Financing a Business Acquisition

acquisitions finance

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

In this guide, we’ll walk you through the main options of acquisition financing, various types, characteristics, and challenges. Hopefully, they will help you determine the most appropriate financing for your next acquisition.

What is acquisition finance?

Acquiring private companies is an expensive form of growing your company’s assets. This type of business deal allows acquiring companies to expand into new markets and increase profits. 

The combined entity can benefit from additional financial resources leading to rapid growth. A smaller business often has limited assets, which may not be enough to finance an acquisition. Using other options is a great way to expand business operations — business acquisition can be a great way to take advantage of economies of scale.

Funding for business acquisition means using different financing opportunities, debt, and equity to complete an acquisition. The business acquisition funding types include the following:

  • Debt security 
  • Small Business Association (SBA) loans
  • Owner financing
  • Loans from private equity firms and commercial banks

Companies on both sides of the deal need to have enough cash flow for financing acquisitions and to complete the transaction. Therefore, the main focus of acquisition finance is to determine the best way to finance the purchase of a target company. This is when the cost and flexibility of the financing structure are connected to the company’s cash flow based on equity, working capital, and growth potential.

Acquisition finance refers to the needed monetary resources that enable acquiring companies to fulfill their purchase objectives.

How does acquisition financing work

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

A business looking for acquisition financing can apply for loans from banks and 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 assets for collateral, it’s more likely that a bank will approve financing. 

Challenges during acquisition financing 

It might be challenging to get asset-backed financing from a bank when it comes to acquiring, and target companies are regarded as an unstable business that heavily relies on accounts receivable rather than cash flow.

Acquisition financing frequently entails using a variety of financing options. Alternative lenders that mature companies most frequently use include equity, debt, and mezzanine financing. 

Finding the right combination with the lowest costs and fees is difficult given the variety of financing options available. Thorough research and consulting with professionals are essential for making the right decisions and implementing the most effective acquisition capital structure.

In this kind of transaction, flexibility is important, as businesses should feel secure and confident that they can adjust their financing plans to adapt to various situations. Financing options can change based on current market conditions, credit history, and company valuation.

Acquisition financing also involves many financial covenants. These are financial promises or agreements into which the borrowing party enters. It ensures the company complies with the loan agreement terms. 

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. Acquiring a company by equity acquisition
  3. Earnout
  4. Cash acquisition
  5. Acquisitions finance through debt
  6. Acquisitions through mezzanine or quasi debt
  7. Leveraged buyout (LBO)
  8. Vendor Take-Back Loan (VTB)

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 valuation approaches, such as Comparative Company Analysis, DCF Valuation Analysis, and Comparative Transaction Valuation Analysis.

2. Equity acquisition

This is the most expensive type of financing in acquisition finance. By purchasing businesses that target businesses with uncertain free cash flows and unstable sectors, equity investment is frequently attractive. Due to the lack of a commitment for recurring payments, this type of acquisition finance 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 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 is 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 company. 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. 

5. Acquisitions finance through debt

One of the most popular methods of funding acquisitions is debt financing. This type of transaction is more common when businesses are unable to pay for acquisitions in cash. Besides being the least costly way to finance a purchase, debt may take many other forms, such as a second lien, unitranche, and 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 method is also known for its flexibility, which makes it appealing to many companies.

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 asset 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’s financing/Vendor Take-Back Loan (VTB)

When the target business serves as the acquiring firm’s internal, deal-specific source of acquisition finance, this is referred to as seller’s financing. This method is used in situations where securing external finance is challenging. Financing options include seller notes, earnouts, and postponed payments.

Conclusion

Getting financed for acquisitions is a complicated process. However, there are many financing methods available for companies, which can be combined to get the most efficient deals. 

The most common ways to finance a business acquisition include cash transactions, stock swaps, debt, mezzanine financing, equity acquisition, leveraged buyouts, and seller financing. It’s crucial to consider how well the funding fits the objectives and particulars of the company agreement. 

There are many aspects that go into securing an acquisition loan for upcoming acquisitions. That’s why the company that wants to acquire another firm has to make sure the business line of credit scores are satisfactory, and all procedures and examinations are effectively managed and tracked.