How to finance a business acquisition
The Office for National Statistics reports 178 completed business acquisitions for last year. Despite the pandemic, businesses continue to be acquired.
So how do you finance a business acquisition? This article explains the various options available to businesses along with top tips.
Why acquire a business?
You may have decided that growth through acquisition is a faster, more cost effective and less risky option for your business.
Trying to grow your business organically can be expensive and time consuming with no guarantee of success.
An acquisition offers a lot of advantages; you can eliminate competition, immediately increase your market penetration and enjoy significant savings due to economies of scale.
Other benefits include:
An acquisition provides you with the opportunity to quickly acquire resources and core competencies not currently held by your company.
It can additionally provide you with immediate access into markets and products, with an established brand and client base; something that may ordinarily take years to achieve.
Increased market share
An acquisition will quickly build market presence for your company, and can make life a lot more difficult for your competitors.
Reduced entry barriers
You may be considering an acquisition as a way of overcoming challenging market entry barriers, which can otherwise be a costly and time-consuming process.
How to finance the purchase
Unless you are able to pay cash for your acquisition, you will require some kind of financing in order to be successful.
Acquisition finance effectively becomes a choice between debt, equity or a combination of both.
Debt involves borrowing money to be repaid, plus interest, whilst equity involves raising money by selling shares in the company.
Debt vs Equity
A loan does not provide an ownership stake and, so, does not cause dilution to the owners’ equity position in the business.
A lender does not have any claim on future profits of the business; they are only entitled to repayment of the loan.
Debt repayments are usually fixed amounts that can be forecasted and planned for. However, unlike equity, debt must be repaid at some point.
You will usually be required to put assets of the company up as collateral for a loan, and may even be required to personally guarantee repayment of it.
Servicing debt repayments may be a significant cash flow burden to your business, and limit the amount of debt you can carry.
Let’s take a look at the most popular debt financing options for business acquisitions.
Senior debt is a secured term loan and as the name suggests it is debt that takes priority over other unsecured or ‘junior’ debt.
The term is relatively short (3-5 years), and the debt may carry a fixed or variable interest rate.
To reduce repayment risk, fixed assets are frequently used as collateral on current assets, intangibles or even the borrower’s stock can be used as security.
Senior debt can also be extended to businesses that are asset light i.e. do not have much in the way of assets to be used as collateral.
Lenders will structure the facility as a cash flow-based loan; so instead of physical assets the lender is lending against a company’s cash flow (or EBITDA).
Loan size is determined as a multiple of EBITDA with 1.5 to 3.5 times being a typical range.
Most senior loans can be structured with a capital repayment holiday (or interest only period) of up to two years, with the remaining initial principal being paid as a bullet payment at the end of the loan term.
Good for: Well established businesses with strong management, good track record of profitability and sustainable cash flows
Mezzanine debt is a loan that can be converted to equity in case of default.
It is high risk and therefore expensive but it’s flexibility still makes it an attractive option for funding acquisitions.
It is usually provided on an interest only basis, making repayment more manageable than other debt structures.
Mezzanine is subordinate to senior debt but senior to common equity.
Mezzanine finance is a complex area of business funding, but it can be a useful way for companies to raise more money than would otherwise be possible based on the strength of the current business alone.
It also offers an alternative to selling large amounts of equity outright, which may be preferable for business owners wishing to keep as much control as possible.
Good for: Businesses that can’t attract enough senior debt, but don’t want to dilute equity further – mezzanine fills the gap between debt and equity.
Asset Based Lending
Asset Based Lending (ABL) is the most popular alternative to bank financing for funding a business acquisition.
With ABL, you are able to use the assets of the company you are trying to buy (and your own company’s assets, if required) as collateral for a loan.
The asset-based lender will make advances at rates from 70% to 90% against assets including receivables, inventory, plant & machinery and property.
It is popular because, depending on the strength of the company’s asset base, it is a very effective method of generating capital that may not be accessible through traditional lending facilities.
Good for: Businesses with good management, systems and controls and a strong asset base.
5 tips for a successful acquisition
1. Common objectives
Firstly, make sure that both businesses have shared business goals and objectives.
Do a lot of research and ask a lot of questions to identify any areas that you may disagree on or are likely to cause friction between the two businesses.
You should be able to establish some common ground in terms of the overall mission of each business, to confirm that the acquisition is in the best interests of both companies.
There’s a lot to think about when acquiring another business; the legal implications, tax considerations and how to effectively restructure the business, for example.
It makes sense to enlist the services of a business advisory specialist – an experienced expert who has seen it all before and can guide you through the acquisition process.
It’s critical to assess both the liquidity in the company you are acquiring, and the liquidity in your own business to ensure that it is sufficient to safeguard the continued growth and success of the combined businesses.
Without assessing your available funds, entering into an acquisition could put your business at risk and make the transaction unsustainable.
4. Due Diligence
You can’t take any shortcuts with due diligence; it gives you the opportunity to investigate fully the business you are buying, validate what has been claimed by the seller and identify any red flags.
Companies planning to acquire a business should insist on receiving full financial and business disclosure from the seller in advance of the acquisition.
Due diligence should include details of the structure of the organisation; assets, audited financial statements, intellectual property, contracts, employee records and tax records.
5. Culture and integration
So often overlooked, but so important – is the culture of the business you are acquiring a good fit with your own?
If the cultures are very different, it is not necessarily a bad thing – provided you are aware of it and take steps to ensure that the two business integrate successfully.
Ensure that your combined workforce communicate openly from the start to establish an integrated and successful working relationship.
Are you considering acquiring a business? We can help you finance it, get in contact today.