business valuation approaches, such as comparable company analysis and DCF valuation analysis.

2. Equity acquisition

This is the most expensive type of financing in acquisition finance. It’s particularly favored when buying an existing business from a volatile industry or with unpredictable cash flows, as it provides financial stability and reduces the risk of default. 

Due to the lack of a commitment to recurring payments, this acquisition financing model is also more flexible.

3. Earnout

An earnout is considered to be the most innovative way to fund an acquisition, as it’s suitable for targets that are adaptable and seeking an exit. A common reason companies use this option is because a small business owner is considering retiring and wants to make some quick money in the process. 

An earnout happens when the target firm agrees to participate in delayed payments that account for the company’s future growth and are frequently larger than a cash agreement. This agreement often calls for the seller to receive a portion of the company’s future profits.

Here the buyer only pays a fraction of the sale price upfront. The remaining amount depends on the future performance of a newly acquired business. This way, the earnout removes some uncertainty for the buyer. 

4. Cash acquisition

A cash deal is the standard exchange of a company’s shares for cash. The equity component in the parent company’s balance sheet remains unchanged.

When a company is getting bought out, cash transactions are more common because the target company is smaller and has less cash on hand than the acquiring company. 

This method ensures immediate liquidity for the selling shareholders, simplifies the transaction process, and allows the acquiring company to gain full ownership and control of the target without altering its capital structure.

5. Acquisitions through debt

One of the most popular methods of funding acquisitions is debt financing, , often in the form of a bank loan. This type of transaction is more common when businesses are unable to pay for acquisitions in cash. Besides being the least costly way to purchase an existing business, debt may take many other forms, such as a second lien or subordinated debt.

Loans are usually given by banks or alternative financial institutions. This method requires an examination of the projected cash flow, profit margins, and liabilities of the target firm. It’s important because banks determine whether to approve a loan or not based on these results.

When it comes to asset-backed financing, banks might give loans based on the security provided by the target firm. The firm’s financial standing is based on fixed assets, receivables, intellectual property, and inventory. Debt financing frequently comes with tax-deductible benefits.

6. Acquisition through mezzanine or quasi debt

Mezzanine financing, sometimes known as mezzanine debt or quasi-debt, combines elements of both debt and equity financing. In general, there is a conversion option to equity. Target firms with a strong balance sheet and growing profitability are good candidates for mezzanine finance. 

This flexible financing option can be especially useful for companies seeking to optimize their capital structure while pursuing ambitious growth strategies.

7. Leveraged buyout (LBO)

A special combination of equity and debt is utilized to fund an acquisition in a leveraged buyout. In an LBO, both the target company’s and the acquiring company’s private equity and acquired assets are regarded as secured collateral. 

Usually, more mature companies are involved in LBO financing deals because they have a solid business’s assets base, consistently produce significant operating cash flows, and require less equity capital. The main goal of a leveraged buyout is to force businesses to generate consistent cash flows sufficient to pay off their debts.

8. Seller financing

Seller financing, also known as owner financing, involves the buyer making a down payment to the seller, who then agrees to finance the remainder of the acquisition deal. This method offers advantages in both buyer’s and seller’s markets. 

In a buyer’s market, it can speed up the sale of a business, while in a seller’s market, it provides a steady stream of income, potentially outperforming traditional fixed-income investments. Buyers can also benefit from reduced costs and flexible terms when dealing directly with the seller, making it an attractive option when securing external financing is challenging.

9. (SBA) business acquisition loans

SBA loans, often facilitated through the Small Business Administration (SBA), offer financing solutions for entrepreneurs aiming to buy a business. The SBA 7(a) loan program, tailored to qualifying borrowers, can be an ideal option, with down payments as low as 10% for acquisitions. However, applicants must adhere to the business acquisition loan requirements, such as limits on net worth, average net income, and overall loan size.

The small business loan process typically involves extensive documentation and credit checks. Nevertheless, the SBA’s support simplifies the process, making it easier for borrowers to secure financing from traditional SBA lenders, who are more willing to extend credit with favorable terms.

An SBA loan is one of the most sought-after options among most small business loans, enabling entrepreneurs to acquire and grow their own businesses.

Debt vs. equity acquisition financing

Debt acquisition financing involves borrowing money to fund a business acquisition. This can be in the form of loans from banks, financial institutions, or private lenders. The acquiring company is required to repay the borrowed amount with interest over a specified period.

Equity acquisition financing involves raising capital by selling shares of the acquiring company to investors. This capital is then used to acquire another business. Equity investors become partial owners and may have a say in company decisions.

