For buyers looking to make acquisitions, it is essential to ensure that financing is arranged before attempting to acquire a target.
Planning and negotiating the acquisition, as well as evaluating the culture of the target company, are important considerations, but they are all dependent on the acquiring company having the means to actually make the purchase.
When providing a letter of intent or a formal offer letter, potential buyers usually specify how they plan to pay for the acquisition.
If the buyer indicates that the deal is dependent on obtaining financing, the seller is likely to see this as a risk to the deal.
On the other hand, if the buyer already has financing in place, it can not only reduce the risk for the seller but also ease the workload for the buyer’s team as they work to complete the acquisition.
There are four main sources of financing that buyers may use when setting up a financing program for an acquisition strategy: Cash on hand, third-party debt, seller-financed debt, and equity.
The last strategy (earnout) is not technically a new financing source but allows the buyer to bridge to the valuation that the seller wants.
CASH ON HAND
Cash on hand, also known as “dry powder,” is often the first choice for funding a deal.
Cash is generally the most affordable capital, especially if it’s a low-interest-rate environment where cash is not gathering much interest.
The opportunity cost of using cash is the value of other investments and organic growth initiatives that the cash could be used for.
THIRD PARTY DEBT
The benefits of using bank debt typically include low interest rates, though recent rate increases make taking on debt more expensive. Debt is generally cheaper than equity capital.
Additionally, a profitable buyer may be able to borrow against the total EBITDA, not just the target’s EBITDA. This increases the capacity of mid-sized buyers more capacity to acquire smaller firms.
If the buyer sets up debt facilities in advance, the buyer can move on the right fit deals quickly and pay cash upfront (from a seller’s perspective). However, third party debt generally comes with covenants that may restrict the buyer’s flexibility in growing the business.
SELLER NOTES
Seller-financed debt involves the buyer paying the seller with notes rather than cash, with the buyer then paying off the notes over time with interest.
The advantage for the seller is that they can potentially receive a higher return on the debt than they would from selling their company outright.
However, seller-financed debt carries risks for both the buyer and seller. The buyer may not have the resources to pay off the debt, and the seller may not receive the full value of the company if the buyer does not pay the debt in full.
EQUITY FINANCING
Equity financing involves the exchange of stock to the seller, making them a stakeholder in the acquiring firm.
When the acquiring company is well-managed and has high growth, utilizing equity as a funding source can be costly. The seller would share in the growth of the acquiring company and dilute the current owners’ ownership.
However, this option requires less up front cash and aligns the interests of both the buyer and seller.
It’s important to know when to use equity financing. Giving up buyer’s equity to purchase a business from an owner who’s retiring may not make sense but could be worth it if the owner is motivated to keep working to increase the overall enterprise value of the firm.
EARNOUT
An earnout is a unique way to finance an acquisition, particularly when the seller is already planning to exit and is open to negotiation on payment terms.
The advantage of an earnout for the seller is that the amount paid is based on the ongoing success of the company. Earnout targets of ~30% of the total value, paid out over three years are not uncommon.
The challenge is that this arrangement can (i) become quite complex to administer and (ii) because the seller may not have the control necessary in the new firm to drive growth as the seller previously did.
If you’re a buyer who’s serious about closing the right acquisition quickly, understand the different sources of financing and prepare in advance of starting the search for targets.