M&A can propel an acquirer's growth and expand its market reach quickly.
However, these transactions often require significant capital investments, making financing a critical consideration.
In this blog post, we'll explore the various financing options available for M&A deals and their respective pros and cons.
1. Cash Reserves
For companies with substantial cash reserves, self-financing an M&A deal can be an attractive option. This approach eliminates the need for external financing, reduces costs and the acquirer maintains full control over the transaction.
However, depleting cash reserves can limit a company's financial flexibility and ability to fund future growth initiatives or weather economic downturns.
2. Equity Financing
Equity financing involves issuing new shares or using existing shares as currency to fund the acquisition.
This method can be advantageous as it does not increase the company's debt burden and aligns the interests of the acquired company's shareholders with those of the acquirer.
However, this option can lead to dilution of existing shareholders' ownership and may require relinquishing some control to new investors (i.e. the target's owners). Generally, sellers who accept equity financing also need to conduct reverse due diligence on the acquirer to gauge the value and risk of the acquirer's equity.
3. Debt Financing
Debt financing, such as bank loans or corporate bonds, is commonly used to fund M&A deals.
This option allows companies to maintain ownership and control while leveraging the acquired company's assets and cash flows to service the debt.
However, excessive debt can increase financial risk, limit future borrowing capacity, and potentially strain the combined entity's cash flows. If the company is already levered, there may be creditor constraints that prevent the acquirer from borrowing more to do acquisitions.
4. Mezzanine Financing
Mezzanine financing is a hybrid form of financing that combines elements of debt and equity.
It typically involves issuing subordinated debt or preferred equity, which can be converted into common equity under certain conditions.
This option can be attractive for companies with limited access to traditional financing sources but may come with higher costs and dilution risks.
5. Earnouts
An earnout is a contingent payment structure where a portion of the purchase price is paid upfront, and the remaining amount is tied to the future performance of the acquired company.
This option can help bridge valuation gaps and align incentives between the buyer and seller.
However, earnouts can create conflicts of interest since the seller remains involved in the business during the earnout period, potentially leading to disputes with the buyer over operational decisions impacting financial performance.
6. Seller Financing
In seller financing, the seller of the target company provides a portion of the financing for the acquisition.
This can take the form of deferred payments, seller notes, or other arrangements where the seller agrees to finance part of the purchase price.
So, given all the options above, how can the acquirer determine the right funding strategy? Here is a simple framework.
Step 1: Assess capital requirements
Determine the total acquisition cost including the purchase price, transaction fees, integration costs, etc.
Evaluate working capital needs for the combined entity post-acquisition.
Consider potential capital expenditures required to achieve synergies.
Step 2: Analyze financial position
Review current cash reserves and ability to fund from internal sources.
Assess existing debt levels and capacity to take on more debt.
Evaluate the balance sheet strength to support different financing options.
Step 3: Understand strategic objectives
Assess how different funding options align with long-term growth plans and vision.
Consider implications on ownership structure, control, and future exit options.
Step 4: Model financial impact
Build integrated financial projections for the combined entity.
Analyze impact on cash flows, profitability, credit metrics under each funding scenario.
Stress test assumptions to identify potential risks and constraints.
Step 5: Seek advice from M&A advisors, or from lenders who have acquisition financing arms
Consult trusted advisors for objective recommendations and leverage their expertise in structuring, negotiating and executing the transaction.