Let’s compare these two approaches in terms of their advantages and disadvantages.

Debt acquisition financingEquity acquisition financing
ProsLower cost. Debt financing often has lower overall costs compared to equity financing because the interest payments are tax-deductible.
Retain ownership. Borrowers maintain ownership and control over their company without dilution of ownership stakes.
Predictable repayment. Loan terms are generally fixed, providing predictability in repayment schedules.
No shareholder dilution. Borrowing doesn’t dilute ownership or control, so profits are not shared with new investors.
No debt repayment. No obligation to make regular debt payments, easing cash flow concerns.
Risk sharing. Investors share the financial risks and rewards, reducing the pressure on the acquiring company.
Expertise and resources. Equity investors may bring expertise, networks, and resources to support the acquisition and growth.
Long-term growth. Equity financing can align with long-term growth objectives.
ConsDebt servicing. Regular interest and principal payments can strain cash flow.
Risk of default. Failure to repay debt can lead to financial distress, loss of assets, or bankruptcy.
Leverage risk. High levels of debt can increase financial risk, especially in economic downturns.
Ownership dilution. Selling equity results in a loss of ownership and control for existing shareholders.
Sharing profits. Equity investors are entitled to a share of the company’s profits.
Complex negotiations. Equity financing often involves complex negotiations and may require giving up a significant portion of the company.

Acquisition financing lenders: what to look for?

When seeking acquisition financing lenders, it’s essential to consider several factors to ensure a successful and beneficial partnership. Here are some key aspects to look for:

  1. Experience in acquisition financing. Choose lenders with a track record in providing financing for business acquisitions. Their familiarity with the complexities of such transactions can streamline the process.
  2. Flexible financing options. Look for lenders offering various financing options, such as lines of credit or mezzanine financing. Flexibility is important when aligning acquisition financing with the business’s unique needs.
  3. Competitive terms. Compare interest rates, fees, and repayment terms from multiple lenders to secure the most favorable terms that suit your financial capabilities.
  4. Online lenders. You can also consider online lenders as they offer streamlined application processes and faster funding.
  5. Transparency and communication. Effective communication and transparency in terms and conditions are crucial. Ensure that the lender is open about fees, requirements, and potential risks.
  6. Reputation and references. Research the lender’s reputation by checking reviews, asking for references, or seeking recommendations from industry peers.
  7. Collateral requirements. Understand the collateral or guarantees the lender may require, as this can impact your risk exposure and ability to secure the loan.
  8. Approval timeline. Consider the lender’s ability to process and approve your application within your desired timeframe. Some acquisitions require swift action, so a lender with a quick approval process can be advantageous.

Preparing for financing a business acquisition

Preparing for financing a business acquisition is a critical step in ensuring a smooth and successful transaction. Here’s a checklist to help you navigate the acquisition process:

  1. Business plan. Develop a comprehensive business plan outlining your acquisition strategy, target company analysis, financial projections, and growth plans. Lenders and investors will scrutinize this document.
  2. Letter of Intent (LOI). Create a LOI to formalize your intent to acquire the business. It sets the framework for negotiations and demonstrates your commitment to the transaction.
  3. Financial documents. Prepare detailed documents relating to your business finances. This includes income statements, balance sheets, and cash flow statements.
  4. Personal finances. Examine your personal finances by reviewing your personal credit reports, federal income tax returns, and personal credit score information. This assessment is crucial, as lenders frequently take into account good personal credit or require a minimum credit score as a key factor in determining your eligibility for financing.
  5. Personal guarantee. Be prepared to provide a personal guarantee for the acquisition loan, which may involve using your personal assets as collateral to secure the loan.
  6. Regulatory compliance. Ensure compliance with all relevant laws and regulations governing the acquisition in your industry and location.

FAQ

An example of acquisition financing is when a company secures a bank loan to fund the purchase of another business. The acquiring company borrows a specific sum, which is then used to acquire the target company. Over time, the acquiring company repays the loan with interest, making it a common approach for funding mergers and acquisitions.

Companies primarily finance acquisitions through debt or equity. Debt financing involves borrowing funds to cover acquisition costs, while equity financing entails issuing new shares to investors for capital.

Financing a business acquisition provides immediate funding, enabling smooth and successful transactions. This efficiency saves valuable time that would otherwise be spent securing capital. Additionally, financing can boost revenue and profit margins, as it allows businesses to acquire additional sources of income.

Project finance primarily assesses the project’s cash flow for viability, while acquisition finance concentrates on the borrower’s cash flow and creditworthiness to determine the viability of the investment.

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