Corporate Finance, Deal Advisory
How To Finance A Business Acquisition: The Top 7 Options
Having advised and supported hundreds of companies with their M&A plans over the years, we are often asked about the best ways to fund a business acquisition, particularly as fewer deals in the current market involve all cash on day one.
After all, buying another business is, in most cases, one of the largest and most impactful transactions a company can make as it looks to expand. There’s plenty to consider, from whether you’re purchasing shares or assets to acting carefully and limiting risk.
But one crucial aspect is understanding the differences between various funding options available to ensure you choose the right option for your business, especially if you don’t have the cash reserves to buy outright and will require an alternative form of financing.
There are seven common options for financing a business acquisition. These are:
- Earnout/deferred consideration
- Vendor equity
- Vendor loan
- External debt finance
- External equity finance
Below, we’ve explored each of these options in more detail.
How To Finance A Business Acquisition: 7 Financing Options
If your business, as the potential buyer, has spare cash on its balance sheet or it is generating material profits and M&A activity can be funded that way, with no outside capital, that is great and a simple and easy way to fund a deal. Remember that companies are typically bought based on a multiple of profits (EBITDA) so it may have to be quite a significant cash balance (depending on the size of the target!)
2. Earnout / deferred consideration
We are seeing more and more deals (especially since Covid) whereby an element of the consideration is deferred for a period of time (sometimes up to 5 years) or is based on the future performance of the business post-deal (an earnout). This is a great way to spread the risk and use future cash flows from your business and the target’s business to fund part of the deal. The issue may be that some sellers want more cash upfront!
M&A activity doesn’t always mean that cash needs to trade hands for the full transaction price. Sometimes you, the buyer, can use your equity as part of the transaction – so the sellers end up with some equity in your company.
For example, if you had two equal-sized businesses both valued at the same valuation on a standalone basis, when merging the companies together the original shareholders of each business would own 50% each of the new company – in this case, it may be that no cash changes hands. This is a great way to keep the sellers interested and motivated in the entire group performance.
4. Vendor equity
One of the easiest ways to finance an M&A transaction is to have the seller agree to not take all of their cash upfront, and instead keep a retained stake in the business. In many scenarios, having the seller involved with the future of the company can be very helpful. Letting them keep a retained stake allows them to participate in the long-term growth that is created, as a minority shareholder.
So, as an example, if the seller retains a 20% stake, only 80% of the transaction value needs to be funded upfront. This is a great way to incentivise sellers to stay involved but is likely to require the sellers to have a “put” option (which is an option to sell back to you) at an agreed point, and possibly an agreed price, in the future.
5. Vendor loan
In a similar way to the above, the seller can remain involved as a debt holder, rather than an equity holder, whereby the seller effectively lends the buyer money (a vendor loan). This allows the seller to get a coupon return on their investment (likely to be greater than they would get from investing their money elsewhere) and is a much easier solution than finding external finance.
6. External debt finance
Bank funding is the most affordable form of external finance, but not the easiest to get, depending on the sector of the target. High street banks have become notoriously fussy in recent years about the businesses they will lend to, but there are plenty of other alternative lenders out there. The more security that can be provided to the bank, e.g. debtors, stock, assets, property, etc, the easier the funding will be.
If the target has predictable cash flows that will allow for servicing of debt, it shouldn’t be too much of a challenge (albeit can be quite expensive, depending on the target) to get a cash flow loan to help fund the acquisition (and remember the bank can borrow against the assets or cash flow of your business as well as the target). There are other debt sources, including:
- Mezzanine financing: Mezzanine financing is a hybrid of debt and equity funding that allows buyers to retain major control of the business, and is most appropriate for businesses that have highly strong cash flows. It can be used as a lower-cost substitute than equity investment for a buyer. It has flexible terms and requirements and can be customized to fit each transaction structure. Mezzanine funding can be extremely advantageous to buyers when bank funding is not a viable option or when raising equity is too expensive.
- Acquiring assets: Asset-based lending, specifically borrowing against assets such as debtors/fixed assets, etc. (usually 50-80% of the asset value) but can be pretty expensive.
7. External equity finance
Acquisition funding through equity investment provides capital by allowing the investors to become shareholders in your business or the target business. Equity is a great way to raise capital without a repayment profile but is the most expensive as you (the buyer) would be giving away a chunk of the upside opportunity down the line. The equity holder is also likely to want to have decision-making powers and veto rights on certain decisions, but this can be the most appropriate where bank funding is not an option.
How can Gerald Edelman help?
If you’re looking for advice on how to finance a business acquisition, contact our Deal Advisory team today to book a consultation.